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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


|    |  |                                                                                     
|--- |  | ------------------------------------------------------------------------------------
|(X) |  | ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended September 30, 2002


OR


|(  ) |  | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
|---- |  | ----------------------------------------------------------------------------------------

For the transition period from __________ to __________


Commission File 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                               
|(Address of principal executive offices)                       |  | (Zip Code)                          

(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 [X] NO [ ]

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. [ ]

Indicate by check mark whether the registrant is an accelerated filer (as
defined in Exchange Act Rule 12b-2). YES [ ] NO [X]

As of December 6, 2002, the issuer had outstanding 57,933,265 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 $66,607,730. For purposes of the foregoing
disclosure and without admitting whether any person is an affiliated 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 6, 2002:

|                                   |  |  |            | 
|---------------------------------- |  |  | ---------- | 
|Class A Common Stock, no par value |  |  | 58,294,533 | 
|Class B Common Stock, no par value |  |  | 13,500     | 

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, 2003 in connection
with the registrants Annual Meeting of Shareholders to be held on March 13,
2003, is incorporated by reference into Part III of this report.



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|                                                                  |                                                                                               |  |  |  |  |  |  | 
|----------------------------------------------------------------- | --------------------------------------------------------------------------------------------- |  |  |  |  |  |  | 
|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 
|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. CONTROLS AND PROCEDURES                                                             
|PART IV                                                          
|                                                                  | Item 15. EXHIBITS, FINANCIAL STATEMENTS AND SCHEDULES AND REPORTS ON FORM 8-K                
|SIGNATURES                                                       
|CERTIFICATIONS                                                   
|CERTIFICATIONS                                                   
|INDEX TO CONSOLIDATED FINANCIAL STATEMENTS                       
|Avanir Pharmaceuticals NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
|EXHIBIT 21.1                                                     
|EXHIBIT 23.1                                                     
|EXHIBIT 99.1                                                     
|EXHIBIT 99.2                                                     



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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 have no 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.

The Company

Avanir Pharmaceuticals, based in San Diego and incorporated in California in
1988, is a biopharmaceutical drug discovery and development company engaged in
research, development, commercialization, licensing and sales of innovative
drug products and antibody generation services. Avanirs first commercialized
product, docosanol 10% cream, also known as Abreva® in the United States and
Canada, is a topical treatment for cold sores. Avanir has licensed docosanol
10% cream in the United States and in several foreign countries. Avanir is
continuing to expand its commercialization efforts for docosanol 10% cream
while pursuing a broader effort to discover new drugs and develop others that
are already in our development pipeline.

Avanirs drug development pipeline consists of programs in both clinical and
pre-clinical stages. Avanirs research is focused primarily on discovery and
development of small molecules that can be taken orally as potential treatments
for several central nervous system disorders, inflammatory diseases and
cholesterol reduction. Avanirs subsidiary, Xenerex Biosciences, is engaged in
research aimed at developing completely human antibody products to target
antigens, including antigens provided by partner companies.

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 coming from
this research. We have licensed and continue to seek licensees in other
countries for docosanol 10% cream and other potential products in our 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.

Both Avanirs and Xenerexs offices and research facilities are located at
11388 Sorrento Valley Road, Suite 200, San Diego, California 92121. Our
telephone number is (858) 622-5200 and our e-mail address is info@avanir.com.
Additional information about Avanir and Xenerex can be found on our websites,
at www.avanir.com and www.xenerex.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.gov and our website at www.avanir.com.

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Docosanol 10% Cream

Avanir continues to make progress in commercializing docosanol 10% cream in
various areas of the world. Following marketing approval in the United States
in July 2000, Avanir has witnessed the success of the product in the U.S. and
has continued to pursue licensing and regulatory approvals in several foreign
countries. In addition to having a license agreement in the United States,
Avanir has license and marketing agreements for docosanol 10% cream in Canada,
the Republic of Korea, Israel, Italy and Egypt. Avanir has assisted its
partners in obtaining marketing approvals with regulatory agencies in Korea,
Israel and Canada, which have all approved docosanol 10% cream as an
over-the-counter (OTC) treatment for cold sores. For the last three fiscal
years, substantially all of Avanirs revenues have come from milestone payments
and royalties on product sales in the U.S. by GlaxoSmithKline, Avanirs North
American licensee.

GlaxoSmithKline and Drug Royalty USA.Marketed under the trade name Abreva® in
the U.S. by GlaxoSmithKline, Abreva® is the largest selling consumer healthcare
product in the U.S. for the treatment of cold sores. GlaxoSmithKline launched
Abreva in October 2000 and we expect that GlaxoSmithKline will launch Abreva in
Canada in late-2003. Under the license agreement with GlaxoSmithKline, 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.

In December 2002, Avanir sold an undivided interest in the GlaxoSmithKline
license agreement to Drug Royalty USA, and received an initial payment of $20.5
million. Avanir expects to receive an additional $3.6 million payment from
Drug Royalty USA if an extension is granted on one of Avanirs key patents.
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). During fiscal 2002, Boryung
obtained regulatory approval to market docosanol 10% cream as an OTC product in
the Republic of Korea. The 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 entire
supply of docosanol from Avanir and pay us a royalty on product sales. Boryung
launched the product under the name Herepair in June 2002.

CTS Chemical Industries, Ltd. (CTS). During fiscal 2002, our licensee, CTS,
obtained regulatory approval to market docosanol 10% cream as an OTC product in
Israel. Initially signed in July 1993, the license agreement with CTS gives
CTS the exclusive rights to manufacture, market and sell docosanol 10% cream in
Israel. The agreement requires that CTS purchase its entire supply of
docosanol from Avanir and pay us a royalty on product sales. We expect that
CTS will launch the product under the trade name Abrax in January 2003.

Bruno Farmaceutici.During fiscal 2002, we entered into an agreement with
Bruno Farmaceutici giving Bruno the exclusive rights to manufacture and market
docosanol 10% cream in Italy. The 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 subject to Italian regulatory
agency approval, which will be sought using the process of mutual recognition
after a decision on marketing approval has been made in Sweden.

Biopharm.During fiscal 2002 we signed an agreement with Biopharm giving
Biopharm the exclusive rights to manufacture and market docosanol 10% cream in
Egypt and select countries in the Middle East.

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Biopharm is currently going through the regulatory approval process in Egypt.
The agreement requires that Biopharm purchase its entire supply of docosanol
from Avanir and pay us a royalty on product sales.

Regulatory review process underway in Sweden.In May 2002 we filed for
marketing approval for docosanol 10% cream with the Medical Products Agency
(MPA) in Sweden. We selected Sweden as the lead country for seeking
regulatory approval in Europe. If we are successful in Sweden, we plan to
pursue the process of mutual recognition in order to obtain regulatory approval
throughout the European Union. We expect that the MPAs initial review of our
submission should be completed by the end of the first calendar quarter of
2003.

Regulatory approval strategy in Japan.With the aid of consultants, we are
investigating the requirements necessary for obtaining regulatory approvals to
market docosanol 10% cream in other countries such as Japan. Our strategy is
to seek approval as an OTC product, similar to the regulatory status of the
product in the United States, Canada, Korea and Israel. We believe the value
of license agreements for docosanol 10% cream in foreign countries will be
greater if the product is available for marketing as an OTC product. We can
provide no assurance that we will be able to obtain similar regulatory
approvals either as an OTC product or as a prescription product in other
countries.

Additional potential uses of docosanol 10% cream. In addition to the marketing
and sale of docosanol 10% cream as an OTC product for cold sores, pre-clinical
studies indicate that docosanol 10% cream may have other therapeutic properties
as a topical treatment for genital herpes, herpes zoster (shingles), wound
healing and minor burns. In fiscal 2002, Avanir was awarded a $1.0 million
SBIR Phase II grant from the National Institutes of Health to conduct a
pre-clinical investigation of potential topical formulations of docosanol in
the treatment of genital herpes. In fiscal 2001, the San Diego Regional
Technology Alliance awarded a $150,000 CalTIP grant to investigate the market
for a topical treatment for genital herpes. Due to limited resources, we are
not pursuing development of the product for herpes zoster, wound
healing, or minor burns.

Neurodex

Neurodex is an investigational new drug with a new, orally administered
delivery system for the established drug dextromethorphan (DM). The new
delivery system is a combination of DM and quinidine sulfate (Q), an inhibitor
of the enzyme that rapidly metabolizes DM in the body. We believe this
combination can provide additional therapeutic benefits if unmodified DM can be
present at therapeutic levels in the bloodstream for longer periods of time.
Avanir has the rights to develop several potential indications for Neurodex 
pseudobulbar affect (PBA), neuropathic pain, weaning from narcotics and
anti-depressants, and chronic cough. We estimate that the potential combined
market for the first two indications could reach $3 billion by 2010. We are
currently pursuing development of treatments for PBA and neuropathic pain.

Neurodex for the treatment of pseudobulbar affect.PBA is a symptom
experienced by an estimated one million patients in the United States with
various neurological conditions including Lou Gehrigs disease (amyotrophic
lateral sclerosis or ALS), Alzheimers disease, multiple sclerosis (MS), stroke
and traumatic brain injury. According to a market opportunity assessment
commissioned by Avanir, the market for PBA is expected to be over $450 million
in 2005 and could reach $700 million by the year 2010. Currently no drug is
approved for the treatment of PBA, and Neurodex is the first drug candidate in
clinical development specifically intended to treat PBA.

In June 2002 we completed a Phase II/III clinical trial that examined the
safety and efficacy 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,

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controlled Phase II/III study. The patients received capsules containing
either Neurodex, DM alone, or Q alone, twice daily for four weeks. The
Neurodex arm showed statistically and clinically greater improvements than the
DM-only arm or the Q-only arm in the primary efficacy endpoint, 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 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 study. All four serious adverse events were
considered to be unrelated to the study drug by the physician 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 were expected and were resolved
when therapy was discontinued.

Encouraged by favorable statistical evidence of efficacy and safety in the
first trial, Avanir initiated a second Phase III clinical trial in December
2002 for PBA patients with MS. Favorable results will be needed for the Phase
III clinical trial and other supporting studies for Avanir to file a new drug
application for the PBA indication with the FDA in 2004. We also intend to
initiate in January 2003 an open-label study of PBA in patients with various
central nervous system (CNS) disorders.

We expect to continue internal development of Neurodex through all clinical
phases for the treatment of PBA and plan to file for marketing approval with
the FDA in 2004. Thereafter, we intend to prepare for marketing and selling
Neurodex with our own sales force by mid-to-late 2005, assuming the product is
approved for marketing by the FDA.

In July 2002, we also initiated a Phase II, open-label dose-ranging clinical
trial of Neurodex for the treatment of pain in patients with diabetic
neuropathy. The study is intended to determine the feasibility of developing
this indication in order to expand the potential market for Neurodex.

Partnering strategy.Avanir intends to retain commercial rights to all
indications for Neurodex in the U.S. and license or otherwise partner Neurodex
in Europe and other commercially feasible territories. Avanir anticipates the
prospective partner(s) would continue to carry out clinical development for
multiple indications, including paying for future clinical development costs
associated with the licensed territory. We expect to receive license fees,
milestone payments and/or royalties on product sales by the licensee if the
drug is successfully developed and approved for marketing. There can be no
assurances that we will be successful in obtaining a licensee for the drug. If
we continue to make progress as planned, we anticipate finding one or more
foreign partners and begin receiving cash inflows from payments by the licensee
by the end of 2003.

Pre-clinical research for a potential treatment of allergy and asthma

Our largest and most advanced pre-clinical research efforts are focused on
evaluating our lead compound, code-named AVP-13358, as a potential novel oral
treatment for allergy and asthma. In mid-2001, Avanir scientists identified a
small molecule that was found to be effective in suppressing the synthesis of
immunoglobulin epsilon (IgE) as well as other critical mediators of the
allergic response. In December 2002, following an evaluation of results of
recent toxicology studies conducted on AVP-13358, Avanir filed with the FDA for
an Investigational New Drug (IND) application.

Allergy and asthma are respiratory diseases affecting millions of people
worldwide. We estimate the worldwide market for sales of products that treat
allergy and asthma is over $10 billion a year. After

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several decades of research, scientists have established that allergic
individuals commonly produce abnormally high levels of an antibody known as
IgE, the antibody responsible for triggering allergic responses. The end
result is an unpleasant to debilitating health condition.

Both allergies and asthma are 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.

Avanir intends to develop a safe, effective, oral product formulation capable
of significantly inhibiting production of IgE and preventing or reducing the
signs and symptoms of allergy and asthma. AVP-13358 appears capable of
suppressing the synthesis of IgE and other critical mediators of the allergic
response. Although we have tested AVP-13358 in certain laboratory and animal
models, no human trials have yet begun.

Presently, no small-molecule drugs are available for the treatment of IgE,
either via neutralization or suppression of synthesis or release. Avanir hopes
that its new small molecule agent could become a first-line agent for the
treatment of allergy and asthma.

MIF inhibitor technology

Avanir has made important progress in increasing the potency of acquired
compounds that regulate the target, MIF (macrophage migration inhibitory
factor), a protein known to be a significant cause of 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 TNFαa validated
target. 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 TNFα by binding to TNFα or TNFα receptor, respectively. Avanirs research is focused on
developing an orally bioactive 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 (CCM Technology)

Avanir is engaged in a very early stage drug discovery program focused on
research of potential cholesterol-lowering agents that could be valuable in 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 have a
proprietary technology, code-named CCM, that we are using to identify peptides
that may be capable of accelerating the removal of excess cholesterol from
peripheral tissues and transporting it to the liver for

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elimination. Because our CCM technology platform is at a very early stage of
research, we are unable to predict the cost and timing for development of a
drug.

Xenerex Biosciences

In mid-2000, Avanir created a subsidiary, Xenerex Biosciences, to exploit a
proprietary platform technology for producing antibodies in mice that are
indistinguishable from antibodies isolated directly from humans. This
technology is able to generate many unique antibody products with potential
applications in the diagnosis and treatment of a wide array of human diseases.

Xenerex Biosciences is still in the early stages of development as a human
antibody generation services company. Since formation, Xenerex has entered
into three R&D collaborations with biotechnology companies that have their own
proprietary antigen targets. The goal is to provide each client with a panel
of antibodies that meet specific desired characteristics so that an optimal
antibody product candidate can be selected for further development.

Under its collaboration with EOS Biotechnology, Xenerex is using its antibody
generation technology to develop fully human antibodies to three cancer targets
identified by Eos. Xenerex has entered into a similar agreement with Peregrine
Pharmaceuticals to generate antibodies to Peregrines therapeutic targets for
the treatment of solid tumor cancers. The third collaboration is with the DNAX
Research Institute, a subsidiary of The Schering- Plough Corporation. Under
the terms of the DNAX agreement, Xenerex has been contracted to generate
antibodies to two targets provided by DNAX. All three research collaborations
provide the opportunity to earn research fees during the antibody generation
effort and to earn milestone payments if an antibody product candidate,
developed through the collaboration, advances into clinical development.
Xenerex also could earn royalties on product sales if any product were to be
approved by the FDA.

Xenerex is also in the early stages of development of its own product portfolio
through internally funded development efforts and through corporate research
collaborations.

In July 2002, Xenerex received a small grant from the Center for the
Commercialization of Advanced Technology (CCAT), to begin work on developing
antibodies to the toxins produced by the infectious disease anthrax. 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.

Xenerex owns a patented technology that enables the generation of fully human
antibodies from human lymphoid cells engrafted into severe combined
immunodeficient (SCID) mice. The Xenerex technology stimulates engrafted human
cells in the mice with the antigenic target to which the cells respond by
producing antibodies specific to the target. The antibody generation
technology is combined with a process for identifying the individual human
cells that are producing antibodies of interest and then rescuing 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. The technology developed
by Xenerex is different from other competitive methods known to generate human
antibodies. The company believes that for certain types of diseases, such as
infectious diseases, its technology may have unique advantages over other
current competitive technologies.

Xenerex intends to take several infectious disease antibody product candidates
through early characterization efforts, includingin vitroand in vivotesting
to validate their potential as viable commercial product development
candidates. The company will then determine whether to out-license,

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partner, or develop these product opportunities. There can be no assurance
that Xenerex will be successful in its development efforts.

Inventory and Docosanol Supply

We purchase the drug substance docosanol, from a large, single supplier in
Western Europe. This manufacturing source has been inspected by the FDA and
found to be operating under good manufacturing conditions (GMP). Both Avanir
and GlaxoSmithKline currently rely on the FDA-approved 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 what we believe is a prudent
quantity of the active ingredient, which may serve as a strategic reserve or
for sales to our licensees. We currently store our raw material in the United
States. Any material disruption in the supply of docosanol would require us to
find an alternate supply source, which may require a significant amount of time
and expense.

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 which may be in direct
competition with our proposed products. We also must compete with these
institutions in recruiting highly qualified scientific personnel. We do not
have the resources to compete with major pharmaceutical companies on a wide
scale basis in the areas of clinical testing, regulatory approvals,
manufacturing and marketing.

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



| |  |  | OTC monograph preparations, including Carmex®, Viractin® and
others;                                                                                 
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | Zovirax® acyclovir (oral and topical) and Valtrex®
valacyclovir (oral) prescription products marketed by Biovail
Corporation and GlaxoSmithKline, 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 modulation program. Our pre-clinical IgE modulation 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. In June
2000 the collaborative team submitted a Biologic License Application (BLA) to
the FDA for their drug. The drug was not approved, however, and they are
currently developing additional data requested by the FDA as a part of the BLA.
Other competitive and successful products already established in the
marketplace include non-sedative antihistamine products, such as
Shering-Ploughs

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Claritin® loratadine ($3 billion in annual sales) and Aventis
Allegra®/Telfast® ($1 billion in annual sales).

Antibody generation services.The human antibody generation services business
is highly competitive. Several companies, including Abgenix, Medarex, Inc.,
and Cambridge Antibody Technology, have been in business longer and have
substantially greater financial resources and personnel than we have at
Xenerex.

Patents and proprietary rights

Patents. Avanir presently owns or has the rights to 76 issued patents (22 U.S.
and 54 foreign) and 151 applications pending (12 U.S. and 139 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 regulating the target IgE in
controlling symptoms of allergy and asthma, and compounds capable of regulating
the target MIF in the treatment of several inflammatory diseases.

|                                                     |  |                                 |    |                  |  |              |   |        |   |                  |    |         |    |  |    |         |   |  |    |  |    |  |     | 
|---------------------------------------------------- |  | ------------------------------- | -- | ---------------- |  | ------------ | - | ------ | - | ---------------- | -- | ------- | -- |  | -- | ------- | - |  | -- |  | -- |  | --- | 
|                                                     |  | Patents and Patent Applications
|                                                     |  |                                
|                                                     |  | United States                   |    | Foreign         
|                                                     |  |                                 |    |                 
|Description:                                         |  | Issued                          |    | Expiration Dates |  | Pending      |   | Issued |   | Expiration Dates |    | Pending
|                                                     |  |                                 |    |                  |  |              |   |        |   |                  |    |        
|Docosanol-related
technologies                       |  |                                 | 10 |                  |  | 2009 to 2016 |   |        | 2 |                  |    |         | 37 |  |    | Various |   |  | 44 | 
|Xenerex proprietary
antibody generation
technologies |  |                                 | 2  |                  |  | 2012 to 2015 |   |        | 0 |                  |    |         | 14 |  |    | Various |   |  |    | 
|IgE regulation technology                            |  |                                 | 4  |                  |  | 2018 to 2019 |   |        | 7 |                  |    |         | 3  |  |    | Various |   |  | 71 | 
|Neurodex                                             |  |                                 | 6  |                  |  | 2010 to 2015 |   |        | 2 |                  |    |         | 0  |  |    |         |  |  |    |  | 12 | 
|MIF inhibitor technology                             |  |                                 | 0  |                  |  |              |  |        |   |                  | 1  |         |    |  | 0  |         |   |  |   |  |    |  | 12  | 
|Other                                                |  |                                 |    |                  |  |              |   |        |   |                  |    |         |    |  |    |         |   |  |    |  |    |  |     | 
|Total                                                |  |                                 | 22 |                  |  |              |   |        |   |                  | 12 |         |    |  | 54 |         |   |  |    |  |    |  | 139 | 
|                                                     |  |                                 |    |                  |  |              |   |        |   |                  |    |         |    |  |    |         |   |  |    |  |    |  |     | 

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. We are currently
awaiting a decision from the U.S Patent and Trademark Office regarding our
application for patent term extension of the Companys docosanol use patent
from April 28, 2009, to April 28, 2014.

Xenerex proprietary antibody generation technologies.We own the rights to
several issued patents related to antibody generation technologies used within
Xenerex Biosciences.

IgE 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 pre-clinical research for the
regulation of IgE in the treatment of various inflammatory diseases.

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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.

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 to which
might not be available to us. In addition, the National Institutes of Health
regulations provide that, if federally funded entities do not timely pursue
patent applications for patentable inventions, 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 each through the end of fiscal 2002, 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
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 FDA 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:



| |  |  | nonclinical pharmacological studies to obtain preliminary
information on the safety and efficacy of a drug; and
| | - |  | ---------------------------------------------------------------------------------------------------------------

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| |  |  | nonclinical evaluation in vitroand in vivoincluding
extensive toxicology.
| | - |  | -------------------------------------------------------------------------

The results of these nonclinical studies may be submitted to the FDA as part of
an investigational new drug application. The sponsor of an investigational new
drug application may commence human testing of the compound only after being
notified by the FDA that the agency has activated the investigational new drug
application, which usually occurs within 30 days of submission of the
application.

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.                                                                                                                                                     

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.

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.

We currently intend 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

At December 6, 2002, we employed 57 persons, including 39 engaged in research
and development activities, clinical and regulatory affairs, and commercial
development, and 18 engaged in administrative functions such as human
resources, finance, accounting, purchasing and investor relations. Our staff
includes 19 employees with doctoral degrees. Eleven of our employees are
engaged full-time in work at Xenerex Biosciences. We believe that our
relationship with our employees is good.

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Risk factors that might affect future operations

We expect our quarterly revenues and operating results to fluctuate for a
number of reasons.

Future operating results will continue to be subject to 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 royalty
revenues from sales of Abreva®by GlaxoSmithKline. Payments of future
royalties will be limited to the royalty rate times 50% of contract
sales in excess of $62 million a year. Payments of royalties on
contract sales in excess of $62 million, if any, are expected to occur
annually after the end of each calendar year. Revenues of up to $24.1
million from the sale to Drug Royalty USA will be deferred and
recognized ratably over the life of the agreement.                                                                                                                                                                                                                                                                                                                                                                                     
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | Concentration of significant customers, suppliers and industries 
Milestone payments and royalties earned from a single licensee
(GlaxoSmithKline) accounted for approximately 95% and 99% of our fiscal
2002 and 2001 revenues, respectively. We have now received all of the
milestone payments from GlaxoSmithKline. With the sale of our Abreva
royalty rights to Drug Royalty USA, future royalty revenues from
GlaxoSmithKline will come exclusively from our remaining 50% share of
Abreva royalties on contract sales in excess of $62 million a year. Our
business could be adversely affected if GlaxoSmithKline terminated its
business relationship with us or significantly reduced the amount of
marketing and promotion of Abreva. 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 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.                                                                                                                                                                                                                                                                                                                                                                                                   

If Abreva contract sales never exceed $62 million a year, or if GlaxoSmithKline
experiences problems in manufacturing or reduces promotion of the product, then
our royalties, if any, from sales of Abreva will be materially and adversely
affected.

Our royalty revenues from sales of Abreva in the future will be substantially
influenced by the level of GlaxoSmithKlines marketing and promotion of the
product. If GlaxoSmithKlines sales of Abreva never exceed $62 million a year,
or if they experience any problem or delay in manufacturing, or a material
reduction in product promotion, then our business operations and financial
condition could be significantly affected.

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Avanir and its licensees may not be successful in obtaining regulatory approval
of docosanol 10% cream immediately as an 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 our efforts to obtain
regulatory approval as an over-the-counter (OTC) product and to market and
sell docosanol 10% cream in foreign countries, 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 pre-clinical 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 those compounds, in which event we will be forced to
write-off the development costs for that compound. If a compound appears to be
safe and effective in pre-clinical 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.

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

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 our
competitors, including such companies as Bayer Corp. and Schering Plough, have
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.

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We may issue additional shares of our Class A common stock. These issuances may
dilute the value of our Class A common stock to current shareholders and may
adversely affect the market price of our Class A common stock.

We anticipate that we may raise additional capital in the next twelve months
through the sale of shares of our Class A common stock. 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 prices higher than the current market
price, the issuance of additional shares may depress our market price and
dilute earnings per share.

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, the Republic of 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 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.                                                                                        

Our antibody generation services subsidiary, Xenerex Biosciences, faces intense
competition and rapid technological change. If we fail to provide services
that keep pace with new technologies and gain market acceptance, our services
and technologies could become obsolete.

The biotechnology industry is highly competitive and subject to significant and
rapid technological change. We compete with several companies that offer
antibody generation services to other companies. These competitors have
specific expertise or technology related to antibody development and introduce
new or modified technologies from time to time. These companies include
Abgenix, Inc, Medarex, GenPharm, Kirin Brewing Co., Genmab, Cambridge Antibody
Technology Group, Protein Design Labs, Dyax, and MorphoSys. Many of these
companies, either alone or together with their customers, have substantially
greater financial resources, larger research and development staffs, and
substantially greater experience than we do.

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Our failure or inability to comply with government regulations regarding the
development, production, testing, manufacturing and marketing of our other
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. In addition, 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, which 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 emotional lability in MS patients may experience setbacks or
failures for reasons we have not anticipated. Our Phase II open-label dose
escalation clinical trial of Neurodex for the treatment of neuropathic pain may
not show proof of concept. Our observations during pre-clinical research of
our lead compound for treating allergy and asthma may not be relevant to the
development of, indicate 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.

Business interruptions could adversely affect our business.

Our operations are vulnerable to interruption by fire, earthquake, power loss,
telecommunications failure, terrorist attacks and other events beyond our
control. For example, during 2001, California experienced shortages in
adequate supply of electricity, resulting in rolling blackouts, where certain
areas are not provided with any electricity for periods of up to two hours.
The immediate impact was a significant increase in power rates. Additionally,
the loss of electrical power or blackouts for any significant periods of time
could harm our vendors and our ability to conduct experiments and provide
services. Further, we could lose valuable data made to date in experiments
currently underway. We have attempted to mitigate the severity of power losses
by installing emergency power equipment, which we intend to use for those
electrical needs that we consider to be the most critical to operating our
business. However, the emergency power unit does not cover all of our
electrical needs.

Our acquisition and alliance activities, if any, could disrupt our ongoing
business.

We intend to continue to make investments in products and technologies, acquire
or in-license technologies, and, in the future, could acquire entire companies
to expand our product development pipeline and sales revenues. Acquisitions
and strategic alliances often involve risks, including: difficulty in
assimilating the acquired technologies, operations and employees, difficulty in
managing research collaborations, difficulty in retaining key employees of an
acquired operation, disruption of our ongoing

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business, inability to successfully integrate the acquired technology and
operations into our business and lack of experience in developing the acquired
technology.

Our inability to 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 57 people in Avanir and
our subsidiary, Xenerex Biosciences, and we expect to hire additional people
over the next twelve months. While we have employment and employee retention
agreements with certain key executives, they are limited in scope and provide
no real assurance that any of these people will continue their employment with
us. We do not have any key person life insurance policies. The industry in
which we compete has a high level of employee mobility and aggressive
recruiting of skilled personnel, which creates intense competition for
qualified personnel, particularly in product research, development, sales and
marketing.

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 for
docosanol, with 47 U.S. and foreign docosanol patents and 46 additional
docosanol-related patent applications pending. We also have patents and patent
applications pending on other products and technologies, and have in-licensed
the rights to market a potential product that treats multiple central nervous
system disorders that has 6 issued patents and 14 pending applications.
Because of the competitive nature of the biopharmaceutical industry, we cannot
assure you that:



| |  |  | the claims in the 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 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.                  

Additionally, we have applied for a five-year extension for one of our key
docosanol patents. If the patent extension is granted, we will receive
approximately $3.6 million from Drug Royalty USA in connection with the sale of
our future Abreva royalty rights. There can be no assurance, however, that the
patent extension will be granted and that we will be entitled to receive this
payment.

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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 develop independently similar or superior technology. In addition, 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
$2 million per incident and $2 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.

The conversion of redeemable convertible preferred stock currently outstanding
will have a dilutive effect on our Class A common stock.

As of December 6, 2002, the Company had outstanding 50 shares of Series D
redeemable convertible preferred stock. The Series D stock can be converted at
any time into shares of our Class A common stock at a price equal to 86% of the
then-current market price. Based on our recent stock price, these shares would
convert into approximately 582,000 shares of Class A common stock. If our
stock price

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were to drop, the number of shares that may be acquired upon conversion of the
Series D stock would proportionately increase.

We do not intend to declare or pay cash dividends in the foreseeable future.

We do not intend to declare or pay cash dividends on our Class A or Class B
common stock in the foreseeable future. We expect to retain any earnings, if
and when achieved, to finance our business.




Item 2. PROPERTIES

We currently lease 27,047 square feet of laboratory and office space at 11388
Sorrento Valley Road, Suite 200, San Diego, California for an average base rent
of approximately $753,000 per year over the lease commitment period. On
February 1, 2001, the Company signed an amendment to the lease for an
additional 165 square feet of office space. The lease has scheduled rent
increases each year and expires on August 31, 2008. See Note 6, Commitments
and Contingencies, to our financial statements annexed to this report and
Exhibit 10.9.

On May 20, 2002, we signed a ten-year lease for approximately 26,770 square
feet of office space in buildings located adjacent to our existing facilities,
commencing on January 15, 2003. Our total financial commitment to the lessor
for the term of the lease is $9,742,080 (See Exhibit 10.12). We delivered an
irrevocable standby letter of credit to the lessor in the amount of $468,475 to
secure our performance under the lease. We also entered into a $4.5 million
construction contract in December 2002 for tenant improvements. The lessor is
obliged to pay $2 million of the total construction costs for these tenant
improvements.




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.

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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 2001    |  |                      |      |     |  |   |      | 
|First Quarter  |  | $                    | 9.50 |     |  | $ | 3.00 | 
|Second Quarter |  | $                    | 6.50 |     |  | $ | 3.75 | 
|Third Quarter  |  | $                    | 6.30 |     |  | $ | 3.03 | 
|Fourth Quarter |  | $                    | 6.25 |     |  | $ | 2.50 | 
|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 | 

On December 6, 2002, the closing sales price of Class A Common Stock was $1.08
per share.

As of December 6, 2002, we had approximately 950 holders of record and
approximately 22,137 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.

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Item 6. SELECTED CONSOLIDATED FINANCIAL DATA

The selected consolidated financial data set forth below at September 30, 2002
and 2001, and for the fiscal years ended September 30, 2002, 2001 and 2000, 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, 2000, 1999 and 1998, and for
the years ended September 30, 1999 and 1998, 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,
|                                                               |         |   |                                 
|                                                               |         |   | 2002                             |            | 2001 |   | 2000       |            | 1999 |   | 1998      
|                                                               |         |   |                                  |            |      |   |            |            |      |   |           
|Statement of operations data:                                  |         |   |                                  |            |      |   |            |            |      |   |            |            |  |   |            |            |  |   |            |           
|Revenues                                                       |         | $ | 8,853,742                        |            |      | $ | 12,678,602 |            |      | $ | 10,252,818 |            |  | $ |           |            |  | $ |           |           
|Net income (loss)                                              |         |   | (10,249,512                      | )          |      |   | 233,122    |            |      |   | (582,283   | )          |  |   | (8,554,036 | )          |  |   | (8,210,548 | )         
|Net income (loss) attributable to
common shareholders          |         |   | (10,292,798                      | )          |      |   | 189,888    |            |      |   | (801,806   | )          |  |   | (8,583,182 | )          |  |   | (8,210,548 | )         
|Basic net income (loss) per share                              |         | $ | (0.18                            | )          |      | $ | 0.00       |            |      | $ | (0.02      | )          |  | $ | (0.21      | )          |  | $ | (0.21      | )         
|Diluted net income (loss) per share                            |         | $ | (0.18                            | )          |      | $ | 0.00       |            |      | $ | (0.02      | )          |  | $ | (0.21      | )          |  | $ | (0.21      | )         
|Weighted average number of shares
of common stock outstanding: |         |   |                                  |            |      |   |            |            |      |   |            |            |  |   |            |            |  |   |            |           
|                                                               | Basic   |   |                                  | 58,206,969 |      |   |            | 57,475,748 |      |   |            | 51,784,214 |  |   |            | 41,704,265 |  |   |            | 39,519,609 | 
|                                                               | Diluted |   |                                  | 58,206,969 |      |   |            | 61,130,415 |      |   |            | 51,784,214 |  |   |            | 41,704,265 |  |   |            | 39,519,609 | 

|                            |                                                            |   |               |            |      |   |            |            |      |   |            |            |  |   |           |         |  |   |           |           | 
|--------------------------- | ---------------------------------------------------------- | - | ------------- | ---------- | ---- | - | ---------- | ---------- | ---- | - | ---------- | ---------- |  | - | --------- | ------- |  | - | --------- | --------- | 
|                            |                                                            |   | September 30,
|                            |                                                            |   |              
|                            |                                                            |   | 2002          |            | 2001 |   | 2000       |            | 1999 |   | 1998      
|                            |                                                            |   |               |            |      |   |            |            |      |   |           
|Balance sheet data:         |                                                            |   |               |            |      |   |            |            |      |   |            |            |  |   |           |         |  |   |           |          
|Cash and cash equivalents   |                                                            | $ | 8,630,547     |            |      | $ | 16,542,545 |            |      | $ | 19,699,768 |            |  | $ | 122,674   |         |  | $ | 6,508,341 |          
|Investments in securities   |                                                            |   | 4,538,460     |            |      |   | 5,308,691  |            |      |   | 1,568,474  |            |  |   |          |         |  |   |          |          
|                            |                                                            |   |               |            |      |   |            |            |      |   |            |            |  |   |           |         |  |   |           |          
|                            | Total cash, cash equivalents and
investments in securities |   |               | 13,169,007 |      |   |            | 21,851,236 |      |   |            | 21,268,242 |  |   |           | 122,674 |  |   |           | 6,508,341 | 
|Working capital             |                                                            |   | 5,918,083     |            |      |   | 16,027,577 |            |      |   | 18,774,423 |            |  |   | (956,190  | )       |  |   | 4,819,830 |          
|Total assets                |                                                            |   | 20,332,929    |            |      |   | 27,053,953 |            |      |   | 23,519,237 |            |  |   | 1,765,215 |         |  |   | 7,653,800 |          
|Convertible notes payable   |                                                            |   |              |            |      |   |           |            |      |   |           |            |  |   |          |         |  |   | 1,000,000 |          
|Total liabilities           |                                                            |   | 5,752,259     |            |      |   | 2,592,490  |            |      |   | 1,922,929  |            |  |   | 1,701,019 |         |  |   | 2,064,485 |          
|Convertible preferred stock |                                                            |   | 521,189       |            |      |   | 502,903    |            |      |   | 465,920    |            |  |   |          |         |  |   |          |          
|Shareholders equity        |                                                            |   | 14,059,481    |            |      |   | 23,958,560 |            |      |   | 21,130,388 |            |  |   | 64,196    |         |  |   | 5,589,315 |          

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|                                                               |         |                       |           |                |  |               |            |                    |  |   |            |            |  |   |            |            | 
|-------------------------------------------------------------- | ------- | --------------------- | --------- | -------------- |  | ------------- | ---------- | ------------------ |  | - | ---------- | ---------- |  | - | ---------- | ---------- | 
|Quarterly statement of operations data                         |         | Fiscal Quarters Ended
|                                                               |         |                       |          
|for fiscal year 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 | 

|                                                               |         |                       |           |                |  |               |            |                    |  |   |            |            |  |   |           |            | 
|-------------------------------------------------------------- | ------- | --------------------- | --------- | -------------- |  | ------------- | ---------- | ------------------ |  | - | ---------- | ---------- |  | - | --------- | ---------- | 
|Quarterly statement of operations data                         |         | Fiscal Quarters Ended
|                                                               |         |                       |          
|for fiscal year 2001:                                          |         | December 31, 2000     |           | March 31, 2001 |  | June 30, 2001 |            | September 30, 2001
|                                                               |         |                       |           |                |  |               |            |                   
|Revenues                                                       |         | $                     | 5,065,732 |                |  | $             | 1,272,204  |                    |  | $ | 513,739    |            |  | $ | 5,826,927 |           
|Net income (loss)                                              |         |                       | 3,103,104 |                |  |               | (2,685,331 | )                  |  |   | (1,992,359 | )          |  |   | 1,807,708 |           
|Net income (loss) attributable to
common shareholders          |         |                       | 3,092,144 |                |  |               | (2,695,954 | )                  |  |   | (2,003,151 | )          |  |   | 1,796,849 |           
|Basic net income (loss) per share                              |         | $                     | 0.05      |                |  | $             | (0.05      | )                  |  | $ | (0.03      | )          |  | $ | 0.03      |           
|Diluted net income (loss) per share                            |         | $                     | 0.05      |                |  | $             | (0.05      | )                  |  | $ | (0.03      | )          |  | $ | 0.03      |           
|Weighted average number of shares
of common stock outstanding: |         |                       |           |                |  |               |            |                    |  |   |            |            |  |   |           |           
|                                                               | Basic   |                       |           | 57,216,732     |  |               |            | 57,346,992         |  |   |            | 57,542,291 |  |   |           | 57,794,901 | 
|                                                               | Diluted |                       |           | 61,783,306     |  |               |            | 57,346,992         |  |   |            | 57,542,291 |  |   |           | 61,237,629 | 

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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 a biopharmaceutical drug discovery and development company. Avanir is
engaged in research, discovery, development, licensing, and sales of innovative
drug products, and through its subsidiary, Xenerex Biosciences (Xenerex),
sales of antibody generation and product development services.

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 North America by GlaxoSmithKline,
Avanirs licensee, Abreva® (docosanol 10% cream) was launched in the United
States in late 2000. According to AC Nielson, Abreva is the largest selling
consumer healthcare product in the U.S. for the treatment of cold sores. From
inception of the GlaxoSmithKline license agreement through September 30, 2002,
Avanir has earned $31 million in license fees, milestone payments and royalties
on Abreva contract sales.

On December 24, 2002, Avanir sold an undivided interest in its license
agreement with GlaxoSmithKline to Drug Royalty USA, and received an initial
payment of $20.5 million. Avanir expects to receive an additional $3.6 million
from Drug Royalty USA upon a grant of a patent extension for one of Avanirs
key patents. 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 the cold
sore product outside North America and several other indications for the
products active ingredient, docosanol 10% cream.

Avanir continues to expand the docosanol franchise worldwide. We now have
license agreements for docosanol 10% cream in Canada, Italy, the Republic of
Korea, Israel and Egypt. Since May 2002 the product has been approved for
marketing as an OTC product in Canada, Korea and Israel. In May 2002, we filed
for marketing approval of docosanol 10% cream with the Medical Products Agency
(MPA) in Sweden. We selected Sweden as the lead country for our initial
European regulatory efforts and intend to pursue the process of mutual
recognition in obtaining regulatory reviews in selected states of the European
Union. In June 2002, our marketing partner in Korea launched docosanol 10%
cream under the brand name Herepair. We expect that CTS will launch the
product under the trade name Abrax in January 2003.

Avanirs drug development pipeline consists of clinical, pre-clinical and drug
discovery programs. Current clinical development programs are centered on
Neurodex® (formerly AVP-923), which could potentially provide a novel approach
for the treatment of several central nervous system disorders. The leading
clinical development program is for the treatment of pseudobulbar affect (PBA).
PBA is experienced by approximately one million patients with various
neurological conditions, including Lou

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Gehrigs disease (amyotrophic lateral sclerosis or ALS), Alzheimers disease,
multiple sclerosis (MS), stroke and traumatic brain injury. PBA is a condition
for which no FDA-approved drug is indicated. Our pre-clinical research and
drug discovery programs are directed primarily toward large therapeutic areas,
including allergy and asthma, inflammatory diseases and cholesterol reduction.

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 pre-clinical 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.

We also intend for Xenerex to establish new research collaborations as it
produces human monoclonal antibodies to selected targets. Xenerex now has
three collaborative research agreements in place with its partners to generate
antibodies to eight target antigens and has a federal research grant to produce
antibodies to the toxins produced by the infectious disease anthrax. Xenerex
is also producing antibodies to targets identified internally for future
research and development by the Company.

Revenue-generating Contracts

As of December 6, 2002, we had nine active commercial contracts and three
active government-funded research grants that are generating or could generate
important revenues in the future to help fund our research and development
programs. Five of the commercial contracts are in the form of docosanol 10%
cream (Abreva) license agreements, one contract is for the commercialization of
Neurodex, and three other contracts are through Xenerex and are in the form of
antibody research service agreements. Avanir also has been awarded $1.2
million in government grants to be used for investigating the development of a
potential docosanol-based genital herpes product and an antibody to anthrax.

We expect that substantially all of our revenues for the next two quarters will
be earned from license fees, milestone payments, sales of the raw material
docosanol, research fees, grants and royalties under existing contracts and
research grants. For the last two years, GlaxoSmithKline has been our most
significant revenue source, representing over 95% of the Companys revenues in
fiscal 2002. A list of our revenue-generating contractual arrangements is set
forth as follows.

Revenue-generating Contracts

|                                 |  |                                      |  |                   |  |                          
|-------------------------------- |  | ------------------------------------ |  | ----------------- |  | -------------------------
|                                 |  | Type of Agreement                    |  | Date of Agreement |  | Product License,         
|Company or Research Grant        |  | or Grant Award                       |  | or Grant Award    |  | Service or Research      
|                                 |  |                                      |  |                   |  |                          
|GlaxoSmithKline                  |  | License of Abreva®
(U.S. and Canada) |  | March 31, 2000    |  | Cold sore product
license
|CTS Chemical Industries, LTD     |  | Docosanol license
(Israel)           |  | July 6, 1993      |  | Cold sore product
license
|Boryung Pharmaceuticals Co., LTD |  | Docosanol license
(South Korea)      |  | March 11, 1994    |  | Cold sore product
license
|BioPharm Group                   |  | Docosanol license
(Egypt)            |  | January 11, 2002  |  | Cold sore product
license
|Bruno Farmaceutici S.p.A         |  | Docosanol license
(Italy)            |  | July 29, 2002     |  | Cold sore product
license
|Medison Pharma, Ltd.             |  | Neurodex research and                |  | August 6, 2002    |  | Pseudobulbar Affect      

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|                                                                                                         |  |                                                                                        |  |                                   |  |                                                          
|-------------------------------------------------------------------------------------------------------- |  | -------------------------------------------------------------------------------------- |  | --------------------------------- |  | ---------------------------------------------------------
|                                                                                                         |  | commercialization
(Israel)                                                             |  |                                   |  | research and
commercialization                           
|Eos Biotechnology, Inc.                                                                                  |  | Antibody research by
Xenerex                                                           |  | December 21, 2001                 |  | Antibody generation
services                             
|Peregrine Pharmaceuticals                                                                                |  | Antibody research by
Xenerex                                                           |  | June 7, 2001                      |  | Antibody generation
services                             
|DNAX Research, Inc.                                                                                      |  | Antibody research by
Xenerex                                                           |  | January 21, 2002                  |  | Antibody generation
services                             
|Small Business Innovative Research
(SBIR) Grant and California
Technology Investment Partnership
Program |  | Federal research grant and
State research grant                                        |  | March 12, 2002 and
April 26, 2002 |  | Pre-clinical
research of
potential genital
herpes product
|California Center for Advanced
Technology (CCAT)                                                         |  | Department of Defense
grant administered
through San Diego State
University Foundation |  | June 19, 2002                     |  | Pre-clinical
anthrax antibody
research                   

Research and Development Programs and Products in Clinical Development

We are currently conducting research on a number of potential therapeutic
products and technology platforms that are in various phases of clinical and
pre-clinical development. Pharmaceutical research and development (R&D)
programs, by their very nature, require a substantial amount of financial and
human resources and there is no assurance that they will be approved for
marketing by domestic and/or foreign regulatory agencies. The costs to develop
all of Avanirs potential drugs through all clinical phases would cost
substantially in excess of funds currently available to the Company. As a
result, we do not intend to complete all clinical development stages ourselves
for several of our programs. We intend to use our own funds to develop
Neurodex through all clinical phases for the treatment of PBA. Our strategy
for our other drug development programs is to use our own funds in the
pre-clinical and early clinical stages and then partner or license our
technology when our research has been validated either by Phase I or Phase II
clinical data.

For many of our programs, the higher costs of the later stages of clinical
development requires that we 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 other 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 a new drug application (NDA) with the FDA
or that the NDA will be approved. The following table sets forth the status
of, and costs attributable to, our proprietary research and clinical
development programs.

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Research and Development Projects and Other Research Programs Expense

|                                                                                                                                                                                                                                                                                                                    |       |      |                    |           |                     |      |               |           |           |     |           |            |  |   |           |           |  |   |           |            |          |                |   |  | 
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | ----- | ---- | ------------------ | --------- | ------------------- | ---- | ------------- | --------- | --------- | --- | --------- | ---------- |  | - | --------- | --------- |  | - | --------- | ---------- | -------- | -------------- | - |  | 
|                                                                                                                                                                                                                                                                                                                    |       |      | Three Months Ended |           | Twelve Months Ended |      | Inception     |           |           |     |          
|                                                                                                                                                                                                                                                                                                                    |       |      | September 30,      |           | September 30,       |      | Through       |           | Estimated
|                                                                                                                                                                                                                                                                                                                    |       |      |                    |           |                     |      | September 30, |           | Cost to  
|                                                                                                                                                                                                                                                                                                                    |       |      |                    |           |                     |      |               |           |           |     |           |            |  |   |           |           |  |   | 2002      |            | Complete
|Company-funded Projects (1):                                                                                                                                                                                                                                                                                        |       | 2002 |                    | 2001      |                     | 2002 |               | 2001      |           | (2) |           | Project   
|                                                                                                                                                                                                                                                                                                                    |       |      |                    |           |                     |      |               |           |           |     |           |           
|Develop Neurodex for FDA
marketing approval in
treating PBA. Initial Phase
II/III clinical trial has
been completed and a Phase
III clinical trial is
underway. Estimated timing
to complete all phases of
project: mid-2004 calendar
year                                                                          |       | $    | 624,526            |           |                     | $    | 505,863       |           |           | $   | 2,600,271 |            |  | $ | 1,502,738 |           |  | $ | 4,590,706 |            |          | $7-9million   
|Develop Neurodex for
partnering or licensing
outside the U.S. as a
potential treatment for
neuropathic pain at end of
Phase II clinical trials
Phase II dose-ranging trial
is currently underway
Estimated timing to
complete project: second
quarter of calendar year
2003                                         |       |      | 154,211            |           |                     |      | 145,443       |           |           |     | 1,163,598 |            |  |   | 799,495   |           |  |   | 2,245,236 |            |          | $1-2million   
|Develop AVP-13358 as an IgE
Regulator for partnering or
licensing as a treatment
for allergy and asthma
after completion of Phase I
clinical trials. Estimated
timing to complete project
is fourth calendar quarter
2003                                                                                           |       |      | 1,647,963          |           |                     |      | 440,374       |           |           |     | 4,265,312 |            |  |   | 1,379,031 |           |  |   | 8,262,945 |            |          | $3-5million   
|Government-funded Projects:                                                                                                                                                                                                                                                                                         |       |      |                    |           |                     |      |               |           |           |     |           |            |  |   |           |           |  |   |           |            |          |                |   | 
|Pre-clinical research is
for potential treatments
for genital herpes and
anthrax. Estimated timing
to complete the various
projects varies from one to
two years                                                                                                                                                    |       |      | 109,315            |           |                     |      | 6,650         |           |           |     | 142,173   |            |  |   | 87,217    |           |  |   | 256,855   |            |          | $0.9million(3)
|Other Pre-clinical Research
Projects:                                                                                                                                                                                                                                                                               |       |      |                    |           |                     |      |               |           |           |     |           |            |  |   |           |           |  |   |           |            |          |                |   | 
|We use proprietary drug
discovery and technology
platforms (MIF, CCM®,
monoclonal antibody
technology) to pursue
potential treatments for
anti-inflammation and
cholesterol reduction. The
costs and timing to
complete our pre-clinical
research are unpredictable
because of the
unpredictability of our
research |       |      | 835,884            |           |                     |      | 1,415,603     |           |           |     | 3,192,710 |            |  |   | 2,693,629 |           |  |   | 6,171,925 |            |          |                |  | 
|Other (4)                                                                                                                                                                                                                                                                                                           |       |      | 599,292            |           |                     |      | 464,830       |           |           |     | 2,238,420 |            |  |   | 1,682,475 |           |  |   | 9,064,276 |            |          |                |  | 
|                                                                                                                                                                                                                                                                                                                    |       |      |                    |           |                     |      |               |           |           |     |           |            |  |   |           |           |  |   |           |            |          |                |   | 
|                                                                                                                                                                                                                                                                                                                    | Total |      | $                  | 3,971,191 |                     |      | $             | 2,978,763 |           |     | $         | 13,602,484 |  |   | $         | 8,144,585 |  |   | $         | 30,591,943 |          |                |   |  | 
|                                                                                                                                                                                                                                                                                                                    |       |      |                    |           |                     |      |               |           |           |     |           |            |  |   |           |           |  |   |           |            |          |                |   | 

1.     At September 30, 2002, 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 R&D programs.

2.     Inception dates are on or after October 1, 1998, at which time we began
identifying and tracking costs for these research programs.

3.     The Company was awarded $1.2 million in state and federal research grants
related to genital herpes and anthrax research.

4.     Other includes primarily laboratory occupancy costs and scientific
management.

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Neurodex Research Projects

Neurodex is a patented, orally administered combination of dextromethorphan
(DM) and an enzyme inhibitor that sustains elevated levels of DM on a proposed
twelve-hour dosing schedule. Avanir is currently developing Neurodex for use
in two indications: pseudobulbar affect (PBA) and neuropathic pain.

Treatment of pseudobulbar affect. In June 2002, Avanir successfully completed
a pivotal Phase II/III clinical trial for the treatment of PBA in patients with
ALS. Preliminary results reported in June showed the endpoint of the study was
statistically significant in favor of Neurodex when compared to either of the
other two treatment arms. Additional statistical analysis of the study results
has confirmed efficacy in the primary endpoint as well as efficacy in
pre-specified secondary endpoints. As expected, based on its pharmacology,
adverse events including nausea, drowsiness and dizziness were reported with
greater frequency in the Neurodex group. In November 2002 Avanir reported the
complete results of the study at the ALS/MND conference in Melbourne,
Australia.

In late 2002, Avanir initiated a second Phase III trial for Neurodex for the
treatment of PBA in MS patients. Avanir also intends to initiate in early 2003
an open-label safety study in patients with symptoms of PBA. If we are
successful in completing the remaining studies, we intend to file an NDA with
the FDA by mid-2004. Assuming the FDA approves Neurodex for marketing under
normal FDA review guidelines, the drug could be available for sale by mid-2005
and we would expect to begin receiving revenues from sales of the drug in the
third calendar quarter of 2005.

Treatment of neuropathic pain. In July 2002, we initiated a Phase II,
open-label dose-ranging clinical trial of Neurodex for the treatment of pain in
patients with diabetic neuropathy. The study is intended to determine the
feasibility of developing this indication in order to expand the potential
market for Neurodex.

Partnering strategy. Avanir intends to retain commercial rights to all
indications for Neurodex in the U.S. and license or otherwise partner Neurodex
in Europe and other commercially feasible territories outside the U.S. Avanir
anticipates the prospective partner(s) will continue to carry out clinical
development for all feasible indications, including paying for future clinical
development costs associated with the licensed territory. We expect to receive
license fees, milestone payments and/or royalties on product sales by the
licensee if the drug is successfully developed and approved for marketing.
There can be no assurances that we will be successful in obtaining a licensee
for the drug. If we continue to make progress as planned, we anticipate
finding a partner(s) in Europe and possibly other territories and begin
receiving material net cash inflows from payments by the licensee by the fourth
calendar quarter 2003.

We caution that many of our development efforts related to Neurodex could
experience delays, setbacks and failures, with no assurance that our clinical
research for either PBA or neuropathic pain will ever reach completion in the
timeframes planned. Further, we cannot provide any assurance that we will be
successful in finding a licensee, or that the licensee will be successful in
carrying out the remainder of the clinical development, file an NDA or obtain
approval from the FDA for marketing the drug. If we or our licensee were to
experience one or more setbacks or failures in the development of the drug, we
or our licensee may have to repeat the research at additional cost or abandon
the development program.

Allergy and Asthma Pre-clinical Research (IgE Regulator) Project

A key component in the pathophysiology of both allergy and asthma is the
overproduction of immunoglobulin epsilon (IgE) antibodies. We have identified
a family of orally active small molecules that selectively inhibit or prevent
the production of IgE antibodies and associated mediators and

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cytokines. In December 2002, we
filed with the FDA for an Investigational New Drug (IND) application
for our lead compound to treat allergy and asthma. Assuming the IND is accepted by the FDA for the product and we
successfully complete Phase I clinical trials, we intend to begin shortly
thereafter the process of seeking a licensee for continued development of the
drug. We expect that clinical trials for this drug in the large therapeutic
area of allergy and asthma would require substantially more financial resources
than will be available to us for the foreseeable future. Therefore, our
strategy is to license the drug for further development by another company and
receive license fees, milestone payments and/or royalties if the drug is
successfully developed. Assuming we are successful in our toxicology studies
and the FDA accepts our IND application, we intend by the fourth calendar
quarter of 2003 to license the drug to another company that has the resources
to fund and carry out the development program. We anticipate that such a
license arrangement would provide Avanir with license fees and/or milestone
payments as well as royalties on product sales if the technology is
successfully developed and approved for marketing by the FDA.

We caution that many of our development efforts related to IgE could experience
delays, setbacks and failures, with no assurance that our research will ever
reach completion of our intended plan, that we will be successful in finding a
licensee, or that the licensee will be successful in carrying out the remainder
of the clinical development, file an NDA or obtain approval from the FDA. If
we or our licensee were to experience one or more setbacks or failures in the
development of the drug, we or our licensee may have to repeat the research at
additional cost or abandon the development program.

Government-funded Research Projects

We have been awarded three government-funded research grants totaling $1.2
million that are intended to reimburse us for costs of certain pre-clinical
research related to a potential treatment for genital herpes and antibodies for
anthrax. Our $1 million Phase II Small Business Innovative Research (SBIR)
grant and $150,000 California Technology Investment Partnership (CalTIP) grant
are for pre-clinical and market research related to the development of a
topical treatment for genital herpes (HSV-2) over a two-year period. We are
using the SBIR grant to fund certain pre-clinical research related to genital
herpes. We are using the CalTIP funds for defining and assessing the market
including assessment of competitive landscape, product opportunities, FDA
regulatory review expectations, brand identification and possible brand names
for a potential genital herpes product. Additionally, in fiscal 2002, we were
awarded a $75,000 grant from the California Center for Advanced Technology for
research and development in fiscal 2002 and 2003 related to finding
one or more antibodies to the toxins produced by anthrax.

Other Pre-clinical Research Projects

Anti-inflammatory research (MIF inhibitor) In mid-2001 we acquired a
proprietary series of compounds that appear to inhibit or block the activity of
macrophage migration inhibitory factor (MIF). MIF is a protein that plays a
central role in inflammation pathways. Our research indicates that MIF may
serve as a potential drug target in a variety of diseases, including rheumatoid
arthritis, Crohns disease, colitis, asthma and sepsis. Our goal is to
identify and develop an orally administered compound that can be developed as
an innovative therapy for the treatment of inflammatory diseases. Our MIF
technology platform is currently in the early pre-clinical stage of development
and is at too early of a stage of development to predict the cost and timing to
complete the project.

Cholesterol reduction (CCM technology)- Our research on cholesterol lowering
agents is a very early stage drug discovery program that has been implemented
to discover agents that will be valuable in 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

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lipoproteins (HDL) remove excess cholesterol from peripheral tissues, and
transport it to the liver for elimination. We have a proprietary technology,
code-named CCM, that we are using to identify peptides that may be capable of
accelerating the removal of excess cholesterol from peripheral tissues and
transporting it to the liver for elimination. Because our CCM technology
platform is at a very early stage of research, we are unable to predict the
cost and timing for development of a drug. This product is currently in the
pre-clinical development stage for a possible method of reducing undesirable
levels of cholesterol.

Monoclonal antibodies research As of September 30, 2002, we were engaged in
research collaborations with three companies that desire to use our proprietary
technology to produce fully human monoclonal antibodies to potential disease
targets. These research collaborations typically provide us with advance
payments to conduct research and provide for milestone payments in the event
that we are successful in meeting certain predetermined stages of development.
Xenerex is also conducting research on developing antibodies to targets
internally identified for possible addition to the Companys own drug discovery
and development programs. Because all of our research is at a very early
pre-clinical 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- On January 15, 2002, we entered into a
collaborative research and development agreement with Shanghai New Asiatic
Pharmaceutical Company, Ltd., a division of Shanghai Pharmaceutical Co., Ltd.
Under the agreement, we provided clinical and pre-clinical research information
on docosanol 10% cream to Shanghai New Asiatic. Shanghai New Asiatic is
responsible for evaluating the regulatory approval requirements and size of the
markets for the treatment of cold sores, genital herpes and herpes zoster
(shingles). There can be no assurance that either the regulatory approval
requirements or the size of market will be attractive to Shanghai New Asiatic
to ensure the product will be developed.

CRITICAL ACCOUNTING POLICIES

Because of the significance of our revenue recognition policies to our
financial statements, we believe it is appropriate to include our revenue
recognition policies as critical accounting policies.

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 GlaxoSmithKline. On
March 31, 2000, we transferred the rights to GlaxoSmithKline to manufacture,
use, and sell Abreva® in the United States and Canada 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 that territory. 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 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
reasonable assured.

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Royalties on Licensed Products

We recognize royalty revenues from our licensed products based on the reported
sales by our licensee and computed in accordance with the specific terms of the
license agreement. Since the launch of Abreva® in October 2000 up to September
30, 2002, 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 Future Royalty Revenues

In order to increase our cash position and to further fund our current
development programs, we sold an undivided interest in our license agreement
with GlaxoSmithKline to Drug Royalty USA and received an initial payment of
$20.5 million. Because of the ongoing involvement with Drug Royalty USA in
earning future royalty revenues, we have classified the amount received from
the purchaser as deferred revenue. The amount classified as deferred revenue
will be amortized under the units-of-revenue method, whereby amortization for a
period is calculated by computing the ratio of proceeds received from the
purchaser to the total payments expected to be made to the purchaser over the
term of the license purchase agreement and then applying that ratio to the
periodic cash payment.

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.

As of September 30, 2002, Xenerex had entered into three research collaboration
arrangements, all of which have research initiation fees. In these agreements,
the customer provides antigens to Xenerex. Xenerex performs research to
develop potential antibodies for those antigens (initial phase). If, after a
reasonable commercial effort is made to develop an antibody, it is determined
that none exists, the contract is complete and the initiation fee is
recognized. If antibodies are developed, they are provided to the customer and
a determination is made by the customer to have Xenerex perform further
research or terminate the remaining contract. If the customer decides to have
Xenerex continue research on the developed antibodies, there exists in the
contract milestones that are tied to the completion of the different phases of
effort. Examples of milestones include when the customer files the Biologics License Application and
when the customer obtains regulatory approval.

The research collaboration agreements also define the amount of royalties on
product sales by the licensee, assuming the licensee successfully develops and
obtains approval for marketing a product. The license fees and royalty rates,
while defined as part of the research collaboration agreement, would still be
subject to completion of a definitive license agreement with the customer.

Xenerex Research Initiation Fees- Xenerex defers research initiation fees and
recognizes the revenue once Xenerex has completed its efforts to create
antibodies. Under existing research agreements, if Xenerex fails
to create antibodies, then the contract may be terminated with no
additional performance obligations, indicating that the earnings
process is complete, provided Xenerex has made a commercially reasonable effort
to create antibodies. The status of Xenerexs three existing collaborative
agreements are as follows:

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| |  |  | Peregrine Pharmaceuticals The Peregrine contract provides
for the creation of antibodies to three target antigens provided by
Peregrine. As of September 30, 2002, Xenerex had advanced to the
second stage of the research collaboration agreement for one of the
three target antigens. The second stage is intended to provide
Peregrine with more information on selected panels of the antibodies
that meet the antibody characteristics desired by Peregrine. We
earned and recognized a pro-rata portion of the research initiation
fee as revenue associated with our efforts and included the amount
in our contract and license fee revenues for fiscal 2002. We have
not completed the performance associated with stage two or other
milestones in the agreement and have not earned or recognized any
other revenues in fiscal 2002.             
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | Eos Biotechnology, Inc. The Eos contract provides for the
creation of antibodies to three target antigens provided by Eos. As
of September 30, 2002, Xenerex had advanced to the second stage of
the research collaboration agreement for two of the three target
antigens. The second stage is intended to provide Eos with more
information on selected panels of the antibodies that meet the
antibody characteristics desired by Eos. We earned and recognized
the research initiation fee as revenue associated with our
commercial efforts on all three antigens and included the amount in
our contract and license fee revenues in the prior fiscal year ended
September 30, 2001. We have not completed the performance
associated with stage two or other milestones in the agreement and
have not earned or recognized any revenues in fiscal 2002.
|
| |  |  | DNAX Research, Inc. The DNAX contract provides for the
creation of antibodies to two target antigens provided by DNAX. We
have not completed the commercial efforts associated with the
research initiation fees or achieved any of the milestones in the
agreement. Therefore, as of September 30, 2002, we had not earned
or recognized any revenues under the agreement.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   

Xenerexs receipt of milestone payments In the research phases of the
research collaboration agreement, Xenerex may receive payment either to start a
research phase or to complete a research phase (including receipt by the
customer of the deliverable). Xenerex recognizes 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;                   
| 
| |  | Payment for the delivered products or services is not contingent on
delivery of the remaining products or services; and              
| 
| |  | We have an enforceable claim to receive the amount due in the event
we do not deliver the remaining undelivered products or services.

Commercial phase of Xenerex research contracts- Xenerex research collaboration
agreements provide that a final license agreement will be executed to
incorporate the terms and conditions for the commercial phase of the contract.
We will evaluate revenue recognition for the commercial phase once a license
agreement is executed and the commercial phase has commenced.

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. Regardless of when we receive
the payment associated with a research phase, we defer the revenue recognition
until the service is completed or product is delivered.

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NATURE OF OPERATING EXPENSES

Avanirs operating expenses are influenced substantially by the amount of
spending devoted to our clinical development programs and drug discovery
research. During the past two years, we have substantially expanded our drug
development pipeline, which requires that we allocate significant amounts of
our resources to research and development activities. 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 annual operating expenses will increase
for the foreseeable future, in light of our expanded product development
pipeline. Our business is exposed to significant risks, as discussed in the
section entitled Risk factors that might affect future operations, which may
result in additional expenses, delays and lost opportunities that could have a
material adverse effect on our financial condition and results of operations.

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 2002 and 2001

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 of $190,000, or approximately breakeven on a
per share basis.

We expect to continue to pursue our drug development strategy focused on large
market therapeutic areas with 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 at current or higher rates in our existing
research and clinical development programs, which we expect will result in a
loss for fiscal 2003.

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 $41,000 in sales
of the active ingredient docosanol, $160,000 in federal and state grant
revenues, 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

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sales. Other revenues in fiscal 2001 included $73,000 in government grant
revenues, and $70,000 in contract and license fees from other areas.

If we are successful in completing the Phase III clinical trial and open label
study of Neurodex for the treatment of PBA by December 2003 and we are able to
obtain approval from the FDA by mid-2005 to market the product, then we should
be able to meet our plan for marketing and selling Neurodex by mid-to-late
2005.

Expenses  2002 vs. 2001

Operating expenses. Our total operating expenses increased to $19.8 million in
fiscal 2002, compared to $13.6 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 $3.8
million on clinical development of Neurodex, including $2.6 million on a Phase
II/III clinical trial for the potential treatment of PBA in patients who have
Lou Gehrigs disease and $1.2 million in R&D related to the treatment of
neuropathic pain. We also spent $4.3 million on pre-clinical 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 pre-clinical programs addressing inflammation and
cholesterol reduction, antibody generation technology and operation of our
laboratory facilities.

In fiscal 2001 we spent $2.3 million on Neurodex, including $1.5 million
related to the Phase II/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 pre-clinical research focused
on a novel treatment for allergy and asthma. The balance of R&D activities was
primarily related to other pre-clinical programs addressing inflammation and
cholesterol reduction, antibody generation technology and operation of our
laboratory facilities.

General and administrative expenses. Our general and administrative expenses
increased to $4.6 million in fiscal 2002, compared to $3.5 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 at Xenerex Biosciences. Fiscal
2001 expenses primarily reflected travel, legal and overall business
development staff costs necessary to pursue international licensing of
docosanol 10% cream.

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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. The increased levels of interest expense
will continue for the foreseeable future. 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.

Comparison of fiscal years 2001 and 2000

Net income (loss)  2001 vs. 2000

The net income attributable to common shareholders for fiscal 2001 was
$190,000, or slightly better than breakeven on a per-share basis, compared with
a net loss of $802,000, or $0.02 per share, for fiscal 2000. This represents
an improvement of $1.0 million or $0.02 per share in fiscal 2001 over the net
loss in fiscal 2000. Increased revenues from milestone payments and royalties
on sales of Abreva contributed to earning a profit in fiscal 2001 compared with
a loss in fiscal 2000, as further discussed below.

Revenues  2001 vs. 2000

Revenues in fiscal 2001 increased to $12.7 million, compared to $10.3 million
in fiscal 2000. The $2.4 million increase in revenues for fiscal 2001 resulted
primarily from the launch of our cold sore product, Abreva, in the United
States by our licensee, GlaxoSmithKline, in October 2000. Avanir earned $10.0
million in milestone payments and $2.5 million in royalty revenues on sales of
Abreva in fiscal 2001, compared to $10.0 million in milestone payments under
the license agreement in the prior year. Other revenues in fiscal 2001
included $73,000 in federal grant revenues and $70,000 in contract and license
fees from other areas. Other revenues in fiscal 2000 included $225,000 in
sales of the active ingredient, docosanol.

Expenses  2001 vs. 2000

Operating expenses. Our total operating expenses increased to $13.6 million in
fiscal 2001, compared to $10.8 million in fiscal 2000. Operating expenses in
fiscal 2001 were higher than fiscal 2000 by $6.9 million excluding litigation
settlement charges of $4.1 million in fiscal 2000. The net increase in
operating expenses during fiscal 2001 is described in the following paragraphs.

Purchased in-process research and development expense.In fiscal 2001, we
charged $917,000 to in-process research and development expense, which
represents the cost of in-process technologies obtained in our acquisition of
the MIF inhibitor technology and know-how from the Ciblex Corporation (See Note
2 to the Financial Statements, Purchased in-process research and
development).

Research and development (R&D) expenses. R&D expenses amounted to $7.2 million
in fiscal 2001, compared to $2.4 million for fiscal year 2000. In fiscal 2001,
we spent $2.3 million or 32% of total R&D

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expenditures on a Phase II/III clinical trial of Neurodex in the potential
treatment of emotional lability in ALS patients. We also spent $1.4 million or
19% of total R&D expenditures on pre-clinical research focused on a novel
treatment for allergy and asthma, including development and scaled-up
manufacture of the lead compound. Within Xenerex, we spent $1.3 million or 18%
of total R&D expenditures on development of antibody generation technology.
The balance of R&D spending was primarily related to other pre-clinical
programs addressing inflammation and cholesterol reduction and operation of our
laboratory facilities. In fiscal 2000, R&D activities primarily related to
drug discovery efforts in seeking a lead compound intended for the treatment of
allergy and asthma and for Phase II clinical trials of Neurodex as an intended
treatment for emotional lability in ALS and other neurodegenerative diseases.

General and administrative expenses. Our general and administrative expenses
increased to $3.5 million in fiscal 2001 from $3.3 million during fiscal 2000.
These increased expenses primarily relate to:



| |  |  | increased staff size and higher administrative support
costs for most of fiscal 2001 as the Company increased its level
of operating activity in drug discovery, clinical development,
and business development following approval of Abreva by the FDA;
partially offset by
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | lower legal expenses related to defense of claims
against the Company.                                                                                                                                                                                                      

Sales and marketing expenses. Sales and marketing expenses increased to $1.2
million in fiscal 2001 from $692,000 during fiscal 2000. In fiscal 2001,
business development activities, including travel, legal and overall staff
costs, increased substantially as we pursued international licensing of
docosanol 10% cream. In fiscal 2000, we maintained a lower level of marketing
and sales staff while awaiting the FDAs approval of Abreva for marketing in
the United States.

Other Income and Expenses  2001 vs. 2000

Interest income. Interest income increased to $1.1 million in fiscal 2001,
compared to $434,000 in fiscal 2000. The increase in interest income during
fiscal 2001 was primarily due to higher investment balances, partially offset
by lower interest rates on investments compared with fiscal 2000.

Other Income. Other income for fiscal 2001 amounted to $3,000, representing
rental income from Healthscan Metabolic Imaging, LLC for sharing an emergency
power generator under an equipment lease agreement.

Interest expense. Interest expense decreased to $7,000 in fiscal 2001,
compared to $516,000 in fiscal 2000. The high level of interest expense in
fiscal 2000 related to the amortization of debt issue costs and interest
expense incurred on an aggregate of $1.5 million in redeemable convertible
debt, portions of which were outstanding up to 71 days in fiscal 2000.

Liquidity and Capital Resources

At September 30, 2002, we had cash and cash equivalents of $8.6 million and a
net working capital balance of $5.9 million. At September 30, 2001, we had
cash and cash equivalents of $16.5 million and a net working capital balance of
$16.0 million. Explanations of the changes in net cash provided by or used for
operating, investing and financing activities are provided below.

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|                                                     |                                           |   |                          |            |                     |   |                          |            |   |   |            |            |  
|---------------------------------------------------- | ----------------------------------------- | - | ------------------------ | ---------- | ------------------- | - | ------------------------ | ---------- | - | - | ---------- | ---------- | -
|                                                     |                                           |   | September 30,            |            | Increase (decrease) |   | September 30,           
|                                                     |                                           |   | 2002                     |            | during fiscal 2002  |   | 2001                    
|                                                     |                                           |   |                          |            |                     |   |                         
|Cash and cash equivalents                            |                                           | $ | 8,630,547                |            |                     | $ | (7,911,998               | )          |   | $ | 16,542,545 |           
|Cash
and investments in securities                   |                                           | $ | 13,169,007               |            |                     | $ | (8,682,229               | )          |   | $ | 21,851,236 |           
|                                                     |                                           |   |                          |            |                     |   |                          |            |   |   |            |           
|Net working capital                                  |                                           | $ | 5,918,083                |            |                     | $ | (10,109,494              | )          |   | $ | 16,027,577 |           
|                                                    
|                                                     |                                           |   |                          |            |                     |   |                          |            |   |   |            |           
|                                                     |                                           |   | Year
Ended
September 30, |            | Increase
(decrease) |   | Year
ended
September 30,
|                                                     |                                           |   | 2002                     |            | during fiscal 2002  |   | 2001                    
|                                                     |                                           |   |                          |            |                     |   |                         
|Net cash provided by (used for) operating
activities |                                           | $ | (6,928,478               | )          |                     | $ | (7,562,929               | )          |   | $ | 634,451    |           
|Net cash used for investing activities               |                                           |   | (1,205,737               | )          |                     |   | 4,034,641                |            |   |   | (5,240,378 | )         
|Net cash provided by financing activities            |                                           |   | 222,217                  |            |                     |   | (1,226,487               | )          |   |   | 1,448,704  |           
|                                                     |                                           |   |                          |            |                     |   |                          |            |   |   |            |           
|                                                     | Net decrease in cash and cash equivalents |   | $                        | (7,911,998 | )                   |   | $                        | (4,754,775 | ) |   | $          | (3,157,223 | )
|                                                     |                                           |   |                          |            |                     |   |                          |            |   |   |            |           

Note 6 (Commitments and Contingencies) of the financial statements filed with
this Report discusses the Companys material commitments for capital
expenditures and is incorporated herein by reference. We anticipate
being able to satisfy the obligations described in Note 6 out of cash and cash
equivalents held by the Company as of September 30, 2002 and
subsequent proceeds
that the Company received from the sale of future Abreva royalties to
Drug Royalty USA.

Operating activities. Net cash used for operating activities in fiscal 2002
amounted to $6.9 million, compared to net cash provided by operating activities
of $634,000 during fiscal 2001. 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. Net cash
provided by operating activities for fiscal 2001 is attributable primarily to
$233,000 in net income, $867,000 in purchases of in-process R&D using common
stock, and $373,000 in depreciation and amortization, partially offset by an
$803,000 increase in accounts receivable and a $231,000 decrease in accounts
payable.

Investing activities. Net cash used for investing activities during fiscal
2002 amounted to $1.2 million, including $9.7 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. As short-term interest rates came
down through most of fiscal 2001 and 2002, we sought to achieve higher yields
on our available cash by investing in securities that had maturities longer
than one year. We maintained an investment strategy of seeking higher yields
through longer maturities of government securities and bank CDs through most of
fiscal 2001 and 2002. We invested $9.0 million in long-term investments in
securities for fiscal 2002, but also sold $9.7 million in long-term investments
in securities late in fiscal 2002 to raise cash levels and to realize gains on
several of our investments. Net cash used for investing activities totaled
$5.2 million in fiscal 2001, including $4.5 million in investments in
securities, $1.0 million in purchases of property and equipment and $538,000
related to patent costs.

Financing activities. Net cash provided by financing activities during fiscal
2002 amounted to $222,000 and reflected $261,000 in proceeds from issuances of
common stock and $287,000 from issuance 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. During fiscal 2001, we
received $1.5 million from issuances of common stock, repaid $195,000 in
outstanding debt and paid $6,000 in dividends on preferred stock, yielding $1.4
million in net cash provided by financing activities.

Subsequent to September 30, 2002, we increased our cash and short and long-term
investments by $20.5 million from the sale of an undivided interest in our
license agreement with GlaxoSmithKline to Drug Royalty USA. As of
December 24,
2002, our cash and short and long-term investments in securities

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amounted to approximately $28 million, which should provide us with
sufficient liquidity to sustain our planned level of operations well into
fiscal 2004. 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. Potential alternatives that we
are considering for raising capital include, but are not limited to, partnering
arrangements where partners share development costs, issuance of debt or equity
securities, and licensing or sales of any of our platform technologies or new
drug candidates.

Recent Accounting Pronouncements

In June 2001, the Financial Accounting Standards Board (FASB) approved
Statement of Financial Accounting Standards No. 142 (SFAS No. 142), Goodwill
and Other Intangible Assets. SFAS No. 142 supercedes APB Opinion No. 17,
Intangible Assets, and requires goodwill and other intangible assets that
have an indefinite useful life to no longer be amortized; however, these assets
must be reviewed at least annually for impairment. Application of SFAS No. 142
became effective for the Company on October 1, 2002. The application of SFAS
No. 142 did not have a material impact on the Companys financial statements.

In August 2001, the FASB issued SFAS No. 144, Accounting for the Impairment or
Disposal of Long-Lived Assets. This statement addresses financial accounting
and reporting for the impairment or disposal of long-lived assets. This
statement supercedes SFAS No. 121, Accounting for the Impairment of Long-Lived
Assets and for Long-Lived Assets to be Disposed Of, and the accounting and
reporting provisions of APB Opinion No. 30, Reporting the Results of
Operations  Reporting the Effects of a Disposal of a Segment of a Business,
and Extraordinary, Unusual and Infrequently Occurring Events and Transactions,
for the disposal of a segment of a business (as previously defined in that
Opinion). SFAS No. 144 became effective for the Company on October 1, 2002.
The application of SFAS No. 144 did not have a material impact on the Companys
financial statements.

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 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. The Company will adopt the provisions of SFAS No.
146 for exit or disposal activities that are initiated after December 31, 2002.




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.

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Interest rate sensitivity

Our investment portfolio consists primarily of fixed income instruments with an
average duration of 2.3 years as of September 30, 2002 (2.8 years as of
September 30, 2001). The primary objective of our investments in debt
securities is to preserve principal while achieving attractive yields, without
significantly increasing risk. We carry some investments that we intend to
hold to maturity and others that we classify 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 increase as its
duration increases.




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.

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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 13, 2003.

Executive officers of the Registrant

The names of our executive officers and their ages as of December 6, 2002
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.  |  |     | 60 |          |  | President and Chief Executive Officer                                               
|James E. Berg             |  |     | 51 |          |  | Vice President, Clinical and Regulatory Affairs                                     
|R. Martin Emanuele, Ph.D. |  |     | 48 |          |  | Vice President, Corporate Development                                               
|Gregory P. Hanson         |  |     | 56 |          |  | Vice President, Finance; Chief Financial
Officer and Secretary                      
|J. David Hansen           |  |     | 51 |          |  | Vice President, Avanir; President and Chief
Operating Officer of Xenerex Biosciences
|Jagadish C. Sircar, Ph.D. |  |     | 67 |          |  | Vice President, Drug Discovery                                                      

Gerald J. Yakatan, Ph.D. Dr. Yakatan has served as President and Chief
Executive Officer since March 1998. Dr. Yakatan also serves as a director and
as the Chief Executive Officer of Avanirs subsidiary, Xenerex Biosciences. In
addition, Dr. Yakatan serves or has served in the following positions: from
July 1995 to February 1998 has served on a half-time basis as our Vice
President of Drug Development; from 1996 to present, Chairman of IriSys
Research & Development, LLC, a company he founded in 1996 specializing in
contract drug formulation development services; from 1990 until 1995, president
and chief executive officer of San Diego-based Tanabe Research Laboratories,
USA, Inc., an inflammation drug discovery research and development company.
Earlier in his career, Dr. Yakatan held various positions over a seven-year
span at Warner-Lambert Co., including Vice President of Product Development for
the Pharmaceutical Research Division; and for approximately eight years he was
a faculty member of the University of Texas at Austin and Assistant Director of
the Drug Dynamics Institute at the College of Pharmacy. Dr. Yakatan has over
60 scientific and professional publications in the areas of pharmacokinetics,
biopharmaceutics, analysis of drugs in biological fluids and drug stability.
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. From August 1992 to March 1997, Mr. Berg was
Director of Clinical Affairs and Product

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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.

R.     Martin Emanuele, Ph.D.Dr. Emanuele has served as Vice President, Corporate
Development since August 2002. In this capacity, 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 research and development 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.

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 CFO and Corporate Secretary for the companys subsidiary,
Xenerex Biosciences. 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 a Vice President of Avanir
since September 1998 and also
the President and Chief Operating Officer of the Avanirs subsidiary, Xenerex
Biosciences since April 2000. In addition, Mr. Hansen has served in the
following positions: from December 1989 to September 1998, various management
positions at Dura Pharmaceuticals, San Diego, California, 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 pre-clinical 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,
all from the University of Calcutta, Calcutta, India. Dr. Sircar has a total of
154 patents, presentations and publications that are credited to him.

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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. CONTROLS AND PROCEDURES



|(a) |  | Under the supervision and with the participation of our management,
including our principal executive officer and principal financial officer,
we conducted an evaluation of our disclosure controls and procedures, as
such term is defined under Rule 13a-14(c) promulgated under the Securities
Exchange Act of 1934, as amended (the Exchange Act), within 90 days of
the filing date of this report. Based on their evaluation, our principal
executive officer and principal financial officer concluded that our
disclosure controls and procedures are effective.
|--- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|   
|(b) |  | There have been no significant changes, including corrective actions with
regard to significant deficiencies or material weaknesses, in our internal
controls or in other factors that could significantly affect these
controls subsequent to the date of the evaluation referenced in paragraph
(a) above.                                                                                                                                                                                                                                                               




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



| |  |  | None
| |  |  | ----

39



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(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 (15)                                                                         
|     |  |                                                                                                                                                                                   
|3.3  |  | Certificate of Amendment of the Articles of Incorporation of the Registrant, dated
February 19, 1999 (15)                                                                         
|     |  |                                                                                                                                                                                   
|3.4  |  | Amended and Restated Bylaws of the Registrant (15)                                                                                                                                
|     |  |                                                                                                                                                                                   
|4.1  |  | Forms of Class A and Class B Common Stock Certificates (3)                                                                                                                        
|     |  |                                                                                                                                                                                   
|4.2  |  | Form of Class G Stock Purchase Warrant issued in connection with Convertible Note,
dated February 26, 1997 (4)                                                                    
|     |  |                                                                                                                                                                                   
|4.3  |  | Registration Rights Agreement, dated February 26, 1997, with RGC International
Investors, LDC (4)                                                                                 
|     |  |                                                                                                                                                                                   
|4.4  |  | Registration Rights Agreement with Promethean Investment Group, LLC (5)                                                                                                           
|     |  |                                                                                                                                                                                   
|4.5  |  | Class A Common Stock Investment Agreement with Promethean Investment Group, LLC (5)                                                                                               
|     |  |                                                                                                                                                                                   
|4.6  |  | Certificate of Determination with respect to Series C Junior Participating Preferred
Stock of the Registrant (6)                                                                  
|     |  |                                                                                                                                                                                   
|4.7  |  | Rights Agreement, dated as of March 5, 1999, with American Stock Transfer & Trust
Company (6)                                                                                     
|     |  |                                                                                                                                                                                   
|4.8  |  | Form of Rights Certificate with respect to the Rights Agreement, dated as of March 5,
1999 (6)                                                                                    
|     |  |                                                                                                                                                                                   
|4.9  |  | Certificate of Determination, dated March 26, 1999, with respect to Series D redeemable
convertible preferred stock of the Registrant (7)                                         
|     |  |                                                                                                                                                                                   
|4.10 |  | Form of Series D Convertible Preferred Stock Certificate (7)                                                                                                                      
|     |  |                                                                                                                                                                                   
|4.11 |  | Form of Class J Stock Purchase Warrant issued in connection with Series D redeemable
convertible preferred stock (7)                                                              
|     |  |                                                                                                                                                                                   
|4.12 |  | Securities Purchase Agreement for Series D Convertible Preferred Stock (7)                                                                                                        
|     |  |                                                                                                                                                                                   
|4.13 |  | Registration Rights Agreement for Series D Convertible Preferred Stock (7)                                                                                                        
|     |  |                                                                                                                                                                                   
|4.14 |  | Amendment to the Class A Common Stock Investment Agreement with Promethean Investment
Group, LLC (7)                                                                              
|     |  |                                                                                                                                                                                   
|4.15 |  | Class K Stock Purchase Warrant, dated as of April 1, 1999, issued to Redington, Inc. (8)                                                                                          
|     |  |                                                                                                                                                                                   
|4.16 |  | Amendment No. 1 to Registration Rights Agreement, dated as of November 23, 1999, with
AMRO International, S.A and The Endeavour Capital Fund, S.A. (9)                            
|     |  |                                                                                                                                                                                   
|4.17 |  | Amendment No. 1 to Rights Agreement, dated November 30, 1999, with American Stock
Transfer & Trust Company (9)                                                                    
|     |  |                                                                                                                                                                                   
|4.18 |  | 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 (11)
|     |  |                                                                                                                                                                                   
|4.19 |  | Form of Class N Stock Purchase Warrant, issued in connection with Common Stock Purchase
Agreement dated January 25, 2000 (11)                                                     
|     |  |                                                                                                                                                                                   
|10.1 |  | Form of Employment Agreement, dated as of February 1999, with certain executive
officers and key employees of the Registrant (2)                                                  
|     |  |                                                                                                                                                                                   
|10.2 |  | Amended and Restated 1998 Stock Option Plan (15)                                                                                                                                  

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|      |  |                                                                                                                                                                                     
|----- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|10.3  |  | Amended and Restated 1994 Stock Option Plan (15)                                                                                                                                    
|      |  |                                                                                                                                                                                     
|10.4  |  | Employment Agreement with Gerald J. Yakatan, dated November 29, 2001 (15)                                                                                                           
|      |  |                                                                                                                                                                                     
|10.5  |  | Form of Retention Agreement with certain Executive Officers of the Registrant (10)                                                                                                  
|      |  |                                                                                                                                                                                     
|10.6  |  | Form of Indemnification Agreement with certain Directors and Executive Officers of the
Registrant (10)                                                                              
|      |  |                                                                                                                                                                                     
|10.7  |  | Common Stock Purchase 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 (11)
|      |  |                                                                                                                                                                                     
|10.8  |  | License Agreement, dated March 31, 2000, by and between Avanir Pharmaceuticals and SB
Pharmco Puerto Rico, a Puerto Rico Corporation (12)                                           
|      |  |                                                                                                                                                                                     
|10.9  |  | Standard Industrial Net Lease by and between Avanir Pharmaceuticals and BC Sorrento,
LLC, effective September 1, 2000 (13)                                                          
|      |  |                                                                                                                                                                                     
|10.10 |  | License Agreement, dated August 1, 2000, by and between Avanir Pharmaceuticals
(Licensee) and Irisys Research and Development, LLC, a California limited liability
company (13)   
|      |  |                                                                                                                                                                                     
|10.11 |  | Amended and Restated 2000 Stock Option Plan (14)                                                                                                                                    
|      |  |                                                                                                                                                                                     
|10.12 |  | Standard Industrial Net Lease by and between Avanir Pharmaceuticals (Tenant) and
Sorrento Plaza, a California limited partnership (Landlord), effective May 20, 2002
(16)       
|      |  |                                                                                                                                                                                     
|21.1  |  | List of Subsidiaries                                                                                                                                                                
|      |  |                                                                                                                                                                                     
|23.1  |  | Independent Auditors Consent                                                                                                                                                       
|      |  |                                                                                                                                                                                     
|99.1  |  | Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of
the Sarbanes-Oxley Act of 2002                                                              
|      |  |                                                                                                                                                                                     
|99.2  |  | Certification pursuant to 18 U.S.C. Section 1350, as adopted 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 Quarterly Report on Form 10-Q for the quarter ended March 31, 1999, filed
May 17, 1999.                                              
|   
|(3) |  | 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.                          
|   
|(4) |  | Incorporated by reference to the similarly described exhibit included with the
Registrants Current Report on Form 8-K, filed March 10, 1997.                                                                                    
|   
|(5) |  | Incorporated by reference to the similarly described exhibit included with the
Registrants Current Report on Form 8-K, filed January 25, 1999.                                                                                  
|   
|(6) |  | Incorporated by reference to the similarly described exhibit included with the
Registrants Current
Report on Form 8-K, filed March 11, 1999.                                                                                    
|   
|(7) |  | Incorporated by reference to the similarly described exhibit included with the
Registrants Current
Report on Form 8-K, filed April 1, 1999.                                                                                     

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##### Table of Contents



|(8)  |  | Incorporated by reference to the similarly described exhibit included with the
Registrants Current Report on Form 8-K, filed April 20, 1999.                                              
|---- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|    
|(9)  |  | Incorporated by reference to the similarly described exhibit included with the
Registrants Current Report on Form 8-K, filed December 3, 1999.                                            
|    
|(10) |  | Incorporated by reference to the similarly described exhibit included with the
Registrants Quarterly Report on Form 10-Q for the quarter ended June 30, 1998.                             
|    
|(11) |  | Incorporated by reference to the similarly described exhibit included with the
Registrants Current Report on Form 8-K, filed February 4, 2000.                                            
|    
|(12) |  | Incorporated by reference to the similarly described exhibit included with the
Registrants Current Report on Form 8-K, filed May 4, 2000.                                                 
|    
|(13) |  | Incorporated by reference to the similarly described exhibit included with the
Registrants Quarterly Report on Form 10-Q, filed August 14, 2000.                                          
|    
|(14) |  | Incorporated by reference to the similarly described exhibit included with the
Registrants definitive proxy statement for the 2002 Annual Meeting of Shareholders,
filed January 17, 2002.
|    
|(15) |  | Incorporated by reference to the similarly described exhibit included with the
Registrants Annual Report on Form 10-K, filed
December 21, 2001.                                           
|    
|(16) |  | Incorporated by reference to the similarly described exhibit included with the
Registrants Quarterly Report on Form 10-Q, filed August 13, 2002.                                          

42



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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.

Date: December 26, 2002

| |  |                        |  |                                                               
| |  | ---------------------- |  | --------------------------------------------------------------
| |  | Avanir PHARMACEUTICALS
| |  |                        |  |                                                               
| |  | By:                    |  | /s/Gerald J. Yakatan, Ph.D.                                   
| |  |                        |  |                                                               
| |  |                        |  | Gerald J. Yakatan, Ph.D.
President and Chief Executive Officer

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 26, 2002
|                                                      |  |                                                                                                  |  |                  
|/s/Gregory P. Hanson

Gregory P. Hanson               |  | Vice President, Finance and Chief
Financial Officer
(Principal Financial and Accounting Officer) |  | December 26, 2002
|                                                      |  |                                                                                                  |  |                  
|/s/James B. Glavin

James B. Glavin                   |  | Chairman of the Board                                                                            |  | December 26, 2002
|                                                      |  |                                                                                                  |  |                  
|/s/Dennis J. Carlo, Ph.D.

Dennis J. Carlo, Ph.D.     |  | Director                                                                                         |  | December 26, 2002
|                                                      |  |                                                                                                  |  |                  
|/s/Michael W. George

Michael W. George               |  | Director                                                                                         |  | December 26, 2002
|                                                      |  |                                                                                                  |  |                  
|/s/Susan Golding

Susan Golding                       |  | Director                                                                                         |  | December 26, 2002
|                                                      |  |                                                                                                  |  |                  
|/s/Edward L. Hennessy, Jr.

Edward L. Hennessy, Jr.   |  | Director                                                                                         |  | December 26, 2002
|                                                      |  |                                                                                                  |  |                  
|/s/Charles A. Mathews

Charles A. Mathews             |  | Director                                                                                         |  | December 26, 2002
|                                                      |  |                                                                                                  |  |                  
|/s/Kenneth E. Olson

Kenneth E. Olson                 |  | Director                                                                                         |  | December 26, 2002
|                                                      |  |                                                                                                  |  |                  
|/s/Harold F. Oberkfell

Harold F. Oberkfell           |  | Director                                                                                         |  | December 26, 2002



43



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##### Table of Contents






CERTIFICATIONS

I, Gerald J. Yakatan, certify that:



|1. |  | I have reviewed this annual report on Form 10-K of Avanir
Pharmaceuticals;                                                                                                                                                                                                                                              
|-- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|  
|2. |  | Based on my knowledge, this annual report does not contain any
untrue statement of a material fact or omit to state a material fact
necessary to make the statements made, in light of the circumstances
under which such statements were made, not misleading with respect to
the period covered by this annual report;
|  
|3. |  | Based on my knowledge, the financial statements, and other
financial information included in this annual report, fairly present in
all material respects the financial condition, results of operations
and cash flows of the registrant as of, and for, the periods presented
in this annual report;                   
|  
|4. |  | The registrants other certifying officer and I are responsible for
establishing and maintaining disclosure controls and procedures (as
defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and
have:                                                                                                   



| | a. |  | designed such disclosure controls and procedures to
ensure that material information relating to the registrant,
including its consolidated subsidiary, is made known to us by
others within that entity, particularly during the period in
which this annual report is being prepared;
| | -- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| | b. |  | evaluated the effectiveness of the registrants
disclosure controls and procedures as of a date within 90 days
prior to the filing date of this annual report (the Evaluation
Date); and                                                                                             
|
| | c. |  | presented in this annual report our conclusions about
the effectiveness of the disclosure controls and procedures based
on our evaluation as of the Evaluation Date;                                                                                                                   



|5. |  | The registrants other certifying officer and I have disclosed,
based on our most recent evaluation, to the registrants auditors and
the audit committee of registrants board of directors:
|-- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | a. |  | all significant deficiencies in the design or operation
of internal controls which could adversely affect the
registrants ability to record, process, summarize and report
financial data and have identified for the registrants auditors
any material weaknesses in internal controls; and
| | -- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| | b. |  | any fraud, whether or not material, that involves
management or other employees who have a significant role in the
registrants internal controls; and                                                                                                                                        



|6. |  | The registrants other certifying officer and I have indicated in
this annual report whether there were significant changes in internal
controls or in other factors that could significantly affect internal
controls subsequent to the date of our most recent evaluation,
including any corrective actions with regard to significant
deficiencies and material weaknesses.
|-- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

Date: December 26, 2002

| |  |                                                 
| |  | ------------------------------------------------
| |  | /s/Gerald J. Yakatan, Ph.D.                     
| |  |                                                 
| |  | Gerald J. Yakatan, Ph.D.
Chief Executive Officer

44



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##### Table of Contents






CERTIFICATIONS

I, Gregory P. Hanson, certify that:



|1. |  | I have reviewed this annual report on Form 10-K of Avanir
Pharmaceuticals;                                                                                                                                                                                                                                              
|-- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|  
|2. |  | Based on my knowledge, this annual report does not contain any
untrue statement of a material fact or omit to state a material fact
necessary to make the statements made, in light of the circumstances
under which such statements were made, not misleading with respect to
the period covered by this annual report;
|  
|3. |  | Based on my knowledge, the financial statements, and other
financial information included in this annual report, fairly present in
all material respects the financial condition, results of operations
and cash flows of the registrant as of, and for, the periods presented
in this annual report;                   
|  
|4. |  | The registrants other certifying officer and I are responsible for
establishing and maintaining disclosure controls and procedures (as
defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and
have:                                                                                                   



| | a. |  | designed such disclosure controls and procedures to
ensure that material information relating to the registrant,
including its consolidated subsidiary, is made known to us by
others within that entity, particularly during the period in
which this annual report is being prepared;
| | -- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| | b. |  | evaluated the effectiveness of the registrants
disclosure controls and procedures as of a date within 90 days
prior to the filing date of this annual report (the Evaluation
Date); and                                                                                             
|
| | c. |  | presented in this annual report our conclusions about
the effectiveness of the disclosure controls and procedures based
on our evaluation as of the Evaluation Date;                                                                                                                   



|5. |  | The registrants other certifying officer and I have disclosed,
based on our most recent evaluation, to the registrants auditors and
the audit committee of registrants board of directors:
|-- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | a. |  | all significant deficiencies in the design or operation
of internal controls which could adversely affect the
registrants ability to record, process, summarize and report
financial data and have identified for the registrants auditors
any material weaknesses in internal controls; and
| | -- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| | b. |  | any fraud, whether or not material, that involves
management or other employees who have a significant role in the
registrants internal controls; and                                                                                                                                        



|6. |  | The registrants other certifying officer and I have indicated in
this annual report whether there were significant changes in internal
controls or in other factors that could significantly affect internal
controls subsequent to the date of our most recent evaluation,
including any corrective actions with regard to significant
deficiencies and material weaknesses.
|-- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

Date: December 26, 2002

| |  |                                          
| |  | -----------------------------------------
| |  | /s/ Gregory P. Hanson                    
| |  |                                          
| |  | Gregory P. Hanson
Chief Financial Officer

45



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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-8 
|Notes to Consolidated Financial Statements      |  | F-9 

F-1



---



##### 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, 2002 and 2001, and the
related consolidated statements of operations, shareholders equity and cash
flows for each of the three years in the period ended September 30, 2002.
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, 2002 and 2001, and the results of their
operations and their cash flows for each of the three years in the period ended
September 30, 2002, in conformity with accounting principles generally accepted
in the United States of America.

DELOITTE & TOUCHE LLP

San Diego, California
December 24, 2002

F-2



---



##### Table of Contents



Avanir Pharmaceuticals

CONSOLIDATED BALANCE SHEETS

|                                                |                                                                                  |                                                   |                                                                                                                                                                           |                            |         |               |            |             |         |            |            | 
|----------------------------------------------- | -------------------------------------------------------------------------------- | ------------------------------------------------- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | -------------------------- | ------- | ------------- | ---------- | ----------- | ------- | ---------- | ---------- | 
|                                                |                                                                                  |                                                   |                                                                                                                                                                           |                            |         | September 30,
|                                                |                                                                                  |                                                   |                                                                                                                                                                           |                            |         |              
|                                                |                                                                                  |                                                   |                                                                                                                                                                           |                            |         | 2002          |            | 2001       
|                                                |                                                                                  |                                                   |                                                                                                                                                                           |                            |         |               |            |            
|ASSETS                                          |                                                                                  |                                                   |                                                                                                                                                                           |                            |         |               |            |            
|Current assets:                                 |                                                                                  |                                                   |                                                                                                                                                                           |                            |         |               |            |            
|                                                | Cash and cash equivalents                                                        |                                                   | $                                                                                                                                                                         | 8,630,547                  |         |               | $          | 16,542,545  |        
|                                                | Short-term investments in securities                                             |                                                   |                                                                                                                                                                           | 695,840                    |         |               |            | 23,179      |        
|                                                | Receivables                                                                      |                                                   |                                                                                                                                                                           | 1,098,954                  |         |               |            | 898,676     |        
|                                                | Inventory                                                                        |                                                   |                                                                                                                                                                           | 238,126                    |         |               |            | 222,585     |        
|                                                | Prepaid expenses                                                                 |                                                   |                                                                                                                                                                           | 683,111                    |         |               |            | 581,298     |        
|                                                |                                                                                  |                                                   |                                                                                                                                                                           |                            |         |               |            |            
|                                                |                                                                                  |                                                   | Total current assets                                                                                                                                                      |                            |         | 11,346,578    |            |             |         | 18,268,283 |           
|Investments in securities                       |                                                                                  |                                                   | 2,986,023                                                                                                                                                                 |                            |         |               | 4,897,390  |            
|Restricted investments                          |                                                                                  |                                                   | 856,597                                                                                                                                                                   |                            |         |               | 388,122    |            
|Property and equipment, net                     |                                                                                  |                                                   | 3,180,966                                                                                                                                                                 |                            |         |               | 2,217,094  |            
|Intangible assets, net                          |                                                                                  |                                                   | 1,659,418                                                                                                                                                                 |                            |         |               | 1,174,928  |            
|Other assets                                    |                                                                                  |                                                   | 303,347                                                                                                                                                                   |                            |         |               | 108,136    |            
|                                                |                                                                                  |                                                   |                                                                                                                                                                           |                            |         |               |            |            
|                                                | TOTAL ASSETS                                                                     |                                                   | $                                                                                                                                                                         | 20,332,929                 |         |               | $          | 27,053,953  |        
|                                                |                                                                                  |                                                   |                                                                                                                                                                           |                            |         |               |            |            
|LIABILITIES AND SHAREHOLDERS EQUITY            |                                                                                  |                                                   |                                                                                                                                                                           |                            |         |               |            |            
|Current liabilities:                            |                                                                                  |                                                   |                                                                                                                                                                           |                            |         |               |            |            
|                                                | Accounts payable                                                                 |                                                   | $                                                                                                                                                                         | 2,705,606                  |         |               | $          | 734,701     |        
|                                                | Accrued expenses and other liabilities                                           |                                                   |                                                                                                                                                                           | 1,831,958                  |         |               |            | 852,489     |        
|                                                | Accrued compensation and payroll taxes                                           |                                                   |                                                                                                                                                                           | 462,118                    |         |               |            | 362,028     |        
|                                                | Loan payable                                                                     |                                                   |                                                                                                                                                                           | 299,980                    |         |               |            | 186,122     |        
|                                                | Current portion of capital lease obligations                                     |                                                   |                                                                                                                                                                           | 128,833                    |         |               |            | 105,366     |        
|                                                |                                                                                  |                                                   |                                                                                                                                                                           |                            |         |               |            |            
|                                                |                                                                                  |                                                   | Total current liabilities                                                                                                                                                 |                            |         | 5,428,495     |            |             |         | 2,240,706  |           
|                                                |                                                                                  | Capital lease obligations, net of current portion |                                                                                                                                                                           |                            | 323,764 |               |            |             | 351,784 |           
|                                                |                                                                                  |                                                   |                                                                                                                                                                           |                            |         |               |            |            
|                                                |                                                                                  |                                                   |                                                                                                                                                                           | Total liabilities          |         |               | 5,752,259  |             |         |            | 2,592,490  | 
|                                                |                                                                                  |                                                   |                                                                                                                                                                           |                            |         |               |            |            
|COMMITMENTS AND CONTINGENCIES(Note 6, 9 and 10) |                                                                                  |                                                   |                                                                                                                                                                           |                            |         |               |            |            
|REDEEMABLE CONVERTIBLE PREFERRED STOCK          |                                                                                  |                                                   |                                                                                                                                                                           |                            |         |               |            |            
|                                                | Series D  no par value, 500 shares authorized;
50 shares issued and outstanding |                                                   |                                                                                                                                                                           | 521,189                    |         |               |            | 502,903     |        
|                                                |                                                                                  |                                                   |                                                                                                                                                                           |                            |         |               |            |            
|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; 58,270,533 and
57,976,381 shares issued and outstanding at
September 30,
2002 and 2001, respectively                              |                            |         | 87,053,257    |            |             |         | 86,626,355 |           
|                                                |                                                                                  |                                                   | Class B - 712,000 shares authorized; 13,500 and 36,500
shares issued and outstanding at September 30, 2002
and
2001, respectively (convertible into Class A common
stock) |                            |         | 8,395         |            |             |         | 19,895     |           
|                                                | Accumulated deficit                                                              |                                                   |                                                                                                                                                                           | (73,002,878                | )       |               |            | (62,735,080 | )      
|                                                | Accumulated other comprehensive income                                           |                                                   |                                                                                                                                                                           | 707                        |         |               |            | 47,390      |        
|                                                |                                                                                  |                                                   |                                                                                                                                                                           |                            |         |               |            |            
|                                                |                                                                                  |                                                   |                                                                                                                                                                           | Total shareholders equity |         |               | 14,059,481 |             |         |            | 23,958,560 | 
|                                                |                                                                                  |                                                   |                                                                                                                                                                           |                            |         |               |            |            
|                                                | TOTAL LIABILITIES AND SHAREHOLDERS EQUITY                                       |                                                   | $                                                                                                                                                                         | 20,332,929                 |         |               | $          | 27,053,953  |        
|                                                |                                                                                  |                                                   |                                                                                                                                                                           |                            |         |               |            |            

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,
|                                                       |                                               |                                                                         |                          |            |                          
|                                                       |                                               |                                                                         |                          |            | 2002                      |            | 2001     |            | 2000      
|                                                       |                                               |                                                                         |                          |            |                           |            |          |            |           
|REVENUES:                                              |                                               |                                                                         |                          |            |                           |            |          |            |            |            |          |           
|                                                       | Contract and license revenues                 |                                                                         | $                        | 5,226,167  |                           |            | $        | 10,070,350 |            |            | $        | 10,000,000 |           
|                                                       | Royalty revenues                              |                                                                         |                          | 3,426,403  |                           |            |          | 2,535,717  |            |            |          |           |           
|                                                       | Grant revenues                                |                                                                         |                          | 160,412    |                           |            |          | 72,535     |            |            |          | 27,465     |           
|                                                       | Product sales                                 |                                                                         |                          | 40,760     |                           |            |          |           |            |            |          | 225,353    |           
|                                                       |                                               |                                                                         |                          |            |                           |            |          |            |            |            |          |           
|                                                       |                                               |                                                                         | Total revenues           |            |                           | 8,853,742  |          |            |            | 12,678,602 |          |            |            | 10,252,818 | 
|                                                       |                                               |                                                                         |                          |            |                           |            |          |            |            |            |          |           
|OPERATING EXPENSES:                                    |                                               |                                                                         |                          |            |                           |            |          |            |            |            |          |           
|                                                       | Cost of product sales                         |                                                                         |                          | 4,731      |                           |            |          |           |            |            |          | 261,603    |           
|                                                       | Product launch expenses                       |                                                                         |                          |           |                           |            |          | 728,148    |            |            |          |           |           
|                                                       | Purchased in-process research and development |                                                                         |                          |           |                           |            |          | 917,097    |            |            |          |           |           
|                                                       | Research and development                      |                                                                         |                          | 13,602,484 |                           |            |          | 7,227,488  |            |            |          | 2,373,951  |           
|                                                       | General and administrative                    |                                                                         |                          | 4,587,769  |                           |            |          | 3,481,735  |            |            |          | 3,327,988  |           
|                                                       | Sales and marketing                           |                                                                         |                          | 1,640,812  |                           |            |          | 1,234,604  |            |            |          | 691,975    |           
|                                                       | Litigation settlements                        |                                                                         |                          |           |                           |            |          |           |            |            |          | 4,097,504  |           
|                                                       |                                               |                                                                         |                          |            |                           |            |          |            |            |            |          |           
|                                                       |                                               |                                                                         | Total operating expenses |            |                           | 19,835,796 |          |            |            | 13,589,072 |          |            |            | 10,753,021 | 
|                                                       |                                               |                                                                         |                          |            |                           |            |          |            |            |            |          |           
|LOSS FROM OPERATIONS                                   |                                               |                                                                         | (10,982,054              | )          |                           |            | (910,470 | )          |            |            | (500,203 | )         
|                                                       | Interest income                               |                                                                         |                          | 663,588    |                           |            |          | 1,147,439  |            |            |          | 434,208    |           
|                                                       | Other income                                  |                                                                         |                          | 129,514    |                           |            |          | 2,700      |            |            |          |           |           
|                                                       | Interest expense                              |                                                                         |                          | (60,560    | )                         |            |          | (6,547     | )          |            |          | (516,288   | )         
|                                                       |                                               |                                                                         |                          |            |                           |            |          |            |            |            |          |           
|NET INCOME (LOSS)                                      |                                               | $                                                                       | (10,249,512              | )          |                           | $          | 233,122  |            |            | $          | (582,283 | )         
|                                                       |                                               |                                                                         |                          |            |                           |            |          |            |            |            |          |           
|NET INCOME (LOSS) ATTRIBUTABLE TO COMMON SHAREHOLDERS: |                                               |                                                                         |                          |            |                           |            |          |            |            |            |          |           
|                                                       |                                               | Net income (loss)                                                       |                          | $          | (10,249,512               | )          |          | $          | 233,122    |            |          | $          | (582,283   | )         
|                                                       |                                               | Dividends on redeemable convertible preferred
stock                     |                          |            | (25,000                   | )          |          |            | (24,948    | )          |          |            | (21,914    | )         
|                                                       |                                               | Beneficial conversion feature of preferred stock                        |                          |            |                          |            |          |            |           |            |          |            | (140,000   | )         
|                                                       |                                               | Accretion of discount related to redeemable
convertible preferred stock |                          |            | (18,286                   | )          |          |            | (18,286    | )          |          |            | (57,609    | )         
|                                                       |                                               |                                                                         |                          |            |                           |            |          |            |            |            |          |           
|NET INCOME (LOSS) ATTRIBUTABLE TO COMMON SHAREHOLDERS  |                                               | $                                                                       | (10,292,798              | )          |                           | $          | 189,888  |            |            | $          | (801,806 | )         
|                                                       |                                               |                                                                         |                          |            |                           |            |          |            |            |            |          |           
|NET INCOME (LOSS) PER SHARE:                           |                                               |                                                                         |                          |            |                           |            |          |            |            |            |          |           
|                                                       |                                               |                                                                         |                          |            |                           |            |          |            |            |            |          |           
|                                                       |                                               | BASIC                                                                   |                          | $          | (0.18                     | )          |          | $          | 0.00       |            |          | $          | (0.02      | )         
|                                                       |                                               |                                                                         |                          |            |                           |            |          |            |            |            |          |           
|                                                       |                                               | DILUTED                                                                 |                          | $          | (0.18                     | )          |          | $          | 0.00       |            |          | $          | (0.02      | )         
|                                                       |                                               |                                                                         |                          |            |                           |            |          |            |            |            |          |           
|WEIGHTED AVERAGE NUMBER OF COMMON SHARES OUTSTANDING:  |                                               |                                                                         |                          |            |                           |            |          |            |            |            |          |           
|                                                       |                                               | BASIC                                                                   |                          |            | 58,206,969                |            |          |            | 57,475,748 |            |          |            | 51,784,214 |           
|                                                       |                                               |                                                                         |                          |            |                           |            |          |            |            |            |          |           
|                                                       |                                               | DILUTED                                                                 |                          |            | 58,206,969                |            |          |            | 61,130,415 |            |          |            | 51,784,214 |           
|                                                       |                                               |                                                                         |                          |            |                           |            |          |            |            |            |          |           

See notes to consolidated financial statements.

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##### Table of Contents



Avanir Pharmaceuticals

CONSOLIDATED STATEMENTS OF

SHAREHOLDERS EQUITY


|                            |                                                                                                                        |                                                                                    |            |              |           |             |            |            |           |             |        |               |          |               |        |               |        |        |          |               |          |   |             |             |          |   |  |  |  |   |            |          |           |   |          |          |   | 
|--------------------------- | ---------------------------------------------------------------------------------------------------------------------- | ---------------------------------------------------------------------------------- | ---------- | ------------ | --------- | ----------- | ---------- | ---------- | --------- | ----------- | ------ | ------------- | -------- | ------------- | ------ | ------------- | ------ | ------ | -------- | ------------- | -------- | - | ----------- | ----------- | -------- | - |  |  |  | - | ---------- | -------- | --------- | - | -------- | -------- | - | 
|                            |                                                                                                                        |                                                                                    |            | Common
Stock |           |             |            |            |           |             |        |               |          | Accumulated   |        |               |        |        |          |               |          |  
|                            |                                                                                                                        |                                                                                    |            |              |           | Receivables |            |            |           |             |        | Other         |          | Total         |        |               |        |       
|                            |                                                                                                                        |                                                                                    |            | Class A      |           | Class B     |            | for Common |           | Accumulated |        | Comprehensive |          | Shareholders' |        | Comprehensive
|                            |                                                                                                                        |                                                                                    |            | Shares       |           | Amount      |            | Shares     |           | Amount      |        | Stock         |          | Deficit       |        | Income (Loss) |        | Equity |          | Income (Loss)
|                            |                                                                                                                        |                                                                                    |            |              |           |             |            |            |           |             |        |               |          |               |        |               |        |        |          |              
|                            | BALANCE, October 1, 1999                                                                                               |                                                                                    |            | 45,017,063   |           |             | $          | 62,195,950 |           |             |        | 440,000       |          |               | $      | 38,270        |        |        |          |               |          |   | $           | (62,170,024 | )        |   |  |  |  |   | $          | 64,196   |           |   |          |          |  
|                            | Net loss                                                                                                               |                                                                                    |            |              |           |             |            |            |           |             |        |               |          |               |        |               |        |        |          |               |          |   |             | (582,283    | )        |   |  |  |  |   |            | (582,283 | )         |   | $        | (582,283 | )
|                            | Issuance of Class A common stock in
connection with:                                                                   |                                                                                    |            |              |           |             |            |            |           |             |        |               |          |               |        |               |        |        |          |               |          |   |             |             |          |   |  |  |  |   |            |          |           |   |          |          |  
|                            |                                                                                                                        | Private placement, net of issuance
costs of $527,049                               |            |              | 2,698,791 |             |            |            | 5,472,951 |             |        |               |          |               |        |               |        |        |          |               |          |   |             |             |          |   |  |  |  |   |            |          | 5,472,951 |   |          |          |   | 
|                            |                                                                                                                        | Exercise of warrants                                                               |            |              | 5,961,819 |             |            |            | 7,900,072 |             |        |               |          |               |        |               |        |        |          |               |          |   |             |             |          |   |  |  |  |   |            |          | 7,900,072 |   |          |          |   | 
|                            |                                                                                                                        | Exercise of stock options                                                          |            |              | 1,498,355 |             |            |            | 3,282,983 |             |        |               |          |               |        |               |        |        |          | $             | (649,431 | ) |             |             |          |   |  |  |  |   |            |          | 2,633,552 |   |          |          |   | 
|                            |                                                                                                                        | Litigation settlements                                                             |            |              | 1,135,000 |             |            |            | 4,097,504 |             |        |               |          |               |        |               |        |        |          |               |          |   |             |             |          |   |  |  |  |   |            |          | 4,097,504 |   |          |          |   | 
|                            |                                                                                                                        | Conversions from Class B common stock                                              |            |              | 375,000   |             |            |            | 4,125     |             |        |               | (375,000 | )             |        |               | (4,125 | )      |          |               |          |   |             |             |          |   |  |  |  |   |            |          |          |   |          |          |   | 
|                            | Conversion of Series D redeemable
convertible preferred stock (including
dividends of $7,603)                          |                                                                                    |            | 288,800      |           |             |            | 507,603    |           |             |        |               |          |               |        |               |        |        |          |               |          |   |             |             |          |   |  |  |  |   |            | 507,603  |           |   |          |          |  
|                            | Dividends on preferred stock                                                                                           |                                                                                    |            |              |           |             |            | (21,914    | )         |             |        |               |          |               |        |               |        |        |          |               |          |   |             |             |          |   |  |  |  |   |            | (21,914  | )         |   |          |          |  
|                            | Valuations of:                                                                                                         |                                                                                    |            |              |           |             |            |            |           |             |        |               |          |               |        |               |        |        |          |               |          |   |             |             |          |   |  |  |  |   |            |          |           |   |          |          |  
|                            |                                                                                                                        | Beneficial conversion feature of
redeemable convertible debentures                 |            |              |           |             |            |            | 166,667   |             |        |               |          |               |        |               |        |        |          |               |          |   |             |             |          |   |  |  |  |   |            |          | 166,667   |   |          |          |   | 
|                            |                                                                                                                        | Warrants issued in connection with
redeemable convertible debentures               |            |              |           |             |            |            | 81,308    |             |        |               |          |               |        |               |        |        |          |               |          |   |             |             |          |   |  |  |  |   |            |          | 81,308    |   |          |          |   | 
|                            |                                                                                                                        | Beneficial conversion feature of
Series D redeemable convertible
preferred stock   |            |              |           |             |            |            | 140,000   |             |        |               |          |               |        |               |        |        |          |               |          |   |             |             | (140,000 | ) |  |  |  |   |            |          |          |   |          |          |   | 
|                            |                                                                                                                        | Warrants issued in connection with
Series D redeemable convertible
preferred stock |            |              |           |             |            |            | 106,000   |             |        |               |          |               |        |               |        |        |          |               |          |   |             |             |          |   |  |  |  |   |            |          | 106,000   |   |          |          |   | 
|                            | Accretion of discount related to Series
D redeemable convertible preferred
stock                                       |                                                                                    |            |              |           |             |            |            |           |             |        |               |          |               |        |               |        |        |          |               |          |   |             | (57,609     | )        |   |  |  |  |   |            | (57,609  | )         |   |          |          |  
|                            | Compensation expense related to
valuation of stock options and warrants
granted to non-employees for services
rendered |                                                                                    |            |              |           |             |            | 762,341    |           |             |        |               |          |               |        |               |        |        |          |               |          |   |             |             |          |   |  |  |  |   |            | 762,341  |           |   |          |          |  
|                            |                                                                                                                        |                                                                                    |            |              |           |             |            |            |           |             |        |               |          |               |        |               |        |        |          |               |          |   |             |             |          |   |  |  |  |   |            |          |           |   |          |          |  
|BALANCE, SEPTEMBER 30, 2000 |                                                                                                                        |                                                                                    | 56,974,828 |              |           | $           | 84,695,590 |            |           |             | 65,000 |               |          | $             | 34,145 |               |        | $      | (649,431 | )             |          | $ | (62,949,916 | )           |          |   |  |  |  | $ | 21,130,388 |          |           | $ | (582,283 | )       

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##### Table of Contents



Avanir Pharmaceuticals

CONSOLIDATED STATEMENTS OF

SHAREHOLDERS EQUITY (Continued)


|                                                                                                                        |                                              |  |              |         |             |   |            |          |             |  |               |             |               |               |               |         |        |               |         |  |  |   |             |   |  |   |        |  |  |   |            |          |   |   |         |  | 
|----------------------------------------------------------------------------------------------------------------------- | -------------------------------------------- |  | ------------ | ------- | ----------- | - | ---------- | -------- | ----------- |  | ------------- | ----------- | ------------- | ------------- | ------------- | ------- | ------ | ------------- | ------- |  |  | - | ----------- | - |  | - | ------ |  |  | - | ---------- | -------- | - | - | ------- |  | 
|                                                                                                                        |                                              |  | Common Stock |         |             |   |            |          |             |  |               | Accumulated |               |               |               |         |        |               |         | 
|                                                                                                                        |                                              |  |              |         | Receivables |   |            |          |             |  | Other         |             | Total         |               |               |         |       
|                                                                                                                        |                                              |  | Class A      |         | Class B     |   | for Common |          | Accumulated |  | Comprehensive |             | Shareholders' | Comprehensive
|                                                                                                                        |                                              |  | Shares       |         | Amount      |   | Shares     |          | Amount      |  | Stock         |             | Deficit       |               | Income (Loss) |         | Equity | Income (Loss)
|                                                                                                                        |                                              |  |              |         |             |   |            |          |             |  |               |             |               |               |               |         |        |              
|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 from 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 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 | 

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##### Table of Contents



Avanir Pharmaceuticals

CONSOLIDATED STATEMENTS OF

SHAREHOLDERS EQUITY (Continued)


|                                                                                                                        |                                         |  |              |         |             |   |            |         |             |  |               |         |               |   |               |         |        |   |               |  |  |   |             |   |  |   |         |   |  |   |             |         |  |   |             |   | 
|----------------------------------------------------------------------------------------------------------------------- | --------------------------------------- |  | ------------ | ------- | ----------- | - | ---------- | ------- | ----------- |  | ------------- | ------- | ------------- | - | ------------- | ------- | ------ | - | ------------- |  |  | - | ----------- | - |  | - | ------- | - |  | - | ----------- | ------- |  | - | ----------- | - | 
|                                                                                                                        |                                         |  | Common Stock |         |             |   |            |         |             |  |               |         | Accumulated   |   |               |         |        |   |               |  | 
|                                                                                                                        |                                         |  |              |         | Receivables |   |            |         |             |  | Other         |         | Total         |   |               |         |       
|                                                                                                                        |                                         |  | Class A      |         | Class B     |   | for Common |         | Accumulated |  | Comprehensive |         | Shareholders |   | Comprehensive
|                                                                                                                        |                                         |  | Shares       |         | Amount      |   | Shares     |         | Amount      |  | Stock         |         | Deficit       |   | Income (Loss) |         | Equity |   | Income (Loss)
|                                                                                                                        |                                         |  |              |         |             |   |            |         |             |  |               |         |               |   |               |         |        |   |              
|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 from 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 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 | )
|                                                                                                                        |                                         |  |              |         |             |   |            |         |             |  |               |         |               |   |               |         |        |   |               |  |  |   |             |   |  |   |         |   |  |   |             |         |  |   |             |  

See notes to consolidated financial statements.

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##### Table of Contents



Avanir Pharmaceuticals

CONSOLIDATED STATEMENTS OF CASH FLOWS

|                                                                                                    |                                                   |                                                                                 |                                                      |         |                           |            |            |         |            |            |            |           |            |            |  
|--------------------------------------------------------------------------------------------------- | ------------------------------------------------- | ------------------------------------------------------------------------------- | ---------------------------------------------------- | ------- | ------------------------- | ---------- | ---------- | ------- | ---------- | ---------- | ---------- | --------- | ---------- | ---------- | -
|                                                                                                    |                                                   |                                                                                 |                                                      |         | Years ended September 30,
|                                                                                                    |                                                   |                                                                                 |                                                      |         |                          
|                                                                                                    |                                                   |                                                                                 |                                                      |         | 2002                      |            | 2001       |         | 2000      
|                                                                                                    |                                                   |                                                                                 |                                                      |         |                           |            |            |         |           
|OPERATING ACTIVITIES:                                                                               |                                                   |                                                                                 |                                                      |         |                           |            |            |         |            |            |            |          
|Net income (loss)                                                                                   |                                                   | $                                                                               | (10,249,512                                          | )       |                           | $          | 233,122    |         |            | $          | (582,283   | )        
|Adjustments to reconcile net income (loss) to net cash
provided by (used for) operating activities: |                                                   |                                                                                 |                                                      |         |                           |            |            |         |            |            |            |          
|                                                                                                    | Depreciation and amortization                     |                                                                                 |                                                      | 602,803 |                           |            |            | 373,290 |            |            |            | 145,430   |           
|                                                                                                    | Non-cash interest expense                         |                                                                                 |                                                      |        |                           |            |            |        |            |            |            | 402,990   |           
|                                                                                                    | Compensation paid with stock options and warrants |                                                                                 |                                                      | 179,828 |                           |            |            | 148,051 |            |            |            | 762,341   |           
|                                                                                                    | Litigation settlements paid with common stock     |                                                                                 |                                                      |        |                           |            |            |        |            |            |            | 4,097,504 |           
|                                                                                                    | Purchased in-process R&D paid with common stock   |                                                                                 |                                                      |        |                           |            |            | 867,097 |            |            |            |          |           
|                                                                                                    | Loss on disposal of assets                        |                                                                                 |                                                      | 782     |                           |            |            | 3,187   |            |            |            | 5,553     |           
|                                                                                                    | Patents abandoned                                 |                                                                                 |                                                      |        |                           |            |            |        |            |            |            | 89,433    |           
|Changes in assets and liabilities:                                                                  |                                                   |                                                                                 |                                                      |         |                           |            |            |         |            |            |            |          
|                                                                                                    |                                                   | Receivables                                                                     |                                                      |         | (200,278                  | )          |            |         | (803,247   | )          |            |           | (18,930    | )         
|                                                                                                    |                                                   | Inventory                                                                       |                                                      |         | (15,541                   | )          |            |         | (212,781   | )          |            |           | 213,998    |           
|                                                                                                    |                                                   | Prepaid expenses and other assets                                               |                                                      |         | (297,024                  | )          |            |         | (209,191   | )          |            |           | (75,105    | )         
|                                                                                                    |                                                   | Deferred costs                                                                  |                                                      |         |                          |            |            |         |           |            |            |           | 100,000    |           
|                                                                                                    |                                                   | Accounts payable                                                                |                                                      |         | 1,970,905                 |            |            |         | (230,934   | )          |            |           | (207,432   | )         
|                                                                                                    |                                                   | Accrued expenses and other liabilities                                          |                                                      |         | 979,469                   |            |            |         | 358,934    |            |            |           | 315,820    |           
|                                                                                                    |                                                   | Accrued compensation and payroll taxes                                          |                                                      |         | 100,090                   |            |            |         | 106,923    |            |            |           | 125,531    |           
|                                                                                                    |                                                   |                                                                                 |                                                      |         |                           |            |            |         |            |            |            |          
|                                                                                                    |                                                   |                                                                                 | Net cash provided by (used for) operating activities |         |                           | (6,928,478 | )          |         |            | 634,451    |            |           |            | 5,374,850  |  
|                                                                                                    |                                                   |                                                                                 |                                                      |         |                           |            |            |         |            |            |            |          
|INVESTING ACTIVITIES:                                                                               |                                                   |                                                                                 |                                                      |         |                           |            |            |         |            |            |            |          
|                                                                                                    |                                                   | Investments in securities                                                       |                                                      |         | (9,019,464                | )          |            |         | (4,450,000 | )          |            |           | (1,568,474 | )         
|                                                                                                    |                                                   | Proceeds from sales and maturities of investments in
securities                 |                                                      |         | 9,743,012                 |            |            |         | 757,173    |            |            |           |           |           
|                                                                                                    |                                                   | Patent costs                                                                    |                                                      |         | (537,903                  | )          |            |         | (538,202   | )          |            |           | (118,276   | )         
|                                                                                                    |                                                   | Purchases of property and equipment                                             |                                                      |         | (1,391,382                | )          |            |         | (1,009,349 | )          |            |           | (950,558   | )         
|                                                                                                    |                                                   |                                                                                 |                                                      |         |                           |            |            |         |            |            |            |          
|                                                                                                    |                                                   |                                                                                 | Net cash used for investing activities               |         |                           | (1,205,737 | )          |         |            | (5,240,378 | )          |           |            | (2,637,308 | )
|                                                                                                    |                                                   |                                                                                 |                                                      |         |                           |            |            |         |            |            |            |          
|FINANCING ACTIVITIES:                                                                               |                                                   |                                                                                 |                                                      |         |                           |            |            |         |            |            |            |          
|                                                                                                    |                                                   | Proceeds from issuance of common stock, net                                     |                                                      |         | 260,574                   |            |            |         | 1,478,496  |            |            |           | 16,006,576 |           
|                                                                                                    |                                                   | Proceeds from issuance of convertible preferred stock
and related warrants, net |                                                      |         |                          |            |            |         |           |            |            |           | 1,000,000  |           
|                                                                                                    |                                                   | Dividends paid on preferred stock                                               |                                                      |         | (25,000                   | )          |            |         | (6,250     | )          |            |           |           |           
|                                                                                                    |                                                   | Proceeds from issuance of convertible notes payable,
net                        |                                                      |         |                          |            |            |         |           |            |            |           | 1,344,985  |           
|                                                                                                    |                                                   | Repayment of convertible notes payable                                          |                                                      |         |                          |            |            |         |           |            |            |           | (1,500,000 | )         
|                                                                                                    |                                                   | Proceeds from issuance of notes payable                                         |                                                      |         | 287,371                   |            |            |         | 171,750    |            |            |           | 201,868    |           
|                                                                                                    |                                                   | Payments on loans and capital lease obligations                                 |                                                      |         | (300,728                  | )          |            |         | (195,292   | )          |            |           | (213,877   | )         
|                                                                                                    |                                                   |                                                                                 |                                                      |         |                           |            |            |         |            |            |            |          
|                                                                                                    |                                                   |                                                                                 | Net cash provided by financing activities            |         |                           | 222,217    |            |         |            | 1,448,704  |            |           |            | 16,839,552 |  
|                                                                                                    |                                                   |                                                                                 |                                                      |         |                           |            |            |         |            |            |            |          
|Net increase (decrease) in cash and cash equivalents                                                |                                                   |                                                                                 | (7,911,998                                           | )       |                           |            | (3,157,223 | )       |            |            | 19,577,094 |          
|Cash and cash equivalents at beginning of fiscal year                                               |                                                   |                                                                                 | 16,542,545                                           |         |                           |            | 19,699,768 |         |            |            | 122,674    |          
|                                                                                                    |                                                   |                                                                                 |                                                      |         |                           |            |            |         |            |            |            |          
|Cash and cash equivalents at end of fiscal year                                                     |                                                   | $                                                                               | 8,630,547                                            |         |                           | $          | 16,542,545 |         |            | $          | 19,699,768 |          
|                                                                                                    |                                                   |                                                                                 |                                                      |         |                           |            |            |         |            |            |            |          
|SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:                                                  |                                                   |                                                                                 |                                                      |         |                           |            |            |         |            |            |            |          
|                                                                                                    |                                                   | Interest paid                                                                   |                                                      | $       | 60,560                    |            |            | $       | 6,547      |            |            | $         | 347,722    |           
|SUPPLEMENTAL DISCLOSURES OF NON-CASH INVESTING AND
FINANCING ACTIVITIES:                            |                                                   |                                                                                 |                                                      |         |                           |            |            |         |            |            |            |          
|                                                                                                    |                                                   | Patent purchased with common stock                                              |                                                      | $       |                          |            |            | $       | 111,158    |            |            | $         |           |           
|                                                                                                    |                                                   | Acquisition of minority interest in Xenerex                                     |                                                      | $       |                          |            |            | $       | 97,250     |            |            | $         |           |           
|                                                                                                    |                                                   | Value of conversion discount for convertible
preferred stock                    |                                                      | $       |                          |            |            | $       |           |            |            | $         | 140,000    |           
|                                                                                                    |                                                   | Acquisition of equipment under capital leases                                   |                                                      | $       | 122,662                   |            |            | $       | 495,147    |            |            | $         |           |           
|                                                                                                    |                                                   | Conversions into common stock from preferred stock                              |                                                      | $       |                          |            |            | $       |           |            |            | $         | 507,603    |           

See notes to consolidated financial statements.

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Avanir Pharmaceuticals

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS



|1. |  | DESCRIPTION OF BUSINESS
|-- |  | -----------------------

Avanir Pharmaceuticals (Avanir, we, or the Company) is engaged in
research, development, commercialization, licensing and sales of innovative
pharmaceutical products and in providing antibody generation services.
Avanirs first product, Abreva® (chemical name 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 earns a portion of the royalties
on product sales of Abreva under a license agreement with GlaxoSmithKline for
the North American market. 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 pre-clinical
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 sales of Abreva by GlaxoSmithKline, the timing and success of filing and
obtaining regulatory approvals and finding licensees for products for the rest
of the world, and in establishing research collaborations and successfully
providing antibody generation services at the Companys subsidiary, Xenerex
Biosciences. Avanir currently intends to start selling its next product,
Neurodex, for the treatment of pseudobulbar affect, in mid-to-late 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 with the current year
presentation.

The Companys fiscal year ends on September 30 of each year. The years ended
September 30, 2002, 2001, and 2000, may be referred to as fiscal 2002, fiscal
2001, and fiscal 2000.

The preparation of financial statements in conformity with accounting
principles generally accepted in the United States 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 three major
financial institutions.

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Restricted investments

Restricted investments amounting to $856,597 and $388,122 as of September 30,
2002 and 2001, respectively, represent amounts pledged to our bank as
collateral for letters of credit issued in connection with our real estate
lease agreements.

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 asset-backed and mortgage-backed
securities with original maturities beyond three months. All marketable
securities are held in the Companys name and primarily under the custodianship
of three 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.
As of September 30, 2002 and 2001, the Companys marketable securities were
classified either as available-for-sale or held-to-maturity. 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.

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 primarily 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. Avanir also holds in inventory small quantities of dextromethorphan and
quinidine, compounds useful in the manufacture of Neurodex. Avanir is
developing Neurodex as a potential treatment for pseudobulbar affect and
neuropathic pain. 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 a 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
three 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

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because the Company
limits the amount of credit exposure to any one financial institution and any
one type of investment.

The Company received income substantially from one principal licensee,
GlaxoSmithKline, from fiscal 2000 to 2002. 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.

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, 2002 or 2001. Further, during fiscal 2002 and
2001, the Company had no material impairments to property and equipment or
intangible assets, which consist primarily of patents and trademarks.

We capitalize legal expenses incurred in connection with patent applications,
trademark applications and license agreements. We amortize the costs of
approved patents, trademarks and license agreements over their useful lives or
term of the agreements, whichever is less. 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 and 2001, the Company had obligations 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
chargebacks, 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 customer specific objective 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

F-11



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##### Table of Contents



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.

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 a number of
factors, including 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
auto immune 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.

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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 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 2002, 2001 and 2000 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 2002, 2001 and 2000:

|                                                                                    |                                                     |                                                                         |                                                 |                                                                                                  |         |                           |             |         |           |            |            |          |         |            |          |  
|----------------------------------------------------------------------------------- | --------------------------------------------------- | ----------------------------------------------------------------------- | ----------------------------------------------- | ------------------------------------------------------------------------------------------------ | ------- | ------------------------- | ----------- | ------- | --------- | ---------- | ---------- | -------- | ------- | ---------- | -------- | -
|                                                                                    |                                                     |                                                                         |                                                 |                                                                                                  |         | Years Ended September 30,
|                                                                                    |                                                     |                                                                         |                                                 |                                                                                                  |         |                          
|                                                                                    |                                                     |                                                                         |                                                 |                                                                                                  |         | 2002                      |             | 2001    |           | 2000      
|                                                                                    |                                                     |                                                                         |                                                 |                                                                                                  |         |                           |             |         |           |           
|Numerator:                                                                          |                                                     |                                                                         |                                                 |                                                                                                  |         |                           |             |         |           |            |            |         
|                                                                                    | Net income (loss)                                   |                                                                         | $                                               | (10,249,512                                                                                      | )       |                           | $           | 233,122 |           |            | $          | (582,283 | )      
|Less:                                                                               |                                                     |                                                                         |                                                 |                                                                                                  |         |                           |             |         |           |            |            |         
|                                                                                    | Dividends on redeemable convertible
preferred stock |                                                                         |                                                 | (25,000                                                                                          | )       |                           |             | (24,948 | )         |            |            | (21,914  | )      
|                                                                                    | Beneficial conversion feature of preferred
stock    |                                                                         |                                                 |                                                                                                 |         |                           |             |        |           |            |            | (140,000 | )      
|                                                                                    |                                                     | Accretion of discount related to redeemable
convertible preferred stock |                                                 |                                                                                                  | (18,286 | )                         |             |         | (18,286   | )          |            |          | (57,609 | )         
|                                                                                    |                                                     |                                                                         |                                                 |                                                                                                  |         |                           |             |         |           |            |            |          |        
|                                                                                    |                                                     |                                                                         |                                                 | Net income (loss) attributable to
common shareholders for basic earnings
per share computation   |         |                           | (10,292,798 | )       |           |            | 189,888    |          |         |            | (801,806 | )
|Effect of dilutive securities:                                                      |                                                     |                                                                         |                                                 |                                                                                                  |         |                           |             |         |           |            |            |         
|                                                                                    | Convertible preferred stock                         |                                                                         |                                                 |                                                                                                 |         |                           |             | (5,157  | )         |            |            |         |        
|                                                                                    |                                                     |                                                                         |                                                 |                                                                                                  |         |                           |             |         |           |            |            |          |        
|                                                                                    |                                                     |                                                                         |                                                 | Net income (loss) attributable to
common shareholders for diluted
earnings per share computation |         | $                         | (10,292,798 | )       |           | $          | 184,731    |          |         | $          | (801,806 | )
|                                                                                    |                                                     |                                                                         |                                                 |                                                                                                  |         |                           |             |         |           |            |            |          |        
|Denominator:                                                                        |                                                     |                                                                         |                                                 |                                                                                                  |         |                           |             |         |           |            |            |         
|Shares for basic net income or loss per
share  weighted average shares outstanding |                                                     |                                                                         | 58,206,969                                      |                                                                                                  |         |                           | 57,475,748  |         |           |            | 51,784,214 |         
|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 |                                                                                                  |         | 58,206,969                |             |         |           | 61,130,415 |            |          |         | 51,784,214 |         
|                                                                                    |                                                     |                                                                         |                                                 |                                                                                                  |         |                           |             |         |           |            |            |          |        
|Basic net income (loss) per share                                                   |                                                     | $                                                                       | (0.18                                           | )                                                                                                |         | $                         | 0.00        |         |           | $          | (0.02      | )       
|                                                                                    |                                                     |                                                                         |                                                 |                                                                                                  |         |                           |             |         |           |            |            |          |        
|Diluted net income (loss) per share                                                 |                                                     | $                                                                       | (0.18                                           | )                                                                                                |         | $                         | 0.00        |         |           | $          | (0.02      | )       
|                                                                                    |                                                     |                                                                         |                                                 |                                                                                                  |         |                           |             |         |           |            |            |          |        



|(1) |  | For fiscal 2002, 2001 and 2000, options to purchase 5,739,306, 66,500 and
5,362,150 shares of common stock, respectively, were excluded from the
computation of diluted earnings per share as the inclusion of such shares
would be antidilutive.
|--- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|   
|(2) |  | For fiscal 2002 and 2000, warrants to purchase 1,084,550 and 1,619,578
shares of common stock, respectively, were excluded from the computation
of diluted earnings per share as the inclusion of such shares would be
antidilutive.             
|   
|(3) |  | For fiscal 2002 and 2000, preferred stock convertible into 520,648 and
171,610 shares of common stock, respectively, were excluded from the
computation of diluted earnings per share as the inclusion of such shares
would be antidilutive.     

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##### Table of Contents



Recent accounting pronouncements

In July 2001, the Financial Accounting Standards Board (FASB) approved
Statement of Financial Accounting Standards No. 142 (SFAS No. 142), Goodwill
and Other Intangible Assets. SFAS No. 142 supercedes APB Opinion No. 17,
Intangible Assets, and requires goodwill and other intangible assets that
have an indefinite useful life to no longer be amortized; however, these assets
must be reviewed at least annually for impairment. Application of SFAS No. 142
became effective for the Company on October 1, 2002. The application of SFAS
No. 142 did not have a material impact on the Companys financial statements.

In August 2001, the FASB issued SFAS No. 144, Accounting for the Impairment or
Disposal of Long-Lived Assets. This statement addresses financial accounting
and reporting for the impairment or disposal of long-lived assets. This
statement supersedes SFAS No. 121, Accounting for the Impairment of Long-Lived
Assets and for Long-Lived Assets to be Disposed Of, and the accounting and
reporting provisions of APB Opinion No. 30, Reporting the Results of
Operations  Reporting the Effects of a Disposal of a Segment of a Business,
and Extraordinary, Unusual and Infrequently Occurring Events and Transactions,
for the disposal of a segment of a business (as previously defined in that
Opinion). SFAS No. 144 became effective for the Company on October 1, 2002.
The application of SFAS No. 144 did not have a material impact on the Companys
financial statements.

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 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. The Company will adopt the provisions of SFAS No.
146 for exit or disposal activities that are initiated after December 31, 2002.



|3. |  | BALANCE SHEET DETAILS
|-- |  | ---------------------

The following tables provide details of selected balance sheet items.

|                             |                                                |                             |           |               |           |      |           |           |           | 
|---------------------------- | ---------------------------------------------- | --------------------------- | --------- | ------------- | --------- | ---- | --------- | --------- | --------- | 
|                             |                                                |                             |           | September 30,
|                             |                                                |                             |           |              
|                             |                                                |                             |           | 2002          |           | 2001
|                             |                                                |                             |           |               |           |     
|Property and equipment, net: |                                                |                             |           |               |           |      |           |          
|                             | Leasehold improvements                         |                             | $         | 866,318       |           |      | $         | 753,824   |          
|                             | Computer equipment and related software        |                             |           | 851,952       |           |      |           | 296,862   |          
|                             | Research and development equipment             |                             |           | 2,420,028     |           |      |           | 1,831,645 |          
|                             | Office equipment, furniture, and fixtures      |                             |           | 254,731       |           |      |           | 218,796   |          
|                             | Construction in progress                       |                             |           | 198,094       |           |      |           |          |          
|                             |                                                |                             |           |               |           |      |           |           |          
|                             |                                                |                             | 4,591,123 |               |           |      | 3,101,127 |          
|                             | Less accumulated depreciation and amortization |                             |           | (1,410,157    | )         |      |           | (884,033  | )        
|                             |                                                |                             |           |               |           |      |           |           |          
|                             |                                                | Property and equipment, net |           | $             | 3,180,966 |      |           | $         | 2,217,094 | 
|                             |                                                |                             |           |               |           |      |           |           |          
|Intangible assets, net:      |                                                |                             |           |               |           |      |           |          
|                             | Patents and patent applications                |                             | $         | 1,707,956     |           |      | $         | 1,179,840 |          
|                             | Trademarks                                     |                             |           | 86,781        |           |      |           | 84,428    |          
|                             | License agreements                             |                             |           | 56,871        |           |      |           | 49,436    |          
|                             |                                                |                             |           |               |           |      |           |           |          
|                             |                                                |                             | 1,851,608 |               |           |      | 1,313,704 |          
|                             | Less accumulated amortization                  |                             |           | (192,190      | )         |      |           | (138,776  | )        
|                             |                                                |                             |           |               |           |      |           |           |          
|                             |                                                | Intangible assets, net      |           | $             | 1,659,418 |      |           | $         | 1,174,928 | 
|                             |                                                |                             |           |               |           |      |           |           |          

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---



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|4. |  | INVESTMENTS
|-- |  | -----------

The following tables summarize the Companys investments in securities, which
are either held-to-maturity or 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. Investments classified as held-to-maturity are
recorded at amortized cost.

|                          |                         |                                  |                        |       |           |           |           |            |        |            |        |       |         |   |         |   |           |   |           | 
|------------------------- | ----------------------- | -------------------------------- | ---------------------- | ----- | --------- | --------- | --------- | ---------- | ------ | ---------- | ------ | ----- | ------- | - | ------- | - | --------- | - | --------- | 
|                          |                         |                                  |                        |       |           |           |           |            |        | Gross      |        | Gross |         |   |         |  
|                          |                         |                                  |                        |       |           | Amortized |           | Unrealized |        | Unrealized |        | Fair 
|                          |                         |                                  |                        |       |           | Cost      |           | Gains (2)  |        | Losses (2) |        | Value
|                          |                         |                                  |                        |       |           |           |           |            |        |            |        |      
|As of September 30, 2002: |                         |                                  |                        |       |           |           |           |            |        |            |        |       |         |   |         |  
|                          |                         | Certificates of deposit          |                        | $     | 2,056,597 |           |           | $          | 10,434 |            |        | $     |        |   |         | $ | 2,067,031 |  
|                          |                         | Government 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 (1)       |                        |       | 856,597   |           |           |            |        |            |        |       |         |   |         |   |           |  
|                          |                         |                                  |                        |       |           |           |           |            |        |            |        |       |         |   |         |   |           |  
|                          |                         |                                  | Long-term investments  |       |           | 3,842,620 |           |            |        |            |        |       |         |   |         |   |           |   |          
|                          |                         |                                  |                        |       |           |           |           |            |        |            |        |       |         |   |         |   |           |  
|                          |                         |                                  |                        | Total |           | $         | 4,538,460 |            |        |            |        |       |         |   |         |   |           |   |           | 
|                          |                         |                                  |                        |       |           |           |           |            |        |            |        |       |         |   |         |   |           |  

|                          |                         |                         |                                  |                       |           |           |           |            |            |        |        |       |   |   |   |   |           |   |           | 
|------------------------- | ----------------------- | ----------------------- | -------------------------------- | --------------------- | --------- | --------- | --------- | ---------- | ---------- | ------ | ------ | ----- | - | - | - | - | --------- | - | --------- | 
|                          |                         |                         |                                  |                       |           |           |           |            |            | Gross  |        | Gross |   |   |   |  
|                          |                         |                         |                                  |                       |           | Amortized |           | Unrealized | Unrealized | Fair  
|                          |                         |                         |                                  |                       |           | Cost      |           | Gains (3)  |            | Losses |        | Value
|                          |                         |                         |                                  |                       |           |           |           |            |            |        |        |      
|As of September 30, 2001: |                         |                         |                                  |                       |           |           |           |            |            |        |        |       |   |   |   |  
|                          |                         | Certificates of deposit |                                  | $                     | 411,301   |           |           | $          |           |        |        | $     |  |   |   | $ | 411,301   |  
|                          |                         | Government securities   |                                  |                       | 4,650,000 |           |           |            | 48,952     |        |        |       |  |   |   |   | 4,698,952 |  
|                          |                         | Commercial paper        |                                  |                       | 200,000   |           |           |            | 8,862      |        |        |       |  |   |   |   | 208,862   |  
|                          |                         |                         |                                  |                       |           |           |           |            |            |        |        |       |   |   |   |   |           |  
|                          |                         |                         |                                  | Total                 |           | $         | 5,261,301 |            |            | $      | 57,814 |       |   | $ |  |   |           | $ | 5,319,115 | 
|                          |                         |                         |                                  |                       |           |           |           |            |            |        |        |       |   |   |   |   |           |  
|Reported as:              |                         |                         |                                  |                       |           |           |           |            |            |        |        |       |   |   |   |  
|                          | Short-term investments: |                         |                                  |                       |           |           |           |            |            |        |        |       |   |   |   |   |          
|                          |                         |                         | Classified as held-to-maturity   |                       | $         | 23,179    |           |            |            |        |        |       |   |   |   |   |           |   |          
|                          |                         |                         |                                  |                       |           |           |           |            |            |        |        |       |   |   |   |   |           |  
|                          | Long-term investments:  |                         |                                  |                       |           |           |           |            |            |        |        |       |   |   |   |   |          
|                          |                         |                         | Classified as
available-for-sale |                       |           | 4,497,390 |           |            |            |        |        |       |   |   |   |   |           |   |          
|                          |                         |                         | Classified as held-to-maturity   |                       |           | 400,000   |           |            |            |        |        |       |   |   |   |   |           |   |          
|                          |                         |                         | Restricted investments (1)       |                       |           | 388,122   |           |            |            |        |        |       |   |   |   |   |           |   |          
|                          |                         |                         |                                  |                       |           |           |           |            |            |        |        |       |   |   |   |   |           |  
|                          |                         |                         |                                  | Long-term investments |           |           | 5,285,512 |            |            |        |        |       |   |   |   |   |           |   |           | 
|                          |                         |                         |                                  |                       |           |           |           |            |            |        |        |       |   |   |   |   |           |  
|                          |                         |                         |                                  | Total                 |           | $         | 5,308,691 |            |            |        |        |       |   |   |   |   |           |   |           | 
|                          |                         |                         |                                  |                       |           |           |           |            |            |        |        |       |   |   |   |   |           |  



|(1) |  | Restricted investments amounting to $856,597 as of September 30, 2002
and $388,122 as of September 30, 2001 represent amounts that we pledged
to our bank as collateral for letters of credit issued in connection
with our leases of office and laboratory space.
|--- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

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|(2) |  | 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.                    
|--- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|   
|(3) |  | Includes government securities with maturities in excess of 90 days
and having gross unrealized gains totaling $47,390, which has been
reported as accumulated other comprehensive income on the consolidated
balance sheet as of September 30, 2001. These securities either matured
or were called at par during fiscal 2002.
|   
|5.  |  | 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.



|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. Our total financial commitment for the term of the lease is
$6,061,497. We have included $154,911 and $91,790 of deferred rent in total
accrued expenses and other liabilities as of September 30, 2002 and 2001,
respectively. We delivered an irrevocable standby letter of credit to the
lessor in the amount of $388,122, to secure our performance under the lease.
Lease expenses for fiscal 2002, 2001 and 2000 were $818,557, $754,785 and
$401,281, respectively.

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. The lease has scheduled rent increases each
year and expires on January 14, 2013. Our total financial commitment for the
term of the lease is $9,742,080. On August 5, 2002 we delivered an irrevocable
standby letter of credit to the lessor in the amount of $468,475 to secure our
performance under the lease.

Future minimum payments under non-cancelable operating leases as of September
30, 2002 are as follows:

|                          |       |                  |           |            | 
|------------------------- | ----- | ---------------- | --------- | ---------- | 
|Year Ending September 30, |       | Minimum Payments
|                          |       |                 
|2003                      |       | $                | 1,293,909 |           
|2004                      |       |                  | 1,577,740 |           
|2005                      |       |                  | 1,637,499 |           
|2006                      |       |                  | 1,701,315 |           
|2007                      |       |                  | 1,763,807 |           
|Thereafter                |       |                  | 6,395,703 |           
|                          |       |                  |           |           
|                          | Total |                  | $         | 14,369,973 | 
|                          |       |                  |           |           

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).

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Future minimum payments under the capital leases as of September 30, 2002 are
as follows:

|                                    |       |                                   |         |         |         | 
|----------------------------------- | ----- | --------------------------------- | ------- | ------- | ------- | 
|Year Ending September 30,           |       | Minimum Payments                 
|                                    |       |                                  
|2003                                |       | $                                 | 171,784 |        
|2004                                |       |                                   | 171,784 |        
|2005                                |       |                                   | 158,253 |        
|2006                                |       |                                   | 28,742  |        
|2007                                |       |                                   | 7,185   |        
|                                    |       |                                   |         |        
|                                    | Total |                                   |         | 537,748 |        
|                                    |       | Less amount representing interest |         |         | 85,151  | 
|                                    |       |                                   |         |        
|Present value of net lease payments |       |                                   | 452,597 |        
|                                    |       | Less current portion              |         |         | 128,833 | 
|                                    |       |                                   |         |        
|Long-term portion of obligation     |       | $                                 | 323,764 |        
|                                    |       |                                   |         |        

Construction contract.In connection with the lease with Sorrento Plaza LP, we
entered into a $4.5 million construction contract in December 2002 with
Biostruct Inc., whereby we are obligated to pay for construction and tenant
improvements. The lessor is responsible for contributing $2 million to the
construction contract, representing a tenant improvement allowance.

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.



|7. |  | SHAREHOLDERS EQUITY
|-- |  | --------------------

Preferred stock

Preferred stock consists of Series C junior participating preferred stock and
Series D redeemable convertible preferred stock.

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 will 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 newly created 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.

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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.At September 30, 2002, 50 shares of Series D redeemable convertible
preferred stock remained outstanding in connection with a securities purchase
agreement made with certain investors on March 22, 1999. In connection with
the issuances of preferred stock and warrants in fiscal 2000 and 1999, 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 $0.944 per share also remained
outstanding on September 30, 2002. The expiration dates for the warrants vary
from March 31, 2004 to February 18, 2005.

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.

As of September 30, 1999, none of the Series D Shares were outstanding;
however, Class J Warrants to purchase 100,000 shares of Class A common stock at
$0.9144 per share were outstanding. On November 29, 1999, one of the investors
exercised its Class J Warrants to purchase 50,000 shares of Class A common
stock at $0.9144 per share, for cash in the amount of $45,720.

On February 18, 2000, we received $1,000,000 in exchange for issuing 100 Series
D Shares and Class J Warrants to purchase 50,000 shares of Class A common
stock. The Class J warrants issued in connection with the financing have an
exercise price equal to 120% of the market price for Class A common stock, as
defined in our Certificate of Determination, or $2.715 per share.

We estimated the value of the warrants issued on February 18, 2000 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 are accreting the discount over the
three-year life of the Series D redeemable convertible preferred stock or
sooner if converted 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.

On June 12, 2000, one of the holders of Series D Shares exercised its right to
convert 50 shares, representing $500,000 in redeemable convertible preferred
stock and $7,603 in accrued and unpaid dividends, into 288,800 shares of Class
A common stock, for an average stock price of $1.7576 per share.

The remaining Series D holders may 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
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

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##### Table of Contents





| | - |  | 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, 1999 to September 30, 2002:

|                            |                                                                                         |  |                             |     |        |   |         |           |  
|--------------------------- | --------------------------------------------------------------------------------------- |  | --------------------------- | --- | ------ | - | ------- | --------- | -
|                            |                                                                                         |  | Series D Redeemable        
|                            |                                                                                         |  | Convertible Preferred Stock
|                            |                                                                                         |  |                            
|                            |                                                                                         |  | Shares                      |     | Amount
|                            |                                                                                         |  |                             |     |       
|Balance, October 1, 1999    |                                                                                         |  |                            |     |        | $ |        |          
|                            | Issuance of Series D Shares in February 2000 for
cash                                   |  |                             | 100 |        |   |         | 1,000,000 |  
|                            | Valuation of warrants issued in connection with
redeemable convertible preferred stocks |  |                             |     |        |   |         | (106,000  | )
|                            | Accretion of Series D redeemable
convertible preferred stock                            |  |                             |     |        |   |         | 57,609    |  
|                            | Preferred stock dividends accrued between February
2000 and September 2000              |  |                             |     |        |   |         | 21,914    |  
|                            | Conversion into 288,800 shares of Class A common
stock                                  |  |                             | (50 | )      |   |         | (507,603  | )
|                            |                                                                                         |  |                             |     |        |   |         |          
|Balance, September 30, 2000 |                                                                                         |  | 50                          |     |        |   | 465,920 |          
|                            | Accretion of Series D redeemable
convertible preferred stock                            |  |                             |     |        |   |         | 18,286    |  
|                            | Preferred stock dividends accrued between October
2000 and September 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 |          
|                            |                                                                                         |  |                             |     |        |   |         |          

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. 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).

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##### Table of Contents



Issuances of Class A common stock.During fiscal 2002 we issued an aggregate
of 271,152 shares of Class A common stock in connection with the exercise
of stock purchase warrants (80,000 shares), and employee stock options (191,152
shares). Details of the transactions are shown in the tables that follow.

|                        |  |         |          |        |         |          |        |           |         |        |        |               |      |  |      | 
|----------------------- |  | ------- | -------- | ------ | ------- | -------- | ------ | --------- | ------- | ------ | ------ | ------------- | ---- |  | ---- | 
|Warrants and            |  |         |          |        |         |          |        |           |         | Amount |        | Average Price
|Stock Options Exercised |  | Date    |          | Shares |         | Received |        | Per Share
|                       
|Stock options           |  | Various |          |        | 191,152 |          |        | $         | 170,574 |        |        | $             | 0.89 | 
|Class K warrants        |  |         | 12/12/01 |        |         |          | 80,000 |           |         |        | 90,000 |               |      |  | 1.13 | 

Class B common stock conversions.During fiscal 2002 and 2001, 23,000 and
28,500 shares of Class B common stock, respectively, converted to 23,000 and
28,500 shares of Class A common stock, respectively.

Warrants

Class G warrants.As of September 30, 2002, 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 the fiscal 2001 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, which
registers the resale of shares purchasable upon exercise of the warrant.

Class H warrants. The Class H warrant to purchase 100,000 shares of Class A
common stock at $2.40 expired on February 26, 2002. The holder of the Class H
warrant did not exercise any rights to purchase Class A common stock during
fiscal 2002.

Class J warrants. See Preferred Stock  Series D redeemable convertible
preferred stock and Class J stock purchase warrants above.

Class K warrant. On December 12, 2001, the Class K warrant holder exercised
its right to purchase 80,000 shares of Class A common stock at an exercise
price of $1.125 per share, for cash in the aggregate amount of $90,000. A
warrant to purchase 100,000 shares at $3.50 per share issued in fiscal 2000
was canceled in fiscal 2001 because certain milestones related to services
were not achieved. Both warrants related to services provided or milestones
to be achieved by our consultant for investor relations. We recorded
compensation expense of $128,639 and $150,448 related to the valuation of
services rendered and milestones that were achieved under the warrants in
fiscal 2001 and 2000, respectively. As of September 30, 2002, Class K
warrants to purchase 107,500 shares of Class A common stock at $1.125 per
share remained outstanding and fully vested. The expiration dates of the
warrants vary from June 14, 2003 to June 14, 2005.

Class M warrants. As of September 30, 2002, Class M warrants to purchase
87,123 shares of Class A common stock at an exercise price of $1.284 remained
outstanding in connection with the issuance of $1.5 million in redeemable 11%
convertible debentures in November 1999. The cost of these warrants was fully
amortized prior to fiscal 2001. During fiscal 2001, the holders exercised
their rights to purchase 107,581 shares of Class A common stock at an exercise
price of $1.284 per share for cash in the aggregate amount of $138,134. None
of the Class M warrants were exercised in fiscal 2002. The Class M warrants
expired on November 30, 2002. (See Note 8, Redemption of 11% Convertible
Debentures).

Class N warrants. At September 30, 2002, 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

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##### Table of Contents



placement in January 2000.
None of the Class N warrants were exercised in fiscal 2001 or 2002. The Class
N warrants expire on January 31, 2004.

The following table summarizes all warrant activity for the period October 1,
1999 to September 30, 2002:

|                                  |              |  |                      |            |                |   |                 |      |  |   |            |            | 
|--------------------------------- | ------------ |  | -------------------- | ---------- | -------------- | - | --------------- | ---- |  | - | ---------- | ---------- | 
|                                  |              |  | 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, 1999    |              |  | 7,029,818            |            |                | $ | 1.33            |      |  | $ | 0.78$2.40 |           
|                                  | Issued       |  |                      | 1,113,948  |                |   | $               | 1.53 |  |   | $          | 1.13$3.50 | 
|                                  | Cancelled    |  |                      | (296,144   | )              |   | $               | 1.75 |  |   | $          | 1.13$1.28 | 
|                                  | Expired      |  |                      | (122,083   | )              |   | $               | 1.38 |  |   | $          | 1.38       | 
|                                  | Tendered (1) |  |                      | (144,142   | )              |   | $               | 0.78 |  |   | $          | 0.78       | 
|                                  | Exercised    |  |                      | (5,961,819 | )              |   | $               | 1.37 |  |   | $          | 0.78$2.44 | 
|                                  |              |  |                      |            |                |   |                 |      |  |   |            |           
|Outstanding at September 30,
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 |           
|                                  |              |  |                      |            |                |   |                 |      |  |   |            |           



---

|(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 2002, we issued incentive stock options
under our 2000 Stock Option Plan to the officers of the Company for the
purchase of 350,000 shares of Class A common stock at exercise prices ranging
from $1.50 to $3.29 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 15, 2002, we issued to our
non-employee directors stock options to purchase an aggregate of 80,000 shares
of Class A common stock at an exercise price of $3.24 per share as part of a
provision for an annual formula grant under our 1994 Stock Option Plan. The
option price represents the closing market price for the common stock on the
date of grant.

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. The 2000
Plan allows us to grant options to our officers, directors, employees and
consultants. As of September 30, 2002, 1,292,792 shares of Class A common
stock were available for grant under the 2000 Plan.

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, 2002, options to purchase 47,303 shares
of Class A common stock were available for grant under the 1998 Plan.

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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, 2002, 70,077 shares of
Class A common stock were available for grant under the 1994 Plan.

Other stock options. In July 1993, we granted options to purchase an aggregate
of 3,843,750 shares of Class A common stock to certain of our employees,
consultants, directors and original investors in the Company at an option price
of $3.56 per share. Recipients of these options waived all of their respective
rights to an aggregate of 3,843,750 shares of Class B common stock and options
to purchase Class B common stock held in an escrow account. These options were
fully exercisable when issued and they expire on July 17, 2003.

In September 1994, we reduced the exercise price on certain options granted to
several employees, officers, directors and consultants to purchase an aggregate
of 3,285,250 shares of Class A and Class B common stock to $2.75 per share.

The following table summarizes all common stock option activity from October 1,
1999 to September 30, 2002:

|                                  |           |  |                          |            |                |  |                 |         |   |   |      |      | 
|--------------------------------- | --------- |  | ------------------------ | ---------- | -------------- |  | --------------- | ------- | - | - | ---- | ---- | 
|                                  |           |  | Number of Shares         |            |                |  |                
|                                  |           |  | Underlying Stock Options |            | Weighted      
|                                  |           |  |                          |            | Average Option
|                                  |           |  | Class A                  |            | Class B        |  | Price Per Share
|                                  |           |  |                          |            |                |  |                
|Outstanding at October 1, 1999    |           |  | 7,224,124                |            |                |  | 28,000          |         |   | $ | 2.16 |     
|                                  | Granted   |  |                          | 1,649,000  |                |  |                 |         |   |   | $    | 1.73 | 
|                                  | Exercised |  |                          | (1,482,355 | )              |  |                 | (16,000 | ) |   | $    | 2.19 | 
|                                  | Canceled  |  |                          | (2,028,619 | )              |  |                 | (12,000 | ) |   | $    | 2.71 | 
|                                  |           |  |                          |            |                |  |                 |         |   |   |      |     
|Outstanding at September 30, 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 |     
|                                  |           |  |                          |            |                |  |                 |         |   |   |      |     
|Exercisable at September 30, 2002 |           |  | 4,780,299                |            |                |  |                |         |   | $ | 2.09 |     
|                                  |           |  |                          |            |                |  |                 |         |   |   |      |     

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##### Table of Contents



We have applied APB Opinion No. 25 and related interpretations in accounting
for our employee stock options. Accordingly, we have not recognized any
compensation expense for stock options granted at the fair market value of our
Class A common stock. If compensation expense for stock options granted under
the stock option plans had been determined based on the fair value at the grant
date consistent with the methodology prescribed under SFAS No. 123, then our
pro forma net income (loss) and net income (loss) per share would have been as
follows:

|                                                       |             |  |                           |             |      |  |      |            |   |  |   |            |  
|------------------------------------------------------ | ----------- |  | ------------------------- | ----------- | ---- |  | ---- | ---------- | - |  | - | ---------- | -
|                                                       |             |  | Years Ended September 30,
|                                                       |             |  |                          
|                                                       |             |  | 2002                      |             | 2001 |  | 2000
|                                                       |             |  |                           |             |      |  |     
|Net income (loss)
attributable to
common
shareholders: |             |  |                           |             |      |  |      |            |   |  |   |           
|                                                       | As reported |  | $                         | (10,292,798 | )    |  | $    | 189,888    |   |  | $ | (801,806   | )
|                                                       | Pro forma   |  | $                         | (12,641,001 | )    |  | $    | (1,478,488 | ) |  | $ | (2,210,593 | )
|Net income (loss)
per share, basic
and diluted:        |             |  |                           |             |      |  |      |            |   |  |   |           
|                                                       | As reported |  | $                         | (0.18       | )    |  | $    | 0.00       |   |  | $ | (0.02      | )
|                                                       | Pro forma   |  | $                         | (0.22       | )    |  | $    | (0.03      | ) |  | $ | (0.04      | )

We estimate the weighted average fair values per share of the options granted
during fiscal 2002, 2001 and 2000 to be $2.91, $3.94, and $1.73, respectively,
using the Black-Scholes option-pricing model and the following assumptions:

|                        |  |                           |     |      |  |      |     |   |  |  |     |  
|----------------------- |  | ------------------------- | --- | ---- |  | ---- | --- | - |  |  | --- | -
|                        |  | Years Ended September 30,
|                        |  |                          
|                        |  | 2002                      |     | 2001 |  | 2000
|                        |  |                           |     |      |  |     
|Risk free interest rate |  |                           | 4.4 | %    |  |      | 5.8 | % |  |  | 6   | %
|Expected life (years)   |  |                           | 4.2 |      |  |      | 4.1 |   |  |  | 4.3 |  
|Expected volatility     |  |                           | 128 | %    |  |      | 158 | % |  |  | 153 | %
|Expected dividends      |  | None                      |     | None |  | None

The following table summarizes information concerning outstanding and
exercisable Class A and Class B stock options as of September 30, 2002:

|                |       |             |                     |         |                     |          |             |             |          |          |      |      |  |  |           |        |  |   |      |      | 
|--------------- | ----- | ----------- | ------------------- | ------- | ------------------- | -------- | ----------- | ----------- | -------- | -------- | ---- | ---- |  |  | --------- | ------ |  | - | ---- | ---- | 
|                |       |             | Options Outstanding |         | Options Exercisable
|                |       |             |                     |         |                    
|                |       |             |                     |         |                     |          | Weighted    |             |          |          |      |      |  |  |           |        |  |   |     
|                |       |             |                     |         |                     |          | Average     |             |          |          |      |      |  |  |           |        |  |   |     
|                |       |             |                     |         |                     |          | Remaining   |             | Weighted |          |      |      |  |  | Weighted 
|                |       |             |                     |         |                     |          | Contractual |             | Average  |          |      |      |  |  | Average  
|Range of        |       | Number      |                     | Life in |                     | Exercise |             | Number      |          | Exercise
|Exercise Prices |       | Outstanding |                     | Years   |                     | Price    |             | Exercisable |          | Price   
|                |       |             |                     |         |                     |          |             |             |          |         
|$0.30 - $0.72   |       |             | 945,742             |         |                     |          | 6.46        |             |          | $        | 0.68 |      |  |  | 945,742   |        |  | $ | 0.68 |     
|                | $0.78 |             |                     | 15,000  |                     |          |             | 6.79        |          |          | $    | 0.78 |  |  |           | 15,000 |  |   | $    | 0.78 | 
|$1.00 - $1.06   |       |             | 225,666             |         |                     |          | 5.24        |             |          | $        | 1.03 |      |  |  | 225,666   |        |  | $ | 1.03 |     
|$1.28 - $2.31   |       |             | 1,587,914           |         |                     |          | 6.47        |             |          | $        | 1.66 |      |  |  | 1,408,505 |        |  | $ | 1.67 |     
|$2.47 - $2.50   |       |             | 506,540             |         |                     |          | 6.11        |             |          | $        | 2.48 |      |  |  | 451,404   |        |  | $ | 2.48 |     
|$2.75 - $3.40   |       |             | 1,646,684           |         |                     |          | 4.80        |             |          | $        | 3.00 |      |  |  | 1,118,559 |        |  | $ | 2.86 |     
|$3.56 - $6.44   |       |             | 811,760             |         |                     |          | 5.27        |             |          | $        | 3.97 |      |  |  | 615,423   |        |  | $ | 3.93 |     
|                |       |             |                     |         |                     |          |             |             |          |          |      |      |  |  |           |        |  |   |      |     
|                |       |             | 5,739,306           |         |                     |          | 5.74        |             |          | $        | 2.25 |      |  |  | 4,780,299 |        |  | $ | 2.09 |     
|                |       |             |                     |         |                     |          |             |             |          |          |      |      |  |  |           |        |  |   |      |     

8. REDEMPTION OF 11% CONVERTIBLE DEBENTURES

Loan agreement. In November 1999, we entered into a loan agreement for $1.5
million in aggregate financing provided by two international financial lenders.
We issued an 18-month redeemable convertible debenture for $750,000 to each
lender, with an interest rate of 11% payable quarterly in arrears. On February
4, 2000 we redeemed the $1.5 million in outstanding convertible debentures plus
$28,151 in accrued and unpaid interest. We paid a 5% redemption premium in
connection with the redemption of these debentures.

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##### Table of Contents



We were able to reduce the interest rate from 11% to 10% according to the terms
of the agreement, because we redeemed the convertible debentures within the
first 90 days of issuance.

Stock purchase warrants. In connection with the issuance and redemption of the
convertible debentures, the lenders and investment bankers retained
fully-vested Class M stock purchase warrants to purchase 467,289 shares of
Class A common stock at an exercise price of $1.284 per share. We valued the
warrants at $81,308, which was fully amortized during fiscal 2000. At
September 30, 2002, Class M stock purchase warrants to purchase 87,123 shares
of Class A common stock remained outstanding.

Debt issue costs. We fully amortized $155,015 in debt issue costs related to
the issuance of the 11% convertible debentures during fiscal 2000.

9. 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. We earned
and received a $5 million milestone payment in fiscal 2002, $10 million in
fiscal 2001 and $10 million in fiscal 2000.




Boryung Pharmaceuticals Company Ltd.In March 1994, we entered into a 12-year
exclusive license and supply agreement with Boryung Pharmaceuticals Company
Ltd. (Boryung), for the manufacture and sale of docosanol 10% cream in the
Republic of Korea (Korea). Under the terms of the agreement, Boryung is
responsible for obtaining the necessary regulatory approvals and for the
subsequent manufacturing, marketing and distribution of docosanol 10% cream.
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 obtained regulatory approval in
fiscal 2002 to market the product in Korea and launched the product in June
2002. Avanir had not earned or recognized any royalties in fiscal 2002
pursuant to this agreement because the earnings process was not complete.

CTS Chemical Industries. In July 1993, we entered into a license agreement
with CTS Chemical Industries, Ltd. (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
registration of approval of the product by the appropriate regulatory
authorities in Israel. Under the terms of the agreement, CTS is responsible
for the manufacture, marketing and distribution of docosanol 10% cream in
Israel. The agreement includes a supply provision under which CTS will
purchase its entire requirement of active ingredient for use in the manufacture
of topical docosanol 10% cream from us directly or from our designee. Avanir
will earn a royalty on product sales under the license agreement following
product launch, anticipated to be 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 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.We have been awarded three government-funded
research grants totaling $1.2 million that are intended to reimburse us for the
cost of certain pre-clinical research related to a potential treatment for
genital herpes and antibodies for anthrax. Our $1 million Phase II Small
Business Innovative Research (SBIR) grant and $150,000 California Technology
Investment Partnership (CalTIP) grant are for pre-clinical and market research
related to the development of a topical treatment for genital herpes (HSV-2)
over a two-year period. We are using the SBIR grant to fund certain
pre-clinical research related to genital herpes.

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##### Table of Contents



We are using the CalTIP funds for defining and assessing the market including
assessment of competitive landscape, product opportunities, FDA regulatory
review expectations, brand identification and possible brand names for a
potential genital herpes product. Additionally, in fiscal 2002 we were awarded
a $75,000 grant from the California Center for Advanced Technology for research
and development in fiscal 2002 and 2003 related to finding one or more antibodies to the
toxins produced by anthrax.

Research collaboration agreements.Xenerex Biosciences (Xenerex), the
Companys subsidiary, is currently engaged in three research collaboration
agreements whereby Xenerex is responsible for generating fully human monoclonal
antibodies to antigen targets provided by its research partners. The
agreements require Xenerex to use commercially reasonable efforts to generate
antibodies to the antigen targets in exchange for an initial fee and do not
guarantee that efforts will be successful. Xenerex could earn additional fees
based on achieving milestones specified in the agreements and earn royalties on
sales if a partner commercializes the antibody. Milestones include a partners
selection of one or more antibodies of interest that Xenerex has generated, if
any, and a partners advancing the product through various stages of clinical
development. The clinical development process will likely take several years
to reach the stage of filing with the FDA for approval to market the product.
Xenerex has received an initial payment from each of its partners that is
intended to offset Xenerex costs of mounting efforts to generate antibodies to
the selected targets. Revenues to be earned on the research collaborations
after an antibody is selected, if any, are outside the control of Xenerex and
are dependent on the progress made by its research partners in the clinical
development process. There can be no assurance that Xenerex will generate
antibodies in sufficient quantities, that any partner will select an
antibody for further development, or that any partner will be successful in
developing and obtaining the necessary regulatory approvals for marketing the
product.

10.     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 combination, Neurodex (formerly called
AVP-923), to treat multiple central nervous system disorders. Our license
agreement includes rights to the patented technology and know-how for the
development and potential marketing of products for treatments of:



| |  |  | pseudobulbar affect (PDA), which is a condition associated with
neurodegenerative diseases such as Amyotrophic Lateral Sclerosis (ALS or
Lou Gehrigs disease), multiple sclerosis (MS), Alzheimers Disease (AD)
and stroke;
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | neuropathic pain;                                                                                                                                                                                                            
|
| |  |  | symptoms of chronic and intractable cough; and                                                                                                                                                                               
|
| |  |  | weaning from narcotics.                                                                                                                                                                                                      

The license agreement requires no upfront payments to be paid to IriSys for a
drugs indication before we complete all the clinical development phases to
confirm the drugs efficacy for that indication. We will be required to make
milestone payments to IriSys in the following two instances for each
indication:



| |  |  | if the FDA accepts the filing of a new drug application; and
| | - |  | ------------------------------------------------------------
|
| |  |  | if the FDA approves the new drug application for marketing. 

Further, if we successfully complete the clinical trials and the FDA accepts
our new drug application, we will be required to pay a royalty to IriSys based
on a percent of sales revenue if we market the product ourselves. If we
license 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 licensed 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 and a patent application as set forth

F-25



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##### Table of Contents






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 license agreement with IriSys are no less favorable to the Company
than those that could have been obtained from an unrelated party.




Research and development.On June 2, 1999, we entered into an agreement for
services with IriSys to develop formulations for a potential drug substance
candidate using our allergy and asthma technology. IriSys fees for services
compared favorably to competitive bids submitted to us at that time. During
fiscal 2001 and 2000, the Company paid IriSys $17,800 and $101,197,
respectively, for services rendered pursuant to this agreement.

On April 2, 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 $20,000 for project initiation.

11.     INCOME TAXES

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,
|                                                            |  |              
|                                                            |  | 2002          |             | 2001
|                                                            |  |               |             |     
|Net operating loss carryforwards                            |  | $             | 27,450,282  |      |  | $ | 23,929,702  |  
|Research credit carryforwards                               |  |               | 4,311,962   |      |  |   | 4,220,002   |  
|Capitalized research and development costs                  |  |               | 1,345,118   |      |  |   | 1,343,792   |  
|Capitalized license fees                                    |  |               | 827,824     |      |  |   | 876,353     |  
|Foreign tax credits                                         |  |               | 595,912     |      |  |   | 253,572     |  
|Other                                                       |  |               | 116,056     |      |  |   | (386,250    | )
|                                                            |  |               |             |      |  |   |             |  
|Net deferred income tax assets                              |  |               | 34,647,154  |      |  |   | 30,237,171  |  
|Less valuation allowance for net deferred income tax assets |  |               | (34,647,154 | )    |  |   | (30,237,171 | )
|                                                            |  |               |             |      |  |   |             |  
|                                                            |  | $             |            |      |  | $ |            |  
|                                                            |  |               |             |      |  |   |             |  

We have provided a valuation allowance against the net deferred income tax
assets recorded as of September 30, 2002 and 2001 due to uncertainties as to
their ultimate realization. The net operating loss and research credit
carryforwards expire on various dates through 2022. In the event of certain
ownership changes, the Tax Reform Act of 1986 imposes certain restrictions on
the amount of net operating loss carryforwards which we may use in any year.
As of September 30, 2002, we had $65,859,907 and $16,108,706 of federal and
California net operating loss carryforwards, respectively.

12.     LITIGATION SETTLEMENTS

On March 24, 2000, the Company, David H. Katz, M.D. (the Companys founder,
former CEO, and a former director), and Mrs. Lee R. Katz (the wife of Dr. Katz)
jointly announced a comprehensive settlement of all disputes, claims and
litigation that they had asserted against each other. Under the settlement
terms, Avanir conveyed to Dr. Katz 975,000 shares of Class A common stock,
valued at $3.9 million, and an additional cash payment in the amount of
$175,000.

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13.     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, and
we did not make any such contributions in fiscal years 2002, 2001 and 2000, nor
in any prior period since inception of the plan.

14.     SUBSEQUENT EVENT

On December 24, 2002, Avanir sold an interest in its license agreement with
GlaxoSmithKline to Drug Royalty USA (Drug Royalty), and received an initial
payment of $20.5 million. Avanir expects to receive an additional $3.6 million
from Drug Royalty upon the grant of a patent extension for one of Avanirs key
patents. Avanir retained the rights to receive 50% of all royalties under the
GlaxoSmithKline license agreement for annual sales of Abreva in excess of
$62.0 million. Avanir also retained the rights to develop and license the cold
sore product outside North America and all other patented indications for the
products active ingredient, dosocanol. We classified the initial amount
received as deferred revenue. The deferred revenue will be recognized ratably
over the life of the license agreement.

* * * * *

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