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SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549


Form 10-K


FOR ANNUAL AND TRANSITIONAL REPORTS PURSUANT TO
SECTIONS 13 OR 15(d)


OF THE SECURITIES EXCHANGE ACT OF 1934


|   |  |                                                                                                 
|-- |  | ------------------------------------------------------------------------------------------------
|þ  |  | ANNUAL REPORT PURSUANT TO SECTION 13 OR
    15(d)
    OF THE SECURITIES EXCHANGE ACT OF 1934    
|  
|   |  | For the fiscal year ended September 30,
    2003                                                
|  
|OR
|  
|o  |  | TRANSITION REPORT PURSUANT TO SECTION 13
    OR 15(d)
    OF THE SECURITIES EXCHANGE ACT OF 1934
|  
|   |  | For the transition period
    from           to                                                 

Commission File No. 1-15803

AVANIR Pharmaceuticals

(Exact name of registrant as specified in its
charter)


|                                                                   |  |                                     
|------------------------------------------------------------------ |  | ------------------------------------
|California                                                         |  | 33-0314804                          
|(State or other jurisdiction of
    incorporation or organization) |  | (I.R.S. Employer Identification No.)
|                                                                  
|11388 Sorrento Valley Road, Suite 200,
    San Diego, California   |  | 92121(Zip Code)                     
|(Address of principal executive
    offices)                       |  |                                     

(858) 622-5200

(Registrants telephone number, including
area code)


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

None


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

Class A Common Stock, no par
value


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

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

Indicate
by check mark whether the registrant is an accelerated filer (as
defined in Exchange Act
Rule 12b-2).     Yes o          No þ

As
of December 11, 2003, the issuer had outstanding
70,753,482 shares of Class A and Class B common
stock held by non-affiliates and the aggregate market value of
these shares on that date was $116,036,000. For purposes of the
foregoing disclosure and without admitting whether any person is
an affiliate of the registrant, all shares owned directly or
indirectly by officers and directors of the registrant have been
treated as owned by an affiliate.

The
number of shares of Common Stock of the registrant issued and
outstanding as of December 11, 2003:

|                                   |  |           
|---------------------------------- |  | ----------
|Class A Common Stock, no par value |  | 71,208,750
|Class B Common Stock, no par value |  | 3,500     

DOCUMENTS INCORPORATED BY REFERENCE

The
registrants definitive Proxy Statement, which will be
filed with the Securities and Exchange Commission on or before
January 28, 2004 in connection with the registrants
Annual Meeting of Shareholders to be held on March 18,
2004, is incorporated by reference into Part III of this report.



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TABLE OF CONTENTS



|                                                             |                                                                                               |  |  |  |  |  |  | 
|------------------------------------------------------------ | --------------------------------------------------------------------------------------------- |  |  |  |  |  |  | 
|PART I                                                      
|                                                             | Item 1. Business                                                                             
|                                                             | Item 2. Properties                                                                           
|                                                             | Item 3. Legal Proceedings                                                                    
|                                                             | Item 4. Submission of Matters to a Vote of Security Holders                                  
|PART II                                                     
|                                                             | Item 5. Market for Registrants Common Equity and Related Stockholder Matters                
|                                                             | Item 6. Selected Consolidated Financial Data                                                 
|                                                             | Item 7. Managements Discussion and Analysis of Financial Condition and Results of Operations
|                                                             | Item 7A. Quantitative and Qualitative Disclosures About Market Risk                          
|                                                             | Item 8. Financial Statements and Supplementary Data                                          
|                                                             | Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure 
|                                                             | Item 9A. Controls and Procedures                                                             
|PART III                                                    
|                                                             | Item 10. Directors and Executive Officers                                                    
|                                                             | Item 11. Executive Compensation                                                              
|                                                             | Item 12. Security Ownership of Certain Beneficial Owners and Management                      
|                                                             | Item 13. Certain Relationships and Related Transactions                                      
|                                                             | Item 14. Principal Accountant Fees and Services                                              
|PART IV                                                     
|                                                             | Item 15. Exhibits, Financial Statements and Schedules and Reports on Form 8-K                
|SIGNATURES                                                  
|AVANIR PHARMACEUTICALS CONSOLIDATED BALANCE SHEETS          
|AVANIR PHARMACEUTICALS CONSOLIDATED STATEMENTS OF OPERATIONS
|CONSOLIDATED STATEMENTS OF SHAREHOLDERS EQUITY             
|CONSOLIDATED STATEMENTS OF CASH FLOWS                       
|NOTES TO CONSOLIDATED FINANCIAL STATEMENTS                  
|EXHIBIT 4.2                                                 
|EXHIBIT 10.4                                                
|EXHIBIT 21.1                                                
|EXHIBIT 23.1                                                
|EXHIBIT 31.1                                                
|EXHIBIT 31.2                                                
|EXHIBIT 32.1                                                
|EXHIBIT 32.2                                                



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PART I






|        |         
|------- | --------
|Item 1. | Business

This Annual Report on Form 10-K contains
forward-looking statements concerning future events and
performance of our company. You should not rely excessively on
these forward-looking statements, because they are only
predictions based on our current expectations and assumptions.
Forward-looking statements often contain words like
estimate, anticipate,
believe, plan or expect.
Many known and unknown risks and uncertainties may cause our
actual results to differ materially from those indicated in
these forward-looking statements. You should review carefully
the risks and uncertainties identified in this report. We
disclaim any obligation to update or announce revisions to any
forward-looking statements to reflect actual events or
developments. Except as otherwise indicated herein, all dates
referred to in this Report represent periods or dates fixed with
reference to the calendar year, rather than our fiscal year
ending September 30.

The Company

AVANIR Pharmaceuticals, based in San Diego and
incorporated in California in 1988, is a drug discovery and
development company focused on treatments for central nervous
system disorders and inflammatory diseases. The Companys
lead product candidate, NeurodexTM, is in a
Phase III clinical trial for pseudobulbar affect, also
known as emotional lability, and in Phase II clinical
development for neuropathic pain. An internally discovered small
molecule, AVP-13358, is being developed as a potential treatment
of asthma and is in Phase I clinical development. AVANIR
has established itself as a company that is capable of
developing a drug through all preclinical and clinical phases of
development and experienced in preparing and submitting new drug
applications. The Companys first commercialized product,
Abreva®, has been approved by the U.S. Food and Drug
Administration (FDA) and is marketed in North America by
GlaxoSmithKline Consumer Healthcare (GlaxoSmithKline). Abreva is
the leading over-the-counter (OTC) product for the
treatment of cold sores.

AVANIRs preclinical research and drug
discovery programs are focused primarily on small molecules that
can be taken orally as therapeutic treatments. Using its
proprietary XenerexTM technology, AVANIR is also
conducting research to develop injectable human monoclonal
antibody products for infectious diseases, such as anthrax and
cytomegalovirus, and for other therapeutic applications.

Partnering, licensing and research collaborations
have been, and will continue to be, an important part of
AVANIRs business development strategy. We intend to
partner with pharmaceutical companies that can help fund
AVANIRs research in exchange for sharing in the rights to
commercialize new drugs resulting from this research. We have
licensed and continue to seek licensees for docosanol 10% cream
and other potential products in our pipeline. Research
collaborations also represent an important way to achieve our
development goals, by sharing in the risks and the opportunities
that come from such development efforts.

AVANIRs offices and research facilities are
located at 11388 Sorrento Valley Road, San Diego, California
92121. Our telephone number is (858) 622-5200 and our
e-mail address is info@AVANIR.com. Additional information about
AVANIR can be found on our website, at www.AVANIR.com,
and in our periodic and current reports filed with the
Securities and Exchange Commission (SEC). Copies of
our current and periodic reports filed with the SEC are
available at the SEC Public Reference Room at 450 Fifth
Street, N.W., Washington, D.C. 20549, and online at
www.sec.govand our website at www. AVANIR.com.

Docosanol 10% Cream

AVANIR has continued to commercialize docosanol
10% cream (known as Abreva in the U.S. and Canada) by pursuing
regulatory approvals and license arrangements in several foreign
countries. In November 2003, the Swedish Medical Products Agency
approved docosanol 10% cream for marketing as a
non-prescription, OTC topical treatment for cold sores.
Sweden will act as the Reference Member State during the mutual
recognition process for obtaining further regulatory approvals
of docosanol 10% cream in the European Union. AVANIR has foreign
license agreements for docosanol 10% cream in the Republic of
Korea, Israel, Italy and Egypt, and is seeking additional
licensees for the rest of Europe and Japan. AVANIR has assisted
its

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partners in obtaining OTC marketing approvals
with regulatory agencies in Korea, Israel and Canada. For the
last three years, substantially all of AVANIRs revenues
have come from milestone payments and royalties on product sales
in the U.S. by GlaxoSmithKline and from sale of an undivided
interest in the GlaxoSmithKline license agreement to Drug
Royalty USA.


GlaxoSmithKline and Drug Royalty
USA.GlaxoSmithKline launched Abreva
in the U.S. in October 2000. Under the license agreement with
GlaxoSmithKline subsidiary, SB Pharmco Puerto Rico, Inc.,
AVANIR has received milestone payments and royalties totaling
$31 million. Abreva sales are somewhat seasonal, as the
incidences of cold sores increase during the winter months. We
expect that GlaxoSmithKline will launch Abreva in Canada in
2004, however, the timing of such launch is outside our control.

During fiscal 2003, AVANIR sold an undivided
interest in the GlaxoSmithKline license agreement to Drug
Royalty USA for $24.1 million. AVANIR retained the right to
receive 50% of all royalties under the GlaxoSmithKline license
agreement for annual sales of Abreva in excess of
$62 million. AVANIR also retained its rights to develop and
license docosanol 10% cream outside North America for the
treatment of cold sores and to develop and license docosanol 10%
cream in all jurisdictions for all other indications other than
cold sore treatment.

Boryung Pharmaceuticals Company, Ltd.
(Boryung).Boryung
launched docosanol 10% cream as an OTC product under the trade
name Herepair in the Republic of Korea in June 2002. The Boryung
license agreement, initially signed in July 1994, gives Boryung
the exclusive rights to manufacture, market and sell docosanol
10% cream in Korea. The agreement requires that Boryung purchase
its supply of docosanol from AVANIR and pay us a royalty on
product sales.

CTS Chemical Industries, Ltd.
(CTS).CTS launched
docosanol 10% cream as an OTC product under the trade name Abrax
in Israel in January 2003. The CTS license agreement,
initially signed in July 1993, gives CTS the exclusive rights to
manufacture, market and sell docosanol 10% cream in Israel. The
agreement requires that CTS purchase its supply of docosanol
from AVANIR and pay us a royalty on product sales.

Bruno Farmaceutici
(Bruno).The Bruno license
agreement, signed in July 2002, gives Bruno the exclusive rights
to manufacture, market and sell docosanol 10% cream in Italy.
The Bruno license agreement requires that Bruno purchase its
entire supply of docosanol from AVANIR and pay us a royalty on
product sales. Marketing and sales of docosanol 10% cream is
anticipated to begin in 2004, subject to Italian regulatory
agency approval, which will be sought using the mutual
recognition process.

Biopharm Group (Biopharm).The Biopharm license agreement, signed
in January 2002 gives Biopharm the exclusive rights to
manufacture, market and sell docosanol 10% cream in Egypt and
select countries in the Middle East. Biopharm is currently going
through the regulatory approval process in Egypt. The agreement
requires that Biopharm purchase its supply of docosanol from
AVANIR and pay us a royalty on product sales.

Commercial development strategy in other
countries.We are pursuing licensing
opportunities for docosanol 10% cream in other countries in
Europe and in Japan. Further, in Japan, we intend to have the
licensee seek approval as an OTC product, similar to the
regulatory status of the product in the United States, Canada,
Korea, Israel and Sweden. However, we can provide no assurance
that any of our licensees will be able to obtain regulatory
approval, either as an OTC product or as a prescription product,
in Japan or in other countries that do not participate in the
mutual recognition process.

Additional potential uses of docosanol 10%
cream.During fiscal 2003, AVANIR
continued to conduct preclinical research on potential topical
formulations of docosanol in the treatment of genital herpes and
other research related to the market for topical treatments. Our
genital herpes research during the past two years has been
funded by a $1.0 million SBIR Phase II grant from the
National Institutes of Health and an aggregate of $150,000 in
grants from the San Diego Regional Technology Alliance.

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Neurodex

Neurodex is a patented orally administered
formulation of dextromethorphan (DM) and
quinidine (Q), which helps to sustain elevated levels of
dextromethorphan in the human body. We believe this patented
formulation can provide therapeutic benefits if DM is present at
higher levels in the bloodstream. AVANIR has the rights to
develop Neurodex for the treatment of pseudobulbar affect
(PBA or emotional lability), neuropathic pain,
weaning from narcotics and anti-depressants, and chronic cough.
We are currently developing Neurodex for the treatment of PBA
and neuropathic pain.

Neurodex for the treatment of pseudobulbar
affect.PBA affects a diverse
population of patients with neurologic disorders, including
those with Alzheimers disease, multiple sclerosis (MS),
Lou Gehrigs disease (amyotrophic lateral sclerosis or ALS)
and Parkinsons disease, and those with neuronal damage
following stroke and traumatic brain injury. PBA is typically
characterized by periodic episodes of laughing or crying out of
proportion or context to, or incongruent to, the basic social
setting. We expect the market for PBA to reach $450 million
by 2005 and could reach $700 million by the year 2010.
Currently, no drug is approved for the treatment of PBA.
Further, we are not aware of any other drugs in development that
specifically address the condition of PBA.

In fiscal 2003, AVANIR initiated the second of
two required Phase III clinical trials of Neurodex to
examine the safety and efficacy of the drug in the treatment of
PBA. The second Phase III clinical trial is being conducted at
23 sites in patients with MS, whereas the first
Phase III clinical trial was in patients with ALS. The
study parameters for the Phase III clinical trial in
MS patients include a goal of the same number of study
patients and use of the same CNS-LS scale (described below) that
was used in the Phase III clinical trial in
ALS patients. Since January 2003, AVANIR has also been
engaged in an open-label study of PBA at 33 sites in a diverse
population of patients with various neurologic disorders. We
expect to complete the Phase III clinical trial of Neurodex
for the treatment of PBA in MS patients and submit a new drug
application (NDA) to the FDA for that indication in the second
half of the 2004 calendar year.

In fiscal 2002, we completed a Phase III clinical
trial of Neurodex in the treatment of PBA in patients suffering
from ALS. A total of 140 patients with ALS who also suffer
from PBA were enrolled at 17 academic study sites throughout the
U.S. in the double blind, controlled Phase III study. The
patients received capsules containing either Neurodex, or DM
alone, or Q alone, twice daily for four weeks. The Neurodex
arm showed statistically and clinically greater improvements
than the DM-only arm (p=0.001) and the Q-only arm (p=0.0002) in
the primary efficacy end point: change in the CNS-Lability Scale
(CNS-LS). CNS-LS is a validated scale that measures the severity
and frequency of a subjects episodes of pathological
laughing and/or crying. In the intent-to-treat population, the
adjusted mean improvement in CNS-LS for patients treated with
Neurodex was approximately twice the improvement in patients
treated with either DM only or Q only.

Neurodexs side effects reported in the
Phase III clinical trial of Neurodex in ALS patients in
fiscal 2002 were as anticipated, based on the pharmacology of
DM. Four serious adverse events (including one death attributed
to the progression of ALS) were reported during the
Phase III clinical trial. All four events were considered
to be unrelated to the test articles by the investigator who
reported them. Early withdrawal due to adverse events occurred
in 24% of Neurodex patients, 6% of DM-only patients, and 8% of
Q-only patients. Adverse events reported for Neurodex included
nausea, dizziness, somnolence, and diarrhea. All of these types
of adverse events resolved when therapy was discontinued.

Neurodex for the treatment of neuropathic
pain.In June 2003, we completed a
four-week open label dose escalation study of Neurodex in
patients with painful diabetic neuropathy. Results from the
study indicated that Neurodex was well tolerated up to the
highest target dose in the non-placebo controlled study.
Patients in the study reported decreased pain intensity that was
significantly different from baseline (p<0.0001).
Additionally, 91% and 97% of the patients reported pain relief
by Day 8 and Day 15, respectively, compared to
baseline. The pain relief reported by the patients during the
study improved with the duration of the study.

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The clinical trial was conducted at five
U.S. sites in 36 adult volunteers with diabetic
neuropathy who experienced pain on a daily basis in the lower
extremities for at least the previous three months. The study
was designed to evaluate the safety and tolerability of
escalating doses of Neurodex for future clinical trials. Various
pain assessments were included as a preliminary evaluation of
pain relief. Three patients did not complete the study, two due
to adverse events (one serious and not related, one serious and
possibly related) and one due to inability to comply with the
protocol. Commonly reported adverse events (reported by three or
more individuals) included nausea, constipation, diarrhea, dry
mouth, fatigue, dizziness, insomnia, headache, upper respiratory
tract infection and somnolence. Most adverse events were either
mild or moderate in intensity, and 92% of the participants
completed the study. There was minimal need for rescue pain
medication; rescue medications were taken on a mean of
1.3 days during the four-week study.

At least half of the 15.7 million Americans
who have diabetes are estimated to suffer from nerve damage
caused by the disease, according to the American Diabetes
Association. The damaged nerves can alter the sensitivity of
pain centers in the spinal cord and consequently intensify pain
transmission within the central nervous system. Diabetic
neuropathic pain currently is most commonly treated with
tricyclic antidepressants, anticonvulsants, opioid analgesics
and local anesthetics. Most of these treatments have limited
effectiveness or undesirable side effects. There is no drug
approved in the U.S. specifically for diabetic neuropathic pain.
AVANIR intends to develop Neurodex as a viable competitor in the
$1 billion plus neuropathic pain market.

Commercialization strategy.We are currently evaluating
alternatives for commercialization of Neurodex for PBA and
neuropathic pain. Such alternatives include, among others,
developing our own sales force for certain market segments, and
co-promotion or licensing arrangements, possibly with a partner
that could contribute to the development costs of the program.
There can be no assurances as to the timing of a license or
co-promotion arrangement, if any.

Allergy and asthma drug AVP-13358

We are currently engaged in a Phase I clinical
trial program for AVP-13358. In December 2002, following an
evaluation of results of toxicology studies conducted on
AVP-13358, AVANIR submitted an Investigational New Drug (IND)
application to the FDA to begin Phase I testing of the
drug. In October 2003, we announced that AVP-13358 was well
tolerated at single rising doses up to five milligrams in a
randomized, placebo-controlled Phase I clinical trial.
Presence of the drug in the bloodstream, or exposure, was
demonstrated at all four oral dose levels tested between one and
five milligrams. Preclinical studies of AVP-13358 in animal
models demonstrated the compound is capable of suppressing the
synthesis of immunoglobulin epsilon (IgE) as well as other
critical mediators of the allergic response. Also, in-vitrostudies have demonstrated that AVP-13358 is capable of
down-regulating IgE and suppressing the antigen-stimulated IL-4
and IL-5 receptor (IL-4Ra) on leukocytes. No inhibitory effects
on antigen-specific IgG responses were observed. AVP-13358 is
orally active and appears to be selective for the suppression of
antigen specific IgE and Th2 cytokine-mediated diseases.

Both allergies and asthma are respiratory
diseases caused by agents called allergens. Allergens trigger
the initial phase of an asthma or allergy attack, and symptoms
such as sneezing, coughing, stuffy nose, itching, chest
tightness, wheezing, tingling and shortness of breath soon
develop. In allergy-prone people, the presence of invading
allergens triggers the immune system to produce an extra amount
of the antibody known as IgE. IgE binds to mast cells, found in
the mucosal lining of our airways. IgE and the allergen bind
together or cross link on the surface of the mast cell, causing
the mast cell to degranulate and release histamine and other
chemical mediators that cause the symptoms of allergy and
asthma. We believe that if IgE overproduction can be addressed,
then the allergic response, which can range from mild sneezing
to a serious asthmatic attack, may be reduced or prevented.

We estimate the worldwide market for sales of
products that treat allergy and asthma is over $10 billion
a year. The FDAs recent approval of XolairTM,
an injectible antibody that neutralizes the target IgE, helps
validate IgE as a target in the treatment of patients with
asthma. Presently, no small-molecule drugs (ones that can be
taken orally) have been approved by the FDA for the
down-regulation of IgE, either via neutralization or suppression
of its synthesis or release. We believe our new small molecule
agent,

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AVP-13358, is an attractive candidate for
developing as a treatment for allergy and asthma. There can be
no assurances that AVP-13358 will successfully complete all of
the rising doses planned for testing the safety and
bioavailability in the Phase I clinical trials, nor that it will
successfully complete all of the other clinical trials required
to successfully obtain the FDAs approval of the drug.


Other development programs

MIF inhibitor technology.AVANIR has continued to conduct
research on drug candidates that appear capable of regulating
the target, MIF (macrophage migration inhibitory factor), a
protein believed to be a significant causal factor in several
inflammatory diseases. Modulation of MIF activity may offer a
novel therapeutic intervention in rheumatoid arthritis, sepsis,
ulcerative colitis, Crohns disease, inflammatory
neurological diseases, glomerulonephritis and asthma. MIF is
known to regulate the synthesis and/or release of
TNFa  validated target for inflammatory diseases. We
believe these diseases still have unmet therapeutic needs. Sales
of current drugs for these diseases exceed several billion
dollars in the United States alone. Examples of successful
commercialization of injectable drugs that target
pro-inflammatory proteins are Enbrel® by Immunex
Corporation and Remicade® by Johnson & Johnson,
both of which target TNFa by binding to TNFa or the TNFa
receptor, respectively. AVANIRs research is focused on
developing an oral small molecule that targets MIF. Our research
program is at an early stage of development and will take
several years of development effort to determine whether or not
it will be successful.

Cholesterol reduction
(CCMTMTechnology).We are engaged in
research focused on certain types of small molecules for the
treatment and prevention of hyper-cholesterolemia (high
cholesterol). Cholesterol is transported in the blood in large
cholesterol-rich particles called lipoproteins. Generally,
low-density lipoproteins (LDL) deliver the cholesterol to
peripheral tissues including aorta and coronary arteries,
whereas high-density lipoproteins (HDL) remove excess
cholesterol from peripheral tissues, and transport it to the
liver for elimination. We are evaluating compounds that may be
capable of accelerating the removal of excess cholesterol from
peripheral tissues and transporting it to the liver for
elimination. Because our research is at the preclinical stage of
development, we are unable to predict the cost and timing for
development of a drug.

Cancer research.AVANIR has developed an experimental compound, AVP-893, that has
showed selective growth inhibition against a variety of cancer
cell lines in preclinical testing and early compound screening
performed by the National Cancer Institute (NCI). Early compound
screening by NCI indicated AVP-893 and other AVANIR compounds
appear to be unlike any existing drugs that have been screened
by NCI for anti-cancer activity, either in terms of structure,
tumor activity profile, or apparent mechanism of action. We
expect that NCI will continue testing the compounds in their
assays. If the compounds show favorable outcomes through
additional testing, AVANIR will seek to out-license the
compounds.

XenerexTM Technology

AVANIRS XenerexTM technology is
a patented technology in the early stages of development that is
used to develop human monoclonal antibodies for the treatment of
infectious diseases and other therapeutic applications. Our
technology enables the generation of fully human antibodies from
human lymphoid cells engrafted into severe combined
immunodeficient (SCID) mice. We stimulate engrafted human cells
in the mice with the antigenic target to which the cells respond
by producing antibodies specific to the target. We identify the
human cells that are producing antibodies of interest and then
rescue the antibody DNA by standard recombinant technology. The
Xenerex technology mimics the in vivohuman antibody
response as it generates multiple antibodies with various
combinations of affinity and specificity characteristics to an
antigenic target.

We have used the Xenerex technology in three
R&D collaborations with other biotechnology companies that
have their own proprietary antigen targets. The research
collaborations provided the opportunity to earn research fees
during the antibody generation effort and milestone payments if
we were able to provide an antibody product candidate that is
attractive for development by the research partner. In 2003 we
changed our R&D strategy to put more emphasis on internal
development programs, particularly those related to infectious
diseases, an area we believe represents a better fit for our
technology.

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During 2003, we were awarded a total of $350,000
in government grants related to our research using our Xenerex
technology. The Center for the Commercialization of Advanced
Technology (CCAT) provided us with $150,000 in grants to develop
an antibody to the anthrax toxin and a blood donor program. CCAT
is a public/ private partnership between the
U.S. Department of Defense and the San Diego State
University Foundation to provide seed monies for promising
technologies in the area of bio-defense. We also received
government grants of $100,000 to develop antibodies to
cytomegalovirus (CMV) and $100,000 to continue development of
our antibody to the anthrax toxin. There can be no assurance
that we will be successful in any of our development efforts
using the Xenerex technology.

Inventory and Docosanol Supply

We purchase the drug substance, docosanol, from a
large supplier in Western Europe. This manufacturing source was
inspected by the FDA in 1998 and found to be operating under
current good manufacturing practices (cGMP). Both AVANIR and
GlaxoSmithKline have relied on this supplier for purchases of
the raw material. We believe GlaxoSmithKline maintains reserves
of the raw material as a precautionary measure in the event of a
delay or problem in the manufacture of docosanol. We also
maintain a certain quantity of the active ingredient for sale to
our licensees. We currently store our raw material in the United
States. Any material disruption in manufacturing could cause a
delay in shipments and possible loss of sales, which would be
outside our control.

Competition

The pharmaceutical industry is characterized by
rapidly evolving technology and intense competition. Many
companies of all sizes, including major pharmaceutical companies
and specialized biotechnology companies, engage in activities
similar to our activities. Many of our competitors have
substantially greater financial and other resources and larger
research and development and clinical and regulatory affairs
staffs. In addition, colleges, universities, governmental
agencies and other public and private research organizations
continue to conduct research and are becoming more active in
seeking patent protection and licensing arrangements to collect
royalties for use of technologies that they have developed. Some
of our competitors products and technologies are in direct
competition with ours. We also must compete with these
institutions in recruiting highly qualified scientific personnel.

Docosanol 10% cream.As the international product launch for docosanol 10% cream
(Abreva® in the United States and Canada) progresses, the
drug will face intense worldwide competition from the following
products:



| |   |                                                                                                                                                                            
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | OTC monograph preparations, including
    Carmex®, Zilactin®, Campho®, Orajel®,
    Herpecin® and others;                                                                  
|
| |  | Zovirax® acyclovir (oral and topical) and
    Valtrex® valacyclovir (oral) prescription products marketed
    by Biovail Corporation and GlaxoSmithKline, respectively, and
|
| |  | Famvir® famciclovir (oral) and Denavir®
    penciclovir (topical) prescription products marketed by Novartis.                                                              

Neurodex.If
approved by the FDA for the treatment of neuropathic pain,
Neurodex will compete with other drug products that are
currently prescribed by physicians, including narcotic products,
non-narcotic products, and off-label uses of other drugs, such
as anticonvulsants.

IgE down-regulation
program.Our IgE down-regulation
program competes with several research approaches and numerous
compounds under development by large pharmaceutical and
biotechnology companies. One such example is the anti-IgE
therapy using rhuMAB-E25 (Xolair®), a recombinant humanized
monoclonal antibody developed in a collaboration between
Genentech, Tanox and Novartis. The injectable antibody Xolair
was approved for marketing by the FDA in 2003. Other competitive
and successful products already established in the marketplace
include non-sedative antihistamine products, such as
Shering-Ploughs Claritin® loratadine ($3 billion
in annual sales) and Aventis Allegra®/ Telfast®
($1 billion in annual sales).

6



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Antibody generation technology.Several companies, including Abgenix,
Medarex, Inc., and Cambridge Antibody Technology, have human
antibody generation technologies and have been in business
longer and have substantially greater financial resources and
personnel than we have.

Patents and Proprietary Rights

Patents.AVANIR
presently owns or has the rights to 82 issued patents (25
U.S. and 57 foreign) and 213 applications pending (21
U.S. and 192 foreign). Patents and patent applications
owned by the Company are for docosanol-related products and
technologies, Xenerex technologies for developing monoclonal
antibodies, Neurodex, compounds capable of down-regulating the
target IgE in controlling symptoms of allergy and asthma,
compounds capable of down-regulating the target MIF in the
treatment of several inflammatory diseases, and compounds for
lowering cholesterol.

|                               |                         |                                 |    |                  |  |         |              |              |  |                  |    |         |  |  |    |    |  |  |         |         |  |  |     |   | 
|------------------------------ | ----------------------- | ------------------------------- | -- | ---------------- |  | ------- | ------------ | ------------ |  | ---------------- | -- | ------- |  |  | -- | -- |  |  | ------- | ------- |  |  | --- | - | 
|                               |                         |                                
|                               |                         | Patents and Patent Applications
|                               |                         |                                
|                               |                         |                                 |    |                 
|                               |                         | United States                   |    | Foreign         
|                               |                         |                                 |    |                 
|Description:                   |                         | Issued                          |    | Expiration Dates |  | Pending |              | Issued       |  | Expiration Dates |    | Pending
|                               |                         |                                 |    |                  |  |         |              |              |  |                  |    |        
|Docosanol-related technologies |                         |                                 | 10 |                  |  |         | 2009 to 2016 |              |  |                  | 2  |         |  |  | 39 |    |  |  | Various |         |  |  | 46  |  
|Xenerex proprietary antibody   |                         |                                 |    |                  |  |         |              |              |  |                  |    |         |  |  |    |    |  |  |         |         |  |  |     |  
|                               | generation technologies |                                 |    | 5                |  |         |              | 2012 to 2015 |  |                  |    | 4       |  |  |    | 14 |  |  |         | Various |  |  |     | 1 | 
|IgE down-regulation technology |                         |                                 | 4  |                  |  |         | 2018 to 2019 |              |  |                  | 10 |         |  |  | 4  |    |  |  | Various |         |  |  | 101 |  
|Neurodex                       |                         |                                 | 6  |                  |  |         | 2010 to 2015 |              |  |                  | 1  |         |  |  | 0  |    |  |  |        |         |  |  | 15  |  
|MIF inhibitor technology       |                         |                                 | 0  |                  |  |         |             |              |  |                  | 3  |         |  |  | 0  |    |  |  |        |         |  |  | 29  |  
|Cholesterol                    |                         |                                 | 0  |                  |  |         |             |              |  |                  | 1  |         |  |  | 0  |    |  |  |         |         |  |  | 0   |  
|                               |                         |                                 |    |                  |  |         |              |              |  |                  |    |         |  |  |    |    |  |  |         |         |  |  |     |  
|Total                          |                         |                                 | 25 |                  |  |         |              |              |  |                  | 21 |         |  |  | 57 |    |  |  |         |         |  |  | 192 |  
|                               |                         |                                 |    |                  |  |         |              |              |  |                  |    |         |  |  |    |    |  |  |         |         |  |  |     |  

Docosanol-related technologies.These patents and patent applications
pending cover both medical and veterinary uses of topical and
systemic formulations of docosanol 10% cream in the
U.S. and in foreign countries. We also have been granted
rights under selected U.S. and foreign patents and patent
applications related to docosanol 10% cream held by a third
party.

Xenerex proprietary antibody generation
technologies.We own the rights to
several issued patents related to our Xenerex antibody
generation technology.

IgE down-regulation technology.Our patents and patent applications
are for the use of various small molecules and related general
structures currently under development or being used in clinical
and preclinical research for the regulation of IgE in the
treatment of various inflammatory diseases.

Neurodex.We have
in-licensed the rights to develop, manufacture and sell a drug
combination of dextromethorphan and an enzyme inhibitor for the
treatment of several central nervous system disorders.

MIF inhibitor technology.The patent applications pending for
our MIF inhibitor technology are in regard to the use of one or
more of a series of small molecule compounds that target MIF as
a potential novel therapeutic intervention in rheumatoid
arthritis, sepsis, ulcerative colitis, Crohns disease,
inflammatory neurological diseases, glomerulonephritis and
asthma.

Cholesterol
reduction.The patent application
pending in the United States for our cholesterol reduction
technology relates to the general structures currently under
development in preclinical research.

We cannot assure you that the claims in our
pending patent applications will be issued as patents, that any
issued patents will provide us with significant competitive
advantages, or that the validity or enforceability of any of our
patents will not be challenged or, if instituted, that these
challenges will not be successful. The cost of litigation to
uphold the validity and prevent infringement of our patents
could be substantial. Furthermore, we cannot assure you that
others will not independently develop similar technologies or
duplicate our technologies or design around the patented aspects
of our technologies. We can provide no assurance that our
proposed technologies will not infringe patents or other rights
owned by others, the licenses

7



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to which might not be available to us. In
addition, the National Institutes of Health regulations provide
that, if federally funded entities do not pursue patent
applications for patentable inventions in a timely manner, then
the government may exercise its right to own these inventions.


In addition, the approval process for patent
applications in foreign countries may differ significantly from
the process in the U.S. The patent authorities in each
country administer that countrys laws and regulations
relating to patents independently of the laws and regulations of
any other country and the patents must be sought and obtained
separately. Therefore, approval in one country does not
necessarily indicate that approval can be obtained in other
countries.

Proprietary rights.In some cases, we may rely on trade
secrets and confidentiality agreements to protect our
innovations. We can provide no assurance that:



| |   |                                                                          
| | - | -------------------------------------------------------------------------
| |  | our trade secrets will be maintained;                                    
|
| |  | secrecy obligations will be honored; or                                  
|
| |  | others will not independently develop similar or
    superior technology.

If consultants, key employees or other third
parties apply technological information independently developed
by them or by others to our projects, we may be subject to
disputes regarding the proprietary rights to this information
that may not be resolved in our favor.

Information regarding the status of our various
research and development programs, and the amounts spent on
major programs through the last two fiscal years, can be found
under the caption Managements Discussion and
Analysis of Financial Condition and Results of Operations.

Government Regulations

The FDA and comparable regulatory agencies in
foreign countries regulate extensively the manufacture and sale
of the pharmaceutical products that we have developed or
currently are developing. The FDA has established guidelines and
safety standards that are applicable to the nonclinical
evaluation and clinical investigation of therapeutic products
and stringent regulations that govern the manufacture and sale
of these products. The process of obtaining regulatory approval
for a new therapeutic product usually requires a significant
amount of time and substantial resources. The steps typically
required before a product can be produced and marketed for human
use include:



| |   |                                                                                                            
| | - | -----------------------------------------------------------------------------------------------------------
| |  | animal pharmacology studies to obtain preliminary
    information on the safety and efficacy of a drug; and
|
| |  | nonclinical evaluation in vitroand in
    vivoincluding extensive toxicology studies.                      

The results of these nonclinical studies may be
submitted to the FDA as part of an investigational new drug
(IND) application. The sponsor of an IND application may
commence human testing of the compound 30 days after submission
of the IND, unless notified to the contrary by the FDA.

The clinical testing program for a drug typically
involves three phases:



| |   |                                                                                                                                                                                                                                                                                                                                
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | Phase 1investigations are generally conducted
    in healthy subjects. In certain instances, subjects with a
    terminal disease, such as cancer, may participate in
    Phase 1 studies that determine the maximum tolerated dose
    and initial safety of the product;                                                     
|
| |  | Phase 2studies
    are conducted in limited numbers of subjects with the disease or
    condition to be treated and are aimed at determining the most
    effective dose and schedule of administration, evaluating both
    safety and whether the product demonstrates therapeutic
    effectiveness against the disease; and
|
| |  | Phase 3studies
    involve large, well-controlled investigations in diseased
    subjects and are aimed at verifying the safety and effectiveness
    of the drug.                                                                                                                                                             

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Data from all clinical studies, as well as all
nonclinical studies and evidence of product quality, typically
are submitted to the FDA in a New Drug Application (NDA).

The FDAs Center for Drug Evaluation and
Research (CDER) or the Center for Biologics Evaluation and
Research (CBER) must approve a new drug application or biologics
license application for a drug before the drug may be marketed
in the U.S. At the time, if ever, that we begin to market
our proposed products for commercial sale in the U.S., any
manufacturing operations that may be established in or outside
the U.S. will be subject to rigorous regulation, including
compliance with current good manufacturing practices. We also
may be subject to regulation under the Occupational Safety and
Health Act, the Environmental Protection Act, the Toxic
Substance Control Act, the Export Control Act and other present
and future laws of general application. In addition, the
handling, care and use of laboratory mice, including the
hu-PBL-SCID mice and rats, are subject to the Guidelines for the
Humane Use and Care of Laboratory Animals published by the
National Institutes of Health.

Regulatory obligations continue post-approval,
and include the reporting of adverse events when a drug is
utilized in the broader commercial population. Promotion and
marketing of drugs is also strictly regulated, with penalties
imposed for violations of FDA regulations, the Federal Trade
Commissions Lanham Act, and other federal and state laws,
including the federal anti-kickback statute.

We currently intend to continue to seek approval
to market docosanol 10% cream and other proposed products in
foreign countries, which may have regulatory processes that
differ materially from those of the FDA. We anticipate that we
will rely upon pharmaceutical or biotechnology companies to
license our proposed products or independent consultants to seek
approvals to market our proposed products in foreign countries.
We cannot assure you that approvals to market any of our
proposed products can be obtained in any country. Approval to
market a product in any one foreign country does not necessarily
indicate that approval can be obtained in other countries.

Human resources

As of December 11, 2003, we employed
63 persons, including 46 engaged in research and
development activities, clinical and regulatory affairs, and
commercial development, and 17 engaged in administrative
functions such as human resources, finance, accounting,
purchasing and investor relations. Our staff includes
24 employees with Ph.D. or M.D. degrees. We believe that
our relationship with our employees is good.

Risk factors that might affect future
operations

We expect that we will need to raise
additional capital to fund ongoing operations. If we cannot
raise additional capital, we may be forced to curtail
operations. If we succeed in raising additional capital, it may
affect our stock price and future revenues.

In order to maintain sufficient cash and
investments for future operations, we will need to raise
additional capital. We expect to seek to raise additional
capital over the next twelve months through various
alternatives, including licensing or sales of our technologies
and drug candidates and sale of shares of our Class A
common stock.



| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | If we raise capital through licensing or sales of
    one or more of our technologies and drug candidates, then we may
    lose an opportunity for product sales if a product is
    successfully developed, approved by the FDA and marketed. If we
    license any of our technologies or drug candidates, then the
    development of the product or technology will no longer be in
    our control. A licensee might not ever reach any of the
    milestones in a license agreement and we would not earn any
    additional payments in such an event. Further, if we sell any of
    our technologies or drug candidates, there can be no assurance
    that the sales price will cover our investment in such
    technology or drug candidate.
|
| |  | If we raise capital by issuing additional shares
    of Class A common stock at a price per share less than the
    then-current market price per share, then the value of the
    shares of Class A common stock outstanding will be diluted
    or reduced. Further, even if we were to sell shares of common
    stock at                                                                                                                                                                                                                                                                                                                                                                                                                            

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| |   |                                                                                                                                                                                                                                                                                                                                                                                         
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |   | prices equal to or higher than the current market
    price, the issuance of additional shares may depress the market
    price of our common stock and dilute your voting rights in the
    Company.                                                                                                                                                                                   
|
| |  | We may not be able raise capital on terms that we
    find acceptable, if at all. If we are unable to raise additional
    capital to fund future operations, then we might have to reduce
    operations or defer or abandon one or more of our clinical or
    preclinical research programs. Any of these actions could be
    expected to have an adverse effect on our stock price.

AVANIR and its licensees may not be successful
in obtaining regulatory approval of docosanol 10% cream
immediately as an over-the-counter (OTC) product in
the rest of the world or in licensing, marketing and selling the
product in foreign countries.

AVANIR and its licensees face a wide variety of
risks in foreign countries in obtaining regulatory approval and
in marketing and selling docosanol 10% cream, including:



| |   |                                                                                                                                                                                                                                                                                                                                                             
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | Regulatory approval requirements differ by
    country, and obtaining approvals to market the drug in foreign
    countries may be difficult to obtain, may require additional
    costly and time consuming clinical trials, or may require
    prescription status first before obtaining sufficient experience
    to warrant approval as an OTC product;
|
| |  | Building product awareness of a new drug, whether
    prescription or OTC, among customers or retail store decision
    makers may require a substantial amount of product promotion,
    which does not guarantee success;                                                                                                                                 
|
| |  | Consumers may not perceive that docosanol 10%
    cream is superior to existing and potentially new OTC products
    for oral herpes;                                                                                                                                                                                                                       
|
| |  | Acceptance of docosanol 10% cream in the OTC
    consumer market may not be widespread; and                                                                                                                                                                                                                                                                 
|
| |  | Potential price erosion could occur due to
    competitive products and responses to our products
    introduction.                                                                                                                                                                                                                                        

Developing and testing a drug candidate is a
very expensive and time-consuming process that may not
ultimately lead to a marketable product.

We may spend millions of dollars in preclinical
studies researching the potential safety and efficacy of our
drug candidates. If any such drug candidate fails to demonstrate
the desired safety and efficacy, we may abandon the development
of the compound, in which event we would not recover our
expenditures incurred to date for that compound. If a compound
appears to be safe and effective in preclinical studies, we may
decide to proceed with human clinical trials. The full
complement of clinical trials required to obtain regulatory
approval for a new drug may involve several million dollars.
Because of the Companys limited financial resources, we
may be required to license the compound to a pharmaceutical
company with greater financial resources in order to complete
development of the drug. There is no assurance that we will be
able to find a large pharmaceutical company interested in
licensing the drug or, if we do locate such a licensee, that the
proposed license terms will be acceptable to the Company. In the
event that we are unable to find a large pharmaceutical partner
or licensee on acceptable terms, we may be forced to abandon one
or more of our drug candidates.

We expect our quarterly operating results to
fluctuate significantly from period-to-period for a number of
reasons.

Future operating results will continue to be
subject to significant quarterly fluctuations based on a variety
of factors, including:



| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                   
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | Limited rights to future Abreva
    royalties In December 2002
    we sold to Drug Royalty USA the rights to a substantial portion
    of our future royalty revenues from sales of Abreva by
    GlaxoSmithKline. We will not receive any future royalty payments
    unless and until annual Abreva sales exceed $62 million, at
    which time we will receive one-half of the stated royalty rate
    on any excess sales. We

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| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |   | expect that any royalty payments on these excess
    sales, if any, would occur only once a year, after the end of
    each calendar year.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|
| |  | Concentration of significant customers,
    suppliers and industries
    Milestone payments, royalties earned, and revenues recognized
    from the sale of rights to royalties from a single licensee
    (GlaxoSmithKline) accounted for approximately 73% and 95% of our
    fiscal 2003 and 2002 revenues, respectively. We have now
    received all of the milestone payments from GlaxoSmithKline for
    North America. With the sale of our Abreva royalty rights to
    Drug Royalty USA, future royalty payments from GlaxoSmithKline
    will come exclusively from our remaining 50% share of Abreva
    royalties on contract sales in excess of $62 million a
    year. Additionally, we purchase our raw materials from a sole
    foreign supplier that has been approved for manufacture by the
    FDA. Any disturbances or delays in the manufacture of the raw
    materials could seriously and adversely affect our business.
|
| |  | Achievement of milestones under license
    agreements may be outside our
    control Recognition of
    revenue under several of our license agreements may depend
    solely on the efforts and performance of our licensees in
    reaching milestones outside of our control. Such milestones may
    include specific events, such as regulatory approval, product
    launch, the passage of time, or reaching a sales threshold.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|
| |  | Acquisitions/alliances
    If, in the future, we acquire technologies, products, or
    businesses, or we form alliances with companies requiring
    technology investments or commitments, we will face a number of
    risks to our business. The risks that we may encounter include
    those associated with integrating operations, personnel, and
    technologies acquired or licensed, and the potential for unknown
    liabilities of the acquired business. Our business and operating
    results on a quarterly basis could be adversely affected if any
    of our acquisition or alliance activities are not successful.                                                                                                                                                                                                                                                                                                           

Foreign sales of docosanol 10% cream and other
potential products are subject to various foreign trade
risks.

Our license agreement with GlaxoSmithKline is for
the United States and Canada only. We also have exclusive
license agreements for docosanol 10% cream for Israel, South
Korea, Italy and Egypt. We are holding discussions with other
potential licensees for marketing and selling docosanol 10%
cream in other countries not already licensed. However, we may
not finalize any license or distribution arrangements for other
territories on a timely basis or on favorable terms, if at all.
Further, our foreign licensees expose us to various foreign
trade risks relating to development and marketing of docosanol
10% cream. We may arrange for contracts in the future for the
manufacture, marketing and distribution of docosanol 10% cream
overseas by foreign licensees, which will be substantially
outside our control. Even if we are able to obtain experienced
licensees in foreign markets, specific risks that could impact
significantly our ability to deliver products abroad include:



| |   |                                                                                                                              
| | - | -----------------------------------------------------------------------------------------------------------------------------
| |  | difficulties in obtaining regulatory approval of
    docosanol 10% cream in foreign countries;                               
|
| |  | changes in the regulatory and competitive
    environments in foreign countries;                                             
|
| |  | changes in a specific countrys or
    regions political or economic conditions;                                            
|
| |  | difficulty in finding foreign partners with
    sufficient capital to effectively launch, market and promote the
    product;
|
| |  | shipping delays;                                                                                                             
|
| |  | difficulties in managing operations across
    disparate geographic areas;                                                   
|
| |  | fluctuations in foreign currency exchange rates;                                                                             
|
| |  | prices of competitive products;                                                                                              
|
| |  | difficulties associated with enforcing agreements
    through foreign legal systems;                                         
|
| |  | trade protection measures, including customs
    duties and export quotas; and                                               
|
| |  | foreign tax withholding laws.                                                                                                

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Our research and development programs face
intense competition and rapid technological change. If we fail
to develop products that keep pace with competitive products and
new technologies, our products and technologies could become
obsolete.

The biotechnology industry is highly competitive
and subject to significant and rapid technological change. We
compete with hundreds of companies that develop and market
products and technologies in similar areas as our research. Each
competitor may have specific expertise and technologies that are
better than ours. Many of these companies, either alone or
together with their research partners, have substantially
greater financial resources, larger research and development
staffs, and substantially greater experience than we do.

Our failure or inability to comply with
government regulations regarding the development, production,
testing, manufacturing and marketing of our products may
adversely affect our operations.

Governmental authorities in the U.S., including
the FDA, and other countries highly regulate the development,
production, testing, manufacturing and marketing of
pharmaceutical products. The clinical testing and regulatory
approval process can take a number of years and requires the
expenditure of substantial resources. Failure to obtain, or
delays in obtaining, these approvals will adversely affect our
business operations, including our ability to commence marketing
of any proposed products. We may find it necessary to use a
significant portion of our financial resources for research and
development and the clinical trials necessary to obtain these
approvals for our proposed products. We will continue to incur
costs of development without any assurance that we will ever
obtain regulatory approvals for any of our products under
development. Additionally, we cannot predict the extent to which
adverse governmental regulation might arise from future U.S. or
foreign legislative or administrative action. Moreover, we
cannot predict with accuracy the effects of any future changes
in the regulatory approval process and in the domestic health
care system for which we develop our products. Future changes
could affect adversely the time frame required for regulatory
review, our financial resources, and the sale prices of our
proposed products, if approved for sale.

Unsuccessful or lengthy research and
development programs for proposed new products could negatively
affect our business.

The drug development process is lengthy and
capital intensive. Our drug development programs are exposed to
all of the risks inherent in product development based on
innovative technologies, including unanticipated development
problems and the possible lack of funding or collaborative
partners. Any of a number of problems in the development process
could result in the abandonment or substantial change in the
development of a specific product. Our Phase III clinical trial
of Neurodex for the treatment of pseudobulbar affect in multiple
sclerosis patients may experience setbacks or failures for
reasons we have not anticipated. Our Phase I clinical trial of
our lead compound for treating allergy and asthma may not
demonstrate the efficacy of, or have the safety profile
necessary for, a proposed product for human use. Unsuccessful
clinical trial results for our proposed products could affect
materially and adversely our future business operations and
financial condition.

Our financial results could be affected by
potential changes in the accounting rules governing the
recognition of stock-based compensation expense.

We measure compensation expense for our employee
stock compensation plans under the intrinsic value method of
accounting prescribed by Accounting Principles Board Opinion
No. 25, Accounting for Stock Issued to
Employees. In addition, we provide pro forma disclosures
of our operating results in our Notes to Consolidated Financial
Statements as if the fair value method of accounting had been
applied in accordance with SFAS No. 123, Accounting
for Stock-based Compensation. Had we accounted for our
compensation expense under the fair value method of accounting
prescribed by SFAS No. 123, the charges would have been
significantly higher, by approximately $1,554,000, $2,176,000,
and $1,540,000 during fiscal 2003, 2002, and 2001, respectively.
Currently, the U.S. Congress, the Securities and Exchange
Commission and the Financial Accounting Standards Board are
considering changes to accounting rules concerning the
recognition of stock option compensation expense. If one or more
of these proposals are implemented, we and other companies may
be required to measure compensation expense using the fair value
method, which would adversely affect

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our results of operations by reducing our income
or increasing our losses by an amount equal to the difference in
the two measurement methods.


Business interruptions could adversely affect
our business.

Our operations are vulnerable to interruption by
fire, earthquake, power loss, telecommunications failure, and
other events beyond our control. For example, during 2001 and
again in 2003, we experienced blackouts, where there
were periods of time lasting several hours in which our utility
provider was unable to provide us with electrical power. The
loss of electrical power or blackouts for any
significant periods of time could adversely affect our ability
to conduct experiments and could also harm our vendors. Further,
we could lose valuable data made to date in experiments
currently underway. We have mitigated the severity of power
losses by installing on our premises emergency power equipment,
which we have used on several occasions to supply electricity in
the areas that we consider to be the most critical to our
operations. However, the emergency power unit does not cover all
of our electrical needs and, further, it might not operate
properly in the event of a power loss.

Our inability to attract and retain key
management and scientific personnel could negatively affect our
business.

Our success depends on the performance of a small
core staff of key management and scientific employees with
biotech experience. Given our small staff size and programs
currently under development, we depend substantially on our
ability to hire, train, retain and motivate high quality
personnel, especially our scientists and management team in this
field. If we were to lose one or more of our key scientists,
then we would likely lose some portion of our institutional
knowledge and technical know-how, potentially causing a
substantial delay in one or more of our development programs
until adequate replacement personnel could be hired and trained.

Our future success also depends on our continuing
ability to identify, hire, train and retain highly qualified,
technical, sales, marketing and customer service personnel. We
presently employ approximately 63 people. Further, we might hire
additional people over the next twelve months. Other than our
chief executive officer, our executives do not have employment
agreements. We do not have key person life insurance
policies for any of our executives. The industry in which we
compete has a high level of employee mobility and aggressive
recruiting of skilled personnel. This type of environment
creates intense competition for qualified personnel,
particularly in product research and development, sales and
marketing, and accounting and finance.

Our patents may be challenged and our pending
patents may be denied. Either result would seriously jeopardize
our ability to compete in the intended markets for our proposed
products.

We rely substantially on the protection of our
intellectual property through our ownership or control of issued
patents and patent applications. Patents and patent applications
owned or controlled by the Company are for docosanol-related
products and technologies, NeurodexTM, compounds
capable of regulating the target IgE in controlling symptoms of
allergy and asthma, compounds capable of regulating the target
MIF in the treatment of several inflammatory diseases, and
Xenerex technologies for developing monoclonal antibodies.
Because of the competitive nature of the biopharmaceutical
industry, we cannot assure you that:



| |   |                                                                                                                                                                                                  
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | the claims in any pending patent applications
    will be allowed or that patents will be granted;                                                                                               
|
| |  | present and future competitors will not develop
    similar or superior technologies independently, duplicate our
    technologies or design around the patented aspects of our
    technologies;
|
| |  | our proposed technologies will not infringe other
    patents or rights owned by others, including licenses that may
    not be available to us;                                                 
|
| |  | any of our issued patents will provide us with
    significant competitive advantages; or                                                                                                        
|
| |  | challenges will not be instituted against the
    validity or enforceability of any patent that we own or, if
    instituted, that these challenges will not be successful.                      

13



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##### Table of Contents



Our inability to obtain or maintain patent
protections for our products in foreign markets may negatively
affect our financial condition.

The process for the approval of patent
applications in foreign countries may differ significantly from
the process in the U.S. These differences may delay our plans to
market and sell docosanol 10% cream and other products in the
international marketplace. Approval in one country does not
indicate that approval will be obtained in other countries. The
patent authorities in each country administer that
countrys laws and regulations relating to patents
independently of the laws and regulations of any other country
and we must seek and obtain the patents separately. Our
inability to obtain or maintain patent protections for docosanol
10% cream and other products in foreign markets would severely
hamper our ability to generate international sales from our
first product and other products still under development.

If we do not protect our technical
innovations, then our business may be negatively
affected.

We rely substantially on confidentiality
agreements to protect our innovations. We cannot assure you that
secrecy obligations will be honored, or that others will not
independently develop similar or superior technology.
Additionally, if our consultants, key employees or other third
parties apply technological information independently developed
by them or by others to our projects, then disputes may arise as
to the ownership rights of these innovations. It is costly to
litigate these disputes and an unfavorable result could
adversely affect our intellectual property portfolio as well as
our business and financial condition.

Developing new pharmaceutical products for
human use involves product liability risks, for which we
currently have limited insurance coverage.

The testing, marketing, and sale of
pharmaceutical products involves the risk of product liability
claims by consumers and other third parties. We maintain product
liability insurance coverage for our clinical trials in the
amount of $5 million per incident and $5 million in
the aggregate. However, product liability claims can be high in
the pharmaceutical industry and our insurance may not
sufficiently cover our actual liabilities. If a suit against our
business or proposed products is successful, then the lack or
insufficiency of insurance coverage could affect materially and
adversely our business and financial condition. Furthermore,
various distributors of pharmaceutical products require minimum
product liability insurance coverage before their purchase or
acceptance of products for distribution. Failure to satisfy
these insurance requirements could impede our ability to achieve
broad distribution of our proposed products.

We could incur significant liabilities as a
result of material litigation.

In the ordinary course of business, we face
various claims brought by third parties, including claims
relating to the safety or efficacy of our products. Any of these
claims could subject us to costly litigation and, while we
generally believe that we have adequate insurance to cover many
different types of liabilities, our insurance carriers may deny
coverage or our policy limits may be inadequate to fully satisfy
any damage awards or settlements. If this were to happen, the
payment of any such awards could have a material adverse effect
on our operations and financial position. Additionally, any such
claims, whether or not successful, could damage our reputation
and business.

Abreva faces competition from a number of
existing and well-established products and the companies that
market their products.

We have the opportunity to earn royalties on
Abreva product wholesale sales if sales exceed $62 million
a year. Abreva competes with several other products for
oral-facial herpes currently on the market in the U.S., as well
as other products or potential products that are or may be under
development or undergoing FDA review. Most of the competing
products are manufactured by companies having substantial
financial resources, research and development facilities and
manufacturing and marketing experience. Even with Abreva being
marketed by one of the worlds largest consumer healthcare
companies, GlaxoSmithKline, not all competitive responses and
the impacts of those responses can be foreseen.

14



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##### Table of Contents






Item 2.     Properties

In connection with two lease agreements, we
currently lease 57,582 square feet of laboratory and office
space in three buildings located at 11388, 11404, and 11408
Sorrento Valley Road, San Diego, California for a combined base
rental payment of approximately $137,000 per month in fiscal
2004. These two leases have scheduled rent increases each year
and expire on August 31, 2008 and January 14, 2013,
respectively. See Note 6, Commitments and
Contingencies, to our financial statements annexed to this
report and Exhibits 10.6 and 10.8.

We maintain irrevocable standby letters of credit
to the lessors, totaling $857,000 to secure our performance
under the leases. We also completed $4.1 million in tenant
improvements in fiscal 2003 for the three buildings that we
lease.




Item 3.     Legal
Proceedings

In the ordinary course of business, we face
various claims brought by third parties, including claims
relating to the safety or efficacy of our products. Any of these
claims could subject us to costly litigation and, while we
generally believe that we have adequate insurance to cover many
different types of liabilities, our insurance carriers may deny
coverage or our policy limits may be inadequate to fully satisfy
any damage awards or settlements. If this were to happen, the
payment of any such awards could have a material adverse effect
on our results of operations and financial position.
Additionally, any such claims, whether or not successful, could
damage our reputation and business.






|        |                                                        
|------- | -------------------------------------------------------
|Item 4. | Submission of Matters to a Vote of Security
    Holders

Not applicable.




PART II






|        |                                                                          
|------- | -------------------------------------------------------------------------
|Item 5. | Market for Registrants Common Equity
    and Related Stockholder Matters

Our Class A common stock trades under the
symbol AVN on The American Stock Exchange (the
AMEX). The following table sets forth the high and
low quarterly closing quotations for our Class A common
stock over the past two fiscal years, as quoted on the AMEX.

|               |  |              |      |     |  |   |      | 
|-------------- |  | ------------ | ---- | --- |  | - | ---- | 
|               |  |             
|               |  | Class A     
|               |  | Common Stock
|               |  |             
|               |  | High         |      | Low
|               |  |              |      |    
|Fiscal 2002    |  |              |      |     |  |   |      | 
|First Quarter  |  | $            | 4.88 |     |  | $ | 2.82 | 
|Second Quarter |  | $            | 4.97 |     |  | $ | 2.67 | 
|Third Quarter  |  | $            | 3.00 |     |  | $ | 1.30 | 
|Fourth Quarter |  | $            | 1.85 |     |  | $ | 1.14 | 
|Fiscal 2003    |  |              |      |     |  |   |      | 
|First Quarter  |  | $            | 1.24 |     |  | $ | 0.90 | 
|Second Quarter |  | $            | 1.63 |     |  | $ | 0.77 | 
|Third Quarter  |  | $            | 2.22 |     |  | $ | 0.91 | 
|Fourth Quarter |  | $            | 2.00 |     |  | $ | 1.42 | 

On December 11, 2003, the closing sales
price of Class A Common Stock was $1.64 per share.

As of December 11, 2003, we had
approximately 1,060 holders of record and approximately 19,663
beneficial owners of our Class A Common Stock. We have not
paid any dividends on our Class A or Class B common
stock since our inception and do not expect to pay dividends on
our common stock in the foreseeable future.

15



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##### Table of Contents








|        |                                         
|------- | ----------------------------------------
|Item 6. | Selected Consolidated Financial
    Data

The selected consolidated financial data set
forth below at September 30, 2003 and 2002, and for the
fiscal years ended September 30, 2003, 2002 and 2001, are
derived from our audited consolidated financial statements
included elsewhere in this report. This information should be
read in conjunction with those consolidated financial
statements, the notes thereto, and the independent
auditors report thereon, and with Managements
Discussion and Analysis of Financial Condition and Results of
Operations. The selected consolidated financial data set
forth below at September 30, 2001, 2000 and 1999, and for
the years ended September 30, 2000 and 1999, are derived
from our audited consolidated financial statements that are
contained in reports previously filed with the SEC.

Summary Financial Information

|                                                                   |         |                                  |             |            |  |      |             |            |  |      |            |            |  |   |            |            |  |   |            |            | 
|------------------------------------------------------------------ | ------- | -------------------------------- | ----------- | ---------- |  | ---- | ----------- | ---------- |  | ---- | ---------- | ---------- |  | - | ---------- | ---------- |  | - | ---------- | ---------- | 
|                                                                   |         |                                 
|                                                                   |         | Fiscal Years Ended September 30,
|                                                                   |         |                                 
|Statement of operations data:                                      |         | 2003                             |             | 2002       |  | 2001 |             | 2000       |  | 1999
|                                                                   |         |                                  |             |            |  |      |             |            |  |     
|Revenues                                                           |         | $                                | 2,438,733   |            |  | $    | 8,853,742   |            |  | $    | 12,678,602 |            |  | $ | 10,252,818 |            |  | $ |           |           
|Net income (loss)                                                  |         | $                                | (23,236,348 | )          |  | $    | (10,249,512 | )          |  | $    | 233,122    |            |  | $ | (582,283   | )          |  | $ | (8,554,036 | )         
|Net income (loss) attributable to common
    shareholders          |         | $                                | (23,264,293 | )          |  | $    | (10,292,798 | )          |  | $    | 189,888    |            |  | $ | (801,806   | )          |  | $ | (8,583,182 | )         
|Basic net income (loss) per share                                  |         | $                                | (0.39       | )          |  | $    | (0.18       | )          |  | $    | 0.00       |            |  | $ | (0.02      | )          |  | $ | (0.21      | )         
|Diluted net income (loss) per share                                |         | $                                | (0.39       | )          |  | $    | (0.18       | )          |  | $    | 0.00       |            |  | $ | (0.02      | )          |  | $ | (0.21      | )         
|Weighted average number of shares of common stock
    outstanding: |         |                                  |             |            |  |      |             |            |  |      |            |            |  |   |            |            |  |   |            |           
|                                                                   | Basic   |                                  |             | 59,896,135 |  |      |             | 58,206,969 |  |      |            | 57,475,748 |  |   |            | 51,784,214 |  |   |            | 41,704,265 | 
|                                                                   | Diluted |                                  |             | 59,896,135 |  |      |             | 58,206,969 |  |      |            | 61,130,415 |  |   |            | 51,784,214 |  |   |            | 41,704,265 | 

|                            |                                                                |               |            |            |  |      |            |            |  |      |            |            |  |   |            |            |  |   |           |         | 
|--------------------------- | -------------------------------------------------------------- | ------------- | ---------- | ---------- |  | ---- | ---------- | ---------- |  | ---- | ---------- | ---------- |  | - | ---------- | ---------- |  | - | --------- | ------- | 
|                            |                                                                |              
|                            |                                                                | September 30,
|                            |                                                                |              
|Balance sheet data:         |                                                                | 2003          |            | 2002       |  | 2001 |            | 2000       |  | 1999
|                            |                                                                |               |            |            |  |      |            |            |  |     
|Cash and cash equivalents   |                                                                | $             | 12,198,408 |            |  | $    | 8,630,547  |            |  | $    | 16,542,545 |            |  | $ | 19,699,768 |            |  | $ | 122,674   |        
|Investments in securities   |                                                                |               | 5,258,881  |            |  |      | 4,538,460  |            |  |      | 5,308,691  |            |  |   | 1,568,474  |            |  |   |          |        
|                            |                                                                |               |            |            |  |      |            |            |  |      |            |            |  |   |            |            |  |   |           |        
|                            | Total cash, cash equivalents and investments in
    securities |               | $          | 17,457,289 |  |      | $          | 13,169,007 |  |      | $          | 21,851,236 |  |   | $          | 21,268,242 |  |   | $         | 122,674 | 
|Working capital             |                                                                | $             | 10,619,216 |            |  | $    | 5,918,083  |            |  | $    | 16,027,577 |            |  | $ | 18,774,423 |            |  | $ | (956,190  | )      
|Total assets                |                                                                | $             | 29,645,257 |            |  | $    | 20,332,929 |            |  | $    | 27,053,953 |            |  | $ | 23,519,237 |            |  | $ | 1,765,215 |        
|Deferred revenues           |                                                                | $             | 22,742,641 |            |  | $    | 233,333    |            |  | $    | 125,000    |            |  | $ |           |            |  | $ |          |        
|Total liabilities           |                                                                | $             | 28,608,026 |            |  | $    | 5,752,259  |            |  | $    | 2,592,490  |            |  | $ | 1,922,929  |            |  | $ | 1,701,019 |        
|Convertible preferred stock |                                                                | $             |           |            |  | $    | 521,189    |            |  | $    | 502,903    |            |  | $ | 465,920    |            |  | $ |          |        
|Shareholders equity        |                                                                | $             | 1,037,231  |            |  | $    | 14,059,481 |            |  | $    | 23,958,560 |            |  | $ | 21,130,388 |            |  | $ | 64,196    |        

16



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|                                                                   |                   |                       |            |                |  |               |            |                    |  |   |            |            |  |   |            |            | 
|------------------------------------------------------------------ | ----------------- | --------------------- | ---------- | -------------- |  | ------------- | ---------- | ------------------ |  | - | ---------- | ---------- |  | - | ---------- | ---------- | 
|                                                                   |                   |                      
|                                                                   |                   | Fiscal Quarters Ended
|Quarterly statement of operations data                             |                   |                      
|for fiscal 2003:                                                   |                   | December 31, 2002     |            | March 31, 2003 |  | June 30, 2003 |            | September 30, 2003
|                                                                   |                   |                       |            |                |  |               |            |                   
|Revenues                                                           |                   | $                     | 819,106    |                |  | $             | 621,643    |                    |  | $ | 398,222    |            |  | $ | 599,762    |           
|Net loss                                                           |                   | $                     | (4,237,999 | )              |  | $             | (5,977,934 | )                  |  | $ | (6,029,428 | )          |  | $ | (6,990,987 | )         
|Net loss attributable to common shareholders                       |                   | $                     | (4,248,858 | )              |  | $             | (5,988,693 | )                  |  | $ | (6,035,755 | )          |  | $ | (6,990,987 | )         
|Basic net loss per share                                           |                   | $                     | (0.07      | )              |  | $             | (0.10      | )                  |  | $ | (0.10      | )          |  | $ | (0.11      | )         
|Diluted net loss per share                                         |                   | $                     | (0.07      | )              |  | $             | (0.10      | )                  |  | $ | (0.10      | )          |  | $ | (0.11      | )         
|Weighted average number of shares of common stock
    outstanding: |                   |                       |            |                |  |               |            |                    |  |   |            |            |  |   |            |           
|                                                                   | Basic and diluted |                       |            | 58,296,555     |  |               |            | 58,352,406         |  |   |            | 58,741,635 |  |   |            | 64,147,835 | 

|                                                                   |         |                       |           |                |  |               |            |                    |  |   |            |            |  |   |            |            | 
|------------------------------------------------------------------ | ------- | --------------------- | --------- | -------------- |  | ------------- | ---------- | ------------------ |  | - | ---------- | ---------- |  | - | ---------- | ---------- | 
|                                                                   |         |                      
|                                                                   |         | Fiscal Quarters Ended
|Quarterly statement of operations data                             |         |                      
|for fiscal 2002:                                                   |         | December 31, 2001     |           | March 31, 2002 |  | June 30, 2002 |            | September 30, 2002
|                                                                   |         |                       |           |                |  |               |            |                   
|Revenues                                                           |         | $                     | 6,130,215 |                |  | $             | 738,378    |                    |  | $ | 819,340    |            |  | $ | 1,165,809  |           
|Net income (loss)                                                  |         | $                     | 2,765,509 |                |  | $             | (3,699,588 | )                  |  | $ | (4,895,265 | )          |  | $ | (4,420,168 | )         
|Net income (loss) attributable to common
    shareholders          |         | $                     | 2,754,650 |                |  | $             | (3,710,347 | )                  |  | $ | (4,906,074 | )          |  | $ | (4,431,027 | )         
|Basic net income (loss) per share                                  |         | $                     | 0.05      |                |  | $             | (0.06      | )                  |  | $ | (0.08      | )          |  | $ | (0.08      | )         
|Diluted net income (loss) per share                                |         | $                     | 0.04      |                |  | $             | (0.06      | )                  |  | $ | (0.08      | )          |  | $ | (0.08      | )         
|Weighted average number of shares of common stock
    outstanding: |         |                       |           |                |  |               |            |                    |  |   |            |            |  |   |            |           
|                                                                   | Basic   |                       |           | 58,029,403     |  |               |            | 58,240,466         |  |   |            | 58,275,445 |  |   |            | 58,284,033 | 
|                                                                   | Diluted |                       |           | 61,455,499     |  |               |            | 58,240,466         |  |   |            | 58,275,445 |  |   |            | 58,284,033 | 






|        |                                                                                          
|------- | -----------------------------------------------------------------------------------------
|Item 7. | Managements Discussion and Analysis
    of Financial Condition and Results of Operations

This annual report on Form 10-K contains
forward-looking statements concerning future events and
performance of our company. You should not rely excessively on
these forward-looking statements, because they are only
predictions based on our current expectations and assumptions.
When used in this report, the words intend,
estimate, anticipate,
believe, plan and expect and
similar expressions as they relate to AVANIR are included to
identify forward-looking statements. Many factors could cause
our actual results to differ materially from those indicated in
these forward-looking statements. You should review carefully
the factors identified in this report as set forth below and
under the caption Risk Factors that Might Affect Future
Operations. We disclaim any obligation to update or
announce revisions to any forward-looking statements to reflect
actual events or developments. Except as otherwise indicted
herein, all dates referred to in this Report represent periods
or dates fixed with reference to the calendar year, rather than
our fiscal year ending September 30.

Overview

AVANIR Pharmaceuticals, based in San Diego and
incorporated in California in 1988, is engaged in research,
discovery, development and licensing of innovative drug products
for several therapeutic areas, including herpes simplex,
pseudobulbar affect (PBA), also known as emotional
lability, neuropathic pain, allergy and asthma, cholesterol
reduction, and other inflammatory diseases. Using our
proprietary XenerexTM technology, we also develop
human monoclonal antibodies for infectious diseases and other
therapeutic applications.

AVANIR successfully developed the first
over-the-counter (OTC) drug that has been approved by the United
States Food and Drug Administration (FDA) for the treatment of
cold sores. Marketed in the U.S. by GlaxoSmithKline
Consumer Healthcare, Abreva® (docosanol 10% cream) was
launched in late 2000 and has been the largest selling consumer
healthcare product in the U.S. for the treatment of cold
sores since

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introduction. From inception of the license
agreement with GlaxoSmithKline subsidiary, SB Pharmco
Puerto Rico, through September 30, 2003, AVANIR has
received over $55 million in license fees, milestone
payments and royalties on Abreva contract sales and sale of
certain interests in future royalties.


In fiscal 2003, AVANIR sold an undivided interest
in its license agreement with GlaxoSmithKline to Drug Royalty
USA for $24.1 million. AVANIR retained the right to receive
50% of all royalties under the GlaxoSmithKline license agreement
for annual sales of Abreva in excess of $62 million. AVANIR
also retained its rights to market and/or license the cold sore
product outside North America and to develop docosanol 10% cream
for other indications.

Outside the U.S., docosanol 10% cream is approved
for OTC marketing in Sweden, Canada, the Republic of Korea and
Israel. The Swedish Medical Products Agency (MPA) approved
docosanol 10% cream for marketing in November 2003. The Swedish
MPA is a reference state for the mutual recognition process for
regulatory approvals by other states in the European Union. In
addition to the GlaxoSmithKline license agreement, AVANIR has
license agreements for docosanol 10% cream in Italy, the
Republic of Korea, Israel and Egypt. The product is already
being marketed under the trade names Herepair in Korea and Abrax
in Israel.

AVANIRs drug development pipeline consists
of clinical, preclinical and earlier stage drug discovery
programs. Neurodex is in Phase III clinical development for
the treatment of PBA and should be ready for submission of a new
drug application (NDA) with the FDA in 2004. PBA affects a
diverse population of patients with neurologic disorders, such
as Alzheimers disease, multiple sclerosis (MS), Lou
Gehrigs disease (amyotrophic lateral sclerosis or ALS),
Parkinsons disease, and those with neuronal damage
following stroke and traumatic brain injury. We have
successfully completed one Phase II study of Neurodex for
the treatment of neuropathic pain. We are also engaged in a
Phase I clinical trial of AVP-13358 for the treatment of
allergy and asthma and have published interim results of single
rising dose studies. Our preclinical research and drug discovery
programs are directed primarily toward large therapeutic areas,
including cholesterol reduction and other inflammatory diseases.
We also are using our XenerexTM technology to produce
human monoclonal antibodies for anthrax, cytomegalovirus, and
other infectious diseases and selected targets for collaborative
partners.

Licensing our products and partnering with other
companies represent important sources of funds for us to achieve
cash inflows and pursue development of several potential drugs
and technology platforms. We intend to fund our current
preclinical development programs, if successful, at least until
we are able to obtain Investigational New Drug (IND) status and
begin clinical trials. Thereafter, our strategy is to seek
partners for co-development or to grant licenses to develop and
market our potential new drugs. Co-development would allow us to
share development costs and product revenues. Licensing would
provide an opportunity to receive license fees and milestone
payments as the product is developed and royalties on product
sales if a product were to be successfully launched.

Critical Accounting Policies and
Estimates

The preparation of financial statements in
accordance with accounting principles generally accepted in the
United States requires that management make a number of
assumptions and estimates that affect the reported amounts of
assets, liabilities, revenues and expenses in our consolidated
financial statements and accompanying notes. Management bases
its estimates on historical information and assumptions believed
to be reasonable. Although these estimates are based on
managements best knowledge of current events and
circumstances that may impact the Company in the future, actual
results may differ from these estimates.

Our critical accounting policies are those that
affect our financial statements materially and involve a
significant level of judgment by management. Our critical
accounting policies regarding revenue recognition are in the
following areas: milestone payments in license agreements,
royalties on licensed products, sale of rights to future
royalties, and recognition of revenues in research contracts.
Our critical accounting policies regarding expense recognition
are principally related to research contracts. Our critical
accounting policies also include the valuation of long-lived and
intangible assets.

18



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| |                                             
| | --------------------------------------------
| | Milestone Payments in License
    Agreements

We recognize revenues from license fees when the
performance requirements have been met, the fee is fixed or
determinable, and collection of fees is probable. We defer
revenues and recognize them ratably over the life of the
agreement when we have continuing obligations to perform under
the agreement.

Our largest and most significant license
agreement is with SB Pharmco Puerto Rico, Inc., a subsidiary of
GlaxoSmithKline (GlaxoSmithKline). On March 31,
2000, we transferred the rights to manufacture, use, and sell
Abreva in the United States and Canada to GlaxoSmithKline and
gave them full control, authority and responsibility over
research, development, registration including actions required
to obtain appropriate government approvals, and
commercialization of the product in those territories.
GlaxoSmithKline has achieved and paid all of the performance
milestones under the agreement. With regard to the milestones,
we have no further performance obligations. Future revenues, if
any, to be earned under the GlaxoSmithKline agreement will come
solely from royalty revenues.

We expect to enter into additional license
agreements in the future. We expect that each license agreement
will have its own set of circumstances and terms of performance.
We will consider the specific facts and circumstances of each
license agreement to determine the appropriate revenue
recognition for such items, including nonrefundable up-front
fees and milestone payments and taking into consideration when
the earnings process is complete and collection is reasonably
assured.



| |                                   
| | ----------------------------------
| | Royalties on Licensed
    Products

We recognize royalty revenues from our licensed
products based on the reported sales by our licensees and
computed in accordance with the specific terms of the license
agreements. Since the launch of Abreva in October 2000 through
September 30, 2003, substantially all of our royalties have
come from GlaxoSmithKline. We have entered into additional
license agreements that contain royalties as a source of
revenues, and we expect to enter into additional similar license
agreements with foreign-based companies.



| |                                        
| | ---------------------------------------
| | Sales of Rights to Future
    Royalties

In December 2002, we sold an undivided interest
in our license agreement with GlaxoSmithKline to Drug Royalty
USA, Inc. (Drug Royalty USA) and received a payment
of $20.5 million at closing and an additional
$3.6 million in April 2003. Because of our ongoing
involvement with GlaxoSmithKline in earning future royalty
revenues, we have recorded the amounts received from Drug
Royalty USA, net of costs of the transaction and after the
forgiveness of certain advances, as deferred revenue. (See
Note 5, Asset Sale, in the accompanying
financial statements.) The amount recorded as deferred revenue
is being recognized as revenue under the units-of-revenue
method. Under this method, the amount of deferred revenue being
recognized as revenue in each period is calculated by
multiplying (i) the ratio of the royalty payments due to
Drug Royalty USA for the period to the total remaining royalties
that we expect GlaxoSmithKline will pay Drug Royalty USA over
the term of the agreement, by (ii) the unamortized deferred
revenue amount. The portion of deferred revenue classified as
part of current liabilities represents the amount we expect to
realize as revenue within the next 12 months.



| |                                                  
| | -------------------------------------------------
| | Recognition of Revenues in Research
    Contracts

In certain circumstances, we may enter into
research contracts or collaborations having obligations to
deliver to the customer multiple products and/or services
(multiple deliverables) in exchange for fees or milestone
payments. Such contracts could include antibody generation
services agreements and other forms of research collaborations.

Antibody generation services.As of September 30, 2003, we were
engaged in work on two research collaboration agreements, both
of which have research initiation fees. In these agreements, the
customer provides us with the target antigens. We then perform
research services to develop potential antibodies for those
antigens. If we are able to estimate the period of service in
the contract in advance of beginning the work, then we recognize
such research initiation fees ratably as revenue over the
estimated period of service. If

19



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##### Table of Contents



we are unable to identify the period of service
in the contract in advance of beginning the work, we defer
research initiation fees and recognize such fees as revenue once
we have completed our efforts to create the antibodies. In the
research phases of the research collaboration agreement, we may
receive payment either to start a research phase or to complete
a research phase (including receipt by the customer of the
deliverable). We recognize revenue once the product has been
delivered, because the earning process would be complete and an
exchange has been made. Factors taken into consideration in
recognizing revenues include the following:




| |   |                                                                                                                               
| | - | ------------------------------------------------------------------------------------------------------------------------------
| |  | The performance criteria have been met;                                                                                       
|
| |  | Any undelivered products or services are not
    essential to the functionality of the delivered products or
    services; and
|
| |  | Payment for the delivered products or services is
    not contingent on delivery of the remaining products or services.       

Other research contracts.As with all our research contracts,
including the up-front initiation fee, we defer revenue
recognition until services have been rendered or products (e.g.
developed antibodies) are delivered. The milestones established
within the contract are set to approximate the effort associated
with the completion of each phase.



| |                                                  
| | -------------------------------------------------
| | Recognition of Expenses in Research
    Contracts

Pursuant to managements assessment of the
progress that has been made on clinical trials and other
research contracts, we recognize expenses related to such
contracts as the services are provided.



| |                                                  
| | -------------------------------------------------
| | Valuation of Long-Lived and Intangible
    Assets

We assess the impairment of identifiable
intangible assets and long-lived assets whenever events or
changes in circumstances indicate that the carrying value may
not be recoverable. Factors we consider important that could
trigger an impairment review include the following:



| |   |                                                                                                                             
| | - | ----------------------------------------------------------------------------------------------------------------------------
| |  | a significant underperformance relative to
    expected historical or projected future operating results;                   
|
| |  | a significant change in the manner of our use of
    the acquired asset or the strategy for our overall business;
    and/or
|
| |  | a significant negative industry or economic trend.                                                                          

When we determine that the carrying value of
intangible assets or long-lived assets are not recoverable based
upon the existence of one or more of the above indicators of
impairment, we may be required to record impairment charges for
these assets that have not been previously recorded.

Nature of Operating Expenses

AVANIRs operating expenses are influenced
substantially by the amount of spending devoted to clinical
development programs and drug discovery research. During the
past three years, we have substantially expanded our drug
development pipeline, which requires that we allocate
significant amounts of our resources to research and development
activities, which have increased substantially over the same
period. Our spending on new business development and on general
and administrative support staff tends to follow trends in our
spending for research, but to a lesser extent. Other components
of our operating costs include maintenance and operation of our
laboratory and office facilities, depreciation, professional and
consulting fees related to clinical trials and regulatory
compliance, insurance, and investor relations. We expect
spending on research and development to continue to represent
approximately 70% of our operating expenses for fiscal 2004.
Building rent amounting to approximately $1.6 million in
fiscal 2004 has scheduled rent increases of approximately 4% a
year for at least the next three years. Our business is exposed
to significant risks, as discussed in the section entitled
Risk factors that might affect future operations,
which may result in

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additional expenses, delays and lost
opportunities that could have a material adverse effect on our
results of operations and financial condition.


Effects of Inflation

We believe the impact of inflation and changing
prices on net sales revenues and on net income from continuing
operations has been immaterial during the past three years.
Prices for electricity increased in early fiscal 2001, however,
our operations do not consume a substantial amount of
electricity other than for providing lighting and air
conditioning for our offices and laboratories.

Results of Operations

Comparison of Fiscal Years 2003 and
2002



| |                             
| | ----------------------------
| | Revenues  2003 vs.
    2002

Revenues in fiscal 2003 amounted to
$2.4 million, compared to $8.9 million in fiscal 2002.
Revenues for fiscal 2003 included $1.8 million in revenues
that the Company recognized from the sale of Abreva®
royalty rights to Drug Royalty USA and $587,000 from government
research grants. Revenues for fiscal 2002 included a final
$5.0 million milestone payment relating to the one-year
anniversary of Abreva® product launch and $3.4 million
in royalty revenues on Abreva product sales. Other revenues in
fiscal 2002 included $160,000 in federal and state grant
revenues, $41,000 in sales of docosanol, and $226,000 in
research contracts and license fees from other areas.

During fiscal 2004, we expect to recognize
approximately $1.8 million in revenues from the sale
transaction to Drug Royalty USA, with a corresponding reduction
in deferred revenue. Also during the fiscal year, we expect to
earn approximately $800,000 from sales of docosanol to licensees
and $500,000 in revenues from research being performed under
government research grants. Potential revenues from license
fees, milestone payments, and royalties on foreign sales of
docosanol 10% cream will depend substantially on the timing of
approvals by foreign regulatory agencies and our ability to
enter into additional license arrangements. Potential revenues
from licensing and/or selling products in clinical and
preclinical development, including Neurodex for the treatment of
PBA and neuropathic pain and treatments for inflammatory
diseases and high cholesterol, are less predictable.



| |                             
| | ----------------------------
| | Revenue-generating Contracts

Partnering, licensing and research collaborations
have been, and will continue to be, an important part of
AVANIRs business development strategy. We intend to
partner with pharmaceutical companies that can help fund
AVANIRs research in exchange for sharing in the rights to
commercialize new drugs resulting from this research. We have
licensed and continue to seek licensees in other countries for
docosanol 10% cream and other potential products in our
development pipeline. Research collaborations also represent an
important way to achieve our development goals, while sharing in
the risks and the opportunities that come from such development
efforts.

21



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As of September 30, 2003, we had several
contracts and grants that are generating or could generate
revenues in the future to help fund our research and development
programs. Five contracts are in the form of docosanol 10% cream
license agreements, one contract is for a Neurodex license, and
two contracts are in the form of antibody research service
agreements. For the last three years, the GlaxoSmithKline
license arrangement has been our most significant revenue
source, representing approximately 95% of the Companys
cumulative revenues during the last three fiscal years. A list
of our revenue-generating contracts is set forth in the
following table.

Revenue-generating Contracts

|                                                            |  |                                                                                                                                                                                  |  |                                                                                 
|----------------------------------------------------------- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | --------------------------------------------------------------------------------
|                                                            |  |                                                                                                                                                                                  |  | Product License, Sale,                                                          
|Company or Research Grant                                   |  | Description                                                                                                                                                                      |  | Service or Research                                                             
|                                                            |  |                                                                                                                                                                                  |  |                                                                                 
|GlaxoSmithKline                                             |  | Undivided interest in the license agreement for
    Abreva® (U.S. and Canada)                                                                                                    |  | Cold sore product license                                                       
|Drug Royalty USA                                            |  | License Purchase Agreement with Drug Royalty USA
    represents an undivided interest in the Abreva license agreement
    (U.S. and Canada)                                      |  | Sale of undivided interest in Abreva license
    agreement and royalties        
|Miscellaneous docosanol licenses outside North
    America  |  |  Israel  CTS Chemical
    Industries, Ltd.
     Republic of Korea  Boryung
    Pharmaceuticals Co., Ltd.
     Egypt  BioPharm Group
     Italy  Bruno Farmaceutici S.p.A |  | Cold sore product licenses                                                      
|Medison Pharma, Ltd.                                        |  | Neurodex license (Israel)                                                                                                                                                        |  | Research and commercialization agreement related
    to PBA                     
|DNAX Research, Inc. and Peregrine Pharmaceuticals           |  | Pre-funded antibody research currently totaling
    $233,000 and one antibody license                                                                                            |  | Antibody generation services and antibody license                               
|Miscellaneous Federal and State Government grant
    awards |  | Represents five grant awards totaling
    approximately $1.5 million                                                                                                             |  | Preclinical research related to genital herpes,
    anthrax, and cytomegalovirus



| |                             
| | ----------------------------
| | Expenses  2003 vs.
    2002

Operating expenses.Our total operating expenses increased to $25.9 million in
fiscal 2003, compared to $19.5 million in fiscal 2002. The
33% increase in operating expenses was primarily caused by a 36%
increase in spending on research and development programs.
Research and development programs accounted for 72% and 70% of
total operating expenses for fiscal 2003 and 2002, respectively.
General and administrative expenses accounted for 18% and 22% of
total operating expenses for fiscal 2003 and 2002, respectively.
Sales and marketing expenses accounted for 10% and 8% of total
operating expenses for fiscal 2003 and 2002, respectively. These
and other costs are more fully described below.

Research and development (R&D)
expenses.R&D expenses totaled
$18.6 million in fiscal 2003, compared to
$13.6 million in fiscal 2002. We had four clinical trials
and studies under way throughout most of fiscal 2003, compared
to only one clinical trial in fiscal 2002. The Phase III
clinical trial and open label study of Neurodex in the treatment
of PBA accounted for $5.1 million, or 27%, of total R&D
spending. Completion of toxicology, submitting an
investigational new drug (IND) application to the FDA, and
completion of the initial dose levels in Phase I clinical
trials of our lead compound for the treatment of allergy and
asthma accounted for $4.7 million, or 25%, of total R&D
spending. An additional 11% of R&D spending was devoted to
the development of Neurodex in the treatment of neuropathic
pain, currently in Phase II clinical

22



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development. Approximately 12% of spending was
focused on research on a group of compounds targeting MIF as a
potential treatment for inflammatory diseases. In fiscal 2002,
preclinical research focused on a novel treatment for allergy
and asthma, including toxicology studies, scaled-up manufacture
of the lead compound, development of second generation
compounds, and other related contract research, accounted for
36% of total R&D spending. Also in fiscal 2002, clinical
development of Neurodex for the treatment of PBA, including a
Phase III clinical trial in patients with Lou Gehrigs
disease, accounted for 22% of R&D spending. R&D related
to the treatment of neuropathic pain and research on candidates
for regulating MIF each accounted for 10% of total R&D
spending. The balance of R&D activities in both fiscal 2003
and 2002 was primarily related to other preclinical programs
addressing cholesterol reduction and programs funded by
government research grants.


Pharmaceutical R&D programs, by their very
nature, require a substantial amount of financial and human
resources and there is no assurance that any drug candidate will
be approved for marketing by domestic and/ or foreign regulatory
agencies. The later stages of clinical development typically
require substantially greater funds for development than the
earlier stages. Thus, for many of our larger development
programs, we intend to license our technology or partner with
other pharmaceutical companies that have substantially greater
financial resources. We expect that our licensees will continue
to develop and fund those projects and pay us up-front license
fees, milestone payments, and royalties on product sales if
those products are successfully developed and approved for
marketing by the FDA and foreign regulatory agencies. We caution
that many of our development efforts could experience delays,
setbacks and failures, with no assurance that any of our
clinical research or our potential licensees or partners will
ever reach the stage of an NDA with the FDA or that any NDA will
be approved. The following table sets forth the status of, and
costs attributable to, our proprietary research and clinical
development programs.

Research and Development Projects and Other
Research Programs Expense

|                                                                                                                                                                                     |  |                    |           |                   |  |               |           |           |  |            |           |            |  |   |           |  |  |   |            |  |  |   |     |    
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ |  | ------------------ | --------- | ----------------- |  | ------------- | --------- | --------- |  | ---------- | --------- | ---------- |  | - | --------- |  |  | - | ---------- |  |  | - | --- | ---
|                                                                                                                                                                                     |  |                    |           |                   |  |               |           |          
|                                                                                                                                                                                     |  | Three Months Ended |           | Fiscal Year Ended |  | Inception     |           | Estimated
|                                                                                                                                                                                     |  | September 30,      |           | September 30,     |  | Through       |           | Cost to  
|                                                                                                                                                                                     |  |                    |           |                   |  | September 30, |           | Complete 
|                                                                                                                                                                                     |  | 2003(2)            |           | 2002(2)           |  | 2003(2)       |           | 2002(2)   |  | 2003(2)(3) |           | Project(2)
|                                                                                                                                                                                     |  |                    |           |                   |  |               |           |           |  |            |           |           
|Company-funded Projects(1):                                                                                                                                                          |  |                    |           |                   |  |               |           |           |  |            |           |            |  |   |           |  |  |   |            |  |  |   |     |    
|Develop Neurodex for FDA marketing approval in
    treating PBA. Estimated timing to complete remaining phases of
    project necessary to submit an NDA with FDA: Second Half, 2004 |  | $                  | 1,719,327 |                   |  | $             | 703,134   |           |  | $          | 5,055,929 |            |  | $ | 2,957,523 |  |  | $ | 10,455,649 |  |  | $ | 6M  |    
|Develop Neurodex for neuropathic pain. Phase II
    open-label study completed                                                                                                       |  |                    | 792,823   |                   |  |               | 173,621   |           |  |            | 2,093,097 |            |  |   | 1,323,465 |  |  |   | 4,758,072  |  |  |   |    | (4)
|Develop AVP-13358 as a treatment for allergy and
    asthma. Estimated timing to complete Phase I, bioanalytical work
    and license the product: 2005                              |  |                    | 1,223,059 |                   |  |               | 1,855,389 |           |  |            | 4,709,587 |            |  |   | 4,851,325 |  |  |   | 14,504,951 |  |  | $ | 8M  |    
|Research on regulating the target MIF as a
    potential treatment for inflammatory diseases. Estimated timing
    to complete Phase I and to license the product: 2006              |  |                    | 610,231   |                   |  |               | 278,817   |           |  |            | 2,222,095 |            |  |   | 1,300,153 |  |  |   | 5,047,534  |  |  | $ | 11M |    

23



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|                                                                                                                                                                                                                                      |       |                    |           |                   |  |               |         |           |  |            |           |            |  |  |           |            |  |  |            |            |  |   |      |     | 
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | ----- | ------------------ | --------- | ----------------- |  | ------------- | ------- | --------- |  | ---------- | --------- | ---------- |  |  | --------- | ---------- |  |  | ---------- | ---------- |  | - | ---- | --- | 
|                                                                                                                                                                                                                                      |       |                    |           |                   |  |               |         |          
|                                                                                                                                                                                                                                      |       | Three Months Ended |           | Fiscal Year Ended |  | Inception     |         | Estimated
|                                                                                                                                                                                                                                      |       | September 30,      |           | September 30,     |  | Through       |         | Cost to  
|                                                                                                                                                                                                                                      |       |                    |           |                   |  | September 30, |         | Complete 
|                                                                                                                                                                                                                                      |       | 2003(2)            |           | 2002(2)           |  | 2003(2)       |         | 2002(2)   |  | 2003(2)(3) |           | Project(2)
|                                                                                                                                                                                                                                      |       |                    |           |                   |  |               |         |           |  |            |           |           
|Government-funded Projects:                                                                                                                                                                                                           |       |                    |           |                   |  |               |         |           |  |            |           |            |  |  |           |            |  |  |            |            |  |   |      |    
|Preclinical R&D for potential treatments for
    genital herpes, CMV and anthrax, and development of a blood
    donor program for infectious diseases. Estimated timing to
    complete the various projects is up to two years      |       |                    | 202,866   |                   |  |               | 123,074 |           |  |            | 783,287   |            |  |  | 161,706   |            |  |  | 1,081,896  |            |  | $ | 0.8M | (5)
|Other Preclinical Research Projects:                                                                                                                                                                                                  |       |                    |           |                   |  |               |         |           |  |            |           |            |  |  |           |            |  |  |            |            |  |   |      |    
|Research on potential treatments for cancer,
    lowering cholesterol and treating infectious diseases. Costs and
    timing to complete preclinical R&D are unpredictable because
    of the uncertainty of outcomes of the research |       |                    | 1,013,949 |                   |  |               | 837,156 |           |  |            | 3,694,022 |            |  |  | 3,008,311 |            |  |  | 13,301,858 |            |  |   |     |    
|                                                                                                                                                                                                                                      |       |                    |           |                   |  |               |         |           |  |            |           |            |  |  |           |            |  |  |            |            |  |   |      |    
|                                                                                                                                                                                                                                      | Total |                    | $         | 5,562,255         |  |               | $       | 3,971,191 |  |            | $         | 18,558,017 |  |  | $         | 13,602,484 |  |  | $          | 49,149,960 |  |   |      |     | 
|                                                                                                                                                                                                                                      |       |                    |           |                   |  |               |         |           |  |            |           |            |  |  |           |            |  |  |            |            |  |   |      |    



---



|    |                                                                                                                                                                                                                                                                          
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | At September 30, 2003, we held the worldwide
    rights to manufacture, market and sell all of the products in
    clinical development and any of the products that might come
    from our internal R&D programs. All dates in the schedule
    refer to calendar year.
|   
|(2) | Each project includes allocation of laboratory
    occupancy costs. M refers to millions. Estimated
    costs and timing to complete the projects are subject to the
    availability of funds.                                                                        
|   
|(3) | Inception dates are on or after October 1,
    1998, at which time we began identifying and tracking costs for
    these research programs.                                                                                                                              
|   
|(4) | Clinical development, licensing and/or
    co-promotion strategies are being evaluated. See Research
    and Development Program Strategy.                                                                                                                             
|   
|(5) | State and Federal research grants totaling
    $1.5 million are for research related to genital herpes,
    anthrax, cytomegalovirus (CMV) and a blood donor program.                                                                                                    

Research and Development Program
Strategy

We are pursuing an R&D program strategy that
is intended to provide a stream of potential products in various
stages of development as well as in several therapeutic areas
and technology platforms. Our approach is not to rely on any one
therapeutic area or technology platform, but to extend our
development expertise across several therapeutic areas,
technology platforms and research targets that each could lead
to one or more products. To help conserve cash resources as we
continue these R&D programs, we intend to use our own funds
for clinical trials that are relatively small and license our
products and technologies to others when we expect the
development costs will exceed available cash resources. We are
pursuing this strategy because the costs of pursuing all of our
development programs through all clinical phases are beyond our
available cash resources. There can be no assurances that we
will be successful in licensing any of our products or
technologies. If we are unable to license one or more of our
products and technologies in a timely manner, then we may have
to slow down the rate of development of some of our early-stage
programs, which could allow competition to catch up or surpass
our programs.

Neurodex for the treatment of PBA.We are currently engaged in a
140-patient Phase III clinical trial of Neurodex for the
treatment of PBA in patients with multiple sclerosis. We are
also engaged in a 300-patient open label study for the treatment
of PBA in a broader pool of patients who could have any one of
several neurodegenerative diseases. Prior to engaging in these
studies, we had completed the initial Phase III clinical
trial of PBA in patients with ALS, in May 2002. Our goal is to
submit an NDA with the FDA in the second half of the 2004
calendar year.

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Neurodex for the treatment of neuropathic
pain.In June 2003, we announced the
completion of a four-week open-label dose escalation study of
Neurodex in patients with painful diabetic neuropathy. Results
of the non-placebo controlled Phase II study indicated that
Neurodex was well tolerated up to the highest target dose, and
patients reported decreased pain intensity that was
significantly different from baseline
(p < 0.0001). Out of 36 adult patients with
diabetic neuropathy who experience pain on a daily basis in the
lower extremities, three did not complete the study. Of those
patients not completing the study, two were due to adverse
events (one serious and not related, one serious and possibly
related) and one due to inability to comply with the protocol.
Commonly reported adverse events (reported by three or more
individuals) included nausea, constipation, diarrhea, dry mouth,
fatigue, dizziness, insomnia, headache, upper respiratory tract
infection, and somnolence. Most adverse events were either mild
or moderate in intensity, and 92% of participants completed the
study. This program remains in the Phase II stage of
clinical development, while we evaluate alternatives for
continued development of Neurodex in the treatment of
neuropathic pain, including continuing development with our own
expenditures or with the funding of a potential co-promotion
partner or potential licensee.

Neurodex R&D spending
strategy.We are currently evaluating
alternatives for commercialization of Neurodex for PBA and
neuropathic pain. Such alternatives include, among others,
developing our own sales force for certain market segments, and
co-promotion or licensing arrangements, possibly with a partner
that could contribute to the development costs of the program.
There can be no assurances as to the timing of a license or
co-promotion arrangement, if any.

Development program for allergy and asthma
(IgE regulator).In fiscal 2003, we
increased the estimated costs to complete the project by
$3.0 million and timing to complete the project by one year
to allow for additional toxicology studies and more extensive
Phase I testing that were required by the FDA. In October
2003, we announced that AVP-13358 was well tolerated at single
rising doses up to five milligrams in a randomized,
placebo-controlled Phase I clinical trial. Presence of the
drug in the bloodstream, or exposure, was demonstrated at all
four oral dose levels tested between one and five milligrams.
AVP-13358 is a novel drug molecule discovered by AVANIR
scientists that is intended to inhibit the production of IgE, a
well-known mediator of allergy and asthma. Phase 1a trials
are intended to establish safety of the drug in single rising
doses in healthy volunteers and to assess the compounds
effect on certain disease biomarkers. These trials will be
followed by Phase Ib clinical trials using rising
multi-doses in healthy patients. Assuming the successful
completion of Phase 1a clinical trials and adequate funds to
continue development without a partner, we estimate that Phase
Ib clinical trials for this compound will be completed 2004.
Assuming these results are favorable, we expect to license the
drug to a larger pharmaceutical company for further development.

Anti-inflammatory research program (MIF
inhibitor).We are currently
conducting research on several potential drug candidates capable
of inhibiting or blocking the activity of macrophage migration
inhibitory factor. Our research indicates that MIF may serve as
a potential drug target in a variety of diseases, including
rheumatoid arthritis, Crohns disease, colitis and asthma.
Assuming we are successful in finding a lead compound and
submitting an IND to the FDA, we intend to license the compound
to another pharmaceutical company for further development. Any
delays to our product development timeline or in submitting an
IND could cause a similar delay in the timing of when we expect
that we could license our MIF technology.

Government research contracts.AVANIR also is engaged in research
funded by $1.5 million in government research grants. The
government research grants are to be used for investigating the
market potential for a topical genital herpes treatment,
conducting research on various docosanol-based formulations for
genital herpes, development of antibodies to anthrax toxins and
cytomegalovirus, and development of a blood donor program
intended to find high-affinity antibodies to infectious
diseases. We expect the current government-funded research
programs will continue through fiscal year 2004.

Cholesterol
reduction We are engaged
in preclinical research focused on certain types of small
molecules that can be taken orally as a potential treatment or
means of prevention of hyper-cholesterolemia (high cholesterol).
Cholesterol is transported in the blood in large
cholesterol-rich particles called lipoproteins. Generally,
low-density lipoproteins (LDL) deliver the cholesterol to
peripheral tissues including aorta

25



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and coronary arteries, whereas high-density
lipoproteins (HDL) remove excess cholesterol from
peripheral tissues, and transport it to the liver for
elimination. We are evaluating certain compounds that may be
capable of accelerating the removal of excess cholesterol from
peripheral tissues. Because our research is at the preclinical
stage of development, we are unable to predict the cost and
timing for development of a drug.


Monoclonal antibodies
research In fiscal 2003,
we collaborated with three other companies in efforts to use our
XenerexTM technology to produce fully human
monoclonal antibodies for potential disease targets provided by
those companies. The research collaborations provided us with
advance payments to conduct the research, and the possibility
for milestone payments if any of the antibody products we
developed reached further stages of development. If a product
were eventually sold, we would receive royalties on product
sales. In December 2003 we announced that we had entered into a
license agreement with Peregrine Pharmaceuticals for one of the
antibodies that we had developed for the treatment of solid
tumor cancers. We changed our emphasis during the year to focus
more on finding antibodies for our own disease targets,
particularly infectious diseases. We successfully developed
multiple antibodies that demonstrate high potency against
anthrax toxins in vitroand in vivoand
against anthrax spores in vivo. Much of our work
targeting infectious diseases has been funded by government
research grants. Because all of our research is at a very early
preclinical stage of development and is unpredictable in terms
of the outcome, we are unable to predict the cost and timing for
development of any antibody or drug.

Other collaborative research
programs Under an
agreement signed in 2002, we provided clinical and preclinical
research information on docosanol 10% cream to Shanghai New
Asiatic Pharmaceutical Company, Ltd. for the purposes of
evaluating the regulatory approval requirements and size of the
markets for the treatment of cold sores, genital herpes and
herpes zoster (shingles) in the Peoples Republic of China.
In 2003 we terminated the collaboration with Shanghai New
Asiatic, because of the lack of progress that they had made.
Presently, we are not pursuing any further research
collaborations in the Peoples Republic of China.

General and administrative
expenses.Our general and
administrative expenses increased slightly to $4.7 million
in fiscal 2003, compared to $4.2 million in fiscal 2002.
These increased expenses primarily relate to:



| |   |                                                                                                                                                                                                                                                                            
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | a $283,000 increase in building occupancy costs,
    including utilities, maintenance and insurance resulting from
    the increase in usable office space, which amounted to
    57,625 square feet in fiscal 2003, compared to
    27,195 square feet in fiscal 2002; and
|
| |  | increased legal and consulting costs relating to
    compliance with the Sarbanes-Oxley Act of 2002 and related rules
    and regulations.                                                                                                                                 

Sales and marketing
expenses.Sales and marketing expenses
increased to $2.6 million in fiscal 2003, compared to
$1.6 million during fiscal 2002. Higher expenses in fiscal
2003 were related to market research and planning and
preparation for product launch of Neurodex for the treatment of
PBA. Fiscal 2002 expenses included legal, travel and consulting
costs related to out-licensing docosanol 10% cream in Europe and
the Middle East, establishing business relations in the
Peoples Republic of China, and additional licensing and
other commercial development activities related to marketing our
antibody generation services.



| |                                              
| | ---------------------------------------------
| | Other Income and Expenses  2003
    vs. 2002

Interest income.Interest income decreased to $266,000 in fiscal 2003, compared
to $664,000 million in fiscal 2002. The decrease in
interest income during fiscal 2003 was primarily due to lower
investment balances and lower average interest rates on
investments compared with fiscal 2002.

Other Income.Other
income for fiscal 2003, consisting of rental income, decreased
to $27,000, compared to $130,000 in fiscal 2002. Fiscal 2002
included fees earned under a contract that provided a period of
exclusivity in negotiations. AVANIR also received rental income
from Healthscan Metabolic Imaging, LLC for sharing an emergency
power generator under an equipment lease agreement.

Interest expense.Interest expense decreased to $45,000 in fiscal 2003, compared
to $61,000 in fiscal 2002. Lower interest expense for fiscal
2003 was due to lower interest rates on extended payment plans
for our

26



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##### Table of Contents



insurance policies and a reduction in the
principal amounts due under capital leases initiated in fiscal
2002. Interest expense for fiscal 2002 was primarily related to
the addition of $618,000 in new capital equipment lease
financing transactions for an emergency power generator and
various new pieces of laboratory equipment.




| |                             
| | ----------------------------
| | Net Loss  2003 vs.
    2002

For fiscal 2003, the net loss attributable to
common shareholders was $23.3 million, or $0.39 per share,
compared to $10.3 million, or $0.18 per share in fiscal
2002.

We expect to continue to pursue our drug
development strategy focused on the development of Neurodex,
followed by other programs in earlier stages of development that
are in large therapeutic areas and that have significant
partnering and licensing potential. To help fund and develop our
products, we intend to seek licensees and partners to share the
costs of development. Some of these potential license
arrangements could materially change our outlook for future
revenues and costs. However, the timing of such potential
arrangements is unpredictable. To reach the stage of partnering
or licensing our product candidates or technologies or marketing
our own products, we expect to continue to invest primarily in
our clinical development programs, which we expect will
contribute to a loss for fiscal 2004.

Comparison of Fiscal Years 2002 and
2001



| |                             
| | ----------------------------
| | Revenues  2002 vs.
    2001

Revenues in fiscal 2002 decreased to
$8.9 million, compared to $12.7 million in fiscal
2001. The $3.8 million decrease in revenues for fiscal 2002
resulted primarily from the completion of milestone payments
under the license agreement with our licensee, GlaxoSmithKline,
in October 2001. Revenues for fiscal 2002 included a final
$5.0 million milestone payment upon reaching the one-year
anniversary of Abreva® product launch and $3.4 million
in royalty revenues on Abreva product sales. Other revenues in
fiscal 2002 included $160,000 in federal and state grant
revenues, $41,000 in sales of the active ingredient docosanol,
and $226,000 in contract and license fees from other areas.
Revenues in fiscal 2001 included $10.0 million in milestone
payments and $2.5 million in royalty revenues on Abreva
product sales. Other fiscal 2001 revenues included $73,000 in
government grant revenues, and $70,000 in contract and license
fees from other areas.



| |                             
| | ----------------------------
| | Expenses  2002 vs.
    2001

Operating expenses.Our total operating expenses increased to $19.5 million in
fiscal 2002, compared to $13.3 million in fiscal 2001.
Operating expenses in fiscal 2002 were higher than fiscal 2001
by $6.2 million. The net increase in operating expenses
during fiscal 2002 is described below.

Research and development (R&D)
expenses.R&D expenses totaled
$13.6 million in fiscal 2002, compared to $8.1 million
(including $917,000 in purchased in-process R&D expenses) in
fiscal 2001. In fiscal 2002, we spent $3.0 million on clinical
development of Neurodex in the treatment of PBA, including a
Phase III clinical trial in patients who have Lou
Gehrigs disease. We also spent $1.3 million in
R&D related to the treatment of neuropathic pain. We also
spent $4.9 million in fiscal 2002 on preclinical research
focused on a novel treatment for allergy and asthma, including
toxicology studies, scaled-up manufacture of the lead compound,
development of second-generation compounds, and other contract
research. The balance of R&D activities was primarily
related to other preclinical programs addressing inflammation
and cholesterol reduction and antibody generation technology.

In fiscal 2001 we spent $2.3 million on
Neurodex, including $1.5 million related to the
Phase III clinical trial for the potential treatment of PBA
in patients with Lou Gehrigs disease and $800,000 related
to the treatment of neuropathic pain. We also spent
$1.4 million on preclinical research focused on a novel
treatment for allergy and asthma. The balance of R&D
activities was primarily related to other preclinical programs
addressing inflammation and cholesterol reduction, and antibody
generation technology.

27



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##### Table of Contents



General and administrative
expenses.Our general and
administrative expenses increased to $4.2 million in fiscal
2002, compared to $3.2 million during fiscal 2001. These
increased expenses primarily relate to:



| |   |                                                                                                                                                                                                                                 
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | increased staff size and higher administrative
    support costs for most of fiscal 2002 as the Company increased
    its level of operating activity in drug discovery, clinical
    development, and business development, and
|
| |  | increased building occupancy costs including
    utilities, maintenance and insurance.                                                                                                                                          

Sales and marketing
expenses.Sales and marketing expenses
increased to $1.6 million in fiscal 2002, compared to
$1.2 million during fiscal 2001. Fiscal 2002 expenses
included legal, travel and consulting costs related to
out-licensing docosanol 10% cream in Europe and the Middle East,
establishing business relations in the Peoples Republic of
China, and additional licensing and other commercial development
activities related to marketing our antibody generation
services. Fiscal 2001 expenses primarily reflected travel, legal
and overall business development staff costs necessary to pursue
international licensing of docosanol 10% cream.



| |                                              
| | ---------------------------------------------
| | Other Income and Expenses  2002
    vs. 2001

Interest income.Interest income decreased to $664,000 in fiscal 2002, compared
to $1.1 million in fiscal 2001. The decrease in interest
income during fiscal 2002 was primarily due to lower investment
balances and lower interest rates on investments compared with
fiscal 2001.

Other Income.Other
income for fiscal 2002 increased to $130,000, compared to $3,000
in fiscal 2001. The increase in other income during fiscal 2002
was primarily due to fees earned under a contract that provided
a period of exclusivity in negotiations. AVANIR also received
rental income from Healthscan Metabolic Imaging, LLC for sharing
an emergency power generator under an equipment lease agreement.

Interest expense.Interest expense increased to $61,000 in fiscal 2002, compared
to $7,000 in fiscal 2001. Increased interest expense for fiscal
2002 was primarily related to the addition of $618,000 in new
capital equipment lease financing transactions for an emergency
power generator and various new pieces of laboratory equipment.



| |                                      
| | -------------------------------------
| | Net Income (Loss)  2002 vs.
    2001

For fiscal 2002, the net loss attributable to
common shareholders was $10.3 million, or $0.18 per share,
compared to $190,000 in net income attributable to common
shareholders in fiscal 2001, or approximately breakeven on a per
share basis.

Liquidity and Capital Resources

As of September 30, 2003, we had cash, cash
equivalents and investments in securities totaling
$17.5 million, including cash and cash equivalents of
$12.2 million, and a net working capital balance of
$10.6 million. As of September 30, 2002, we had cash,
cash equivalents and investments in securities of
$13.2 million, including cash and cash equivalents of
$8.6 million, and a net working capital balance of
$5.9 million. Explanations of the changes in net cash
provided by or used for operating, investing and financing
activities are provided below.

|                                   |  |               |            |                 |  |               |           |  |  |   |            | 
|---------------------------------- |  | ------------- | ---------- | --------------- |  | ------------- | --------- |  |  | - | ---------- | 
|                                   |  | September 30, |            | Increase During |  | September 30,
|                                   |  | 2003          |            | Fiscal 2003     |  | 2002         
|                                   |  |               |            |                 |  |              
|Cash and cash equivalents          |  | $             | 12,198,408 |                 |  | $             | 3,567,861 |  |  | $ | 8,630,547  | 
|Cash and investments in securities |  | $             | 17,457,289 |                 |  | $             | 4,288,282 |  |  | $ | 13,169,007 | 
|Net working capital                |  | $             | 10,619,216 |                 |  | $             | 4,701,133 |  |  | $ | 5,918,083  | 

28



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##### Table of Contents



|                                                         |  |               |            |               |  |               |            |   |  |   |            |  
|-------------------------------------------------------- |  | ------------- | ---------- | ------------- |  | ------------- | ---------- | - |  | - | ---------- | -
|                                                         |  | Year Ended    |            |               |  | Year Ended   
|                                                         |  | September 30, |            | Change During |  | September 30,
|                                                         |  | 2003          |            | Fiscal 2003   |  | 2002         
|                                                         |  |               |            |               |  |              
|Net cash provided by (used for) operating
    activities |  | $             | 1,140,635  |               |  | $             | 8,069,113  |   |  | $ | (6,928,478 | )
|Net cash used for investing activities                   |  |               | (6,853,933 | )             |  |               | (5,648,196 | ) |  |   | (1,205,737 | )
|Net cash provided by financing activities                |  |               | 9,281,159  |               |  |               | 9,058,942  |   |  |   | 222,217    |  
|                                                         |  |               |            |               |  |               |            |   |  |   |            |  
|Net increase (decrease) in cash and cash
    equivalents |  | $             | 3,567,861  |               |  | $             | 11,479,859 |   |  | $ | (7,911,998 | )
|                                                         |  |               |            |               |  |               |            |   |  |   |            |  

Note 6, Commitments and
Contingencies, of the financial statements filed with this
report describes the Companys material commitments for
leasing obligations and is incorporated herein by reference. We
anticipate being able to satisfy the obligations described in
Note 6 out of cash, cash equivalents and investments in
securities held by the Company as of September 30, 2003 and
proceeds from the sale of Class A Common Stock in December
2003.

Operating
activities.Net cash provided by
operating activities in fiscal 2003 amounted to
$1.1 million, compared to net cash used for operating
activities of $6.9 million during fiscal 2002. On
December 24, 2002, we sold to Drug Royalty USA an undivided
interest in our Abreva® license agreement with
GlaxoSmithKline and received $24.1 million. The net cash
provided by operating activities in fiscal 2003 reflects the
$24.1 million in total cash received from Drug Royalty USA
(See Note 5, Asset Sale in the accompanying
notes to the financial statements) and a royalty payment of
$876,000 from GlaxoSmithKline that contributed substantially to
the $827,000 reduction in receivables, partially offset by the
$23.2 million net loss for the fiscal year and an $846,000
increase in prepaid expenses and other assets. Operating
activities increased substantially in fiscal 2003, as we were
engaged in four clinical trials and studies, compared with only
one in the prior year. Prepaid expenses and other assets
increased by $846,000 during the year, reflecting a number of
payments that were made up-front on signing several
contracts to engage in clinical trials and other services. Net
cash used for operating activities for fiscal 2002 is
attributable primarily to a $10.2 million net loss,
partially offset by a $2.0 million increase in accounts
payable, a $979,000 increase in accrued expenses and $603,000 in
depreciation and amortization.

Investing
activities.Net cash used for
investing activities during the fiscal 2003 amounted to
$6.9 million, including capital expenditures related to
purchases of capital equipment and leasehold improvements
totaling $5.5 million, patent costs of $616,000, and
investments in securities totaling $3.7 million, partially
offset by sales and maturities of investments totaling
$3.0 million. The leasehold improvements were related to
completion of construction of laboratory and office space at our
three leased buildings in San Diego. Net cash used for investing
activities during fiscal 2002 amounted to $1.2 million,
including $9.0 million in investments in securities,
$1.4 million in purchases of property and equipment and
$538,000 in patent costs, partially offset by $9.7 million
in proceeds from sales and maturities of investments in
securities.

In May 2003, we completed construction on
approximately 30,400 square feet of existing leased
laboratory and office space, located at 11404 and 11408 Sorrento
Valley Road, San Diego, California. The facilities at 11404 and
11408 Sorrento Valley Road are subject to a lease between the
Company and Sorrento Plaza, a California limited partnership,
effective May 20, 2002. Leasehold improvements to the
Sorrento Plaza facilities were necessary before we could take
occupancy. The Company also made leasehold improvements to
laboratory and office space at 11388 Sorrento Valley Road
to accommodate the relocation of several departments. The
expenditures at all three facilities are intended to accommodate
current as well as potential future expanded business
operations. (See Note 3, Balance Sheet
Details  Property and Equipment.) As of
December 11, 2003, the Company had 57,582 square feet
of usable laboratory and office space and 63 employees,
with the capacity to accommodate up to 100 employees.

Financing
activities.Net cash provided by
financing activities amounted to $9.3 million during fiscal
2003, compared to $222,000 in cash provided by financing
activities for the same period a year ago. Financing activities
in fiscal 2003 included $9.4 million in net proceeds from a
private placement in common stock, after taking into effect
$644,000 in costs related to the transaction. (See Note 7,
Shareholders Equity.) Financing activities
during fiscal 2002 reflected $261,000 in proceeds from issuances
of common stock and

29



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##### Table of Contents



$287,000 from issuances of notes payable, offset
by payments of $301,000 related primarily to short-term
financing of insurance premiums and $25,000 in payments of
dividends on preferred stock.


We believe that cash, cash equivalents, short and
long-term investments in securities and restricted investments
totaling $17.5 million as of September 30, 2003,
together with the sale of Class A Common Stock that raised
an additional $8.0 million in December 2003 before the
costs of the financing (See Note 7,
Shareholders Equity  Common Stock),
plus anticipated future payments and revenues, should be
sufficient to sustain our planned level of operations for at
least the next twelve months. Additionally, to continue to
enhance our capital base and liquidity and to continue to fund
the development of our drug candidates and technology platforms,
we expect to continue to pursue various alternatives for raising
additional funds during the next twelve months, including
partnering arrangements, issuance of debt or equity securities,
and licensing or sales of any of our platform technologies or
new drug candidates.

Recent Accounting Pronouncements

See Note 2, Summary of Significant
Accounting Policies  Recent Accounting
Pronouncements in the accompanying financial statements
for a discussion of recent accounting pronouncements and their
effect, if any, on the Company.






|         |                                                               
|-------- | --------------------------------------------------------------
|Item 7A. | Quantitative and Qualitative Disclosures
    About Market Risk

As described below, we are exposed to market risk
related to changes in interest rates. Because substantially all
our revenue, expenses, and capital purchasing activities are
transacted in U.S. dollars, our exposure to foreign currency
exchange rates is immaterial. However, in the future we could
face increasing exposure to foreign currency exchange rates as
we expand international distribution of docosanol 10% cream and
purchase additional services from outside the U.S. Until such
time as we are faced with material amounts of foreign currency
exchange rate risks, we do not plan to use derivative financial
instruments, which can be used to hedge such risks. We will
evaluate the use of derivative financial instruments to hedge
our exposures as the needs and risks should arise.

Interest Rate Sensitivity

Our investment portfolio consists primarily of
fixed income instruments with an average duration of
2.0 years as of September 30, 2003 (2.3 years as
of September 30, 2002). The primary objective of our
investments in debt securities is to preserve principal while
achieving attractive yields, without significantly increasing
risk. We classify our investments as of September 30, 2003
as available-for-sale. These available-for-sale securities are
subject to interest rate risk. In general, we would expect that
the volatility of this portfolio would decrease as its duration
decreases.






|        |                                                
|------- | -----------------------------------------------
|Item 8. | Financial Statements and Supplementary
    Data

Our financial statements are annexed to this
report beginning on page F-1.






|        |                                                                                         
|------- | ----------------------------------------------------------------------------------------
|Item 9. | Changes in and Disagreements with
    Accountants on Accounting and Financial Disclosure

Not applicable.






|         |                        
|-------- | -----------------------
|Item 9A. | Controls and Procedures

The Companys Chief Executive Officer and
Chief Financial Officer carried out an evaluation of the
effectiveness of the Companys disclosure controls
and procedures (as defined in the Securities Exchange Act
of 1934 Rules 13a-15(e) and 15(d)-15(e)), as of the end of
the period covered by this report. Based on that evaluation,
these officers have concluded that the Companys disclosure
controls and procedures were adequate and designed to ensure
that material information relating to the Company and the
Companys consolidated subsidiary would be made known to
them by others within those entities.

30



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##### Table of Contents






PART III






|         |                                     
|-------- | ------------------------------------
|Item 10. | Directors and Executive
    Officers

The information relating to our directors that
are required by this item is incorporated by reference from the
information under the caption Election of Directors
contained in our definitive proxy statement (the Proxy
Statement), which will be filed with the Securities and
Exchange Commission in connection our Annual Meeting of
Shareholders to be held on March 18, 2004.

Executive Officers of the Registrant

The names of our executive officers and their
ages as of December 11, 2003 are set forth below. The
officers are elected annually by the Board of Directors and hold
office until their respective successors are qualified and
appointed or until their resignation, removal or
disqualification.

|                          |  |     |    |          |  |                                                                   
|------------------------- |  | --- | -- | -------- |  | ------------------------------------------------------------------
|Name                      |  | Age |    | Position
|                          |  |     |    |         
|Gerald J. Yakatan, Ph.D.  |  |     | 61 |          |  | President and Chief Executive Officer                             
|James E. Berg             |  |     | 52 |          |  | Vice President, Clinical and Regulatory Affairs                   
|R. Martin Emanuele, Ph.D. |  |     | 49 |          |  | Vice President, Licensing and Business Development                
|Gus Fernandez, Pharm.D.   |  |     | 46 |          |  | Vice President, Commercial Development                            
|Gregory P. Hanson, CMA    |  |     | 57 |          |  | Vice President, Finance; Chief Financial Officer
    and Secretary
|J. David Hansen           |  |     | 52 |          |  | Senior Vice President, Corporate Development                      
|Jagadish C. Sircar, Ph.D. |  |     | 68 |          |  | Vice President, Drug Discovery                                    
|Victoria Smith            |  |     | 55 |          |  | Vice President, Administration                                    

Gerald J. Yakatan,
Ph.D.Dr. Yakatan has served as
President and Chief Executive Officer since March 1998 and as
Vice President of Drug Development from July 1995 to February
1998. He also has served as a director of the Company since
February 1998. Dr. Yakatan has extensive executive
management experience in the pharmaceutical industry. In 1996,
he founded IriSys Research & Development, LLC, a privately
held company (IriSys) where he served as President
and Chief Executive Officer until joining AVANIR. He still
serves as Chairman of IriSys. Dr. Yakatan also founded
Tanabe Research Laboratories, USA, Inc., in 1990 and served as
President and Chief Executive Officer until 1995. Earlier in his
career, Dr. Yakatan held various executive positions over a
seven-year period at Warner-Lambert Co./ Parke-Davis, including
Vice President of worldwide product development, and as a member
of the Parke-Davis pharmaceutical research management team and
the Executive Committee where he had significant exposure to all
stages of R&D and the sales and marketing processes. Prior
to joining Warner-Lambert/ Parke-Davis, Dr. Yakatan was a
tenured faculty member of the University of Texas at the Austin
College of Pharmacy where he was Chair of the Department of
Pharmaceutics and Assistant Director of the Drug Dynamics
Institute. He is a Fellow of the American Association of
Pharmaceutical Scientists and the American College of Clinical
Pharmacology. Dr. Yakatan received his B.S. in Pharmacy in
1963 and M.S. in Pharmaceutical Chemistry in 1965 from Temple
University. In 1971, Dr. Yakatan received his Ph.D. in
Pharmaceutical Sciences from the University of Florida.

James E. Berg.Mr. Berg has served as Vice
President, Clinical and Regulatory Affairs, since March 1997.
Mr. Berg led the team responsible for the clinical trials
program for docosanol 10% cream and had the responsibility for
working with the FDA and other regulatory agencies that led to
the approvals of the product in the U.S., Canada and Sweden.
From August 1992 to March 1997, Mr. Berg was Director of
Clinical Affairs and Product Development at the Company. Earlier
in his career, Mr. Berg held various sales and management
positions at QUIDEL Corporation, San Diego, California, and at
Krupp Bilstein Corporation of America, Inc., San Diego,
California. Mr. Berg received his B.A. degree from the
University of Wisconsin in 1973.

31



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##### Table of Contents



R. Martin Emanuele, Ph.D.Dr. Emanuele has served as Vice
President, Licensing and Business Development, since August
2002. Dr. Emanuel is responsible for AVANIRs
partnering, licensing and related business development
activities. From May 1988 to July 2002, Dr. Emanuele was
employed by CytRx Corporation, where he held a number of R&D
and business development positions and attained the position of
Vice President of Research and Business Development. Prior to
CytRx, Dr. Emanuele was a clinical research scientist with
Dupont Critical Care. Dr. Emanuele holds a B.S. from
Colorado State University, an M.S. from Northern Illinois
University, and a Ph.D. in Pharmacology & Experimental
Therapeutics from Loyola University of Chicago.

Gus Fernandez, Pharm.D.Dr. Fernandez has served as Vice
President, Commercial Development since March 2003. In this
capacity, Dr. Fernandez is responsible for the commercial
development activities for the Companys pipeline of
products, which includes comprehensive pre-launch planning
activities for Neurodex. From March 2002 to March 2003, he was
Executive Director, Commercial Development where he was
responsible for business development and licensing activities
and from November 2002 to February 2002, he was Director,
Commercial Development, where he worked in the same capacity.
Prior to joining the Company, Dr. Fernandez held several
senior management level positions at Dura Pharmaceuticals, San
Diego, California, including Senior Manager, Medical Affairs,
Director of Product Management, Regional Director of Sales and
Director, Sales Operations. Prior to joining Dura
Pharmaceuticals, he held a number of sales and marketing
positions at Eli Lilly and Company, Indianapolis, Indiana.
Dr. Fernandez graduated from the University of the Pacific
with a Pharm.D. in pharmacy, where he graduated cum laude. He
also has an M.B.A. degree from Webster University, San Diego,
California.

Gregory P. Hanson,
CMA.Mr. Hanson has served as
Vice President, Finance and Chief Financial Officer
(CFO) and Corporate Secretary since July 1998. Mr. Hanson
also serves as the Corporate Compliance Officer. From September
1995 to July 1998, he was the Chief Financial Officer of XXsys
Technologies Inc., a composite materials technology company; and
from May 1993 to September 1995, he held a number of financial
positions within The Titan Corporation, a diversified
telecommunications and information technology company, including
acting CFO and acting Controller for its subsidiary, Titan
Information Systems. Earlier in his career, Mr. Hanson held
various management positions at Ford Motor Company over a
14-year span and at Solar Turbines Incorporated, a subsidiary of
Caterpillar Inc., over a three-year span. Mr. Hanson has a
B.S. degree in Mechanical Engineering from Kansas State
University and an M.B.A. degree with honors from the University
of Michigan. He is a Certified Management Accountant and has
passed the examination for Certified Public Accountants.

J. David
Hansen.Mr. Hansen has served as
Senior Vice President, Corporate Development, responsible for
business development, licensing and product commercialization
since March 2003. Mr. Hansen joined the Company in
September 1998 as Vice President of Sales and Marketing. In
addition, he became President of the Companys subsidiary,
Xenerex Biosciences, in March 2001. Prior to joining the
Company, Mr. Hansen held various management positions at
Dura Pharmaceuticals, San Diego, California, from December 1989
to September 1998, including Senior Director, Strategic Sales
Systems; National Sales Director, Director of Business
Development and Director of Marketing. Earlier in his career, he
held various management positions at Immunetech Pharmaceuticals,
San Diego, California; Schering/ Key Pharmaceuticals,
Kennilworth, New Jersey; and E.R. Squibb & Sons,
Princeton, New York. Mr. Hansen graduated with honors from
the University of Oregon, with a B.S. degree in Chemistry in
June 1974.

Jagadish Sircar, Ph.D.Dr. Sircar has served as our Vice
President, Drug Discovery since November 2002. From November
1995 to March 2000, he held the position of Director of
Chemistry at AVANIR and from April 2000 to November 2002 he was
Executive Director, Drug Discovery of the Company. Before
joining the Company, Dr. Sircar held the position of Senior
Vice President, Research and Discovery for Biofor, Inc. from
January 1992 to November 1995. From 1969 to 1991,
Dr. Sircar was employed by Warner-Lambert/ Parke-Davis in
its Research Division (currently Pfizer), where he attained the
position of Associate Research Fellow and Chairman of the
Immunoinflammatory Project Team. During his tenure at
Warner-Lambert/ Parke-Davis, he was responsible for the
discovery and preclinical development of six compounds.
Dr. Sircar holds a Ph.D. in Organic Chemistry, an M.S. in
Pure Chemistry and a B.S. (Honors) in Chemistry,

32



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##### Table of Contents



all from the University of Calcutta, Calcutta,
India. Dr. Sircar has a total of 154 patents,
presentations and publications that are credited to him.


Victoria Smith.Ms. Smith has served as Vice
President, Administration since March 2003. From March 2001 to
March 2003, she held the position of Executive Director,
Administration and from June 1998 to March 2001 she held the
position of Director, Administrative Affairs. Prior to joining
the Company, Ms. Smith held various management positions
for Tanabe Research Laboratories, USA, Inc., San Diego,
California, from 1990 to 1996, including Director,
Administrative Affairs; Manager, R&D, Administration, and
Human Resources. In June 1995 she completed the Leadership
Education Awareness Development (LEAD) program in San
Diego, California. Ms. Smith graduated from San Diego State
University with a B.A. degree in Speech Communication in 1982
and from the University of Phoenix with a M.A. degree in
Organizational Management in August 1992.






|         |                       
|-------- | ----------------------
|Item 11. | Executive Compensation

The information required by this item is
incorporated by reference to the information under the caption
Executive Compensation contained in the Proxy
Statement.






|         |                                                                   
|-------- | ------------------------------------------------------------------
|Item 12. | Security Ownership of Certain Beneficial
    Owners and Management

The information required by this item is
incorporated by reference to the information under the caption
Security Ownership of Certain Beneficial Owners and
Management contained in the Proxy Statement.






|         |                                                   
|-------- | --------------------------------------------------
|Item 13. | Certain Relationships and Related
    Transactions

The information required by this item is
incorporated by reference to the information under the caption
Certain Relationships and Related Transactions
contained in the proxy statement.






|         |                                           
|-------- | ------------------------------------------
|Item 14. | Principal Accountant Fees and
    Services

The information required by this item is
incorporated by reference to the information under the caption
Fees for Independent Auditors contained in the proxy
statement.




PART IV






|         |                                                                         
|-------- | ------------------------------------------------------------------------
|Item 15. | Exhibits, Financial Statements and
    Schedules and Reports on Form 8-K

(a) Financial Statements and Schedules



| |                                                                        
| | -----------------------------------------------------------------------
| | (1) Index to consolidated financial
    statements appears on page F-1.

(b) Current Reports on Form 8-K

On July 25, 2003, AVANIR filed a current
report on Form 8-K under Items 5 and 7 regarding the
closing of a private placement of the registrants
Class A common stock.

On August 12, 2003, AVANIR filed a current
report on Form 8-K under Items 7 and 12 furnishing a
press release announcing the registrants results of
operations for the three and nine months ended June 30,
2003.

(c) Exhibits

| |     |  |  |                                                                                                             
| | --- |  |  | ------------------------------------------------------------------------------------------------------------
| | 3.1 |  |  | Restated Articles of Incorporation of the
    Registrant, dated April 4, 1994(1)                            
| | 3.2 |  |  | Certificate of Amendment of the Articles of
    Incorporation of the Registrant, dated November 20, 1998(10)
| | 3.3 |  |  | Certificate of Amendment of the Articles of
    Incorporation of the Registrant, dated February 19, 1999(10)
| | 3.4 |  |  | Amended and Restated Bylaws of the Registrant(10)                                                           

33



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##### Table of Contents



| |       |  |  |                                                                                                                                                                                             
| | ----- |  |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | 4.1   |  |  | Forms of Class A and Class B Common
    Stock Certificates(2)                                                                                                                               
| | 4.2   |  |  | Class G Stock Purchase Warrant                                                                                                                                                              
| | 4.3   |  |  | Certificate of Determination with respect to
    Series C Junior Participating Preferred Stock of the
    Registrant(3)                                                                     
| | 4.4   |  |  | Rights Agreement, dated as of March 5, 1999,
    with American Stock Transfer & Trust Company(3)                                                                                            
| | 4.5   |  |  | Form of Rights Certificate with respect to the
    Rights Agreement, dated as of March 5, 1999(3)                                                                                           
| | 4.6   |  |  | Form of Class J Stock Purchase Warrant
    issued in connection with Series D redeemable convertible
    preferred stock(4)                                                                 
| | 4.7   |  |  | Class K Stock Purchase Warrant, dated as of
    April 1, 1999, issued to Redington, Inc.(5)                                                                                                 
| | 4.8   |  |  | Amendment No. 1 to Rights Agreement, dated
    November 30, 1999, with American Stock Transfer & Trust
    Company(6)                                                                       
| | 4.9   |  |  | Registration Rights Agreement, dated
    January 25, 2000, by and among (i) AVANIR
    Pharmaceuticals and (ii) Bayview LLC, The Endeavour Capital
    Fund, S.A. and Roseworth Group LTD(7)
| | 4.10  |  |  | Form of Class N Stock Purchase Warrant,
    issued in connection with Common Stock Purchase Agreement dated
    January 25, 2000(7)                                                         
| | 4.11  |  |  | Securities Purchase Agreement by and among AVANIR
    Pharmaceuticals and a group of investors dated July 21,
    2003.(13)                                                                 
| | 4.12  |  |  | Form of Class A Stock Purchase Warrant,
    issued in connection with the Securities Purchase Agreement
    dated July 21, 2003(13)                                                         
| | 4.13  |  |  | Securities Purchase Agreement by and among AVANIR
    Pharmaceuticals and a group of investors dated November 25,
    2003(14)                                                              
| | 4.14  |  |  | Form of Class A Stock Purchase Warrant,
    issued in connection with the Securities Purchase Agreement
    dated November 25, 2003(14)                                                     
| | 10.1  |  |  | Amended and Restated 1998 Stock Option Plan(10)                                                                                                                                             
| | 10.2  |  |  | Amended and Restated 1994 Stock Option Plan(10)                                                                                                                                             
| | 10.3  |  |  | Employment Agreement with Gerald J. Yakatan,
    dated November 29, 2001(10)                                                                                                                
| | 10.4  |  |  | Form of Indemnification Agreement with certain
    Directors and Executive Officers of the Registrant                                                                                       
| | 10.5  |  |  | License Agreement, dated March 31, 2000, by
    and between AVANIR Pharmaceuticals and SB Pharmco Puerto
    Rico, a Puerto Rico Corporation(8)                                             
| | 10.6  |  |  | Standard Industrial Net Lease by and between
    AVANIR Pharmaceuticals and BC Sorrento, LLC, effective
    September 1, 2000(9)                                                            
| | 10.7  |  |  | License Agreement, dated August 1, 2000, by
    and between AVANIR Pharmaceuticals (Licensee) and
    Irisys Research and Development, LLC, a California limited
    liability company(9) 
| | 10.8  |  |  | Standard Industrial Net Lease by and between
    AVANIR Pharmaceuticals (Tenant) and Sorrento Plaza,
    a California limited partnership (Landlord),
    effective May 20, 2002(11)    
| | 10.9  |  |  | Amended and Restated 2000 Stock Option Plan(12)                                                                                                                                             
| | 10.10 |  |  | Form of Restricted Stock Grant Notice for use
    with Amended and Restated 2000 Stock Option Plan(12)                                                                                      
| | 10.11 |  |  | 2003 Equity Incentive Plan(12)                                                                                                                                                              
| | 10.12 |  |  | Form of Non-qualified Stock Option Award Notice
    for use with 2003 Equity Incentive Plan(12)                                                                                             
| | 10.13 |  |  | Form of Restricted Stock Grant for use with 2003
    Equity Incentive Plan(12)                                                                                                              
| | 10.14 |  |  | Form of Restricted Stock Grant Notice (cash
    consideration) for use with 2003 Equity Incentive Plan(12)                                                                                  
| | 21.1  |  |  | List of Subsidiaries                                                                                                                                                                        

34



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##### Table of Contents



|     |  |                                                                            
|---- |  | ---------------------------------------------------------------------------
|23.1 |  | Independent Auditors Consent                                              
|31.1 |  | Certification pursuant to Section 302 of
    Sarbanes-Oxley Act of 2002    
|31.2 |  | Certification pursuant to Section 302 of
    Sarbanes-Oxley Act of 2002    
|32.1 |  | Certification pursuant to Section 906 of the
    Sarbanes-Oxley Act of 2002
|32.2 |  | Certification pursuant to Section 906 of the
    Sarbanes-Oxley Act of 2002



---



| |     |                                                                                                                                                                                                                                                  
| | --- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | (1) | Incorporated by reference to the similarly
    described exhibit included with the Registrants Amendment
    No. 4 to the Registration Statement on Form S-1, File
    No. 33-32742, declared effective by the Commission on
    April 13, 1994.
|
| | (2) | Incorporated by reference to the similarly
    described exhibit included with the Registrants
    Registration Statement on Form S-1, File No. 33-32742,
    declared effective by the Commission on May 8, 1990.                              
|
| | (3) | Incorporated by reference to the similarly
    described exhibit included with the Registrants Current
    Report on Form 8-K, filed March 11, 1999.                                                                                            
|
| | (4) | Incorporated by reference to the similarly
    described exhibit included with the Registrants Current
    Report on Form 8-K, filed April 1, 1999.                                                                                             
|
| | (5) | Incorporated by reference to the similarly
    described exhibit included with the Registrants Current
    Report on Form 8-K, filed April 20, 1999.                                                                                            
|
| | (6) | Incorporated by reference to the similarly
    described exhibit included with the Registrants Current
    Report on Form 8-K, filed December 3, 1999.                                                                                          
|
| | (7) | Incorporated by reference to the similarly
    described exhibit included with the Registrants Current
    Report on Form 8-K, filed February 4, 2000.                                                                                          
|
| | (8) | Incorporated by reference to the similarly
    described exhibit included with the Registrants Current
    Report on Form 8-K, filed May 4, 2000.                                                                                               
|
| | (9) | Incorporated by reference to the similarly
    described exhibit included with the Registrants Quarterly
    Report on Form 10-Q, filed August 14, 2000.                                                                                        



|     |                                                                                                                                                                                                                
|---- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(10) | Incorporated by reference to the similarly
    described exhibit included with the Registrants Annual
    Report on Form 10-K, filed December 21, 2001.                                                       
|    
|(11) | Incorporated by reference to the similarly
    described exhibit included with the Registrants Quarterly
    Report on Form 10-Q, filed August 13, 2002.                                                      
|    
|(12) | Incorporated by reference to the similarly
    described exhibit included with the Registrants Quarterly
    Report on Form 10-Q, filed May 13, 2003.                                                         
|    
|(13) | Incorporated by reference to the similarly
    described exhibit included with the Registrants
    Registration on From S-3, File No. 333-107820, declared
    effective by the Commission on August 19, 2003.
|    
|(14) | Incorporated by reference to the similarly
    described exhibit included with the Registrants Current
    Report on Form 8-K, filed December 11, 2003.                                                       

35



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##### Table of Contents






SIGNATURES

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



| |                       
| | ----------------------
| | AVANIR PHARMACEUTICALS



| |     |                             
| | --- | ----------------------------
| | By: | /s/ GERALD J. YAKATAN, PH.D.

| |                                          
| | -----------------------------------------
| |                                          
| | Gerald J. Yakatan, Ph.D.                 
| | President and Chief Executive
    Officer

Date: December 22, 2003

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

|                                                     |  |                                                                                                   |  |                   |  | 
|---------------------------------------------------- |  | ------------------------------------------------------------------------------------------------- |  | ----------------- |  | 
|                                                     |  |                                                                                                   |  |                  
|Signature                                            |  | Title                                                                                             |  | Date             
|                                                     |  |                                                                                                   |  |                  
|                                                    
|/s/ GERALD J. YAKATAN, PH.D.Gerald J. Yakatan, Ph.D. |  | President and Chief Executive Officer (Principal
    Executive Officer)                           |  | December 22, 2003
|                                                    
|/s/ GREGORY P. HANSON, CMAGregory P. Hanson, CMA     |  | Vice President, Finance, Chief Financial Officer
    (Principal Financial and Accounting Officer) |  | December 22, 2003
|                                                    
|/s/ JAMES B. GLAVINJames B. Glavin                   |  | Chairman of the Board                                                                             |  | December 22, 2003
|                                                    
|/s/ STEPHEN G. AUSTIN, CPAStephen G. Austin, CPA     |  | Director                                                                                          |  | December 22, 2003
|                                                    
|/s/ DENNIS J. CARLO, PH.D.Dennis J. Carlo, Ph.D.     |  | Director                                                                                          |  | December 22, 2003
|                                                    
|/s/ MICHAEL W. GEORGEMichael W. George               |  | Director                                                                                          |  | December 22, 2003
|                                                    
|/s/ SUSAN GOLDINGSusan Golding                       |  | Director                                                                                          |  | December 22, 2003
|                                                    
|/s/ CHARLES A. MATHEWSCharles A. Mathews             |  | Director                                                                                          |  | December 22, 2003
|                                                    
|/s/ HAROLD F. OBERKFELLHarold F. Oberkfell           |  | Director                                                                                          |  | December 22, 2003
|                                                    
|/s/ KENNETH E. OLSONKenneth E. Olson                 |  | Director                                                                                          |  | December 22, 2003

36



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##### Table of Contents



AVANIR PHARMACEUTICALS

INDEX TO CONSOLIDATED FINANCIAL
STATEMENTS

|                                                    |  |      |     | 
|--------------------------------------------------- |  | ---- | --- | 
|                                                    |  | Page
|                                                    |  |     
|INDEPENDENT AUDITORS REPORT                        |  |      | F-2 | 
|CONSOLIDATED FINANCIAL STATEMENTS                   |  |      |     | 
|Consolidated Balance Sheets                         |  |      | F-3 | 
|Consolidated Statements of Operations               |  |      | F-4 | 
|Consolidated Statements of Shareholders
    Equity |  |      | F-5 | 
|Consolidated Statements of Cash Flows               |  |      | F-6 | 
|Notes to Consolidated Financial Statements          |  |      | F-7 | 

F-1



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##### Table of Contents



INDEPENDENT AUDITORS REPORT

To the Board of Directors and Shareholders of

AVANIR Pharmaceuticals:


We have audited the accompanying consolidated
balance sheets of AVANIR Pharmaceuticals and subsidiary as of
September 30, 2003 and 2002, and the related consolidated
statements of operations, shareholders equity and cash
flows for each of the three years in the period ended
September 30, 2003. These financial statements are the
responsibility of the Companys management. Our
responsibility is to express an opinion on these financial
statements based on our audits.

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

In our opinion, such consolidated financial
statements present fairly, in all material respects, the
financial position of AVANIR Pharmaceuticals and subsidiary as
of September 30, 2003 and 2002, and the results of their
operations and their cash flows for each of the three years in
the period ended September 30, 2003, in conformity with
accounting principles generally accepted in the United States of
America.

DELOITTE & TOUCHE LLP

San Diego, California

December 19, 2003


F-2



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##### Table of Contents






AVANIR PHARMACEUTICALS

CONSOLIDATED BALANCE SHEETS

|                                                |                                                                                                                                                 |                                                                                                                                                         |                            |            |             |           |           |           |             |            | 
|----------------------------------------------- | ----------------------------------------------------------------------------------------------------------------------------------------------- | ------------------------------------------------------------------------------------------------------------------------------------------------------- | -------------------------- | ---------- | ----------- | --------- | --------- | --------- | ----------- | ---------- | 
|                                                |                                                                                                                                                 |                                                                                                                                                        
|                                                |                                                                                                                                                 | September 30,                                                                                                                                          
|                                                |                                                                                                                                                 |                                                                                                                                                        
|                                                |                                                                                                                                                 | 2003                                                                                                                                                    |                            | 2002      
|                                                |                                                                                                                                                 |                                                                                                                                                         |                            |           
|ASSETS                                         
|Current assets:                                 |                                                                                                                                                 |                                                                                                                                                         |                            |            |             |           |           |          
|                                                | Cash and cash equivalents                                                                                                                       |                                                                                                                                                         | $                          | 12,198,408 |             |           | $         | 8,630,547 |            
|                                                | Short-term investments in securities                                                                                                            |                                                                                                                                                         |                            | 3,888,798  |             |           |           | 695,840   |            
|                                                | Receivables                                                                                                                                     |                                                                                                                                                         |                            | 271,681    |             |           |           | 1,098,954 |            
|                                                | Inventory                                                                                                                                       |                                                                                                                                                         |                            | 210,854    |             |           |           | 238,126   |            
|                                                | Prepaid expenses                                                                                                                                |                                                                                                                                                         |                            | 1,564,315  |             |           |           | 683,111   |            
|                                                |                                                                                                                                                 |                                                                                                                                                         |                            |            |             |           |           |          
|                                                |                                                                                                                                                 | Total current assets                                                                                                                                    |                            |            | 18,134,056  |           |           |           | 11,346,578  |           
|Investments in securities                       |                                                                                                                                                 |                                                                                                                                                         | 513,486                    |            |             |           | 2,986,023 |          
|Restricted investments in securities            |                                                                                                                                                 |                                                                                                                                                         | 856,597                    |            |             |           | 856,597   |          
|Property and equipment, net                     |                                                                                                                                                 |                                                                                                                                                         | 7,742,005                  |            |             |           | 3,180,966 |          
|Intangible assets, net                          |                                                                                                                                                 |                                                                                                                                                         | 2,131,209                  |            |             |           | 1,659,418 |          
|Other assets                                    |                                                                                                                                                 |                                                                                                                                                         | 267,904                    |            |             |           | 303,347   |          
|                                                |                                                                                                                                                 |                                                                                                                                                         |                            |            |             |           |           |          
|                                                |                                                                                                                                                 | TOTAL ASSETS                                                                                                                                            |                            | $          | 29,645,257  |           |           | $         | 20,332,929  |           
|                                                |                                                                                                                                                 |                                                                                                                                                         |                            |            |             |           |           |          
|LIABILITIES AND SHAREHOLDERS
    EQUITY       
|Current liabilities:                            |                                                                                                                                                 |                                                                                                                                                         |                            |            |             |           |           |          
|                                                | Accounts payable                                                                                                                                |                                                                                                                                                         | $                          | 2,853,604  |             |           | $         | 2,705,606 |            
|                                                | Accrued expenses and other liabilities                                                                                                          |                                                                                                                                                         |                            | 1,806,058  |             |           |           | 1,598,625 |            
|                                                | Accrued compensation and payroll taxes                                                                                                          |                                                                                                                                                         |                            | 626,154    |             |           |           | 462,118   |            
|                                                | Loan payable                                                                                                                                    |                                                                                                                                                         |                            | 244,805    |             |           |           | 299,980   |            
|                                                | Current portion of deferred revenue                                                                                                             |                                                                                                                                                         |                            | 1,841,865  |             |           |           | 233,333   |            
|                                                | Current portion of capital lease obligations                                                                                                    |                                                                                                                                                         |                            | 142,354    |             |           |           | 128,833   |            
|                                                |                                                                                                                                                 |                                                                                                                                                         |                            |            |             |           |           |          
|                                                |                                                                                                                                                 | Total current liabilities                                                                                                                               |                            |            | 7,514,840   |           |           |           | 5,428,495   |           
|                                                | Deferred revenue, net of current portion                                                                                                        |                                                                                                                                                         |                            | 20,900,776 |             |           |           |          |            
|                                                | Capital lease obligations, net of current portion                                                                                               |                                                                                                                                                         |                            | 192,410    |             |           |           | 323,764   |            
|                                                |                                                                                                                                                 |                                                                                                                                                         |                            |            |             |           |           |          
|                                                |                                                                                                                                                 | Total liabilities                                                                                                                                       |                            |            | 28,608,026  |           |           |           | 5,752,259   |           
|                                                |                                                                                                                                                 |                                                                                                                                                         |                            |            |             |           |           |          
|COMMITMENTS AND CONTINGENCIES(Notes 6, 8 and 9) |                                                                                                                                                 |                                                                                                                                                         |                            |            |             |           |           |          
|REDEEMABLE CONVERTIBLE PREFERRED
    STOCK      |                                                                                                                                                 |                                                                                                                                                         |                            |            |             |           |           |          
|                                                | Series D  no par value,
    500 shares authorized; no and 50 shares issued and
    outstanding as of September 30, 2003 and 2002, respectively |                                                                                                                                                         |                            |           |             |           |           | 521,189   |            
|                                                |                                                                                                                                                 |                                                                                                                                                         |                            |            |             |           |           |          
|SHAREHOLDERS EQUITY                            |                                                                                                                                                 |                                                                                                                                                         |                            |            |             |           |           |          
|                                                | Preferred stock  no par value,
    9,999,500 shares authorized:                                                                                |                                                                                                                                                         |                            |            |             |           |           |           |            
|                                                |                                                                                                                                                 | Series C Junior Participating 
    1,000,000 shares authorized; no shares issued or outstanding                                                        |                            |            |            |           |           |           |            |           
|                                                | Common stock  no par value:                                                                                                                    |                                                                                                                                                         |                            |            |             |           |           |           |            
|                                                |                                                                                                                                                 | Class A  99,288,000 shares
    authorized; 65,816,434 and 58,270,533 shares issued and
    outstanding as of September 30, 2003 and 2002, respectively |                            |            | 97,286,433  |           |           |           | 87,053,257  |           
|                                                |                                                                                                                                                 | Class B  712,000 shares
    authorized; 13,500 shares issued and outstanding
    (convertible into Class A common stock)                               |                            |            | 8,395       |           |           |           | 8,395       |           
|                                                |                                                                                                                                                 | Accumulated deficit                                                                                                                                     |                            |            | (96,251,049 | )         |           |           | (73,002,878 | )         
|                                                |                                                                                                                                                 | Accumulated other comprehensive income (loss)                                                                                                           |                            |            | (6,548      | )         |           |           | 707         |           
|                                                |                                                                                                                                                 |                                                                                                                                                         |                            |            |             |           |           |          
|                                                |                                                                                                                                                 |                                                                                                                                                         | Total shareholders equity |            |             | 1,037,231 |           |           |             | 14,059,481 | 
|                                                |                                                                                                                                                 |                                                                                                                                                         |                            |            |             |           |           |          
|                                                |                                                                                                                                                 | TOTAL LIABILITIES AND SHAREHOLDERS EQUITY                                                                                                              |                            | $          | 29,645,257  |           |           | $         | 20,332,929  |           
|                                                |                                                                                                                                                 |                                                                                                                                                         |                            |            |             |           |           |          

See notes to consolidated financial statements.

F-3



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##### Table of Contents






AVANIR PHARMACEUTICALS

CONSOLIDATED STATEMENTS OF
OPERATIONS

|                                                           |                                                                             |                           |             |             |            |      |             |             |            |   |          |            |            | 
|---------------------------------------------------------- | --------------------------------------------------------------------------- | ------------------------- | ----------- | ----------- | ---------- | ---- | ----------- | ----------- | ---------- | - | -------- | ---------- | ---------- | 
|                                                           |                                                                             |                          
|                                                           |                                                                             | Years Ended September 30,
|                                                           |                                                                             |                          
|                                                           |                                                                             | 2003                      |             | 2002        |            | 2001
|                                                           |                                                                             |                           |             |             |            |     
|REVENUES:                                                  |                                                                             |                           |             |             |            |      |             |             |            |   |          |           
|                                                           | Research contracts and licenses                                             |                           | $           | 53,000      |            |      | $           | 5,226,167   |            |   | $        | 10,070,350 |           
|                                                           | Royalties and sale of royalty rights                                        |                           |             | 1,780,893   |            |      |             | 3,426,403   |            |   |          | 2,535,717  |           
|                                                           | Government research grants                                                  |                           |             | 587,440     |            |      |             | 160,412     |            |   |          | 72,535     |           
|                                                           | Product sales                                                               |                           |             | 17,400      |            |      |             | 40,760      |            |   |          |           |           
|                                                           |                                                                             |                           |             |             |            |      |             |             |            |   |          |           
|                                                           |                                                                             | Total revenues            |             |             | 2,438,733  |      |             |             | 8,853,742  |   |          |            | 12,678,602 | 
|                                                           |                                                                             |                           |             |             |            |      |             |             |            |   |          |           
|OPERATING EXPENSES:                                        |                                                                             |                           |             |             |            |      |             |             |            |   |          |           
|                                                           | Research and development                                                    |                           |             | 18,558,017  |            |      |             | 13,602,484  |            |   |          | 7,227,488  |           
|                                                           | General and administrative                                                  |                           |             | 4,736,791   |            |      |             | 4,243,829   |            |   |          | 3,226,563  |           
|                                                           | Sales and marketing                                                         |                           |             | 2,621,320   |            |      |             | 1,640,812   |            |   |          | 1,234,604  |           
|                                                           | Cost of product sales                                                       |                           |             | 3,102       |            |      |             | 4,731       |            |   |          |           |           
|                                                           | Purchased in-process research and development                               |                           |             |            |            |      |             |            |            |   |          | 917,097    |           
|                                                           | Product launch expenses                                                     |                           |             |            |            |      |             |            |            |   |          | 728,148    |           
|                                                           |                                                                             |                           |             |             |            |      |             |             |            |   |          |           
|                                                           |                                                                             | Total operating expenses  |             |             | 25,919,230 |      |             |             | 19,491,856 |   |          |            | 13,333,900 | 
|                                                           |                                                                             |                           |             |             |            |      |             |             |            |   |          |           
|LOSS FROM OPERATIONS                                       |                                                                             |                           | (23,480,497 | )           |            |      | (10,638,114 | )           |            |   | (655,298 | )         
|                                                           | Interest income                                                             |                           |             | 265,874     |            |      |             | 663,588     |            |   |          | 1,147,439  |           
|                                                           | Other income                                                                |                           |             | 26,801      |            |      |             | 129,514     |            |   |          | 2,700      |           
|                                                           | Interest expense                                                            |                           |             | (44,927     | )          |      |             | (60,560     | )          |   |          | (6,547     | )         
|                                                           |                                                                             |                           |             |             |            |      |             |             |            |   |          |           
|INCOME (LOSS) BEFORE INCOME TAXES                          |                                                                             |                           | (23,232,749 | )           |            |      | (9,905,572  | )           |            |   | 488,294  |           
|                                                           | Provision for income taxes                                                  |                           |             | (3,599      | )          |      |             | (343,940    | )          |   |          | (255,172   | )         
|                                                           |                                                                             |                           |             |             |            |      |             |             |            |   |          |           
|NET INCOME (LOSS)                                          |                                                                             | $                         | (23,236,348 | )           |            | $    | (10,249,512 | )           |            | $ | 233,122  |           
|                                                           |                                                                             |                           |             |             |            |      |             |             |            |   |          |           
|NET INCOME (LOSS) ATTRIBUTABLE TO COMMON
    SHAREHOLDERS: |                                                                             |                           |             |             |            |      |             |             |            |   |          |           
|                                                           | Net income (loss)                                                           |                           | $           | (23,236,348 | )          |      | $           | (10,249,512 | )          |   | $        | 233,122    |           
|                                                           | Dividends on redeemable convertible preferred
    stock                     |                           |             | (16,122     | )          |      |             | (25,000     | )          |   |          | (24,948    | )         
|                                                           | Accretion of discount related to redeemable
    convertible preferred stock |                           |             | (11,823     | )          |      |             | (18,286     | )          |   |          | (18,286    | )         
|                                                           |                                                                             |                           |             |             |            |      |             |             |            |   |          |           
|NET INCOME (LOSS) ATTRIBUTABLE TO COMMON
    SHAREHOLDERS  |                                                                             | $                         | (23,264,293 | )           |            | $    | (10,292,798 | )           |            | $ | 189,888  |           
|                                                           |                                                                             |                           |             |             |            |      |             |             |            |   |          |           
|NET INCOME (LOSS) PER SHARE:                               |                                                                             |                           |             |             |            |      |             |             |            |   |          |           
|                                                           | BASIC                                                                       |                           | $           | (0.39       | )          |      | $           | (0.18       | )          |   | $        | 0.00       |           
|                                                           |                                                                             |                           |             |             |            |      |             |             |            |   |          |           
|                                                           | DILUTED                                                                     |                           | $           | (0.39       | )          |      | $           | (0.18       | )          |   | $        | 0.00       |           
|                                                           |                                                                             |                           |             |             |            |      |             |             |            |   |          |           
|WEIGHTED AVERAGE NUMBER OF COMMON SHARES
    OUTSTANDING:  |                                                                             |                           |             |             |            |      |             |             |            |   |          |           
|                                                           | BASIC                                                                       |                           |             | 59,896,135  |            |      |             | 58,206,969  |            |   |          | 57,475,748 |           
|                                                           |                                                                             |                           |             |             |            |      |             |             |            |   |          |           
|                                                           | DILUTED                                                                     |                           |             | 59,896,135  |            |      |             | 58,206,969  |            |   |          | 61,130,415 |           
|                                                           |                                                                             |                           |             |             |            |      |             |             |            |   |          |           

See notes to consolidated financial statements.

F-4



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##### Table of Contents



AVANIR PHARMACEUTICALS




CONSOLIDATED STATEMENTS OF SHAREHOLDERS
EQUITY

|                                                                                                                                |                                                                    |              |            |           |   |             |            |             |   |               |        |               |   |               |        |         |   |        |          |   |  |   |             |   |  |   |         |   |  |   |             |           |   |   |             |   | 
|------------------------------------------------------------------------------------------------------------------------------- | ------------------------------------------------------------------ | ------------ | ---------- | --------- | - | ----------- | ---------- | ----------- | - | ------------- | ------ | ------------- | - | ------------- | ------ | ------- | - | ------ | -------- | - |  | - | ----------- | - |  | - | ------- | - |  | - | ----------- | --------- | - | - | ----------- | - | 
|                                                                                                                                |                                                                    |              |            |           |   |             |            |             |   |               |        |              
|                                                                                                                                |                                                                    | Common Stock |            |           |   |             |            |             |   |               |        |              
|                                                                                                                                |                                                                    |              |            |           |   |             |            | Accumulated |   |               |        |              
|                                                                                                                                |                                                                    |              |            |           |   | Receivables |            |             |   | Other         |        |               |   |              
|                                                                                                                                |                                                                    | Class A      |            | Class B   |   | for         |            |             |   | Comprehensive |        | Total         |   | Comprehensive
|                                                                                                                                |                                                                    |              |            |           |   | Common      |            | Accumulated |   | Income        |        | Shareholders |   | Income       
|                                                                                                                                |                                                                    | Shares       |            | Amount    |   | Shares      |            | Amount      |   | Stock         |        | Deficit       |   | (Loss)        |        | Equity  |   | (Loss)
|                                                                                                                                |                                                                    |              |            |           |   |             |            |             |   |               |        |               |   |               |        |         |   |       
|BALANCE, OCTOBER 1, 2000                                                                                                        |                                                                    |              | 56,974,828 |           |   | $           | 84,695,590 |             |   |               | 65,000 |               |   | $             | 34,145 |         |   | $      | (649,431 | ) |  | $ | (62,949,916 | ) |  |   |         |   |  | $ | 21,130,388  |           |   |   |             |  
|Net income                                                                                                                      |                                                                    |              |            |           |   |             |            |             |   |               |        |               |   |               |        |         |   |        | 233,122  |   |  |   | 233,122     |   |  |   |         |   |  |   | 233,122     |           |   | $ | 233,122     |  
|Issuance of Class A common stock in
    connection with:                                                                        |                                                                    |              |            |           |   |             |            |             |   |               |        |               |   |               |        |         |   |        |          |   |  |   |             |   |  |   |         |   |  |   |             |           |   |   |             |  
|                                                                                                                                | Exercise of warrants                                               |              |            | 254,716   |   |             |            | 304,697     |   |               |        |               |   |               |        |         |   |        |          |   |  |   |             |   |  |   |         |   |  |   |             | 304,697   |   |   |             |   | 
|                                                                                                                                | Exercise of stock options, net of taxes                            |              |            | 558,142   |   |             |            | 653,399     |   |               |        |               |   |               |        |         |   |        |          |   |  |   |             |   |  |   |         |   |  |   |             | 653,399   |   |   |             |   | 
|                                                                                                                                | Acquisition of MIF technology                                      |              |            | 170,353   |   |             |            | 867,097     |   |               |        |               |   |               |        |         |   |        |          |   |  |   |             |   |  |   |         |   |  |   |             | 867,097   |   |   |             |   | 
|                                                                                                                                | Acquisition of minority interests in Xenerex                       |              |            | 25,000    |   |             |            | 97,250      |   |               |        |               |   |               |        |         |   |        |          |   |  |   |             |   |  |   |         |   |  |   |             | 97,250    |   |   |             |   | 
|                                                                                                                                | Conversions of Class B common stock                                |              |            | 28,500    |   |             |            | 14,250      |   |               |        | (28,500       | ) |               |        | (14,250 | ) |        |          |   |  |   |             |   |  |   |         |   |  |   |             |          |   |   |             |   | 
|                                                                                                                                | Retired shares                                                     |              |            | (35,158   | ) |             |            | (129,031    | ) |               |        |               |   |               |        |         |   |        |          |   |  |   |             |   |  |   |         |   |  |   |             | (129,031  | ) |   |             |   | 
|Collection of receivables for Class A common stock                                                                              |                                                                    |              |            |           |   |             |            |             |   |               |        |               |   |               |        |         |   |        | 649,431  |   |  |   |             |   |  |   |         |   |  |   | 649,431     |           |   |   |             |  
|Dividends on preferred stock                                                                                                    |                                                                    |              |            |           |   |             | (24,948    | )           |   |               |        |               |   |               |        |         |   |        |          |   |  |   |             |   |  |   |         |   |  |   | (24,948     | )         |   |   |             |  
|Accretion of discount related to Series D
    redeemable convertible preferred stock                                            |                                                                    |              |            |           |   |             |            |             |   |               |        |               |   |               |        |         |   |        |          |   |  |   | (18,286     | ) |  |   |         |   |  |   | (18,286     | )         |   |   |             |  
|Compensation expense related to valuation of
    stock options granted to employees and non-employees for
    services rendered |                                                                    |              |            |           |   |             | 148,051    |             |   |               |        |               |   |               |        |         |   |        |          |   |  |   |             |   |  |   |         |   |  |   | 148,051     |           |   |   |             |  
|Unrealized gains on investments in securities                                                                                   |                                                                    |              |            |           |   |             |            |             |   |               |        |               |   |               |        |         |   |        |          |   |  |   |             |   |  | $ | 47,390  |   |  |   | 47,390      |           |   |   | 47,390      |  
|                                                                                                                                |                                                                    |              |            |           |   |             |            |             |   |               |        |               |   |               |        |         |   |        |          |   |  |   |             |   |  |   |         |   |  |   |             |           |   |   |             |  
|BALANCE, SEPTEMBER 30, 2001                                                                                                     |                                                                    |              | 57,976,381 |           |   |             | 86,626,355 |             |   |               | 36,500 |               |   |               | 19,895 |         |   |        |         |   |  |   | (62,735,080 | ) |  |   | 47,390  |   |  |   | 23,958,560  |           |   | $ | 280,512     |  
|                                                                                                                                |                                                                    |              |            |           |   |             |            |             |   |               |        |               |   |               |        |         |   |        |          |   |  |   |             |   |  |   |         |   |  |   |             |           |   |   |             |  
|Net loss                                                                                                                        |                                                                    |              |            |           |   |             |            |             |   |               |        |               |   |               |        |         |   |        |          |   |  |   | (10,249,512 | ) |  |   |         |   |  |   | (10,249,512 | )         |   | $ | (10,249,512 | )
|Issuance of Class A common stock in
    connection with:                                                                        |                                                                    |              |            |           |   |             |            |             |   |               |        |               |   |               |        |         |   |        |          |   |  |   |             |   |  |   |         |   |  |   |             |           |   |   |             |  
|                                                                                                                                | Exercise of warrants                                               |              |            | 80,000    |   |             |            | 90,000      |   |               |        |               |   |               |        |         |   |        |          |   |  |   |             |   |  |   |         |   |  |   |             | 90,000    |   |   |             |   | 
|                                                                                                                                | Exercise of stock options, net of taxes                            |              |            | 191,152   |   |             |            | 170,574     |   |               |        |               |   |               |        |         |   |        |          |   |  |   |             |   |  |   |         |   |  |   |             | 170,574   |   |   |             |   | 
|                                                                                                                                | Conversions of Class B common stock                                |              |            | 23,000    |   |             |            | 11,500      |   |               |        | (23,000       | ) |               |        | (11,500 | ) |        |          |   |  |   |             |   |  |   |         |   |  |   |             |          |   |   |             |   | 
|Dividends on preferred stock                                                                                                    |                                                                    |              |            |           |   |             | (25,000    | )           |   |               |        |               |   |               |        |         |   |        |          |   |  |   |             |   |  |   |         |   |  |   | (25,000     | )         |   |   |             |  
|Accretion of discount related to Series D
    redeemable convertible preferred stock                                            |                                                                    |              |            |           |   |             |            |             |   |               |        |               |   |               |        |         |   |        |          |   |  |   | (18,286     | ) |  |   |         |   |  |   | (18,286     | )         |   |   |             |  
|Compensation expense related to valuation of
    stock options granted to employees and non-employees for
    services rendered |                                                                    |              |            |           |   |             | 179,828    |             |   |               |        |               |   |               |        |         |   |        |          |   |  |   |             |   |  |   |         |   |  |   | 179,828     |           |   |   |             |  
|Unrealized losses on investments in securities                                                                                  |                                                                    |              |            |           |   |             |            |             |   |               |        |               |   |               |        |         |   |        |          |   |  |   |             |   |  |   | (46,683 | ) |  |   | (46,683     | )         |   |   | (46,683     | )
|                                                                                                                                |                                                                    |              |            |           |   |             |            |             |   |               |        |               |   |               |        |         |   |        |          |   |  |   |             |   |  |   |         |   |  |   |             |           |   |   |             |  
|BALANCE, SEPTEMBER 30, 2002                                                                                                     |                                                                    |              | 58,270,533 |           |   |             | 87,053,257 |             |   |               | 13,500 |               |   |               | 8,395  |         |   | $      |         |   |  |   | (73,002,878 | ) |  |   | 707     |   |  |   | 14,059,481  |           |   | $ | (10,296,195 | )
|                                                                                                                                |                                                                    |              |            |           |   |             |            |             |   |               |        |               |   |               |        |         |   |        |          |   |  |   |             |   |  |   |         |   |  |   |             |           |   |   |             |  
|Net loss                                                                                                                        |                                                                    |              |            |           |   |             |            |             |   |               |        |               |   |               |        |         |   |        |          |   |  |   | (23,236,348 | ) |  |   |         |   |  | $ | (23,236,348 | )         |   | $ | (23,236,348 | )
|Issuance of Class A common stock in
    connection with:                                                                        |                                                                    |              |            |           |   |             |            |             |   |               |        |               |   |               |        |         |   |        |          |   |  |   |             |   |  |   |         |   |  |   |             |           |   |   |             |  
|                                                                                                                                | Exercise of warrants                                               |              |            | 53,200    |   |             |            | 59,850      |   |               |        |               |   |               |        |         |   |        |          |   |  |   |             |   |  |   |         |   |  |   |             | 59,850    |   |   |             |   | 
|                                                                                                                                | Exercise of stock options, net of taxes                            |              |            | 24,000    |   |             |            | 25,500      |   |               |        |               |   |               |        |         |   |        |          |   |  |   |             |   |  |   |         |   |  |   |             | 25,500    |   |   |             |   | 
|                                                                                                                                | Restricted stock granted to directors                              |              |            | 80,000    |   |             |            | 92,800      |   |               |        |               |   |               |        |         |   |        |          |   |  |   |             |   |  |   |         |   |  |   |             | 92,800    |   |   |             |   | 
|                                                                                                                                | Sale of stock and warrants                                         |              |            | 6,728,396 |   |             |            | 9,381,317   |   |               |        |               |   |               |        |         |   |        |          |   |  |   |             |   |  |   |         |   |  |   |             | 9,381,317 |   |   |             |   | 
|                                                                                                                                | Conversions of Series D Redeemable
    convertible preferred stock |              |            | 660,305   |   |             |            | 536,630     |   |               |        |               |   |               |        |         |   |        |          |   |  |   |             |   |  |   |         |   |  |   |             | 536,630   |   |   |             |   | 
|Dividends on preferred stock                                                                                                    |                                                                    |              |            |           |   |             | (16,120    | )           |   |               |        |               |   |               |        |         |   |        |          |   |  |   |             |   |  |   |         |   |  |   | (16,120     | )         |   |   |             |  
|Accretion of discount related to Series D
    redeemable convertible preferred stock                                            |                                                                    |              |            |           |   |             |            |             |   |               |        |               |   |               |        |         |   |        |          |   |  |   | (11,823     | ) |  |   |         |   |  |   | (11,823     | )         |   |   |             |  
|Compensation expense related to valuation of
    stock options granted to employees and non-employees for
    services rendered |                                                                    |              |            |           |   |             | 153,199    |             |   |               |        |               |   |               |        |         |   |        |          |   |  |   |             |   |  |   |         |   |  |   | 153,199     |           |   |   |             |  
|Unrealized losses on investments in securities                                                                                  |                                                                    |              |            |           |   |             |            |             |   |               |        |               |   |               |        |         |   |        |          |   |  |   |             |   |  |   | (7,255  | ) |  |   | (7,255      | )         |   |   | (7,255      | )
|                                                                                                                                |                                                                    |              |            |           |   |             |            |             |   |               |        |               |   |               |        |         |   |        |          |   |  |   |             |   |  |   |         |   |  |   |             |           |   |   |             |  
|BALANCE, SEPTEMBER 30, 2003                                                                                                     |                                                                    |              | 65,816,434 |           |   | $           | 97,286,433 |             |   |               | 13,500 |               |   | $             | 8,395  |         |   | $      |         |   |  | $ | (96,251,049 | ) |  | $ | (6,548  | ) |  | $ | 1,037,231   |           |   | $ | (23,243,603 | )
|                                                                                                                                |                                                                    |              |            |           |   |             |            |             |   |               |        |               |   |               |        |         |   |        |          |   |  |   |             |   |  |   |         |   |  |   |             |           |   |   |             |  

See notes to consolidated financial statements.

F-5



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##### Table of Contents



AVANIR PHARMACEUTICALS




CONSOLIDATED STATEMENTS OF CASH
FLOWS

|                                                                                                        |                                                                                            |                                                          |             |            |            |      |             |            |            |   |            |            |            |  
|------------------------------------------------------------------------------------------------------- | ------------------------------------------------------------------------------------------ | -------------------------------------------------------- | ----------- | ---------- | ---------- | ---- | ----------- | ---------- | ---------- | - | ---------- | ---------- | ---------- | -
|                                                                                                        |                                                                                            |                                                         
|                                                                                                        |                                                                                            | Years Ended September 30,                               
|                                                                                                        |                                                                                            |                                                         
|                                                                                                        |                                                                                            | 2003                                                     |             | 2002       |            | 2001
|                                                                                                        |                                                                                            |                                                          |             |            |            |     
|OPERATING ACTIVITIES:                                                                                   |                                                                                            |                                                          |             |            |            |      |             |            |            |   |            |           
|Net income (loss)                                                                                       |                                                                                            | $                                                        | (23,236,348 | )          |            | $    | (10,249,512 | )          |            | $ | 233,122    |           
|Adjustments to reconcile net income (loss) to net
    cash provided by (used for) operating activities: |                                                                                            |                                                          |             |            |            |      |             |            |            |   |            |           
|                                                                                                        | Depreciation and amortization                                                              |                                                          |             | 1,011,802  |            |      |             | 602,803    |            |   |            | 373,290    |           
|                                                                                                        | Compensation paid with common stock, stock
    options and warrants                        |                                                          |             | 245,999    |            |      |             | 179,828    |            |   |            | 148,051    |           
|                                                                                                        | Purchased in-process R&D paid with common
    stock                                        |                                                          |             |           |            |      |             |           |            |   |            | 867,097    |           
|                                                                                                        | Loss on disposal of assets                                                                 |                                                          |             | 7,193      |            |      |             | 782        |            |   |            | 3,187      |           
|                                                                                                        | Intangible assets abandoned                                                                |                                                          |             | 74,432     |            |      |             |           |            |   |            |           |           
|Changes in assets and liabilities:                                                                      |                                                                                            |                                                          |             |            |            |      |             |            |            |   |            |           
|                                                                                                        | Receivables                                                                                |                                                          |             | 827,273    |            |      |             | (200,278   | )          |   |            | (803,247   | )         
|                                                                                                        | Inventory                                                                                  |                                                          |             | 27,272     |            |      |             | (15,541    | )          |   |            | (212,781   | )         
|                                                                                                        | Prepaid expenses and other assets                                                          |                                                          |             | (845,761   | )          |      |             | (297,024   | )          |   |            | (209,191   | )         
|                                                                                                        | Accounts payable                                                                           |                                                          |             | 147,998    |            |      |             | 1,970,905  |            |   |            | (230,934   | )         
|                                                                                                        | Accrued expenses and other liabilities                                                     |                                                          |             | 207,431    |            |      |             | 871,136    |            |   |            | 233,934    |           
|                                                                                                        | Accrued compensation and payroll taxes                                                     |                                                          |             | 164,036    |            |      |             | 100,090    |            |   |            | 106,923    |           
|                                                                                                        | Deferred revenue                                                                           |                                                          |             | 22,509,308 |            |      |             | 108,333    |            |   |            | 125,000    |           
|                                                                                                        |                                                                                            |                                                          |             |            |            |      |             |            |            |   |            |           
|                                                                                                        |                                                                                            | Net cash provided by (used for) operating
    activities |             |            | 1,140,635  |      |             |            | (6,928,478 | ) |            |            | 634,451    |  
|                                                                                                        |                                                                                            |                                                          |             |            |            |      |             |            |            |   |            |           
|INVESTING ACTIVITIES:                                                                                   |                                                                                            |                                                          |             |            |            |      |             |            |            |   |            |           
|                                                                                                        | Investments in securities                                                                  |                                                          |             | (3,727,676 | )          |      |             | (9,019,464 | )          |   |            | (4,450,000 | )         
|                                                                                                        | Proceeds from sales and maturities of investments
    in securities                        |                                                          |             | 3,000,000  |            |      |             | 9,743,012  |            |   |            | 757,173    |           
|                                                                                                        | Patent costs                                                                               |                                                          |             | (615,627   | )          |      |             | (537,903   | )          |   |            | (538,202   | )         
|                                                                                                        | Purchases of property and equipment                                                        |                                                          |             | (5,510,630 | )          |      |             | (1,391,382 | )          |   |            | (1,009,349 | )         
|                                                                                                        |                                                                                            |                                                          |             |            |            |      |             |            |            |   |            |           
|                                                                                                        |                                                                                            | Net cash used for investing activities                   |             |            | (6,853,933 | )    |             |            | (1,205,737 | ) |            |            | (5,240,378 | )
|                                                                                                        |                                                                                            |                                                          |             |            |            |      |             |            |            |   |            |           
|FINANCING ACTIVITIES:                                                                                   |                                                                                            |                                                          |             |            |            |      |             |            |            |   |            |           
|                                                                                                        | Proceeds from issuances of common stock and
    warrants, net                              |                                                          |             | 9,466,667  |            |      |             | 260,574    |            |   |            | 1,478,496  |           
|                                                                                                        | Dividends paid on preferred stock                                                          |                                                          |             | (12,500    | )          |      |             | (25,000    | )          |   |            | (6,250     | )         
|                                                                                                        | Proceeds from issuance of notes payable                                                    |                                                          |             | 244,805    |            |      |             | 287,371    |            |   |            | 171,750    |           
|                                                                                                        | Payments on notes and capital lease obligations                                            |                                                          |             | (417,813   | )          |      |             | (300,728   | )          |   |            | (195,292   | )         
|                                                                                                        |                                                                                            |                                                          |             |            |            |      |             |            |            |   |            |           
|                                                                                                        |                                                                                            | Net cash provided by financing activities                |             |            | 9,281,159  |      |             |            | 222,217    |   |            |            | 1,448,704  |  
|                                                                                                        |                                                                                            |                                                          |             |            |            |      |             |            |            |   |            |           
|Net increase (decrease) in cash and cash
    equivalents                                                |                                                                                            |                                                          | 3,567,861   |            |            |      | (7,911,998  | )          |            |   | (3,157,223 | )         
|Cash and cash equivalents at beginning of year                                                          |                                                                                            |                                                          | 8,630,547   |            |            |      | 16,542,545  |            |            |   | 19,699,768 |           
|                                                                                                        |                                                                                            |                                                          |             |            |            |      |             |            |            |   |            |           
|Cash and cash equivalents at end of year                                                                |                                                                                            | $                                                        | 12,198,408  |            |            | $    | 8,630,547   |            |            | $ | 16,542,545 |           
|                                                                                                        |                                                                                            |                                                          |             |            |            |      |             |            |            |   |            |           
|SUPPLEMENTAL DISCLOSURES OF CASH FLOW
    INFORMATION:                                                  |                                                                                            |                                                          |             |            |            |      |             |            |            |   |            |           
|                                                                                                        | Interest paid                                                                              |                                                          | $           | 44,927     |            |      | $           | 60,560     |            |   | $          | 6,547      |           
|                                                                                                        | Income taxes paid                                                                          |                                                          | $           | 3,599      |            |      | $           | 343,940    |            |   | $          | 255,172    |           
|SUPPLEMENTAL DISCLOSURES OF NON-CASH INVESTING
    AND FINANCING ACTIVITIES:                            |                                                                                            |                                                          |             |            |            |      |             |            |            |   |            |           
|                                                                                                        | Patent purchased with common stock                                                         |                                                          | $           |           |            |      | $           |           |            |   | $          | 111,158    |           
|                                                                                                        | Acquisition of minority interest in Xenerex                                                |                                                          | $           |           |            |      | $           |           |            |   | $          | 97,250     |           
|                                                                                                        | Acquisition of equipment under capital leases                                              |                                                          | $           |           |            |      | $           | 122,662    |            |   | $          | 495,147    |           
|                                                                                                        | Conversions of Series D redeemable
    convertible preferred stock to Class A common stock |                                                          | $           | 536,630    |            |      | $           |           |            |   | $          |           |           

See notes to consolidated financial statements.

F-6



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##### Table of Contents



AVANIR PHARMACEUTICALS




NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS

1.     Description of
Business

AVANIR Pharmaceuticals (AVANIR,
we, or the Company) is engaged in
research, development, commercialization and licensing of
innovative pharmaceutical products and in providing antibody
generation services. AVANIRs first product, Abreva®
(chemical name is docosanol 10% cream), is the number one
selling cold sore medication in the U.S. over-the-counter
(OTC) market and the only OTC product in the cold sore
category approved by the U.S. Food and Drug Administration
(FDA). AVANIR is engaged in various stages of discussions and
negotiations for licensing docosanol 10% cream to companies in
various other countries and in obtaining regulatory approvals in
those countries for marketing of the product. The Company is
also engaged in research and development of several drugs in
various phases of clinical and preclinical development. Through
its wholly-owned subsidiary, Xenerex Biosciences, the Company
develops and commercializes completely human antibody products
for partner companies through research collaborations with those
companies and for AVANIR.

AVANIR is subject to various risks and
uncertainties frequently encountered by companies in the early
stages of operations, particularly in the evolving market for
small biotech and specialty pharmaceuticals companies. Such
risks and uncertainties include, but are not limited to, timing
and uncertainty of achieving milestones in clinical trials and
in obtaining approvals by the FDA and regulatory agencies in
other countries.

AVANIRs ability to generate revenues in the
future will depend substantially on the timing and success of
filing and obtaining regulatory approvals and finding licensees
for products for the rest of the world. AVANIR expects that its
next product, Neurodex, for the treatment of pseudobulbar affect
(PBA), will be available for sale in 2005, assuming the
remaining clinical trials and other studies are successful and
the FDA approves the drug for marketing. The Companys
operating expenses depend substantially on the level of
expenditures for research and development programs and the rate
of progress being made on such programs.

2.     Summary of
Significant Accounting Policies



| |                      
| | ---------------------
| | Basis of presentation

The consolidated financial statements include the
accounts of AVANIR Pharmaceuticals and its subsidiary, Xenerex
Biosciences. All significant intercompany accounts and
transactions have been eliminated. Certain amounts from prior
years have been reclassified to conform to the current year
presentation.

The Companys fiscal year ends on
September 30 of each year. The years ended
September 30, 2003, 2002, and 2001 may be referred to as
fiscal 2003, fiscal 2002, and fiscal 2001, respectively.

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



| |                          
| | -------------------------
| | Cash and cash equivalents

Cash and cash equivalents consist of highly
liquid investments with original maturities of three months or
less at the date of acquisition. Substantially all cash and cash
equivalents are under the custodianship of two major financial
institutions.



| |                                         
| | ----------------------------------------
| | Restricted investments in
    securities

Restricted investments in securities amounting to
$856,597 as of both September 30, 2003 and 2002 represent
amounts pledged to our bank as collateral for letters of credit
issued in connection with our real estate lease agreements.

F-7



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##### Table of Contents



AVANIR PHARMACEUTICALS


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



| |            
| | -----------
| | Investments

Investments (Note 4,
Investments) are comprised of marketable securities
consisting primarily of certificates of deposit, U.S. state
and municipal government obligations, corporate bonds, and an
investment in a mutual fund that invests primarily in
asset-backed and mortgage-backed securities. All marketable
securities are held in the Companys name and primarily
under the custodianship of two major financial institutions. The
Companys policy is to protect the value of its investment
portfolio and minimize principal risk by earning returns based
on current interest rates. Short-term investments are marketable
securities with maturities of less than one year from the
balance sheet date. The Companys marketable securities are
classified either as available-for-sale or held-to-maturity. The
Company has no securities classified as trading. The marketable
securities classified as held-to-maturity are carried at
amortized cost and the marketable securities classified as
available-for-sale are carried at fair market value. Unrealized
gains or losses related to marketable securities classified as
available-for-sale are included as part of shareholders
equity, as accumulated other comprehensive income
(loss).

Statement of Financial Accounting Standards
No. 115 (SFAS 115), Accounting for Certain
Investments in Debt and Equity Securities, requires
companies to determine whether a decline in fair value below the
amortized cost basis is other than temporary. If a decline in
fair value is determined to be other than temporary,
SFAS 115 requires the carrying value of the debt or equity
security to be written down to its fair value. The Company does
not have any investments that are impaired.

Carrying amounts of the Companys financial
instruments, including cash and cash equivalents, approximate
fair value because of their short maturities. The fair values of
investments are determined using quoted market prices for those
securities or similar financial instruments.



| |          
| | ---------
| | Inventory

Inventory is stated at the lower of cost
(first-in, first-out) or market. Inventory consists of the raw
material docosanol, which is the active ingredient in docosanol
10% cream. Docosanol in its present form as stored by the
Company has a substantial shelf life, a relatively stable value
and long-term use, and carries a low risk of becoming excess
inventory or obsolete. AVANIR does not own or store any
docosanol 10% cream in its finished product form. The Company
and one of its licensees receive raw materials from a single
supplier. AVANIR also supplies several other licensees with raw
materials from the same supplier. The inability of this sole
supplier to fulfill supply requirements of the Company or its
licensees could materially impact future operating results.



| |                             
| | ----------------------------
| | Concentration of credit risk

Substantially all of AVANIRs cash and cash
equivalents are maintained with two major financial institutions
in the United States. Deposits held with banks may exceed the
amount of insurance provided on such deposits. Generally, these
deposits may be redeemed upon demand and, therefore, bear
minimal risk.

Financial instruments that potentially subject
the Company to concentrations of credit risk consist principally
of marketable securities and interest rate instruments. The
counterparties to the Companys investment securities and
interest rate instruments are various major corporations and
financial institutions of high credit standing. The Company does
not believe there is significant risk of non-performance by
these counterparties because the Company limits the amount of
credit exposure to any one financial institution and any one
type of investment.

The Companys income from fiscal 2000 to
2002 was substantially from its license agreement with
GlaxoSmithKline. The Company performs ongoing credit evaluations
of its customers financial conditions and would limit the
amount of credit extended if deemed necessary but usually
requires no collateral.

F-8



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##### Table of Contents



AVANIR PHARMACEUTICALS


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



| |                                      
| | -------------------------------------
| | Intangibles and long-lived
    assets

The Companys policy regarding long-lived
assets is to review such long-lived assets for impairment
whenever events or changes in circumstances indicate that the
carrying amount of an asset may not be recoverable. If the
review indicates that long-lived assets are not recoverable
(i.e. the carrying amount is less than the future projected
undiscounted cash flows), their carrying amount would be reduced
to fair value. The Company carries no goodwill on its books at
either September 30, 2003 or 2002. Further, during fiscal
2003 and 2002, the Company had no material impairments to
property and equipment or intangible assets, which consist
primarily of patents and trademarks.

We capitalize legal costs incurred in connection
with patent applications, trademark applications and license
agreements. We amortize costs of approved patents and license
agreements over their useful lives, or terms of the agreements,
whichever ones are shorter. For patent and trademark
applications that we abandon, we charge the remaining
unamortized accumulated costs to expense.



| |                                           
| | ------------------------------------------
| | Redeemable convertible preferred
    stock

As of September 30, 2002, the Company had an
obligation to redeem outstanding shares of Series D
redeemable convertible preferred stock at the option of the
holder. Therefore, the preferred stock has been classified
separately from shareholders equity.



| |                    
| | -------------------
| | Revenue recognition

Performance-based license
fees.We recognize revenues from
license fees when the performance requirements have been met,
the fee is fixed or determinable, and collection of fees is
probable. We defer revenues and recognize them ratably over the
life of the agreement when we have continuing obligations to
perform under the agreement.

Royalty revenues.We
recognize royalty revenues from our licensed products when
earned. Net sales figures used for calculating royalties due the
Company can often include deductions for costs of unsaleable
returns, managed care charge-backs, cash discounts, freight and
warehousing, and miscellaneous write-offs, which may vary over
the course of the license agreement. Sales of Abreva®, if
publicly reported by our licensee, GlaxoSmithKline, could differ
from net sales used for calculating royalties and in determining
the royalties earned in accordance with the license agreement.
In agreements where we have sold our rights to future royalties
under license agreements and we maintain continuing involvement
in earning such royalties, we defer revenues and recognize them
ratably over the life of the license agreement.

Revenue arrangements with multiple
deliverables.In certain
circumstances, we enter into revenue arrangements whereby we are
obligated to deliver to the customer multiple products and/or
services (multiple deliverables). Such arrangements could
include antibody generation services agreements and other forms
of research collaborations. In these transactions, we allocate
the total revenue to be earned under the arrangement among the
various elements based on their relative fair value. In the case
of antibody generation services, the allocation is based on
objective, customer-specific evidence of fair value. We
recognize revenue related to the delivered products or services
only if: (i) the above performance or service criteria are
met; (ii) any undelivered products or services are not
essential to the functionality of the delivered products or
services; (iii) payment for the delivered products or
services is not contingent upon delivery of the remaining
products or services; (iv) we have an enforceable claim to
receive the amount due in the event we do not deliver the
undelivered products or services; and (v) as discussed
above, there is evidence of the fair value for each of the
undelivered products or services.

Government research grant
revenues.We recognize revenues from
government research grants during the period in which the
related expenditures are incurred.

F-9



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##### Table of Contents



AVANIR PHARMACEUTICALS


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



| |                              
| | -----------------------------
| | Depreciation and amortization

Property and equipment, net, is stated at cost
less accumulated depreciation and amortization. Depreciation and
amortization is computed using the straight-line method over the
estimated useful life of the asset or the life of the project,
whichever is less, if the equipment has been purchased for a
particular use. Estimated useful lives of three to five years
are used on computer equipment and related software. Office
equipment, furniture and fixtures are depreciated over five
years. Amortization of leasehold improvements is computed using
the shorter of the remaining lease term or eight years.



| |               
| | --------------
| | Self-insurance

We self-insure for portions of our insurance
policies based on usual and customary deductibles offered by the
insurance carriers, or other factors, such as historical loss
experience, projected risk exposure, cost of insurance, and
AVANIRs ability to absorb potential losses that could
arise based on the amounts of the deductibles.



| |                                          
| | -----------------------------------------
| | Research and development
    expenditures

Costs related to drug discovery and clinical
development are charged to research and development expense as
they are incurred.



| |                                                  
| | -------------------------------------------------
| | Purchased in-process research and
    development

In fiscal 2001, we charged $917,097 to in-process
research and development expense, representing the cost of
in-process technologies that we acquired from the Ciblex
Corporation in fiscal 2001 that could assist us in discovering a
drug capable of regulating macrophage migration inhibitory
factor, a protein thought to play a central role in the early
stages of development of several inflammatory diseases (MIF
inhibitor technology). Included in the acquisition are all
right, title and interest in and to the MIF inhibitor
technology, including a provisional patent application, as well
as any patent which may be issued upon AVANIRs filing of a
patent application regarding the use of certain compounds
provided by Ciblex or similar compounds, in the treatment of
autoimmune and inflammatory diseases. AVANIR also received as
part of the application all preclinical data related to
compounds provided by Ciblex, and all technology and know-how
relating to the foregoing, including laboratory data and
previous experimental results. In return for receiving the
rights to develop the MIF inhibitor technology, AVANIR paid
$50,000 in cash and issued 170,353 shares of the
Companys Class A common stock valued at $867,097, for
a combined value of $917,097 in cash and common stock. If AVANIR
achieves certain milestones in developing a product from the MIF
inhibitor technology, then Ciblex would be entitled to certain
payments upon reaching those milestones, and royalties on sales
if the product is approved for marketing. We will recognize the
expenses related to the achievement of the milestones if and
when they are achieved.



| |                        
| | -----------------------
| | Product launch expenses

AVANIR incurred certain costs related to the
product launch phase for Abreva that were expensed in fiscal
2001. Our obligation to share product launch expenses with
GlaxoSmithKline ceased after June 30, 2001.



| |                                                            
| | -----------------------------------------------------------
| | Computation of net income and net loss per
    common share

We compute basic income (loss) per common
share by dividing the net income and net loss attributable to
common shareholders by the weighted average number of common
shares outstanding during the period (Basic EPS
Method). We compute diluted income (loss) per common
share by dividing the net income and net loss attributable to
common shareholders by the weighted-average number of common and
dilutive

F-10



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##### Table of Contents



AVANIR PHARMACEUTICALS


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

common equivalent shares outstanding during the
period (Diluted EPS Method). Dilutive common
equivalent shares consist of shares issuable upon exercise of
stock options and warrants and conversion of preferred stock. In
the accompanying consolidated statements of operations, we have
presented our net income and net loss per share for fiscal 2003,
2002 and 2001 using both the Basic EPS Method and the Diluted
EPS Method.

The following table is a reconciliation from the
basic to the diluted EPS computations for fiscal 2003, 2002 and
2001:

|                                                                                        |                                                                             |                                                                                                      |            |             |             |      |            |             |             |   |            |           |            | 
|--------------------------------------------------------------------------------------- | --------------------------------------------------------------------------- | ---------------------------------------------------------------------------------------------------- | ---------- | ----------- | ----------- | ---- | ---------- | ----------- | ----------- | - | ---------- | --------- | ---------- | 
|                                                                                        |                                                                             |                                                                                                     
|                                                                                        |                                                                             | Years Ended September 30,                                                                           
|                                                                                        |                                                                             |                                                                                                     
|                                                                                        |                                                                             | 2003                                                                                                 |            | 2002        |             | 2001
|                                                                                        |                                                                             |                                                                                                      |            |             |             |     
|Numerator:                                                                              |                                                                             |                                                                                                      |            |             |             |      |            |             |             |   |            |          
|                                                                                        | Net income (loss)                                                           |                                                                                                      | $          | (23,236,348 | )           |      | $          | (10,249,512 | )           |   | $          | 233,122   |           
|Less:                                                                                   |                                                                             |                                                                                                      |            |             |             |      |            |             |             |   |            |          
|                                                                                        | Dividends on redeemable convertible preferred
    stock                     |                                                                                                      |            | (16,122     | )           |      |            | (25,000     | )           |   |            | (24,948   | )         
|                                                                                        | Accretion of discount related to redeemable
    convertible preferred stock |                                                                                                      |            | (11,823     | )           |      |            | (18,286     | )           |   |            | (18,286   | )         
|                                                                                        |                                                                             |                                                                                                      |            |             |             |      |            |             |             |   |            |          
|                                                                                        |                                                                             | Net income (loss) attributable to common
    shareholders for basic earnings per share computation   |            |             | (23,264,293 | )    |            |             | (10,292,798 | ) |            |           | 189,888    | 
|Effect of dilutive securities:                                                          |                                                                             |                                                                                                      |            |             |             |      |            |             |             |   |            |          
|                                                                                        | Convertible preferred stock                                                 |                                                                                                      |            |            |             |      |            |            |             |   |            | (5,157    | )         
|                                                                                        |                                                                             |                                                                                                      |            |             |             |      |            |             |             |   |            |          
|                                                                                        |                                                                             | Net income (loss) attributable to common
    shareholders for diluted earnings per share computation |            | $           | (23,264,293 | )    |            | $           | (10,292,798 | ) |            | $         | 184,731    | 
|                                                                                        |                                                                             |                                                                                                      |            |             |             |      |            |             |             |   |            |          
|Denominator:                                                                            |                                                                             |                                                                                                      |            |             |             |      |            |             |             |   |            |          
|Shares for basic net income or loss per
    share  weighted average shares outstanding |                                                                             |                                                                                                      | 59,896,135 |             |             |      | 58,206,969 |             |             |   | 57,475,748 |          
|Effect of dilutive securities:                                                          |                                                                             |                                                                                                      |            |             |             |      |            |             |             |   |            |          
|                                                                                        | Stock options(1)                                                            |                                                                                                      |            |            |             |      |            |            |             |   |            | 2,559,869 |           
|                                                                                        | Stock warrants(2)                                                           |                                                                                                      |            |            |             |      |            |            |             |   |            | 909,567   |           
|                                                                                        | Convertible preferred stock(3)                                              |                                                                                                      |            |            |             |      |            |            |             |   |            | 185,231   |           
|                                                                                        |                                                                             |                                                                                                      |            |             |             |      |            |             |             |   |            |          
|                                                                                        |                                                                             | Shares for diluted net income or loss per share                                                      |            |             | 59,896,135  |      |            |             | 58,206,969  |   |            |           | 61,130,415 | 
|                                                                                        |                                                                             |                                                                                                      |            |             |             |      |            |             |             |   |            |          
|Basic and diluted net income (loss) per share                                           |                                                                             | $                                                                                                    | (0.39      | )           |             | $    | (0.18      | )           |             | $ | 0.00       |          
|                                                                                        |                                                                             |                                                                                                      |            |             |             |      |            |             |             |   |            |          



---



|    |                                                                                                                                                                                                                                                                             
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | For fiscal 2003, 2002, and 2001, options to
    purchase 5,308,604, 5,739,306, and 66,500 shares of common
    stock, respectively, were excluded from the computation of
    diluted net income (loss) per share as the inclusion of such
    shares would be antidilutive.
|   
|(2) | For fiscal 2003 and 2002, warrants to purchase
    2,289,900 and 1,084,550 shares of common stock,
    respectively, were excluded from the computation of diluted net
    loss per share as the inclusion of such shares would be
    antidilutive.                        
|   
|(3) | For fiscal 2002, preferred stock that was
    convertible into 520,648 shares of common stock was
    excluded from the computation of diluted net loss per share as
    the inclusion of such shares would be antidilutive.                                                

F-11



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##### Table of Contents



AVANIR PHARMACEUTICALS


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

In December 2002, the Financial Accounting
Standards Board (FASB) issued Statement of Financial
Accounting Standards No. 148 (SFAS
No. 148), Accounting for Stock-based
Compensation  Transition and Disclosure, an Amendment
of FASB Statement No. 123. SFAS No. 148 amends
the disclosure requirements of SFAS No. 123 to require
prominent disclosures in both annual and interim financial
reports about the method of accounting for stock-based
compensation and the effect of the method used on reported
results. SFAS No. 123, as amended, encourages, but does not
require, companies to record compensation cost for stock-based
employee compensation at fair value. The Company has chosen to
continue to account for stock-based compensation using the
intrinsic value method prescribed in Accounting Principles Board
(APB) Opinion No. 25, Accounting for
Stock Issued to Employees, and related interpretations for
all periods presented. Accordingly, compensation costs for stock
options is measured as the excess, if any, of the fair value of
the Companys stock at the date of the grant over the
amount an employee must pay to acquire the stock.

The following table summarizes the impact on the
Companys net income or loss had compensation costs been
determined based upon the fair value at the grant date for
awards under the stock option plans consistent with the
methodology prescribed under SFAS No. 123.

|                                                                                                                      |                                                            |                          |             |             |   |      |             |             |   |   |            |            |  
|--------------------------------------------------------------------------------------------------------------------- | ---------------------------------------------------------- | ------------------------ | ----------- | ----------- | - | ---- | ----------- | ----------- | - | - | ---------- | ---------- | -
|                                                                                                                      |                                                            |                         
|                                                                                                                      |                                                            | Year Ended September 30,
|                                                                                                                      |                                                            |                         
|                                                                                                                      |                                                            | 2003                     |             | 2002        |   | 2001
|                                                                                                                      |                                                            |                          |             |             |   |     
|Net income (loss) attributable to common
    shareholders, as reported                                                |                                                            | $                        | (23,264,293 | )           |   | $    | (10,292,798 | )           |   | $ | 189,888    |           
|Add: Stock-based employee compensation included
    in reported net income (loss) attributable to common shareholders |                                                            |                          | 234,638     |             |   |      | 172,071     |             |   |   | 128,638    |           
|Deduct: Total stock-based employee compensation
    expense determined under fair value based method for all awards   |                                                            |                          | (1,788,674  | )           |   |      | (2,348,203  | )           |   |   | (1,668,376 | )         
|                                                                                                                      |                                                            |                          |             |             |   |      |             |             |   |   |            |           
|                                                                                                                      | Pro forma net loss attributable to common
    shareholders |                          | $           | (24,818,329 | ) |      | $           | (12,468,930 | ) |   | $          | (1,349,850 | )
|                                                                                                                      |                                                            |                          |             |             |   |      |             |             |   |   |            |           
|Net loss per share:                                                                                                   |                                                            |                          |             |             |   |      |             |             |   |   |            |           
|                                                                                                                      | Basic and diluted  as reported                            |                          | $           | (0.39       | ) |      | $           | (0.18       | ) |   | $          | 0.00       |  
|                                                                                                                      | Basic and diluted  pro forma                              |                          | $           | (0.41       | ) |      | $           | (0.21       | ) |   | $          | (0.02      | )

We estimate the weighted average fair values per
share of the options granted during fiscal 2003, 2002 and 2001
to be $0.96, $2.49 and $3.99, respectively, using the
Black-Scholes option-pricing model and the following assumptions:

|                        |  |                           |      |      |  |      |      |   |  |  |      |  
|----------------------- |  | ------------------------- | ---- | ---- |  | ---- | ---- | - |  |  | ---- | -
|                        |  |                          
|                        |  | Years Ended September 30,
|                        |  |                          
|                        |  | 2003                      |      | 2002 |  | 2001
|                        |  |                           |      |      |  |     
|Risk free interest rate |  |                           | 2.72 | %    |  |      | 4.4  | % |  |  | 5.8  | %
|Expected life (years)   |  |                           | 4.63 |      |  |      | 4.2  |   |  |  | 4.1  |  
|Expected volatility     |  |                           | 125  | %    |  |      | 128  | % |  |  | 158  | %
|Expected dividends      |  |                           | None |      |  |      | None |   |  |  | None |  



| |                                     
| | ------------------------------------
| | Recent Accounting
    Pronouncements

In July 2002, the FASB issued SFAS No. 146,
Accounting for Costs Associated with Exit or Disposal
Activities, which addresses financial accounting and
reporting for costs associated with exit or disposal activities
and supersedes EITF Issue 94-3, Liability Recognition
for Certain Employee Termination Benefits and Other Costs to
Exit an Activity (including Certain Costs Incurred in a
Restructuring). SFAS No. 146

F-12



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##### Table of Contents



AVANIR PHARMACEUTICALS


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

requires that a liability for a cost associated
with an exit or disposal activity be recognized when the
liability is incurred. Under Issue 94-3, a liability for an
exit cost as defined in EITF 94-3 was recognized at the
date of an entitys commitment to an exit plan. SFAS
No. 146 also establishes that the liability should
initially be measured and recorded at fair value. SFAS
No. 146 became effective for the Company on January 1,
2003. The application of SFAS No. 146 did not have a
material impact on the Companys financial statements.

In November 2002, the FASB issued FASB
Interpretation No. 45, Guarantors Accounting
and Disclosure Requirements for Guarantees, Including Indirect
Guarantees of Indebtedness of Others, which elaborates on
the disclosures to be made by a guarantor about its obligation
under certain guarantees issued. It also clarifies that a
guarantor is required to recognize, at the inception of a
guarantee, a liability for the fair value of the obligation
undertaken in issuing the guarantee. The Interpretation expands
on the accounting guidance of SFAS No. 5, Accounting
for Contingencies, SFAS No. 57, Related Party
Disclosures, and SFAS No. 107, Disclosures
about Fair Value of Financial Instruments. It also
incorporates without change the provisions of FASB
Interpretation No. 34, Disclosure of Indirect
Guarantees of Indebtedness of Others. FASB Interpretation
No. 45 became effective for the Company on January 1,
2003. The application of FASB Interpretation No. 45 did not
have a material impact on the Companys financial
statements.

In December 2002, the FASB issued SFAS
No. 148, Accounting for Stock-Based
Compensation  Transition and Disclosure, an Amendment
of FASB Statement No. 123. SFAS No. 148 provides
alternative methods of transition for a voluntary change to the
fair value-based method of accounting for stock-based employee
compensation. In addition, SFAS No. 148 amends the
disclosure requirements of SFAS No. 123 to require
prominent disclosures in both annual and interim financial
statements about the method of accounting for stock-based
compensation and the effect of the method used on reported
results. The voluntary transition and amended disclosure
requirements are effective for the Company for the fiscal year
ended September 30, 2003. The interim reporting
requirements became effective for the Companys interim
periods beginning January 1, 2003. The Company currently
accounts for stock-based employee compensation under the
intrinsic value method in accordance with APB No. 25. The
Company does not plan to voluntarily change its method of
accounting, but has implemented the amended disclosure
requirements for the fiscal year ended September 30, 2003.

In January 2003, the FASB issued FASB
Interpretation No. 46 (FIN 46),
Consolidation of Variable Interest Entities, an
Interpretation of ARB No. 51. FIN 46 requires
the consolidation of certain variable interest entities by the
primary beneficiary of the entity if the equity investment at
risk is not sufficient to permit the entity to finance its
activities without additional subordinated financial support
from other parties or if the equity investors lack the
characteristics of a controlling financial interest. FIN 46
is effective for variable interest entities created or acquired
after January 31, 2003. For variable interest entities
created or acquired prior to February 1, 2003, the
provisions of FIN 46 were initially to have been applied in
the first interim or annual period beginning after June 15,
2003. The FASB postponed implementation of FIN 46 in
October 2003 and again in December 2003. Currently, the Company
must apply the provisions of FIN 46 effective
March 31, 2004. The effect, if any, of FIN 46 on the
Companys financial statements has not yet been determined.

In May 2003, the FASB issued SFAS No. 150,
Accounting for Certain Financial Instruments with
Characteristics of Both Liabilities and Equity. SFAS
No. 150 establishes standards for how an issuer classifies
and measures certain financial instruments with characteristics
of both liabilities and equity. It requires that an issuer
classify a financial instrument that is within its scope as a
liability (or an asset in some circumstances). SFAS No. 150
is effective for financial instruments entered into or modified
after May 15, 2003, and otherwise became effective for the
Company on July 1, 2003. The adoption of SFAS No. 150
did not have a material impact on the Companys financial
statements.

F-13



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##### Table of Contents



AVANIR PHARMACEUTICALS


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



|   |                      
|-- | ---------------------
|3. | Balance Sheet Details

The following tables provide details of selected
balance sheet items.

Property and
Equipment.During fiscal 2003, the
Company completed construction on approximately
30,400 square feet of laboratory and office space, located
at 11404 and 11408 Sorrento Valley Road, San Diego, CA. At the
time of completion of construction, $4.1 million that was
classified as construction in progress was reclassified as
leasehold improvements. Property and equipment as of
September 30, 2003 and September 30, 2002 consist of
the following:

|                                          |                              |                    |           |                    |  |       |            |            |   |              |           |           |  |   |           |           |  |   |          |            |   |   |           |           | 
|----------------------------------------- | ---------------------------- | ------------------ | --------- | ------------------ |  | ----- | ---------- | ---------- | - | ------------ | --------- | --------- |  | - | --------- | --------- |  | - | -------- | ---------- | - | - | --------- | --------- | 
|                                          |                              |                    |           |                   
|                                          |                              | September 30, 2003 |           | September 30, 2002
|                                          |                              |                    |           |                   
|                                          |                              | Gross              |           |                    |  | Gross |            |           
|                                          |                              | Carrying           |           | Accumulated        |  |       |            | Carrying   |   | Accumulated  |           |          
|                                          |                              | Value              |           | Depreciation       |  | Net   |            | Value      |   | Depreciation |           | Net      
|                                          |                              |                    |           |                    |  |       |            |            |   |              |           |          
|Research and development equipment        |                              | $                  | 3,544,343 |                    |  | $     | (1,331,544 | )          |   | $            | 2,212,799 |           |  | $ | 2,420,028 |           |  | $ | (867,991 | )          |   | $ | 1,552,037 |          
|Computer equipment and related software   |                              |                    | 1,000,206 |                    |  |       | (383,512   | )          |   |              | 616,694   |           |  |   | 851,952   |           |  |   | (238,199 | )          |   |   | 613,753   |          
|Leasehold improvements                    |                              |                    | 5,000,147 |                    |  |       | (445,435   | )          |   |              | 4,554,712 |           |  |   | 866,318   |           |  |   | (175,410 | )          |   |   | 690,908   |          
|Office equipment, furniture, and fixtures |                              |                    | 549,864   |                    |  |       | (192,064   | )          |   |              | 357,800   |           |  |   | 254,731   |           |  |   | (128,557 | )          |   |   | 126,174   |          
|Construction in progress                  |                              |                    |          |                    |  |       |           |            |   |              |          |           |  |   | 198,094   |           |  |   |         |            |   |   | 198,094   |          
|                                          |                              |                    |           |                    |  |       |            |            |   |              |           |           |  |   |           |           |  |   |          |            |   |   |           |          
|                                          | Total property and equipment |                    | $         | 10,094,560         |  |       | $          | (2,352,555 | ) |              | $         | 7,742,005 |  |   | $         | 4,591,123 |  |   | $        | (1,410,157 | ) |   | $         | 3,180,966 | 
|                                          |                              |                    |           |                    |  |       |            |            |   |              |           |           |  |   |           |           |  |   |          |            |   |   |           |          

Intangible Assets.Effective October 1, 2002, the Company adopted SFAS
No. 142, Goodwill and Other Intangible Assets,
which requires goodwill and other intangible assets that have
indefinite useful lives to no longer be amortized; however,
these assets must be reviewed at least annually for impairment.
Intangible assets with indefinite useful lives consist of costs
of trademarks for AVANIR and Xenerex and similar names intended
for use or potential use in the United States and the rest of
the world. Intangible assets with finite lives continue to be
amortized over their useful lives for the fiscal year ended
September 30, 2003, and are evaluated for impairment
whenever events or changes in circumstances indicate that their
carrying value may not be recoverable under SFAS No. 144,
Accounting for Impairment or Disposal of Long-lived
Assets. AVANIRs amortizable intangible assets
consist of the costs of patents, patent applications, and
licenses.

F-14



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##### Table of Contents



AVANIR PHARMACEUTICALS


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

Intangible assets, consisting of both intangible
assets with finite and indefinite useful lives, are as follows:

|                                               |                             |                         |           |                    |           |       |          |          |          |              |           |           |           |  |           |         |           |  |          |          |          |   |           |         |           | 
|---------------------------------------------- | --------------------------- | ----------------------- | --------- | ------------------ | --------- | ----- | -------- | -------- | -------- | ------------ | --------- | --------- | --------- |  | --------- | ------- | --------- |  | -------- | -------- | -------- | - | --------- | ------- | --------- | 
|                                               |                             |                         |           |                   
|                                               |                             | September 30, 2003      |           | September 30, 2002
|                                               |                             |                         |           |                   
|                                               |                             | Gross                   |           |                    |           | Gross |          |         
|                                               |                             | Carrying                |           | Accumulated        |           |       |          | Carrying |          | Accumulated  |           |          
|                                               |                             | Value                   |           | Amortization       |           | Net   |          | Value    |          | Amortization |           | Net      
|                                               |                             |                         |           |                    |           |       |          |          |          |              |           |          
|Intangible assets with finite lives:           |                             |                         |           |                    |           |       |          |          |          |              |           |           |           |  |           |         |           |  |          |          |          |   |           |        
|                                               | Patent applications pending |                         | $         | 1,464,859          |           |       | $        |         |          |              | $         | 1,464,859 |           |  | $         | 966,781 |           |  | $        |         |          |   | $         | 966,781 |          
|                                               | Patents                     |                         |           | 855,799            |           |       |          | (254,657 | )        |              |           | 601,142   |           |  |           | 741,175 |           |  |          | (192,190 | )        |   |           | 548,985 |          
|                                               | Licenses                    |                         |           | 42,461             |           |       |          | (13,383  | )        |              |           | 29,078    |           |  |           | 41,215  |           |  |          | (6,445   | )        |   |           | 34,770  |          
|                                               | Licenses pending            |                         |           |                   |           |       |          |         |          |              |           |          |           |  |           | 22,101  |           |  |          |         |          |   |           | 22,101  |          
|                                               |                             |                         |           |                    |           |       |          |          |          |              |           |           |           |  |           |         |           |  |          |          |          |   |           |        
|Total intangible assets with finite lives      |                             |                         | 2,363,119 |                    |           |       | (268,040 | )        |          |              | 2,095,079 |           |           |  | 1,771,272 |         |           |  | (198,635 | )        |          |   | 1,572,637 |        
|Intangible assets with indefinite useful lives |                             |                         | 36,130    |                    |           |       |         |          |          |              | 36,130    |           |           |  | 86,781    |         |           |  |         |          |          |   | 86,781    |        
|                                               |                             |                         |           |                    |           |       |          |          |          |              |           |           |           |  |           |         |           |  |          |          |          |   |           |        
|                                               |                             | Total intangible assets |           | $                  | 2,399,249 |       |          | $        | (268,040 | )            |           | $         | 2,131,209 |  |           | $       | 1,858,053 |  |          | $        | (198,635 | ) |           | $       | 1,659,418 | 
|                                               |                             |                         |           |                    |           |       |          |          |          |              |           |           |           |  |           |         |           |  |          |          |          |   |           |        

Amortization expense related to amortizable
intangible assets was $69,405, $53,413, and $47,663 for fiscal
years 2003, 2002 and 2001, respectively. During fiscal 2003,
there were additions of $23,781 and an abandonment of $74,432 in
intangible assets with indefinite useful lives. Based solely on
the amortizable intangible assets as of September 30, 2003,
the estimated annual amortization expense of intangible assets
for the fiscal years ending September 30 is as shown in the
following table. Actual amortization expense to be reported in
future periods could differ from these estimates as a result of
acquisitions, divestitures, asset impairments, and other
relevant factors.

|                                 |          |   |           |           | 
|-------------------------------- | -------- | - | --------- | --------- | 
|Amortization Expense             |          |  
|                                 |          |  
|Fiscal year ending September 30: |          |   |           |          
|2004                             |          | $ | 57,393    |          
|2005                             |          |   | 60,574    |          
|2006                             |          |   | 60,109    |          
|2007                             |          |   | 58,842    |          
|2008                             |          |   | 58,411    |          
|Thereafter                       |          |   | 334,891   |          
|                                 |          |   |           |          
|                                 | Subtotal |   |           | 630,220   | 
|Patent applications pending      |          |   | 1,464,859 |          
|                                 |          |   |           |          
|                                 | Total    |   | $         | 2,095,079 | 
|                                 |          |   |           |          

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##### Table of Contents



AVANIR PHARMACEUTICALS


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

4.     Investments

The following tables summarize the Companys
investments in securities, which are available for sale.
Available-for-sale securities are those investments not intended
for sale in the near term or held to maturity. The
available-for-sale investments are carried at fair value with
unrealized gains or losses reported in shareholders equity
as accumulated other comprehensive income or loss. Investments
classified as held-to-maturity are recorded at amortized cost.

|                          |                                |                                  |       |            |           |            |   |            |        |  |   |         |         |   |   |           |           |  | 
|------------------------- | ------------------------------ | -------------------------------- | ----- | ---------- | --------- | ---------- | - | ---------- | ------ |  | - | ------- | ------- | - | - | --------- | --------- |  | 
|                          |                                |                                  |       | Gross      |           | Gross      |   |           
|                          |                                | Amortized                        |       | Unrealized |           | Unrealized |   |           
|                          |                                | Cost                             |       | Gains(1)   |           | Losses(1)  |   | Fair Value
|                          |                                |                                  |       |            |           |            |   |           
|As of September 30, 2003: |                                |                                  |       |            |           |            |   |            |        |  |   |         |         |   |   |          
|                          | Certificates of deposit        |                                  | $     | 2,056,597  |           |            | $ | 15,575     |        |  | $ |        |         |   | $ | 2,072,172 |          
|                          | Adjustable rate mutual fund(2) |                                  |       | 3,014,365  |           |            |   |           |        |  |   | (18,723 | )       |   |   | 2,995,642 |          
|                          | Government debt securities     |                                  |       | 194,467    |           |            |   |           |        |  |   | (3,400  | )       |   |   | 191,067   |          
|                          |                                |                                  |       |            |           |            |   |            |        |  |   |         |         |   |   |          
|                          |                                | Total                            |       | $          | 5,265,429 |            |   | $          | 15,575 |  |   | $       | (22,123 | ) |   | $         | 5,258,881 | 
|                          |                                |                                  |       |            |           |            |   |            |        |  |   |         |         |   |   |          
|Reported as:              |                                |                                  |       |            |           |            |   |            |        |  |   |         |         |   |   |          
|                          | Short-term investments:        |                                  |       |            |           |            |   |            |        |  |   |         |         |   |   |           |          
|                          |                                | Classified as available-for-sale |       | $          | 3,888,798 |            |   |            |        |  |   |         |         |   |   |           |           | 
|                          |                                |                                  |       |            |           |            |   |            |        |  |   |         |         |   |   |          
|                          | Long-term investments:         |                                  |       |            |           |            |   |            |        |  |   |         |         |   |   |           |          
|                          |                                | Classified as available-for-sale |       |            | 513,486   |            |   |            |        |  |   |         |         |   |   |           |           | 
|                          |                                | Restricted investments(3)        |       |            | 856,597   |            |   |            |        |  |   |         |         |   |   |           |           | 
|                          |                                |                                  |       |            |           |            |   |            |        |  |   |         |         |   |   |          
|                          |                                | Long-term investments            |       |            | 1,370,083 |            |   |            |        |  |   |         |         |   |   |           |           | 
|                          |                                |                                  |       |            |           |            |   |            |        |  |   |         |         |   |   |          
|                          |                                |                                  | Total |            | $         | 5,258,881  |   |            |        |  |   |         |         |   |   |           |           |  | 
|                          |                                |                                  |       |            |           |            |   |            |        |  |   |         |         |   |   |          

|                          |                            |                                  |       |            |           |            |   |            |        |  |   |         |         |   |   |           |           |  | 
|------------------------- | -------------------------- | -------------------------------- | ----- | ---------- | --------- | ---------- | - | ---------- | ------ |  | - | ------- | ------- | - | - | --------- | --------- |  | 
|                          |                            |                                  |       | Gross      |           | Gross      |   |           
|                          |                            | Amortized                        |       | Unrealized |           | Unrealized |   |           
|                          |                            | Cost                             |       | Gains(4)   |           | Losses(4)  |   | Fair Value
|                          |                            |                                  |       |            |           |            |   |           
|As of September 30, 2002: |                            |                                  |       |            |           |            |   |            |        |  |   |         |         |   |   |          
|                          | Certificates of deposit    |                                  | $     | 2,056,597  |           |            | $ | 10,434     |        |  | $ |        |         |   | $ | 2,067,031 |          
|                          | Government debt securities |                                  |       | 2,281,156  |           |            |   | 3,173      |        |  |   | (12,900 | )       |   |   | 2,271,429 |          
|                          | Commercial paper           |                                  |       | 200,000    |           |            |   | 5,542      |        |  |   |        |         |   |   | 205,542   |          
|                          |                            |                                  |       |            |           |            |   |            |        |  |   |         |         |   |   |          
|                          |                            | Total                            |       | $          | 4,537,753 |            |   | $          | 19,149 |  |   | $       | (12,900 | ) |   | $         | 4,544,002 | 
|                          |                            |                                  |       |            |           |            |   |            |        |  |   |         |         |   |   |          
|Reported as:              |                            |                                  |       |            |           |            |   |            |        |  |   |         |         |   |   |          
|                          | Short-term investments:    |                                  |       |            |           |            |   |            |        |  |   |         |         |   |   |           |          
|                          |                            | Classified as available-for-sale |       | $          | 495,840   |            |   |            |        |  |   |         |         |   |   |           |           | 
|                          |                            | Classified as held-to-maturity   |       |            | 200,000   |            |   |            |        |  |   |         |         |   |   |           |           | 
|                          |                            |                                  |       |            |           |            |   |            |        |  |   |         |         |   |   |          
|                          |                            | Short-term investments           |       |            | 695,840   |            |   |            |        |  |   |         |         |   |   |           |           | 
|                          |                            |                                  |       |            |           |            |   |            |        |  |   |         |         |   |   |          
|                          | Long-term investments:     |                                  |       |            |           |            |   |            |        |  |   |         |         |   |   |           |          
|                          |                            | Classified as available-for-sale |       |            | 2,986,023 |            |   |            |        |  |   |         |         |   |   |           |           | 
|                          |                            | Restricted investments(3)        |       |            | 856,597   |            |   |            |        |  |   |         |         |   |   |           |           | 
|                          |                            |                                  |       |            |           |            |   |            |        |  |   |         |         |   |   |          
|                          |                            | Long-term investments            |       |            | 3,842,620 |            |   |            |        |  |   |         |         |   |   |           |           | 
|                          |                            |                                  |       |            |           |            |   |            |        |  |   |         |         |   |   |          
|                          |                            |                                  | Total |            | $         | 4,538,460  |   |            |        |  |   |         |         |   |   |           |           |  | 
|                          |                            |                                  |       |            |           |            |   |            |        |  |   |         |         |   |   |          

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##### Table of Contents



AVANIR PHARMACEUTICALS


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



---



|    |                                                                                                                                                                                                                                                                                                                                                                    
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | Gross unrealized gains of $15,575 and gross
    unrealized losses of $22,123 on government securities, the
    adjustable rate mutual fund, and certificates of deposit
    represent an accumulated net unrealized loss of $6,548, which is
    reported as accumulated other comprehensive loss on
    the consolidated balance sheet as of September 30, 2003.
|   
|(2) | Represents an investment in a mutual fund that
    invests primarily in adjustable rate mortgage-backed securities.                                                                                                                                                                                                                                                
|   
|(3) | Restricted investments amounting to $856,597 as
    of both September 30, 2003 and September 30, 2002
    represent amounts pledged to our bank as collateral for letters
    of credit issued in connection with our leases of office and
    laboratory space.                                                                                                   
|   
|(4) | Gross unrealized gains of $13,607 and gross
    unrealized losses of $12,900 on government securities and
    certificates of deposit represent an accumulated net unrealized
    gain of $707, which is reported as accumulated other
    comprehensive income on the consolidated balance sheet as
    of September 30, 2002.                                  

5.     Asset
Sale

On December 24, 2002, AVANIR sold an
undivided interest in its Abreva® license agreement with SB
Pharmco Puerto Rico, Inc. (SB or
GlaxoSmithKline) to Drug Royalty USA, Inc.
(Drug Royalty USA). Under the terms of the Drug
Royalty USA agreement, Drug Royalty USA acquired the rights to
all royalties accruing after September 30, 2002 from the
sale of Abreva for cold sores in the United States and Canada
payable under the Abreva license agreement, subject to
AVANIRs right to receive 50% of all such royalties payable
on sales of Abreva over $62 million per year. Drug Royalty
USA paid AVANIR $20.5 million at the closing and an
additional $3.6 million in April 2003 upon AVANIRs
receipt from the United States Patent and Trademark Office of a
grant of patent term extension for U.S. Patent Number 4,874,794.
In connection with the sale, AVANIR and Drug Royalty USA entered
into a security agreement pursuant to which AVANIR granted Drug
Royalty USA a security interest in AVANIRs United States
and Canadian patents related to the treatment of cold sores.

AVANIR retains all rights to develop and license
docosanol 10% cream (or Abreva, as marketed by SBs parent,
GlaxoSmithKline) outside the United States and Canada for the
treatment of cold sores. AVANIR also retains all rights to
develop and license docosanol 10% cream worldwide for all other
indications, subject to certain rights of SB in the United
States and Canada.

In recording the sale transaction in December
2002, AVANIR increased cash by $20.4 million (net of
transaction costs), reduced accrued expenses by $301,000 in
connection with the forgiveness of a related advance, and
recorded deferred revenue in the amount of $20.7 million.
We recorded the initial net proceeds of the transaction as
deferred revenue because of our ongoing involvement in earning
future revenues under our license agreement with SB. We also
classified the additional $3.6 million received in April
2003 as deferred revenue, to be recognized ratably over the life
of the license agreement.

The expiration date for U.S. Patent Number
4,874,794 has been extended from April 2009 to April 2014. The
effect of extending the expiration of the patent from 2009 to
2014 is that it has extended the term of the patent royalty and
the accounting period over which the deferred revenue relating
to the patent royalty will be recognized as revenue. Thus, less
deferred revenue has been recognized as revenue during the
fiscal quarters ended June 30 and September 30, 2003
than the fiscal quarter ended March 31, 2003. Deferred
revenues recognized as revenue for fiscal 2003 were
$1.8 million. Abreva® royalties earned for fiscal 2002
were $3.4 million.

Revenue recognition is being determined under the
units-of-revenue method. Under this method, the amount of
deferred revenue to be recognized as revenue in each period is
calculated by multiplying (i) the ratio of the royalty
payments due to Drug Royalty USA for the period to the total
remaining royalties that we

F-17



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##### Table of Contents



AVANIR PHARMACEUTICALS


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

expect SB will pay Drug Royalty USA over the term
of the agreement, by (ii) the unamortized deferred revenue
amount. The portion of deferred revenue classified as part of
current liabilities represents the amount AVANIR expects to
realize as revenue within the next 12 months.

The following table sets forth the deferred
revenue recorded from the sale to Drug Royalty USA of rights to
future Abreva royalties and other deferred revenue balances as
of September 30, 2003 and September 30, 2002.

|                                          |                                                           |                               |            |            |            |       |         |         |         |   |            |            |            | 
|----------------------------------------- | --------------------------------------------------------- | ----------------------------- | ---------- | ---------- | ---------- | ----- | ------- | ------- | ------- | - | ---------- | ---------- | ---------- | 
|                                          |                                                           | Drug Royalty                  |            | Other      |            |      
|                                          |                                                           | USA Agreement                 |            | Agreements |            | Total
|                                          |                                                           |                               |            |            |            |      
|Deferred revenue as of September 30, 2002 |                                                           | $                             |           |            |            | $     | 233,333 |         |         | $ | 233,333    |           
|                                          |                                                           |                               |            |            |            |       |         |         |         |   |            |           
|Changes during the year:                  |                                                           |                               |            |            |            |       |         |         |         |   |            |           
|                                          | Initial proceeds from sale of future Abreva
    royalties |                               |            | 20,500,000 |            |       |         |        |         |   |            | 20,500,000 |           
|                                          | Less cost of transaction                                  |                               |            | (143,982   | )          |       |         |        |         |   |            | (143,982   | )         
|                                          |                                                           |                               |            |            |            |       |         |         |         |   |            |           
|                                          |                                                           | Net proceeds                  |            |            | 20,356,018 |       |         |         |        |   |            |            | 20,356,018 | 
|                                          | Forgiveness of a related advance                          |                               |            | 300,912    |            |       |         |        |         |   |            | 300,912    |           
|                                          |                                                           |                               |            |            |            |       |         |         |         |   |            |           
|                                          |                                                           | Subtotal                      |            |            | 20,656,930 |       |         |         |        |   |            |            | 20,656,930 | 
|                                          |                                                           | Additions to deferred revenue |            |            | 3,620,748  |       |         |         |         |   |            |            | 3,620,748  | 
|                                          | Recognized as revenues during the year                    |                               |            | (1,768,369 | )          |       |         |        |         |   |            | (1,768,369 | )         
|                                          |                                                           |                               |            |            |            |       |         |         |         |   |            |           
|Deferred revenue as of September 30, 2003 |                                                           | $                             | 20,509,308 |            |            | $     | 233,333 |         |         | $ | 22,742,641 |           
|                                          |                                                           |                               |            |            |            |       |         |         |         |   |            |           
|Classified as:                            |                                                           |                               |            |            |            |       |         |         |         |   |            |           
|                                          | Current portion of deferred revenue                       |                               | $          | 1,608,532  |            |       | $       | 233,333 |         |   | $          | 1,841,865  |           
|                                          | Deferred revenue, net of current portion                  |                               |            | 20,900,776 |            |       |         |        |         |   |            | 20,900,776 |           
|                                          |                                                           |                               |            |            |            |       |         |         |         |   |            |           
|                                          |                                                           | Total deferred revenue        |            | $          | 22,509,308 |       |         | $       | 233,333 |   |            | $          | 22,742,641 | 
|                                          |                                                           |                               |            |            |            |       |         |         |         |   |            |           

6.     Commitments
and Contingencies

Operating lease
commitments.On March 20, 2000,
the Company signed an eight-year lease for 27,047 square
feet of office and lab space in a building located at
11388 Sorrento Valley Road, Suite 200, San Diego,
California, commencing on September 1, 2000. On
February 1, 2001, the Company signed an amendment to the
lease for an additional 165 square feet of office and lab space.
The lease has scheduled rent increases each year and expires on
August 31, 2008. As of September 30, 2003, the
financial commitment for the remainder of the term of the lease
is $3,920,497. We delivered an irrevocable standby letter of
credit to the lessor in the amount of $388,122, to secure our
performance under the lease.

On May 20, 2002, we signed a ten-year lease
for approximately 26,770 square feet of office and lab
space in buildings adjacent to our existing facilities,
commencing on January 15, 2003. On April 2, 2003, we
signed an amendment to the lease for an additional
3,600 square feet of storage space in the building located
at 11408 Sorrento Valley Road. The storage space is capable
of being converted into either office or lab space, if needed in
the future. The lease has scheduled rent increases each year and
expires on January 14, 2013. As of September 30, 2003,
the financial commitment for the remainder of the term of the
lease is $9,832,756. We delivered an irrevocable standby letter
of credit to the lessor in the amount of $468,475, to secure our
performance under the lease.

F-18



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##### Table of Contents



AVANIR PHARMACEUTICALS


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

Lease expenses for fiscal 2003, 2002 and 2001
were $1,724,403, $818,557 and $754,785, respectively. We have
included $400,204 and $154,911 of deferred rent in accrued
expenses and other liabilities as of September 30, 2003 and
2002, respectively. Future minimum payments under non-cancelable
operating leases as of September 30, 2003 are as follows:

|                          |       |          |           |            | 
|------------------------- | ----- | -------- | --------- | ---------- | 
|                          |       | Minimum 
|Year Ending September 30, |       | Payments
|                          |       |         
|2004                      |       | $        | 1,640,047 |           
|2005                      |       |          | 1,702,298 |           
|2006                      |       |          | 1,768,703 |           
|2007                      |       |          | 1,833,892 |           
|2008                      |       |          | 1,830,121 |           
|Thereafter                |       |          | 4,978,192 |           
|                          |       |          |           |           
|                          | Total |          | $         | 13,753,253 | 
|                          |       |          |           |           

Capital lease
commitments.On September 21,
2001, January 21, 2002 and May 1, 2002, the Company
acquired several pieces of equipment under three-year, four-year
and five-year capital lease obligations, respectively. Each of
these capital leases provides the Company with the option at the
expiration of the lease term to purchase all the equipment
leased for a price of one dollar ($1.00).

Future minimum payments under the capital leases
as of September 30, 2003 are as follows:

|                                    |       |                                   |         |         |         | 
|----------------------------------- | ----- | --------------------------------- | ------- | ------- | ------- | 
|                                    |       | Minimum                          
|Year Ending September 30,           |       | Payments                         
|                                    |       |                                  
|2004                                |       | $                                 | 171,785 |        
|2005                                |       |                                   | 169,772 |        
|2006                                |       |                                   | 28,742  |        
|2007                                |       |                                   | 9,581   |        
|                                    |       |                                   |         |        
|                                    | Total |                                   |         | 379,880 |        
|                                    |       | Less amount representing interest |         |         | 45,116  | 
|                                    |       |                                   |         |        
|Present value of net lease payments |       |                                   | 334,764 |        
|                                    |       | Less current portion              |         |         | 142,354 | 
|                                    |       |                                   |         |        
|Long-term portion of obligation     |       | $                                 | 192,410 |        
|                                    |       |                                   |         |        

Legal contingencies.In the ordinary course of business, we face various claims
brought by third parties, including claims relating to the
safety or efficacy of our products. Any of these claims could
subject us to costly litigation and, while we generally believe
that we have adequate insurance to cover many different types of
liabilities, our insurance carriers may deny coverage or our
policy limits may be inadequate to fully satisfy any damage
awards or settlements. If this were to happen, the payment of
any such awards could have a material adverse effect on our
operations and financial position. Additionally, any such
claims, whether or not successful, could damage our reputation
and business. Management believes the outcome of currently
identified claims and lawsuits will not have a material adverse
effect on the Companys operations or financial position.

F-19



---



##### Table of Contents



AVANIR PHARMACEUTICALS


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

7.     Shareholders
Equity



| |                
| | ---------------
| | Preferred stock

Preferred stock consists of Series C junior
participating preferred stock and Series D redeemable
convertible preferred stock. None of either series of preferred
stock were issued or outstanding as of September 30, 2003.

Series C junior participating preferred
stock.On March 2, 1999, our
Board of Directors approved a shareholder rights plan (the
Plan). The Plan features a dividend distribution of
one preferred share purchase right (the Right) on
each outstanding share of our Class A and Class B
common stock, payable to shareholders of record on
March 25, 1999. Subject to limited exceptions, the Rights
would be exercisable if a person or group acquires 15% or more
of our common stock or announces a tender offer for 15% or more
of our common stock (a Trigger Event).

Under certain circumstances, each Right will
entitle shareholders to buy one one-hundredth of a share of
Series C junior participating preferred stock of AVANIR at
an exercise price of $10.00 per share. Our Board of Directors
will be entitled to redeem the Rights at $0.01 per Right at any
time before a person has acquired 15% or more of the outstanding
common stock. The Rights will expire on March 25, 2009.

If a Trigger Event occurs, each Right will
entitle its owner, who is not an acquiring person, to purchase
at the Rights then current exercise price, a number of
shares of Class A common stock having a market value at the
time of twice the Rights exercise price. Rights held by
the acquiring person would become void and not be exercisable to
purchase shares at the bargain purchase price. An acquiring
person is defined as a person who acquires 15% or more of the
outstanding shares of common stock.

Series D redeemable convertible preferred
stock and Class J stock purchase
warrants.As of September 30,
2003, none of the Series D redeemable convertible preferred
stock (Series D Shares) remained outstanding.
In May 2003, the holders of Series D Shares exercised their
rights to convert all of the remaining 50 Series D Shares,
representing $500,000 in redeemable convertible preferred stock
and $36,630 in accrued and unpaid dividends, into 660,305 shares
of Class A common stock, for an average price of $0.81 per
share. The Series D Shares were issued in connection with a
securities purchase agreement made with certain investors on
March 22, 1999.

The securities purchase agreement between the
investors and the Company provided for the sale of up to 500
shares of Series D redeemable convertible preferred stock
(Series D Shares) and a corresponding number of
Class J stock purchase warrants (Class J
Warrants). The agreement required that one Class J Warrant
be issued with each Series D Share for an aggregate
purchase price per unit of $10,000. Each Series D Share
carried an annual dividend of $500 payable on a quarterly basis
in cash or, at our option, in stock at the applicable conversion
rate. Each Class J Warrant that was issued as a part of
each $10,000 unit was exercisable into 500 shares of
Class A common stock. The Class J Warrants had an
expiration date of five years from the date of issuance.

We estimated the value of the warrants issued in
connection with the Series D Shares to be $106,000, based
on the Black-Scholes method. We credited (added) $106,000 to
Class A common stock and reported the same amount as a
discount to the Series D redeemable convertible preferred
stock. We accreted the discount over the three-year life of the
Series D redeemable convertible preferred stock or upon
conversion to Class A common stock. We estimated the value
of the beneficial conversion feature of the Series D
redeemable convertible preferred stock issued in February 2000
to be $140,000 based on the terms of the conversion price in the
agreement, which is the lesser of $2.715 per share or 86% of
market price as defined in the Certificate of Determination. In
fiscal 2000, we recorded the effect of the beneficial conversion
feature of $140,000 as a dividend paid, and charged the amount
to the accumulated deficit and added the same amount to
Class A common stock.

F-20



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##### Table of Contents



AVANIR PHARMACEUTICALS


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

According to the Certificate of Determination,
the Series D holders were able to convert any or all of the
Series D Shares into shares of Class A common stock at
a conversion rate equal to $10,000 divided by a conversion price
equal to the lesser of:



| |   |                                                                                                                                            
| | - | -------------------------------------------------------------------------------------------------------------------------------------------
| |  | the fixed conversion
    price an amount equal to
    $2.715 per share of Class A common stock; or                                        
|
| |  | the variable conversion
    price an amount equal to
    86% of the market price of our Class A common stock,
    defined as the lower of:



| |   |                                                                                                                                                                                                                                                                                                                                                                   
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | the average of the five lowest trading prices per
    share of Class A common stock on The American Stock
    Exchange during the 25 trading days immediately preceding a
    given date of determination, where trading price is determined
    as the average of the high and low trading prices of our
    Class A common stock on a particular trading day; or
|
| |  | the average of the high and low trading price per
    share of Class A common stock on The American Stock
    Exchange on the date of determination.                                                                                                                                                                                                              

The following table summarizes the changes in
Series D Shares and conversions into Class A common
stock from October 1, 2000 to September 30, 2003:

|                             |                                                                                      |                       |    |        |   |   |         |          |  
|---------------------------- | ------------------------------------------------------------------------------------ | --------------------- | -- | ------ | - | - | ------- | -------- | -
|                             |                                                                                      |                      
|                             |                                                                                      | Series D Redeemable  
|                             |                                                                                      | Convertible Preferred
|                             |                                                                                      | Stock                
|                             |                                                                                      |                      
|                             |                                                                                      | Shares                |    | Amount
|                             |                                                                                      |                       |    |       
|Balance, October 1, 2000     |                                                                                      |                       | 50 |        |   | $ | 465,920 |         
|                             | Accretion of Series D redeemable convertible
    preferred stock                     |                       |    |       |   |   |         | 18,286   |  
|                             | Preferred stock dividends accrued between
    October 1, 2000 and September 30, 2001 |                       |    |       |   |   |         | 18,697   |  
|                             |                                                                                      |                       |    |        |   |   |         |         
|Balance, September 30, 2001. |                                                                                      |                       | 50 |        |   |   | 502,903 |         
|                             | Accretion of Series D redeemable convertible
    preferred stock                     |                       |    |       |   |   |         | 18,286   |  
|                             |                                                                                      |                       |    |        |   |   |         |         
|Balance, September 30, 2002  |                                                                                      |                       | 50 |        |   |   | 521,189 |         
|                             | Accretion of Series D redeemable convertible
    preferred stock                     |                       |    |       |   |   |         | 11,823   |  
|                             | Preferred stock dividends accrued between
    April 1, 2003 and May 20, 2003         |                       |    |       |   |   |         | 3,618    |  
|                             | Conversion into 288,800 shares of
    Class A common stock                           |                       |    | (50    | ) |   |         | (536,630 | )
|                             |                                                                                      |                       |    |        |   |   |         |         
|Balance, September 30, 2003. |                                                                                      |                       | 0  |        |   | $ | 0       |         
|                             |                                                                                      |                       |    |        |   |   |         |         



| |             
| | ------------
| | Common stock

We have both Class A and Class B common
stock. Holders of Class A common stock have one vote for
each share held of record and holders of Class B common
stock have five votes for each share held of record on all
matters to be voted on by the shareholders. The Class A
common stock and the Class B common stock vote as one class
on all matters requiring shareholder approval, except that under
California law the affirmative vote of a majority of the
outstanding shares of Class A common stock and a majority
of the outstanding shares of Class B common stock, each
voting separately as a class, is required for any amendment to
our articles of incorporation that would alter or change the
powers, preferences or special right of, or increase or decrease
the number of shares of, or create a new class or series of
shares having rights, preferences or privileges prior to, each
respective class of the Companys common stock.

Upon liquidation, holders of both classes of
common stock would be entitled to share ratably in the net
assets available for distribution subject to the rights, if any,
of holders of any preferred stock then outstanding.

F-21



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##### Table of Contents



AVANIR PHARMACEUTICALS


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

Shares of both classes of common stock are not
redeemable and have no preemptive or similar rights. The
Class B common stock may be converted into Class A
common stock on a share-for-share basis at any time at the
election of the holder and will automatically convert into
Class A common stock upon the sale or other transfer to
another holder of Class B common stock (including, without
limitation, conveyance into a trust or transfer by the operation
of any will or the laws of descent and distribution).

Class A common
stock.On March 13, 2003, we
awarded to each non-employee director 10,000 shares of
restricted Class A common stock. The shares awarded to each
director are held in escrow by the Secretary of the Company and
will be released from escrow to a director upon his or her
termination of service as a director of the Company. The value
of the Class A common stock on the date of grant was $1.16
per share. We recorded compensation expense in the amount of
$92,800 in connection with these awards.

On July 23, 2003, we sold and issued
6,728,396 shares of Class A common stock and warrants
to purchase an additional 1,345,673 shares of Class A
common stock to several accredited investors and received
$10,025,320 in gross proceeds. The warrant exercise price is
$2.23 per share. The financing transaction was made pursuant to
the terms of a securities purchase agreement that provided each
investor with a warrant to purchase one share of Class A
common stock for every five shares of Class A common stock
purchased under the agreement. The effect of the financing
transaction was an increase in cash and shareholders
equity in the amount of $9,381,317 after taking into effect the
costs of the transaction.

Also during fiscal 2003, we issued an aggregate
of 77,200 shares of Class A common stock in connection
with the exercise of stock purchase warrants
(53,200 shares) and employee stock options (24,000 shares)
for cash in the aggregate amount of $85,350, representing a
weighted average price per share of $1.11.

During fiscal 2002, we issued 191,152 shares
of Class A common stock in connection with the exercise of
employee stock options for $170,574. We also issued
80,000 shares of Class A common stock in connection
with the exercise of stock purchase warrants for $90,000.

Details of common stock transactions during
fiscal 2003 and 2002 are shown in the tables that follow.

|                                      |                         |       |  |          |  |          |  |               |           |  |   |            |            |  |   |      |  | 
|------------------------------------- | ----------------------- | ----- |  | -------- |  | -------- |  | ------------- | --------- |  | - | ---------- | ---------- |  | - | ---- |  | 
|Common Stock Issued and Warrants      |                         |       |  |          |  | Amount   |  | Average Price
|and Stock Options Exercised           |                         | Date  |  | Shares   |  | Received |  | Per Share(1) 
|                                      |                         |       |  |          |  |          |  |              
|Fiscal year ended September 30, 2003: |                         |       |  |          |  |          |  |               |           |  |   |            |            |  |   |     
|                                      | Private placement       |       |  | 7/23/03  |  |          |  | 6,728,396     |           |  | $ | 10,025,320 |            |  | $ | 1.49 | 
|                                      | Restricted stock grants |       |  | 3/13/03  |  |          |  | 80,000        |           |  |   | 92,800     |            |  | $ | 1.16 | 
|                                      | Stock options           |       |  | 11/13/02 |  |          |  | 24,000        |           |  |   | 25,500     |            |  | $ | 1.06 | 
|                                      | Class K warrants        |       |  | 2/12/03  |  |          |  | 53,200        |           |  |   | 59,850     |            |  | $ | 1.13 | 
|                                      |                         |       |  |          |  |          |  |               |           |  |   |            |            |  |   |     
|                                      |                         | Total |  |          |  |          |  |               | 6,885,596 |  |   | $          | 10,203,470 |  |   |      |  | 
|                                      |                         |       |  |          |  |          |  |               |           |  |   |            |            |  |   |     
|Fiscal year ended September 30, 2002: |                         |       |  |          |  |          |  |               |           |  |   |            |            |  |   |     
|                                      | Stock options           |       |  | Various  |  |          |  | 191,152       |           |  | $ | 170,574    |            |  | $ | 0.89 | 
|                                      | Class K warrants        |       |  | 12/12/01 |  |          |  | 80,000        |           |  |   | 90,000     |            |  | $ | 1.13 | 
|                                      |                         |       |  |          |  |          |  |               |           |  |   |            |            |  |   |     
|                                      |                         | Total |  |          |  |          |  |               | 271,152   |  |   | $          | 260,574    |  |   |      |  | 
|                                      |                         |       |  |          |  |          |  |               |           |  |   |            |            |  |   |     



---



|    |                               
|--- | ------------------------------
|(1) | Rounded to two decimal places.

Additionally, on December 5, 2003, we sold
and issued 5,382,316 shares of Class A common stock
and warrants to purchase an additional 3,229,389 shares of
Class A common stock to several accredited investors and
received approximately $8,020,000 in gross proceeds. The warrant
exercise price is $1.75 per share. The financing transaction was
made pursuant to the terms of a securities purchase agreement
that provided each investor with a warrant to purchase
six-tenths of a share of Class A common stock for every
share of Class A

F-22



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##### Table of Contents



AVANIR PHARMACEUTICALS


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

common stock purchased under the agreement. The
effect of the financing transaction was an increase in cash and
shareholders equity in the amount of $8,019,652 before
taking into effect the costs of the transaction. The placement
agent was paid $415,000 in fees and expenses, and issued a
warrant to purchase 161,470 shares of the Companys
Class A common stock at $1.75 per share, in connection with
this transaction.

Class B common stock
conversions.As of September 30,
2003 there were 13,500 shares of Class B common stock
outstanding. During fiscal 2003 there were no conversions of
Class B common stock. During fiscal 2002,
23,000 shares of Class B common stock were converted
to 23,000 shares of Class A common stock.



| |         
| | --------
| | Warrants

Class A
warrants.See Class A
common stock above.

Class G
warrants.As of September 30,
2003, a Class G warrant to purchase 757,050 shares of
Class A common stock at an exercise price of $1.375 per
share remained outstanding. The holder of the Class G
warrant did not exercise any rights to purchase Class A
common stock during fiscal 2003 or 2002. The Class G
warrant was issued in connection with the conversion of a
convertible note payable issued on February 26, 1997, which
is no longer outstanding. The Class G warrant expires
60 days following the date of effectiveness of a
registration statement with the Securities and Exchange
Commission (SEC) that registers the resale of shares
purchasable upon exercise of the warrant. The
757,050 shares underlying the Class G warrant have not
been registered with the SEC for resale in public markets.

Class J
warrants.As of September 30,
2003, Class J warrants to purchase 50,000 shares of
Class A common stock at $2.71 per share and
50,000 shares of Class A common stock at $0.9144 per
share remained outstanding. None of the Class J warrants
were exercised in fiscal 2003. The Class J warrants were
issued in connection with Series D redeemable convertible
preferred stock that was issued in fiscal 2000 and 1999. The
expiration dates for the warrants vary from March 31, 2004
to February 18, 2005.

Class K
warrant.On February 12, 2003,
the Class K warrant holder exercised its right to purchase
53,200 shares of Class A common stock at an exercise
price of $1.125 per share, for cash in the aggregate amount of
$59,850. As of September 30, 2003, a Class K warrant
to purchase 54,300 shares of Class A common stock at
$1.125 per share remained outstanding and fully vested. The
Class K warrant was issued to an investor relations
consultant in connection with services performed and milestones
achieved in fiscal 2000 and fiscal 2001. The expiration date of
the remaining warrant is March 31, 2004.

Class M
warrants.On November 30, 2003,
Class M warrants to purchase 87,123 shares of
Class A common stock at $1.284 per share expired. None of
the Class M warrants were exercised in either fiscal 2003
or fiscal 2002. During fiscal 2001, the holders exercised their
rights to purchase 107,581 shares of Class A common
stock for the aggregate amount of $138,134.

Class N
warrants.As of September 30,
2003, Class N warrants to purchase 32,877 shares of
Class A common stock at an exercise price of $2.44 per
share remained outstanding in connection with a $6 million
private placement in January 2000. None of the Class N
warrants were exercised in either fiscal 2003, 2002 or 2001. The
Class N warrants expire on January 31, 2004.

F-23



---



##### Table of Contents



AVANIR PHARMACEUTICALS


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

The following table summarizes all warrant
activity for fiscal 2003, 2002 and 2001:

|                                  |             |                      |           |                |   |                 |      |      |  |   |            |            | 
|--------------------------------- | ----------- | -------------------- | --------- | -------------- | - | --------------- | ---- | ---- |  | - | ---------- | ---------- | 
|                                  |             | Shares of Class A    |           | Weighted       |   |                
|                                  |             | Common Stock         |           | Average        |   |                
|                                  |             | Purchasable Upon     |           | Exercise Price |   | Range of       
|                                  |             | Exercise of Warrants |           | per Share      |   | Exercise Prices
|                                  |             |                      |           |                |   |                
|Outstanding at October 1, 2000    |             |                      | 1,619,578 |                |   | $               | 1.41 |      |  | $ | 0.78$3.50 |           
|                                  | Cancelled   |                      |           | (100,000       | ) |                 | $    | 3.50 |  |   | $          | 3.50       | 
|                                  | Tendered(1) |                      |           | (312           | ) |                 | $    | 0.78 |  |   | $          | 0.78       | 
|                                  | Exercised   |                      |           | (254,716       | ) |                 | $    | 1.20 |  |   | $          | 0.78$1.28 | 
|                                  |             |                      |           |                |   |                 |      |      |  |   |            |           
|Outstanding at September 30, 2001 |             |                      | 1,264,550 |                |   | $               | 1.48 |      |  | $ | 0.91$2.72 |           
|                                  | Expired     |                      |           | (100,000       | ) |                 | $    | 2.40 |  |   | $          | 2.40       | 
|                                  | Exercised   |                      |           | (80,000        | ) |                 | $    | 1.13 |  |   | $          | 1.13       | 
|                                  |             |                      |           |                |   |                 |      |      |  |   |            |           
|Outstanding at September 30, 2002 |             |                      | 1,084,550 |                |   | $               | 1.42 |      |  | $ | 0.91$2.72 |           
|                                  | Issued      |                      |           | 1,345,673      |   |                 | $    | 2.23 |  |   | $          | 2.23       | 
|                                  | Expired     |                      |           | (87,123        | ) |                 | $    | 1.28 |  |   | $          | 1.28       | 
|                                  | Exercised   |                      |           | (53,200        | ) |                 | $    | 1.13 |  |   | $          | 1.13       | 
|                                  |             |                      |           |                |   |                 |      |      |  |   |            |           
|Outstanding at September 30, 2003 |             |                      | 2,289,900 |                |   | $               | 1.91 |      |  | $ | 0.91$2.72 |           
|                                  |             |                      |           |                |   |                 |      |      |  |   |            |           



---



|    |                                                                                                                                                
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------
|(1) | Warrant shares tendered represent the amount of
    warrant shares given up, in lieu of cash, for warrants exercised
    (cashless exercise).



| |              
| | -------------
| | Stock options

Stock options to
officers.In fiscal 2003, we issued
incentive stock options under our 2000 Stock Option Plan to the
officers of the Company for the purchase of 435,000 shares
of Class A common stock at exercise prices ranging from
$1.05 to $1.16 per share. The option prices represent the
closing market price for the common stock on the date of grant.

Stock options to non-employee
directors.On March 14, 2003, we
issued to our non-employee directors stock options to purchase
an aggregate of 70,000 shares of Class A common stock
at an exercise price of $1.15 per share as part of a provision
for an annual formula grant under our 1994 Stock Option Plan.
Further, we issued to a new director an option to purchase up to
25,000 shares of Class A common stock at an exercise
price of $1.15 per share as part of his joining the board of
directors. The exercise price of each option represents the
closing market price for the common stock on the date of grant.

2003 Equity Incentive
Plan.On March 13, 2003, the
board of directors approved the adoption of a 2003 equity
incentive plan (the 2003 Equity Incentive Plan) that
provides for the issuance of up to 2,500,000 shares of
Class A common stock. The 2003 Equity Incentive Plan allows
us to grant options, restricted stock awards and stock
appreciation rights to our directors, officers, employees and
consultants. As of September 30, 2003,
2,500,000 shares of Class A common stock remained available
for issuance under the 2003 Equity Incentive Plan.

2000 Stock Option
Plan.On March 23, 2000, our
shareholders approved the adoption of the 2000 Stock Option Plan
(the 2000 Plan), pursuant to which an aggregate of
2,300,000 shares of our Class A common stock have been
reserved for issuance. On March 14, 2002, our shareholders
approved an amendment to the Plan to increase the number of
shares of Class A common stock issuable under the Plan by
1,000,000 shares, for an aggregate of 3,300,000 shares. On
March 13, 2003, we amended the 2000 Plan to allow for the
issuance of restricted stock awards. As of September 30,
2003, 666,240 shares of Class A common stock were available
for grant under the 2000 Plan.

F-24



---



##### Table of Contents



AVANIR PHARMACEUTICALS


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

1998 Stock Option
Plan.On February 19, 1999, our
shareholders approved the 1998 Stock Option Plan (the 1998
Plan). The 1998 Plan as amended in 2002 reserves for
issuance an aggregate of 1,875,000 shares of Class A common
stock. The 1998 Plan allows us to grant options to our
directors, officers, employees and consultants. As of
September 30, 2003, options to purchase 47,303 shares of
Class A common stock were available for grant under the
1998 Plan.

1994 Stock Option
Plan.In March 1994, our shareholders
approved the adoption of the 1994 Stock Option Plan (the
1994 Plan). The 1994 Plan as amended in 1995, 1996,
1997 and 2002 reserves for issuance an aggregate of 2,000,000
shares of Class A common stock. The 1994 Plan allows us to
grant options to our officers, directors, employees and
consultants. The 1994 Plan provides for an automatic annual
grant of an option to purchase 10,000 shares to each director
who is not also one of our employees. The 1994 Plan terminates
on January 14, 2004. As of September 30, 2003, 10,076
shares of Class A common stock were available for grant
under the 1994 Plan.

Canceled stock
options.During fiscal 2003, options
to purchase an aggregate of 1,093,255 shares of Class A
common stock at prices ranging from $1.06 to $3.56 per share
were canceled following their expiration dates. Also, options to
purchase 50,947 shares at prices ranging from $1.16 to $4.15 per
share were canceled due to voluntary and involuntary
terminations. The weighted average price per share for all
canceled options was $2.93.

The following table summarizes all common stock
option activity for fiscal 2003, 2002 and 2001:

|                                  |           |                       |           |                 |   |   |      |      | 
|--------------------------------- | --------- | --------------------- | --------- | --------------- | - | - | ---- | ---- | 
|                                  |           | Number of Shares      |           | Weighted       
|                                  |           | Underlying            |           | Average Option 
|                                  |           | Class A Stock Options |           | Price Per Share
|                                  |           |                       |           |                
|Outstanding at October 1, 2000    |           |                       | 5,362,150 |                 |   | $ | 1.81 |     
|                                  | Granted   |                       |           | 625,760         |   |   | $    | 3.94 | 
|                                  | Exercised |                       |           | (558,142        | ) |   | $    | 1.17 | 
|                                  | Canceled  |                       |           | (134,774        | ) |   | $    | 2.10 | 
|                                  |           |                       |           |                 |   |   |      |     
|Outstanding at September 30, 2001 |           |                       | 5,294,994 |                 |   | $ | 2.13 |     
|                                  | Granted   |                       |           | 650,000         |   |   | $    | 2.91 | 
|                                  | Exercised |                       |           | (191,152        | ) |   | $    | 0.89 | 
|                                  | Canceled  |                       |           | (14,536         | ) |   | $    | 3.37 | 
|                                  |           |                       |           |                 |   |   |      |     
|Outstanding at September 30, 2002 |           |                       | 5,739,306 |                 |   | $ | 2.25 |     
|                                  | Granted   |                       |           | 737,500         |   |   | $    | 1.15 | 
|                                  | Exercised |                       |           | (24,000         | ) |   | $    | 1.06 | 
|                                  | Canceled  |                       |           | (1,144,202      | ) |   | $    | 2.93 | 
|                                  |           |                       |           |                 |   |   |      |     
|Outstanding at September 30, 2003 |           |                       | 5,308,604 |                 |   | $ | 1.96 |     
|                                  |           |                       |           |                 |   |   |      |     
|Exercisable at September 30, 2003 |           |                       | 4,303,092 |                 |   | $ | 1.99 |     
|                                  |           |                       |           |                 |   |   |      |     

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##### Table of Contents



AVANIR PHARMACEUTICALS


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

The following table summarizes information
concerning outstanding and exercisable Class A and
Class B stock options as of September 30, 2003:

|                |  |                     |           |                     |  |          |      |             |  |          |      |  |  |  |           |  |  |   |      | 
|--------------- |  | ------------------- | --------- | ------------------- |  | -------- | ---- | ----------- |  | -------- | ---- |  |  |  | --------- |  |  | - | ---- | 
|                |  |                     |           |                    
|                |  | Options Outstanding |           | Options Exercisable
|                |  |                     |           |                    
|                |  |                     |           | Weighted            |  |          |      |            
|                |  |                     |           | Average             |  | Weighted |      |             |  | Weighted
|                |  |                     |           | Remaining           |  | Average  |      |             |  | Average 
|Range of        |  | Number              |           | Contractual         |  | Exercise |      | Number      |  | Exercise
|Exercise Prices |  | Outstanding         |           | Life in Years       |  | Price    |      | Exercisable |  | Price   
|                |  |                     |           |                     |  |          |      |             |  |         
|$0.30  $0.72   |  |                     | 945,742   |                     |  |          | 5.46 |             |  | $        | 0.68 |  |  |  | 945,742   |  |  | $ | 0.68 | 
|$0.78           |  |                     | 15,000    |                     |  |          | 5.79 |             |  | $        | 0.78 |  |  |  | 15,000    |  |  | $ | 0.78 | 
|$1.00  $1.16   |  |                     | 929,500   |                     |  |          | 8.51 |             |  | $        | 1.13 |  |  |  | 284,674   |  |  | $ | 1.07 | 
|$1.28  $2.31   |  |                     | 1,544,581 |                     |  |          | 5.62 |             |  | $        | 1.64 |  |  |  | 1,460,581 |  |  | $ | 1.65 | 
|$2.47  $2.94   |  |                     | 626,171   |                     |  |          | 5.10 |             |  | $        | 2.56 |  |  |  | 626,171   |  |  | $ | 2.53 | 
|$3.00  $3.57   |  |                     | 911,016   |                     |  |          | 7.70 |             |  | $        | 3.35 |  |  |  | 658,086   |  |  | $ | 3.35 | 
|$4.00  $6.44   |  |                     | 336,594   |                     |  |          | 5.89 |             |  | $        | 4.53 |  |  |  | 312,838   |  |  | $ | 4.53 | 
|                |  |                     |           |                     |  |          |      |             |  |          |      |  |  |  |           |  |  |   |      | 
|                |  |                     | 5,308,604 |                     |  |          | 6.41 |             |  | $        | 1.96 |  |  |  | 4,303,092 |  |  | $ | 1.99 | 
|                |  |                     |           |                     |  |          |      |             |  |          |      |  |  |  |           |  |  |   |      | 

8.     License and
Other Agreements

GlaxoSmithKline.On
March 31, 2000, we signed an exclusive license agreement
with GlaxoSmithKline (NYSE: GSK) for rights to manufacture and
market Abreva® (docosanol 10% cream) as an over the counter
(OTC) product in the United States and Canada as a
treatment for recurrent oral-facial herpes. Under the terms of
the license agreement, GlaxoSmithKline Consumer Healthcare is
responsible for all sales and marketing activities and the
manufacturing and distribution of Abreva in North America. The
terms of the license agreement provided for AVANIR to earn up to
$25 million in milestone payments, and royalties on product
sales. In October 2000, GlaxoSmithKline launched Abreva. We
earned and received all milestones under the agreement. During
fiscal 2003, we sold an undivided interest in the
GlaxoSmithKline license agreement to Drug Royalty USA, and
received $24.1 million. (See Note 5, Asset
Sale.)

Boryung Pharmaceuticals Company Ltd
(Boryung).In March 1994,
we entered into a 12-year exclusive license and supply agreement
with Boryung, for the manufacture and sale of docosanol 10%
cream in the Republic of Korea. Under the terms of the
agreement, Boryung is responsible for manufacturing, marketing
and distribution of docosanol 10% cream, and paying a royalty to
AVANIR on product sales. The agreement includes a supply
provision under which Boryung will purchase its entire
requirement of active ingredient for use in the manufacture of
topical docosanol 10% cream from us directly. Boryung launched
the product, Herepair, in June 2002.

CTS Chemical Industries, Ltd.
(CTS).In July 1993, we
entered into a license agreement with CTS for the manufacture,
marketing and distribution of docosanol 10% cream as a topical
cold sore treatment in Israel. The five-year period of the
license began in June 2002, the date of approval of the product
by regulatory agencies in Israel. Under the terms of the
agreement, CTS is responsible for manufacturing, marketing and
distribution of docosanol 10% cream in Israel, and paying a
royalty to AVANIR on product sales. The agreement includes a
supply provision under which CTS will purchase its entire
requirement of active ingredient from AVANIR for use in the
manufacture of topical docosanol 10% cream. CTS launched the
product, Abrax, in January 2003.

Bruno Farmaceutici.In July 2002, we entered into an agreement with Bruno
Farmacutici (Bruno) giving Bruno the rights to
manufacture and market docosanol 10% cream in Italy,
Europes fourth largest market for the topical treatment of
cold sores. The agreement requires that Bruno purchase its entire

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##### Table of Contents



AVANIR PHARMACEUTICALS


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

requirement of raw materials from AVANIR and pay
us a royalty on product sales. Docosanol 10% cream is not yet
approved for marketing in Italy.

Government Research
Grants.AVANIR is also engaged in
research funded by $1.5 million in government research grants.
The government research grants are to be used for investigating
the market potential for a topical genital herpes treatment,
conducting research on various docosanol-based formulations for
a potential genital herpes product, development of antibodies to
anthrax toxins and cytomegalovirus, and development of a blood
donor program intended to find high-affinity antibodies to
infectious diseases.

9.     Related Party
Transactions



| |                                         
| | ----------------------------------------
| | IriSys Research and Development,
    LLC

License agreement.On August 1, 2000, we entered into an agreement with IriSys
Research and Development, LLC (IriSys) to sublicense
the exclusive worldwide rights to a patented drug formulation,
Neurodex, to treat multiple central nervous system disorders.
Our sublicense agreement includes rights to the patented
technology and know-how for the development and potential
marketing of products for treatments of pseudobulbar affect
(PBA), neuropathic pain, symptoms of chronic and intractable
cough, and patients being weaned from narcotics. If either
(i) the FDA accepts the submission of a new drug
application (NDA) or (ii) the FDA approves the NDA for
marketing, we will be required to make milestone payments to
IriSys.

We are currently developing Neurodex for the
treatment of PBA and neuropathic pain. We have not made any
payments to IriSys, nor have any been due under this agreement,
from the date of entering into this agreement through
September 30, 2003. However, if we successfully submit an
NDA for PBA in 2004, we will pay IriSys $150,000 for achieving
the milestone in 2004. Other payments, if any, will be subject
to our achievement of the milestones indicated above. If we
successfully complete the clinical trials and the FDA accepts
our NDA, we will be required to pay a patent royalty to IriSys
based on a percent of annual net sales revenue if we market the
product ourselves. If we sublicense the product to someone else,
we are required to share equally with IriSys any royalties that
we receive from third parties. The agreement calls for certain
minimum sales levels to be achieved in order for AVANIR to
maintain exclusivity of the marketing rights in the sublicensed
territories.

Dr. Yakatan, president and chief executive
officer of AVANIR, is a founder, chairman and the majority
shareholder of IriSys. IriSys is the exclusive licensee of
certain patents as set forth under an Exclusive Patent License
Agreement between IriSys and the Center for Neurologic Study,
dated as of April 2, 1997. The Company believes that the
terms of the sublicense agreement with IriSys are no less
favorable to the Company than those that could have been
obtained from an unrelated party.

Research and
development.In June 2003, the Company
engaged IriSys to continue Neurodex stability studies previously
being carried out for AVANIR by another company that is no
longer in the business of providing such services. The service
arrangement was transferred to IriSys following termination with
the other company because IriSys was already familiar with the
stability protocol. During fiscal 2003, AVANIR paid IriSys
$18,840 related to continuation of the stability testing.

In April 2002, we entered into an agreement for
services with IriSys to manufacture one lot of Neurodex for
clinical studies and prepare a written stability protocol for
the same lot. AVANIR selected IriSys because of its familiarity
with the product as the licensor to AVANIR. During fiscal 2002,
the Company paid IriSys an aggregate of $55,000 for delivery of
the manufactured material and the written stability protocol.

In June 1999, we entered into an agreement for
services with IriSys to develop formulations for a potential
drug candidate for the treatment of allergy and asthma.
IriSys fees for services compared favorably to competitive
bids submitted to us at that time. During fiscal 2001, the
Company paid IriSys $17,800 for services rendered pursuant to
this agreement.

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##### Table of Contents



AVANIR PHARMACEUTICALS


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

10.     Income
Taxes

Components of the income tax benefit (provision)
are as follows for the fiscal years ended September 30:

|                                                              |  |      |             |      |  |      |            |   |  |   |          |  
|------------------------------------------------------------- |  | ---- | ----------- | ---- |  | ---- | ---------- | - |  | - | -------- | -
|                                                              |  | 2003 |             | 2002 |  | 2001
|                                                              |  |      |             |      |  |     
|Current:                                                      |  |      |             |      |  |      |            |   |  |   |          |  
|State                                                         |  | $    | (3,599      | )    |  | $    | (343,940   | ) |  | $ | (255,172 | )
|                                                              |  |      |             |      |  |      |            |   |  |   |          |  
|Deferred:                                                     |  |      |             |      |  |      |            |   |  |   |          |  
|Federal                                                       |  |      | 8,676,371   |      |  |      | 4,113,560  |   |  |   | 955,548  |  
|State                                                         |  |      | 3,892,419   |      |  |      | 296,424    |   |  |   | 31,744   |  
|                                                              |  |      |             |      |  |      |            |   |  |   |          |  
|                                                              |  |      | 12,568,790  |      |  |      | 4,409,984  |   |  |   | 987,292  |  
|                                                              |  |      |             |      |  |      |            |   |  |   |          |  
|Increase in deferred income tax asset valuation
    allowance |  |      | (12,568,790 | )    |  |      | (4,409,984 | ) |  |   | (987,292 | )
|                                                              |  |      |             |      |  |      |            |   |  |   |          |  
|Total income tax provision                                    |  | $    | (3,599      | )    |  | $    | (343,940   | ) |  | $ | (255,172 | )
|                                                              |  |      |             |      |  |      |            |   |  |   |          |  

A reconciliation of the federal statutory income
tax rate and the effective income tax rate is as follows for the
fiscal years ended September 30:

|                                                              |  |      |     |      |  |      |     |    |  |  |     |  
|------------------------------------------------------------- |  | ---- | --- | ---- |  | ---- | --- | -- |  |  | --- | -
|                                                              |  | 2003 |     | 2002 |  | 2001
|                                                              |  |      |     |      |  |     
|Federal statutory rate                                        |  |      | (34 | )%   |  |      | (34 | )% |  |  | 34  | %
|Increase in deferred income tax asset valuation
    allowance |  |      | 54  |      |  |      | 42  |    |  |  | 202 |  
|State income taxes, net of federal effect                     |  |      | (6  | )    |  |      | (6  | )  |  |  | 6   |  
|Research and development credits                              |  |      | (5  | )    |  |      | (2  | )  |  |  | (73 | )
|Foreign tax credit                                            |  |      |    |      |  |      | (3  | )  |  |  | (52 | )
|State net operating loss limitations                          |  |      | (1  | )    |  |      | 3   |    |  |  | (40 | )
|Other                                                         |  |      | (9  | )    |  |      | 4   |    |  |  | (26 | )
|                                                              |  |      |     |      |  |      |     |    |  |  |     |  
|Effective income tax rate                                     |  |      | 0   | %    |  |      | 3   | %  |  |  | 52  | %
|                                                              |  |      |     |      |  |      |     |    |  |  |     |  

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##### Table of Contents



AVANIR PHARMACEUTICALS


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

Deferred income taxes reflect the income tax
effects of temporary differences between the carrying amounts of
assets and liabilities for financial reporting purposes and the
amounts used for income tax purposes. Significant components of
our net deferred income tax balance were as follows:

|                                                                |  |               |             |      |  |   |             |  
|--------------------------------------------------------------- |  | ------------- | ----------- | ---- |  | - | ----------- | -
|                                                                |  |              
|                                                                |  | September 30,
|                                                                |  |              
|                                                                |  | 2003          |             | 2002
|                                                                |  |               |             |     
|Net operating loss carryforwards                                |  | $             | 27,144,360  |      |  | $ | 27,450,282  |  
|Deferred revenue                                                |  |               | 9,742,947   |      |  |   |            |  
|Research credit carryforwards                                   |  |               | 6,975,107   |      |  |   | 4,311,962   |  
|Capitalized research and development costs                      |  |               | 2,165,757   |      |  |   | 1,345,118   |  
|Capitalized license fees                                        |  |               | 741,529     |      |  |   | 827,824     |  
|Foreign tax credits                                             |  |               | 595,912     |      |  |   | 595,912     |  
|Other                                                           |  |               | (149,668    | )    |  |   | 116,056     |  
|                                                                |  |               |             |      |  |   |             |  
|Net deferred income tax assets                                  |  |               | 47,215,944  |      |  |   | 34,647,154  |  
|Less valuation allowance for net deferred income
    tax assets |  |               | (47,215,944 | )    |  |   | (34,647,154 | )
|                                                                |  |               |             |      |  |   |             |  
|                                                                |  | $             |            |      |  | $ |            |  
|                                                                |  |               |             |      |  |   |             |  

We have provided a full valuation allowance
against the net deferred income tax assets recorded as of
September 30, 2003 and 2002 due to uncertainties as to
their ultimate realization. The net operating loss and research
credit carryforwards expire on various dates through 2023. In
the event of certain ownership changes, the Tax Reform Act of
1986 imposes certain restrictions on the amount of net operating
loss carry forwards that we may use in any year. As of
September 30, 2003, we had $75,982,344 and $14,823,113 of
Federal and California net operating loss carryforwards,
respectively.

11.     Employee
Savings Plan

We have established an employee savings plan
pursuant to Section 401(k) of the Internal Revenue Code.
The plan allows participating employees to deposit into tax
deferred investment accounts 2% to 20% of their salary, subject
to annual limits. We are not required to make matching
contributions under the plan. In fiscal 2003, we contributed
$70,753 to the plan. We did not make a contribution in either of
fiscal years 2002 and 2001, or in any prior period since
inception of the plan.

* * * * *

F-29