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SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549


Form 10-K


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


OF THE SECURITIES EXCHANGE ACT OF
1934


|   |  |                                                                                                 
|-- |  | ------------------------------------------------------------------------------------------------
|þ  |  | ANNUAL REPORT PURSUANT TO SECTION 13 OR
    15(d)
    OF THE SECURITIES EXCHANGE ACT OF 1934    
|  
|   |  | For the fiscal year ended September 30,
    2004                                                
|  
|OR
|  
|o  |  | TRANSITION REPORT PURSUANT TO SECTION 13
    OR 15(d)
    OF THE SECURITIES EXCHANGE ACT OF 1934
|  
|   |  | For the transition period
    from           to                                                 



Commission File No. 1-15803

AVANIR Pharmaceuticals

(Exact name of registrant as specified in its
charter)


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

(858) 622-5200

(Registrants telephone number, including
area code)


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

None


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

Class A Common Stock, no par
value


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

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

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

As
of the Companys most recently completed second fiscal
quarter, the aggregate market value of the outstanding shares of
Class A common stock held by non-affiliates was
approximately $125,000,000. For purposes of the foregoing
disclosure and without admitting whether any person is an
affiliate of the registrant, all shares owned directly or
indirectly by officers and directors of the registrant have been
treated as owned by an affiliate.

The
number of shares of Common Stock of the registrant issued and
outstanding as of December 7, 2004:

|                                   |  |           
|---------------------------------- |  | ----------
|Class A Common Stock, no par value |  | 95,327,908

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, 2005 in connection with the registrants
Annual Meeting of Shareholders to be held in 2005, is
incorporated by reference into Part III of this report.



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|                                           |                  |  |  |  |  |  |  | 
|------------------------------------------ | ---------------- |  |  |  |  |  |  | 
|PART I                                    
|                                           | Item 1. Business
|NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
|EXHIBIT 21.1                              
|EXHIBIT 23.1                              
|EXHIBIT 31.1                              
|EXHIBIT 31.2                              
|EXHIBIT 32.1                              
|EXHIBIT 32.2                              



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PART I






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

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

The Company

AVANIR Pharmaceuticals is a drug discovery and
development company focused primarily on novel treatments for
chronic diseases. AVANIR is currently developing
NeurodexTM for the treatment of pseudobulbar affect
(PBA) and for the treatment of chronic diabetic
neuropathic pain. We have successfully completed two
Phase III trials of Neurodex in the treatment of PBA in
patients with multiple sclerosis (MS) and with Lou
Gehrigs disease (amyotrophic lateral sclerosis or
ALS), and one Phase II trial for the treatment
of diabetic neuropathic pain. We also have a potential product
for allergy and asthma, AVP-13358, which is in Phase I
clinical development.

Our clinical and preclinical research and drug
discovery programs are focused primarily on small molecules that
can be taken orally as therapeutic treatments. Other small
molecule research programs include potential treatments for
atherosclerosis and inflammation, which are both in the
preclinical development stage. Using our proprietary
XenerexTM technology, we are also conducting research
to develop injectable human monoclonal antibody products for
anthrax, cytomegalovirus, and other infectious diseases.

AVANIR has demonstrated that it is capable of
developing a drug from the beginning discovery stage through all
clinical development stages, and in obtaining marketing approval
by the U.S. Food and Drug Administration (FDA).
AVANIRs first product, docosanol 10% cream, (sold as
Abreva® by our marketing partner GlaxoSmithKline Consumer
Healthcare in North America) is the only over-the-counter
(OTC) treatment for cold sores that has been
approved by the FDA.

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

NeurodexTM
PBA Indication

PBA is a symptom complex that is characterized by
unprovoked and uncontrollable episodes of crying or laughing,
and afflicts patients with neurological disorders such as Lou
Gehrigs disease, Alzheimers disease, MS, stroke and
traumatic brain injury. IMS Health has estimated PBA to be a
$450 million market in the United States by 2005. Our
leading drug candidate, Neurodex, is the first drug product in
clinical development specifically intended to treat PBA.
Neurodex is a patented, orally administered combination of
dextromethorphan and an enzyme inhibitor that sustains elevated
levels of dextromethorphan in the human body.

AVANIR has achieved positive results in two
pivotal Phase III clinical trials evaluating the safety and
effectiveness of Neurodex in the treatment of PBA, including the
latest trial completed in 2004 in patients with MS. In the
double blind Phase III clinical study (AVR-106) completed
in June 2004, 150 patients at 22 clinical sites were
randomized to receive either placebo or Neurodex on a 12-hour
dosing schedule for 90 days.

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The Center for Neurological Study Lability Scale
(CNS-LS), a validated instrument that assesses frequency and
severity of PBA episodes, was utilized as the primary efficacy
endpoint. A minimum CNS-LS score was required for inclusion in
the study. For the primary endpoint, patients receiving Neurodex
benefited from a significantly greater reduction in CNS-LS than
those receiving placebo (p<0.0001). The four secondary
endpoints evaluated in the trial also significantly favored
Neurodex, namely in the reduction in number of PBA episodes
(p=0.0002), improvement in assessed quality of life
(p<0.0001), improvement in assessed quality of relationships
(p=0.0001), and reduction in pain (p=0.0271). Except for the
addition of the pain endpoint, the primary and secondary
efficacy endpoints used in the MS study were the same as those
in the previous pivotal trial in which ALS was the underlying
disease.


Overall, Neurodex was well tolerated in the
patient population for AVR-106. The majority of reported side
effects (adverse events) were mild or moderate. Of the adverse
events reported in 5% or more of the patients, a statistically
significant difference between Neurodex and placebo was observed
only for dizziness. In the Neurodex group, 14% of patients
withdrew from therapy due to adverse events, compared to 11%
discontinuing in the placebo group.

The first Phase III trial of Neurodex for
PBA in ALS patients was completed in June 2002 (Neurology,2004; 63:1364-1370). The double blind, controlled,
multicenter clinical trial had three treatment arms and compared
Neurodex to each of its two components, dextromethorphan and
quinidine. Results of earlier Phase I studies demonstrated
that the combination of dextromethorphan and a low dose of
quinidine results in elevated and prolonged dextromethorphan
blood levels (The Journal of Clinical Pharmacology,2004;
44:1132-1142). Dextromethorphan has activity as both a sigma-1
receptor agonist and N-methyl-D-aspartate
(NMDA) receptor antagonist.

AVANIR is in the process of preparing its initial
submission of data under a new drug application
(NDA) to the FDA for Neurodex for the treatment of
PBA. Please refer to Managements Discussion and
Analysis of Financial Condition and Results of Operations
regarding this planned submission. The Company is also
conducting an open-label study of PBA at 39 sites in a diverse
population of patients with various neurologic disorders. The
open label study is intended to establish further safety of the
drug, and includes a study plan for evaluating at least
100 patients taking Neurodex for at least a one-year period
and an additional 200 patients for at least a six-month
period. We intend to complete the NDA submission by mid-2005.

Neurodex  Neuropathic Pain
Indication

Neuropathic pain, arising from nerve injury,
results in a chronic and debilitating form of pain that in the
past has been poorly diagnosed and treated. Conditions that
cause neuropathic pain include trauma (e.g. car accidents),
cancer, viral infection (e.g. herpes zoster) and metabolic
disease (e.g. diabetic neuropathy). For example, at least half
of the 15.7 million Americans who have diabetes are
estimated to suffer from nerve damage caused by the disease,
according to the American Diabetes Association. The damaged
nerves can alter the sensitivity of pain centers in the spinal
cord and consequently intensify pain transmission within the
central nervous system. Diabetic neuropathic pain currently is
most commonly treated with tricyclic antidepressants,
anticonvulsants, opioid analgesics and local anesthetics. Most
of these treatments have limited effectiveness or undesirable
side effects. AVANIR intends to develop Neurodex as a viable
competitor in the $1 billion plus neuropathic pain market.

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

The clinical trial was conducted at five
U.S. sites in 36 adult volunteers with diabetic neuropathy
who experienced pain on a daily basis in the lower extremities
for at least the previous three months. The study was designed
to evaluate the safety and tolerability of escalating doses of
Neurodex for future clinical trials. Various pain assessments
were included as a preliminary evaluation of pain relief. Three
patients did not

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complete the study, two due to adverse events
(one serious and not related, one serious and possibly related)
and one due to inability to comply with the protocol. Commonly
reported adverse events (reported by three or more individuals)
included nausea, constipation, diarrhea, dry mouth, fatigue,
dizziness, insomnia, headache, upper respiratory tract infection
and somnolence. Most adverse events were either mild or moderate
in intensity, and 92% of the participants completed the study.
There was minimal need for alternative (rescue) pain
medication. Rescue medications were taken on a mean of
1.3 days during the four-week study.


We expect to begin a Phase III clinical
trial of Neurodex for the treatment of neuropathic pain in 2005.
Please refer to Managements Discussion and Analysis
of Financial Condition and Results of Operations for more
information. To help fund the cost of the clinical development
program and possibly accelerating our plans for
commercialization of Neurodex, we are considering licensing and
co-promotion opportunities with other companies. There can be no
assurances that the economic terms of any offers made to us
regarding a license or co-promotion arrangement will be
sufficiently attractive to warrant pursuing.

Docosanol 10% Cream

We continue to make progress in commercializing
our cold sore product, docosanol 10% cream (known as
Abreva® in the U.S.), by achieving regulatory approvals and
license arrangements in several foreign countries. Under the
terms of the license agreements, our partners are generally
responsible for all regulatory approvals, sales and marketing
activities, and manufacturing and distribution of the product in
the licensed territories. The terms of the license agreements
typically provide for AVANIR to receive a data transfer fee,
potential milestone payments and royalties on product sales. For
the last three years, a substantial portion of AVANIRs
revenues have come from milestone payments and royalties on
product sales in the U.S. by GlaxoSmithKline and from the
sale of an undivided interest in the GlaxoSmithKline license
agreement to Drug Royalty USA, as further described below.

The table below summarizes the status of
commercialization of docosanol 10% cream in the United States
and various other countries.

|                        |  |                               |  |                                          |  |                                           
|----------------------- |  | ----------------------------- |  | ---------------------------------------- |  | ------------------------------------------
|Country                 |  | Regulatory Status             |  | Licensee                                 |  | Marketing Status                          
|                        |  |                               |  |                                          |  |                                           
|United States           |  | Approved in 2000              |  | SB Pharmco Puerto Rico (GlaxoSmithKline) |  | Abreva launched in 2000                   
|Korea                   |  | Approved in 2002              |  | Boryung Pharmaceutical                   |  | Herepair launched in 2002                 
|Israel                  |  | Approved in 2002              |  | CTS                                      |  | Abrax launched in 2003                    
|Sweden                  |  | Approved in 2003              |  | ACO HUD                                  |  | Launch planned for 2005                   
|Canada                  |  | Approved in 2003              |  | SB Pharmco Puerto Rico (GlaxoSmithKline) |  | Abreva launch expected in late 2005       
|Spain and Portugal      |  | Approved in 2004              |  | To be determined                         |  | Product launch pending a license agreement
|Egypt                   |  | Pending a regulatory decision |  | Biopharm                                 |  | Subject to regulatory approval            
|Norway, Denmark Finland |  | Submitted in December 2004    |  | ACO HUD                                  |  | Subject to regulatory approval            
|Greece and Cyprus       |  | Submitted in December 2004    |  | Gerolymatos                              |  | Subject to regulatory approval            
|Italy                   |  | Submission planned for 2005   |  | Bruno Farmaceutici                       |  | Subject to regulatory approval            
|Turkey and Romania      |  | Submissions planned for 2005  |  | Gerolymatos                              |  | Subject to regulatory approval            

In November 2003, the Swedish Medical Products
Agency approved docosanol 10% cream for marketing as a
non-prescription, OTC topical treatment for cold sores. We
selected Sweden to act as the Reference Member State for
obtaining regulatory approvals of docosanol 10% cream in several
other European countries

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in the European Union. In May 2004, AVANIR
entered into an exclusive agreement with The Gerolymatos Group
of Companies to manufacture and market docosanol 10% cream as a
treatment for cold sores in Greece, Cyprus, Turkey and Romania.
In September 2004, AVANIR signed an exclusive agreement with ACO
HUD to manufacture and market docosanol 10% cream as a treatment
for cold sores in Sweden, Norway, Denmark and Finland.
Stockholm-based ACO HUD is the Scandinavian market leader in
sales of cosmetic and medicinal skincare products. ACO HUD plans
to launch the product in 2005.


The use of Sweden as the Reference Member State
during the mutual recognition process for obtaining further
regulatory approvals of docosanol 10% cream in the European
Union was partially successful in 2004, based on responses from
the four countries where the applications were submitted. We
obtained approvals in Spain and Portugal using the evaluation
conducted by Sweden as the Reference Member State. But we
withdrew our applications in Italy and England, given the nature
of initial questions from the respective regulatory agencies,
limited procedural options, and short timelines provided by the
mutual recognition process. As an alternative, we are proceeding
to assist our local partner in Italy, Bruno Farmaceutici, in its
application for national regulatory approval in that country.
Regarding other countries in the European Union, we plan to
assist our marketing partners in making the necessary regulatory
submissions, which may or may not use the mutual recognition
process.

In fiscal 2003, AVANIR sold an undivided interest
in the GlaxoSmithKline license agreement to Drug Royalty USA for
$24.1 million. AVANIR retained the right to receive 50% of
all royalties under the GlaxoSmithKline license agreement for
annual sales of Abreva in excess of $62 million, a level
that could be achieved in two years assuming current growth
rates. 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.

Docosanol inhibits fusion between the plasma
membrane and the herpes simplex virus (HSV)
envelope, thereby preventing viral entry into cells and
subsequent viral replication. Normally, cold sores progress when
the cold sore infection spreads from infected cells to healthy
ones. Docosanol works by protecting healthy cells so the cold
sore infection is less likely to spread to those cells.

We continue to pursue licensing opportunities for
docosanol 10% cream in other countries in Europe and in Japan.
However, we can provide no assurance that any of our licensees
will be able to obtain regulatory approval, either as an OTC
product or as a prescription product, in Japan or in other
countries that do not participate in the mutual recognition
process.

AVANIR continues to conduct preclinical research
on potential topical formulations of docosanol in the treatment
of genital herpes. Our genital herpes research during the past
three years has been funded by a $1.0 million Small
Business Innovative Research (SBIR) Phase II
grant from the National Institutes of Health and an aggregate of
$150,000 in grants from the San Diego Regional Technology
Alliance.

AVP-13358  Allergy/asthma
Indication

AVP-13358 is a novel, orally active drug molecule
discovered by scientists at AVANIR that is intended to inhibit
or prevent the production of immunoglobulin epsilon
(IgE), a well-known mediator of allergy and asthma.
Both allergies and asthma are respiratory diseases caused by
agents called allergens. In allergy-prone people, the presence
of invading allergens triggers the immune system to produce an
extra amount of IgE, which results in an allergic response that
can range from mild sneezing to a serious asthmatic attack. In
addition to its effect on IgE, this compound has demonstrated an
ability to suppress the antigen-stimulated IL-4 and IL-5
responses with potencies similar to those observed for IgE
suppression. AVP-13358 also suppresses markers of disease in
mouse models of asthma, including pulmonary lavage levels of
IL-4, IL-5, eosinophils, and lymphocytes, as well as expression
of CD23 and the IL-4 receptor (IL4Ra) on leukocytes.

AVANIR is engaged in Phase I clinical
development of AVP-13358. The latest study, completed in 2004,
included 54 healthy volunteers and was intended to assess
safety, tolerability and pharmacokinetics following a single
oral administration. Results from the study suggest AVP-13358
was well tolerated at all doses. The study also demonstrated
AVP-13358 was detectable in the bloodstream at all doses
administered and remains

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in circulation long enough to allow once or twice
daily dosing. We believe AVANIRs approach is unique
because it selectively down-regulates the production of allergen
specific IgE as well as another critical group of mediators
called Th2 cytokines that are up-regulated during asthma or
allergic episodes, without inhibiting antigen-specific IgG
responses.


We estimate the worldwide market for sales of
products that treat allergy and asthma is over $10 billion
a year. The FDAs recent approval of XolairTM,
an injectable antibody that neutralizes the target IgE, helps
validate IgE as a target in the treatment of patients with
asthma. Presently, no small molecule drugs (which can be taken
orally) have been approved by the FDA for the down-regulation of
IgE, either via neutralization or suppression of its synthesis
or release. We believe our new small molecule agent, AVP-13358,
is an attractive candidate for developing as a treatment for
allergy and asthma. There can be no assurances that AVP-13358
will successfully complete all of the repeat rising doses
planned for testing the safety and bioavailability in the
Phase I clinical trials, nor that it will successfully
complete all of the other clinical trials required to
successfully obtain the FDAs approval of the drug.

Other Small Molecule Research
Programs

MIF inhibitor
technology.AVANIR continues to
conduct research on orally active drug candidates that appear
capable of regulating the target, MIF (macrophage migration
inhibitory factor), a protein believed to play a critical role
in inflammatory disorders such as rheumatoid arthritis,
inflammatory bowel disease and psoriasis. In April 2004, AVANIR
presented data on its lead anti-inflammatory compounds at the
Experimental Biology 2004 meeting organized by the Federation of
American Societies for Experimental Biology (FASEB)
in Washington, D.C. At the FASEB, we reported that we had
developed compounds that were effective in both preventing the
progression of colitis, a type of inflammatory bowel disease,
and in reducing the signs and symptoms of ongoing colitis. In
animal models of colitis, increased doses of AVANIRs
compounds also correlated with reduction in tumor necrosis
factor-alpha (TNFa).

AVANIRs MIF inhibitory technology may also
offer a novel therapeutic intervention in inflammatory
neurological diseases, glomerulonephritis and asthma. We believe
all of these inflammatory diseases still have unmet therapeutic
needs. Sales of current drugs for these diseases exceed several
billion dollars in the United States alone. Examples of
successful commercialization of injectable drugs that target
pro-inflammatory proteins are Enbrel® by Immunex
Corporation and Remicade® by Johnson & Johnson,
both of which target TNFa by binding to TNFa or the TNFa
receptor, respectively. 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.

Atherosclerosis.We
made important progress this past year in our atherosclerosis
research program. In March 2004, we reported the discovery of a
series of orally active small molecules that, in animal models,
reduce the fatty deposits in blood vessel walls (commonly called
plaque) typically associated with atherosclerosis. The
experimental animal models that served to evaluate AVANIRs
compounds also showed favorable effects on plasma cholesterol
levels in lowering LDL cholesterol while increasing HDL
cholesterol.

We chose a lead candidate, designated AVP-26452,
with the objective of providing the next generation
of lipid lowering drugs. Unlike currently available drugs that
focus on lowering plasma levels of LDL cholesterol,
AVANIRs compounds are designed to promote a natural
process known as reverse cholesterol transport. The reverse
cholesterol transport pathway may be a more efficient mechanism
to both prevent and reverse vascular diseases.

XenerexTMAntibody Technology

Using our patented, proprietary Xenerex antibody
technology, we are developing antibodies for use as prophylactic
and therapeutic drugs to prevent and treat anthrax infections
and other infectious diseases. Two of our lead antibodies,
AVP-21D9 and AVP-22G12, completely inhibit anthrax toxin complex
assembly, and do so by attaching to distinct domains of the
toxin. Both antibodies bind to the anthrax toxin with a very
high affinity, in the picomolar range. Additionally, these are
two of AVANIRs most potent anthrax toxin

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neutralizing antibodies, exhibiting neutralizing
potency in the stoichiometric range. Our preclinical research to
date has indicated that protection can be afforded by a single
dose of the anthrax antibodies. Mice protected by a single dose
of one of AVANIRs antibodies against a lethal challenge of
anthrax spores were completely protected even after subsequent
exposure to anthrax spores four weeks later.


In February 2004, we received a $750,000 grant
from the National Institute of Allergy and Infectious Diseases
(NIAID) at the National Institutes of Health for
AVANIRs two-year project on Human Antibodies for Exposure/
Protection from Anthrax. This grant follows the initial $100,000
grant from the SBIR program of NIAID that AVANIR was awarded in
October 2003. The combined grants are being used to further
develop AVANIRs fully human monoclonal antibodies to
anthrax toxins using our proprietary technology. We intend to
seek additional government grants to complete the development
process required prior to submitting an investigational new drug
application (IND) to the FDA. However, there can be
no assurance that these research programs will receive
additional government grants.

AVANIR has a cross-license and research
collaboration agreement with VaxGen Inc. for the development and
manufacture of pre-clinical supplies of our monoclonal antibody
candidates for prevention and treatment of anthrax infections.
Such collaboration for manufacturing of supplies becomes
effective only if AVANIR is able to receive additional
government grants. The collaboration, signed in January 2004,
combines AVANIRs proprietary expertise to discover,
characterize and develop highly potent anthrax antibodies with
VaxGens current good manufacturing practices
(cGMP) protein manufacturing capability and
experience gained through its anthrax vaccine development
program.

AVANIRs antibody technology involves the
development and generation of fully human antibodies from human
lymphoid cells engrafted into severe combined immunodeficient
(SCID) mice. We stimulate engrafted human cells in
the mice with the antigenic target to which the cells respond by
producing antibodies specific to the target. We identify the
human cells that are producing antibodies of interest and then
rescue the antibody DNA by standard recombinant technology. Our
technology enables us to mimic the in vivohuman antibody
response in generating multiple antibodies with various
combinations of affinity and specificity characteristics to an
antigenic target. Our antibody technology is at an early stage
of development and we cannot provide any assurances that any of
our preclinical products will ever reach the clinical
development stage or be successful.

Inventory and Docosanol Supply

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

Competition

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

Neurodex for PBA.Although we anticipate that Neurodex will be the first product
to be marketed for the treatment of PBA, assuming the FDA
approves the drug, we are aware that physicians may utilize other

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products in an off-label manner for the treatment
of this disorder. For example, Neurodex may face worldwide
competition from the following products:




| |   |                                                                                                          
| | - | ---------------------------------------------------------------------------------------------------------
| |  | Antidepressants, including Prozac®,
    Celexa®, Zoloft®, Paxil®, Elavil® and
    Pamelor® and others;   
|
| |  | Atypical antipsychotics agents, including
    Zyprexa®, Resperdal®, Abilify®, Geodon® and
    others; and
|
| |  | Miscellaneous agents, including Symmetrel®,
    Lithium and others.                                      

Neurodex for neuropathic
pain.We anticipate that Neurodex for
the treatment of neuropathic pain, if fully developed by the
Company and approved by the FDA for marketing, will compete with
other drug products that are currently prescribed by physicians.
Such products currently prescribed by clinicians to treat
neuropathic pain include:



| |   |                                                                                                                                                
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------
| |  | Cymbalta®                                                                                                                                      
|
| |  | Narcotic products and                                                                                                                          
|
| |  | Off-label uses of non-narcotic products, such as
    the anticonvulsants phenytoin and carbamazepine, and the
    antidepressant amitriptyline.

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

AVP-13358 (IgE down-regulation
program).Our IgE down-regulation
program competes with several research approaches and numerous
compounds under development by large pharmaceutical and
biotechnology companies. One such example is the anti-IgE
therapy using rhuMAB-E25 (Xolair®), a recombinant humanized
monoclonal antibody developed in a collaboration between
Genentech, Tanox and Novartis. The injectable antibody Xolair
was approved for marketing by the FDA in 2003. Other competitive
and successful products already established in the marketplace
include non-sedative antihistamine products, such as
Shering-Ploughs Claritin® loratadine ($3 billion
in annual sales) and Aventis Allegra®/ Telfast®
($1 billion in annual sales).

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

Patents and Proprietary Rights

Patents.AVANIR
presently owns or has the rights to 94 issued patents (26 U.S.
and 68 foreign) and 250 applications pending (30 U.S. and 220
foreign). Patents and patent applications owned by the Company
include docosanol-related products and technologies, Xenerex
technologies for developing monoclonal antibodies,
NeurodexTM, compounds capable of down-regulating the
target IgE in controlling symptoms of

7



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allergy and asthma, compounds capable of
down-regulating the target MIF in the treatment of several
inflammatory diseases, and compounds for the treatment of
atherosclerosis.


|                                                         |  |                                 |    |                  |  |         |              |        |  |                  |    |         |  |  |    |  |  |  |         |  |  |  |     | 
|-------------------------------------------------------- |  | ------------------------------- | -- | ---------------- |  | ------- | ------------ | ------ |  | ---------------- | -- | ------- |  |  | -- |  |  |  | ------- |  |  |  | --- | 
|                                                         |  |                                
|                                                         |  | Patents and Patent Applications
|                                                         |  |                                
|                                                         |  |                                 |    |                 
|                                                         |  | United States                   |    | Foreign         
|                                                         |  |                                 |    |                 
|Description:                                             |  | Issued                          |    | Expiration Dates |  | Pending |              | Issued |  | Expiration Dates |    | Pending
|                                                         |  |                                 |    |                  |  |         |              |        |  |                  |    |        
|Docosanol-related technologies                           |  |                                 | 10 |                  |  |         | 2009 to 2016 |        |  |                  | 4  |         |  |  | 44 |  |  |  | Various |  |  |  | 64  | 
|Xenerex proprietary antibody generation
    technologies |  |                                 | 5  |                  |  |         | 2012 to 2015 |        |  |                  | 3  |         |  |  | 14 |  |  |  | Various |  |  |  | 0   | 
|IgE down-regulation technology                           |  |                                 | 5  |                  |  |         | 2018 to 2019 |        |  |                  | 10 |         |  |  | 9  |  |  |  | Various |  |  |  | 90  | 
|Neurodex                                                 |  |                                 | 6  |                  |  |         | 2010 to 2015 |        |  |                  | 2  |         |  |  | 1  |  |  |  |        |  |  |  | 12  | 
|MIF inhibitor technology                                 |  |                                 | 0  |                  |  |         |             |        |  |                  | 4  |         |  |  | 0  |  |  |  |        |  |  |  | 44  | 
|Atherosclerosis                                          |  |                                 | 0  |                  |  |         |             |        |  |                  | 7  |         |  |  | 0  |  |  |  |         |  |  |  | 10  | 
|                                                         |  |                                 |    |                  |  |         |              |        |  |                  |    |         |  |  |    |  |  |  |         |  |  |  |     | 
|Total                                                    |  |                                 | 26 |                  |  |         |              |        |  |                  | 30 |         |  |  | 68 |  |  |  |         |  |  |  | 220 | 
|                                                         |  |                                 |    |                  |  |         |              |        |  |                  |    |         |  |  |    |  |  |  |         |  |  |  |     | 

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

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

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

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

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

Atherosclerosis.The
patent applications pending for our potential treatment of
atherosclerosis relate to the general structures currently under
development in preclinical research.

We cannot assure you that the claims in our
pending patent applications will be issued as patents, that any
issued patents will provide us with significant competitive
advantages, or that the validity or enforceability of any of our
patents will not be challenged or, if instituted, that these
challenges will not be successful. The cost of litigation to
uphold the validity and prevent infringement of our patents
could be substantial. Furthermore, we cannot assure you that
others will not independently develop similar technologies or
duplicate our technologies or design around the patented aspects
of our technologies. We can provide no assurance that our
proposed technologies will not infringe patents or other rights
owned by others, the licenses to which might not be available to
us. In addition, the National Institutes of Health regulations
provide that, if federally funded entities do not pursue patent
applications for patentable inventions in a timely manner, then
the government may exercise its rights 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.

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



| |   |                                                                          
| | - | -------------------------------------------------------------------------
| |  | Our trade secrets will be maintained;                                    
|
| |  | Secrecy obligations will be honored; or                                  
|
| |  | Others will not independently develop similar or
    superior technology.

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

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

Government Regulations

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



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

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

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



| |   |                                                                                                                                                                                                                                                                                                                                 
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | Phase Iinvestigations are generally conducted
    in healthy subjects. In certain instances, subjects with a
    life-threatening disease, such as cancer, may participate in
    Phase I studies that determine the maximum tolerated dose
    and initial safety of the product;                                              
|
| |  | Phase IIstudies 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 IIIstudies 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 an NDA. Although the FDAs
requirements for clinical trials are well established and we
believe that we have planned and conducted our clinical trials
in accordance with the FDAs applicable regulations and
guidelines, these requirements, including requirements relating
to testing the safety of drug candidates, may be subject to
change as a result of recent announcements regarding safety
problems with approved drugs. (See Risk Factors that Might
Affect Future Operations.)

The FDAs Center for Drug Evaluation and
Research (CDER) 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

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that may be established in or outside the
U.S. will be subject to rigorous regulation, including
compliance with current good manufacturing practices. We also
may be subject to regulation under the Occupational Safety and
Health Act, the Environmental Protection Act, the Toxic
Substance Control Act, the Export Control Act and other present
and future laws of general application. In addition, the
handling, care and use of laboratory mice, including the
hu-PBL-SCID mice and rats, are subject to the Guidelines for the
Humane Use and Care of Laboratory Animals published by the
National Institutes of Health.


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

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

Human Resources

As of December 7, 2004, we employed 60
persons, including 38 engaged in research and development
activities and clinical and regulatory affairs, 5 in commercial
development, and 17 engaged in administrative functions such as
human resources, finance, accounting, purchasing and investor
relations. Our staff includes 29 employees with Ph.D. or M.D.
degrees. None of our employees are members of a union. We
believe that our relationship with our employees is good.

Risk Factors That Might Affect Future
Operations

We have a history of losses and we may never
achieve or maintain profitability.

To date, we have experienced significant
operating losses in funding the research, development and
clinical testing of our drug candidates and we expect to
continue to incur substantial operating losses through at least
fiscal 2006. As of September 30, 2004, our accumulated
deficit was approximately $124.4 million. To achieve
profitability, we would need to generate significant additional
revenue with positive gross margins to offset our other
operating expenses. Additionally, we intend to increase our
pre-launch activities and sales and marketing efforts over the
next several quarters as we prepare for submission of an NDA to
the FDA for Neurodex and await the FDAs decision. We could
also increase spending on our preclinical programs to the extent
our progress in development is favorable. Although we are
seeking to negotiate revenue-generating licenses and/or
co-promotion arrangements for docosanol 10% cream and other
product candidates, we may not find attractive arrangements, if
at all, and any such arrangements may not provide adequate
revenues to cover future operating expenses. Increases in
expenditures may not be offset by new or adequate sources of
revenues, and as a result, we may not achieve or maintain
profitability.

Although our Phase III clinical trial for
Neurodex in MS patients with PBA showed favorable results, we
must submit our results for this study and other studies to the
FDA for review and approval prior to
U.S. commercialization. Any delay in the regulatory review
or approval process may harm our prospects and could harm our
stock price.

We intend to begin submission of an NDA for
Neurodex to the FDA by December 31, 2004 and must obtain
FDA approval prior to commercialization in the United States.
Any delays in our submission or in the FDAs review or
approval would delay market launch and increase our cash
requirements and could increase the volatility of our stock
price and result in additional operating losses.

The process of obtaining FDA approval typically
takes many years and can vary substantially based upon the type,
complexity and novelty of the products involved. FDAs
review and approval of the actual NDA

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submission is expensive and uncertain. Although
we expect to begin submission of an NDA for Neurodex to the FDA
by December 31, 2004, we may not be able to maintain our
proposed schedule and may not complete our submission in a
timely manner. If we submit an NDA for Neurodex, the FDA must
decide whether to accept or reject the submission for filing.
The FDAs official filing of an NDA is the action that
begins the applications substantive review. The FDA may
refuse to file an NDA for review for many reasons, including if
the submission contains insufficient data to demonstrate
efficacy and safety. We cannot be certain that our NDA
submission would be accepted for filing and reviewed by the FDA
or that we would be able to respond to any requests during the
review period in a timely manner without delaying potential
action on our request for approval. Additionally, recent public
announcements regarding safety problems with a few approved
drugs may affect the FDAs policies regarding safety data
for new drug applications and may result in the FDA requiring
additional safety data before accepting our planned NDA
submission and closer surveillance after a drug is approved.


We also cannot be certain that Neurodex will
receive a favorable recommendation from any FDA advisory
committees or be approved for marketing by the FDA. Even if the
FDA grants us marketing approval for Neurodex, we cannot be
certain that we will be able to obtain the labeling claims
necessary or desirable for the promotion of the product. In
addition, delays in approvals or rejections of marketing
applications may be based upon many factors, including
regulatory requests for additional analyses, reports, data
and/or studies, regulatory questions regarding data and results,
changes in regulatory policy during the period of product
development and/or the emergence of new information regarding
our products or other products.

We have yet to market or sell Neurodex or any
of our other potential products.

Although we may market Neurodex in the United
States through the recruitment of experienced marketing and
sales personnel, assuming Neurodex is approved by the FDA, we
have never before marketed or sold any pharmaceutical products.
In order to market or co-market Neurodex or certain other drug
candidates, we will need to hire a significant number of people
with relevant pharmaceutical experience to staff our sales force
and marketing group, and possibly also to make appropriate
arrangements with collaborative partners. If we cannot develop
the required marketing and sales expertise internally or through
our partnering arrangements, our ability to generate revenue
from product sales will likely suffer.

In the international markets, we intend to rely
on collaborative partners to obtain regulatory approvals, and to
market and sell our products in those markets. We have not yet
entered into any collaborative arrangement with respect to
marketing or selling Neurodex with the exception of agreements
relating to Israel. We cannot guarantee that we will be able to
enter into any other arrangements on terms favorable to us, or
at all. If we are able to enter into marketing and selling
arrangements with collaborative partners, we cannot assure you
that such marketing collaborators will apply adequate resources
and skills to their responsibilities, or that their marketing
efforts will be successful. If we are unable to enter into
favorable collaborative arrangements with respect to marketing
or selling Neurodex or docosanol 10% cream or our marketing
collaborators efforts are not successful, our ability to
generate revenue from product sales will suffer.

We expect that we will need to raise
additional capital to fund ongoing operations through at least
2006. If we are unable to raise additional capital, we may be
forced to curtail operations. If we succeed in raising
additional capital through a licensing or financing transaction,
it may affect our stock price and future revenues.

In order to maintain sufficient cash and
investments to fund future operations, we will need to raise
additional capital. We expect to seek to raise additional
capital over the next 12 to 24 months through various
alternatives, including licensing or sales of our technologies
and drug candidates and selling shares of our Class A
common stock.



| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | If we raise capital through licensing or sales of
    one or more of our technologies or drug candidates, then we may
    not realize revenues from product sales for products that are
    successfully developed, approved by the FDA and marketed. If we
    license any of our technologies or drug candidates, then the
    development of these products or technologies may no longer be
    in our control. A licensee might not ever reach any of the
    milestones in a license agreement and we would not earn any
    additional payments

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| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |   | in such an event. Further, if we sell any of our
    technologies or drug candidates, the sales price may not fully
    cover our investment in such technology or drug candidate.                                                                                                                                                                                                                                                                                                                    
|
| |  | If we raise capital by issuing additional shares
    of Class A common stock at a price per share less than the
    then-current market price per share, the value of the shares of
    Class A common stock then outstanding may be reduced.
    Further, even if we were to sell shares of common stock at
    prices equal to or higher than the current market price, the
    issuance of additional shares may depress the market price of
    our Class A common stock and dilute voting rights.
|
| |  | We may not be able to raise capital on terms that
    we find acceptable, or at all. If we are unable to raise
    additional capital to fund future operations, then we might have
    to reduce operations or defer or abandon one or more of our
    clinical or preclinical research programs. Any of these actions
    could be expected to have an adverse effect on our stock price.                                                                                                           

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

Historically, we have had only limited recurring
revenue. As a result, operating results have been, and will
continue to be, subject to significant quarterly fluctuations
based on a variety of factors, including:



| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | Co-promotion or license
    arrangements We are
    currently seeking co-promotion or licensing partners for
    docosanol 10% cream and Neurodex, as well as for our
    compounds targeting IgE (allergy and asthma), MIF
    (inflammation) and apolipoprotein A1 (atherosclerosis). It
    is difficult to predict whether any of these discussions will
    result in a partnering or license arrangement and what the
    financial terms of such an arrangement might be. If we do enter
    into any such arrangements, the recognition of the revenue under
    those arrangements may depend on the efforts and performance of
    our licensees or partners in reaching milestones that are
    outside our control. Such milestones may include specific
    events, such as regulatory approval, product launch, the passage
    of time, or reaching a sales threshold.                                                                                                                                                            
|
| |  | Limited rights to future Abreva
    royalties In December
    2002, we sold to Drug Royalty USA the rights to a
    substantial portion of our future royalty revenues from sales of
    Abreva by GlaxoSmithKline. We will not receive any future
    royalty payments unless and until annual Abreva wholesale sales
    exceed $62 million, at which time we will receive one-half
    of the stated royalty rate on any excess sales. We expect that
    any royalty payments on these excess sales, if any, would occur
    only once a year, after the end of each calendar year.                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|
| |  | Concentration of significant customers,
    suppliers and industries
    Milestone payments, royalties earned, and revenues recognized
    from the sale of rights to royalties from a single licensee
    (GlaxoSmithKline) accounted for approximately 48%, 73% and 95%
    of our fiscal 2004, 2003 and 2002 revenues, respectively. We
    have now received all of the milestone payments from
    GlaxoSmithKline for North America. With the sale of our Abreva
    royalty rights to Drug Royalty USA, future royalty payments
    from GlaxoSmithKline will come exclusively from our remaining
    50% share of Abreva royalties on contract sales in excess of
    $62 million a year. Additionally, we purchase the raw
    material docosanol from a sole foreign supplier that has been
    approved by the FDA for manufacturing. Any disturbances or
    delays in the manufacture of docosanol or other raw materials
    for our products and clinical research programs could seriously
    and adversely affect our business.
|
| |  | Acquisitions/
    alliances If, in the
    future, we acquire technologies, products, or businesses, or we
    form alliances with companies requiring technology investments
    or commitments, we will face a number of risks to our business.
    The risks that we may encounter include those associated with
    integrating operations, personnel, and technologies acquired or
    licensed, and the potential for unknown liabilities of the
    acquired business. Our business and operating results on a
    quarterly basis could be adversely affected if any or our
    acquisition or alliance activities, to the extent they exist in
    the future, are not successful.                                                                                                                                                                                                                                                                                                                                                      

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Our stock price is highly volatile and
investors may not be able to sell their shares at or above the
price they pay for them.

The market price of our Class A common stock
has been, and is likely to continue to be, highly volatile. The
following factors, among others, could have a significant impact
on the market price of our Class A common stock:



| |   |                                                                                                                                                             
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | Our success or failure in entering into license
    and/or co-promotion arrangements for our products and product
    candidates;                           
|
| |  | Unfavorable or delayed announcements by us
    regarding clinical trial results or results of operations, or
    favorable announcements by our competitors;
|
| |  | Delays in meeting goals or performance milestones
    by us or our marketing partners;                                                                      
|
| |  | Comments made by securities analysts, including
    changes in, or failure to achieve, financial estimates or
    milestones;                               
|
| |  | Announcements of financing transactions and/or
    future sales of equity or debt securities;                                                               
|
| |  | Announcements by us of significant acquisitions,
    strategic partnerships, joint ventures or capital commitments;                                         
|
| |  | Sales of our Class A common stock by our
    directors, officers or significant shareholders; and                                                           
|
| |  | Market and economic conditions.                                                                                                                             

In addition, the market for biotechnology and
pharmaceutical stocks has experienced significant price and
volume fluctuations that are frequently unrelated to operating
performance. This price volatility is often more pronounced for
companies with a low stock price and a small market
capitalization, such as ours. These broad market and industry
factors might seriously harm the market price of our
Class A common stock, regardless of our operating
performance.

A significant decline in our stock price, or
other factors, could also result in our Class A common
stock being delisted from the American Stock Exchange and could
result in litigation, including a securities class action
lawsuit. Such a lawsuit against us could result in substantial
costs, potential liabilities and the diversion of
managements attention and resources.

The Board of Directors has the authority to
effect a reverse stock split within a stated range until
March 18, 2005. If implemented, the reverse stock split may
negatively affect the price and liquidity of our Class A
common stock.

At our 2004 Annual Meeting of Shareholders, the
Board of Directors received the authority to implement, within
its discretion and for a period of one year, a reverse split of
our Class A common stock within a range of 1:2 to 1:12.5.
If the Board of Directors were to effect a reverse stock split,
the bid price of the Class A common stock may not continue
at a level in proportion to the reduction in the number of
outstanding shares resulting from the reverse stock split. For
example, if the Board of Directors decided to implement a
reverse stock split at a ratio of 1-for-5, the post-split market
price of our Class A common stock may not be at least five
times greater than the pre-split price. Accordingly, the total
market capitalization of our Class A common stock after a
reverse stock split, if implemented, could be lower than the
total market capitalization before the proposed reverse stock
split. Additionally, the liquidity of our Class A common
stock could be affected adversely by the reduced number of
shares outstanding after the reverse stock split.

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

The drug development process is lengthy and
capital-intensive. Since September 1998, we have spent
approximately $71.6 million in preclinical and clinical
studies researching the safety and efficacy of our drug
candidates and potential drug candidates. If any of our drug
candidates fail to demonstrate the desired safety and efficacy,
we may abandon the development of the compound, in which event
we would not recover our

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expenditures incurred to date for that compound.
If a compound appears to be safe and effective in preclinical
studies, we may decide to proceed with human clinical trials.
The full complement of clinical trials required to obtain
regulatory approval for many of our drug development programs
exceeds our available capital. Because of our limited financial
resources, we may be required to license the compound to a
pharmaceutical company with greater financial resources in order
to complete the development of the drug. We may be unable to
find a large pharmaceutical company interested in licensing the
drug or, if we do locate such a licensee, the proposed license
terms may not 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.


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.

Currently, docosanol 10% cream is approved for
sale in the United States, Canada, Korea, Israel, Sweden, Spain
and Portugal. We are currently seeking approval in various other
countries in the European Union and intend to seek approval in
Japan. AVANIR and its licensees face a variety of risks in
foreign countries in obtaining regulatory approval and in
marketing and selling docosanol 10% cream, including:



| |   |                                                                                                                                                                                                                                                                                                                                                                   
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | Regulatory approval requirements differ by
    country, and obtaining approvals to market the drug in foreign
    countries may be difficult to obtain, may require additional
    costly and time consuming clinical trials, or may require being
    a prescription drug 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.                                                                                                                                                                                                                                              

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. We also have exclusive license
agreements for docosanol 10% cream for approximately fourteen
other countries. We are holding discussions with other potential
licensees for marketing and selling docosanol 10% cream in other
countries not already licensed. However, we may not finalize any
license or distribution arrangements for other territories on a
timely basis or on favorable terms, if at all. Further, our
foreign licensees expose us to various foreign trade risks
relating to development and marketing of docosanol 10% cream. We
may arrange for contracts in the future for the manufacture,
marketing and distribution of docosanol 10% cream overseas by
foreign licensees, which will be substantially outside our
control. Even if we are able to obtain experienced licensees in
foreign markets, specific risks that could impact significantly
our potential revenues on foreign sale 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, including
    related to terrorism;        
|
| |  | Difficulty in finding foreign partners with
    sufficient capital to effectively launch, market and promote the
    product;

14



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##### Table of Contents





| |   |                                                                                     
| | - | ------------------------------------------------------------------------------------
| |  | Manufacturing and shipping delays;                                                  
|
| |  | Difficulties in managing operations across
    disparate geographic areas;          
|
| |  | Fluctuations in foreign 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 inability to attract and retain key
management and scientific personnel could negatively affect our
business.

Our success depends on the performance of a small
core staff of key management and scientific employees with
biotechnology 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.
Other than our chief executive officer, our executives do not
have employment agreements. We do not have key
person life insurance policies for any of our executives.
The industry in which we compete has a high level of employee
mobility and aggressive recruiting of skilled personnel. This
type of environment creates intense competition for qualified
personnel, particularly in product research and development,
sales and marketing, and accounting and finance.

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

We rely substantially on the protection of our
intellectual property through our ownership or control of
94 issued patents and 250 patent applications. Patents and
patent applications owned or controlled by the Company include
docosanol-related products and technologies, Neurodex, compounds
capable of regulating the target IgE in controlling symptoms of
allergy and asthma, compounds capable of regulating the target
MIF in treatment of inflammatory diseases, compounds targeting
apolipoprotein A1 for the treatment of atherosclerosis, and
Xenerex technologies for developing monoclonal antibodies.
Because of the competitive nature of the biopharmaceutical
industry, we cannot assure you that:



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

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

15



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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.


We depend on third parties to manufacture
compounds for our drugs and drug candidates. The failure of
these third parties to perform successfully could harm our
business.

We have utilized, and intend to continue
utilizing, third parties to manufacture docosanol 10% cream,
Neurodex, active pharmaceutical ingredients, and supplies for
our other drug candidates. We have no experience in
manufacturing and do not have any manufacturing facilities.
Currently, we have only a single supplier for the raw material
docosanol and we do not have any long-term supply agreements in
place with this manufacturer. Although we and GlaxoSmithKline
maintain a strategic reserve of the active pharmaceutical
ingredient, docosanol, to mitigate against a short-term supply
disruption, any sustained disruption of our supply could harm
our operations.

Because we depend on clinical research centers
and other contractors for clinical testing and for certain
research and development activities, the results of our clinical
trials and such research activities are, to a certain extent,
beyond our control.

The nature of clinical trials and our business
strategy of outsourcing a substantial portion of our research
require that we rely on clinical research centers and other
contractors to assist us with research and development and
clinical testing activities. As a result, our success depends
partially on the success of these outside parties in performing
their responsibilities. Although we pre-qualify our contractors
and we believe that they will fully perform their contractual
obligations, we cannot directly control the adequacy and
timeliness of the resources and expertise that they apply to
these activities. If our contractors do not perform their
activities in an adequate or timely manner, the development and
commercialization of our drug candidates could be delayed.

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

The testing, marketing, and sale of
pharmaceutical products involves the risk of product liability
claims by consumers and other third parties. We maintain product
liability insurance coverage for our clinical trials in the
amount of $5 million per incident and $5 million in
the aggregate. However, product liability claims can be high in
the pharmaceutical industry and our insurance may not
sufficiently cover our actual liabilities. If a suit against our
business or proposed products is successful, then the lack of 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.

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

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

Business interruptions could adversely affect
our business.

Our operations are vulnerable to interruption by
fire, earthquake, power loss, telecommunications failure, and
other events beyond our control. For example, during 2001 and
again in 2003, we experienced electrical power outages lasting
several hours. The loss of electrical power for any significant
periods of time could adversely affect our ability to conduct
experiments and could also harm our vendors. Further, we could
lose

16



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valuable data made to date in experiments
currently underway. We have mitigated the severity of power
losses by installing emergency power equipment, which we have
used on several occasions to supply electricity to the areas
that we consider to be the most critical to our operations.
However, the emergency power units do not cover all of our
electrical needs and, further, they might not operate properly
in the event of a power loss.


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

We measure compensation expense for our employee
stock compensation plans under the intrinsic value method of
accounting prescribed by Accounting Principles Board Opinion
No. 25, Accounting for Stock Issued to
Employees. In addition, we provide pro forma disclosures
of our operating results in our Notes to Consolidated Financial
Statements as if the fair value method of accounting had been
applied in accordance with SFAS No. 123,
Accounting for Stock-Based Compensation. Had we
accounted for our compensation expense under the fair value
method accounting prescribed by SFAS No. 123, the
charges would have been significantly higher, by approximately
$1,003,000, $1,554,000 and $2,176,000 during fiscal 2004, 2003,
and 2002, respectively. In October 2004, the Financial
Accounting Standards Board (the FASB) announced the
planned effective date for proposed changes to accounting rules
concerning the recognition of stock option compensation expense
to be the first period after June 15, 2005, or effectively
July 1, 2005. We expect that the new FASB rules covering
stock-based compensation will be issued soon. We and other
companies will be required to measure compensation expense using
the fair value method, which will adversely affect our results
of operations by reducing our income or increasing our losses by
an amount equal to the difference in the two measurement methods.

Risks Relating to Our Industry

The pharmaceutical industry is highly
competitive and most of our competitors are larger and have
greater resources. As a result, we face significant competitive
hurdles.

The pharmaceutical and biotechnology industries
are highly competitive and subject to significant and rapid
technological change. We compete with hundreds of companies that
develop and market products and technologies in similar areas as
our research. Additionally, many physicians prescribe
medications for indications other than those for which a certain
drug has been approved (so called off-label use).
For example, if the FDA approves Neurodex for marketing as a
treatment of PBA, physicians may continue prescribing other
products in an off-label manner for the treatment of this
condition, including:



| |   |                                                                                                        
| | - | -------------------------------------------------------------------------------------------------------
| |  | Antidepressants, such as Prozac®,
    Celexa®, Zoloft®, Paxil®, Elavil® and
    Pamelor® and others;   
|
| |  | Atypical antipsychotics agents, such as
    Zyprexa®, Resperdal®, Abilify®, Geodon® and
    others; and
|
| |  | Other agents, such as Symmetrel® and Lithium                                                           

Our competitors may have specific expertise and
technologies that are better than ours and many of these
companies, either alone or together with their research
partners, have substantially greater financial resources, larger
research and development staffs and substantially greater
experience than we do. Accordingly, our competitors may develop
a competing product approved specifically for the treatment of
PBA. If we commence commercial sales for Neurodex, we may
potentially be competing with other companies and their products
with respect to manufacturing efficiencies and marketing
capabilities, areas where we have limited or no direct
experience.

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

Government 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 of the proposed products. We may find it

17



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necessary to use a significant portion of our
financial resources for research and development and the
clinical trials necessary to obtain these approvals for our
proposed products. We will continue to incur costs of
development without any assurance that we will ever obtain
regulatory approvals for any of our products under development.
Additionally, we cannot predict the extent to which adverse
government regulations might arise from future U.S. or
foreign legislative or administrative actions. 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, or the costs of
on-going compliance regulations after marketing approval has
been obtained. Future changes could affect adversely the time
frame required for regulatory review, our financial resources,
and the sales prices of our proposed products, if approved for
sale.


Companies in our industry must protect their
intellectual property rights and operate without infringing on
or misappropriating the proprietary rights of others. Our
inability to do so could be costly and could significantly
affect our business prospects.

Biotechnology companies such as AVANIR rely
heavily on intellectual property rights to protect their
innovations. Although we attempt to protect these rights by
regularly filing patent applications and requiring all employees
to sign confidentiality agreements, we cannot assure you that
patents will be issued, that secrecy obligations will be
honored, or that others will not independently develop similar
or superior technology. Additionally, if our consultants, key
employees or other third parties apply technological information
independently developed by them or by others to our projects,
then disputes may arise as to the ownership rights of these
innovations.

Even if we successfully preserve our intellectual
property rights, other biotechnology or pharmaceutical companies
may allege that our technology infringes on their rights.
Intellectual property litigation is costly, and even if we were
to prevail in such a dispute, the cost of litigation would
adversely affect our business, financial condition and results
of operations. Litigation is also time consuming and would
divert managements attention and resources away from our
operations and other activities. If we were not to prevail in
any litigation, in addition to any damages we would have to pay,
we could be required to stop the infringing activity or obtain a
license. Any required license might not be available to us on
acceptable terms. Some licenses might be non-exclusive, and our
competitors could have access to the same technology licensed to
us. If we were to fail to obtain a required license or were
unable to design around a competitors patent, we would be
unable to sell or continue to develop some of our products,
which would have a material adverse effect on our business,
financial condition and results of operations.

Companies in our industry are frequently
subjected to product liability claims, which can be very costly
to defend against.

In the ordinary course of business, biotechnology
and pharmaceutical companies face various claims brought by
third parties, including claims relating to the safety or
efficacy of 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.



|        |           
|------- | ----------
|Item 2. | Properties

We currently lease 57,582 square feet of
laboratory and office space in three buildings located at 11388,
11404, and 11408 Sorrento Valley Road, San Diego,
California for combined base rental payments of approximately
$142,000 per month in fiscal 2005. Our lease agreements
provide for scheduled rent increases each year. The agreement
for the building at 11388 Sorrento Valley Road expires on
August 31, 2008. The lease agreement for buildings at 11404
and 11408 Sorrento Valley Road expires on January 14,
2013. See Note 4, Commitments and
Contingencies, in the accompanying Notes to Consolidated
Financial Statements and Exhibits 10.2 and 10.7. We
maintain irrevocable standby letters of credit to the lessors or
their creditors, totaling $857,000 to secure our performance
under the leases.

18



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##### Table of Contents





|        |                  
|------- | -----------------
|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

There were no matters submitted to a vote of the
security holders of AVANIR Pharmaceuticals during the fourth
quarter of fiscal 2004.

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 closing sales prices for our Class A common stock in
each of the quarters over the past two fiscal years, as quoted
on the AMEX.

|               |  |              |      |     |  |   |      | 
|-------------- |  | ------------ | ---- | --- |  | - | ---- | 
|               |  |             
|               |  | Class A     
|               |  | Common Stock
|               |  |             
|               |  | High         |      | Low
|               |  |              |      |    
|Fiscal 2004    |  |              |      |     |  |   |      | 
|First Quarter  |  | $            | 1.71 |     |  | $ | 1.42 | 
|Second Quarter |  | $            | 2.24 |     |  | $ | 1.53 | 
|Third Quarter  |  | $            | 1.91 |     |  | $ | 1.33 | 
|Fourth Quarter |  | $            | 3.15 |     |  | $ | 1.56 | 
|Fiscal 2003    |  |              |      |     |  |   |      | 
|First Quarter  |  | $            | 1.24 |     |  | $ | 0.90 | 
|Second Quarter |  | $            | 1.63 |     |  | $ | 0.77 | 
|Third Quarter  |  | $            | 2.22 |     |  | $ | 0.91 | 
|Fourth Quarter |  | $            | 2.00 |     |  | $ | 1.42 | 

On December 7, 2004, the closing sales price
of Class A Common Stock was $3.16 per share.

As of December 7, 2004, we had approximately
19,682 shareholders, including 1,055 holders of record and
an estimated 18,627 beneficial owners. We have not paid any
dividends on our Class A common stock since our inception
and do not expect to pay dividends on our common stock in the
foreseeable future.

19



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##### Table of Contents





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

The selected consolidated financial data set
forth below at September 30, 2004 and 2003, and for the
fiscal years ended September 30, 2004, 2003 and 2002, 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, 2002, 2001 and 2000, and for
the years ended September 30, 2001 and 2000, are derived
from our audited consolidated financial statements that are
contained in reports previously filed with the SEC.

The quarterly consolidated financial data are
derived from unaudited financial statements included in our
Quarterly Reports on Form 10-Q.

Summary Financial Information

|                                                                   |         |                                  |             |            |  |      |             |            |  |      |             |            |  |   |            |            |  |   |            |            | 
|------------------------------------------------------------------ | ------- | -------------------------------- | ----------- | ---------- |  | ---- | ----------- | ---------- |  | ---- | ----------- | ---------- |  | - | ---------- | ---------- |  | - | ---------- | ---------- | 
|                                                                   |         |                                 
|                                                                   |         | Fiscal Years Ended September 30,
|                                                                   |         |                                 
|Statement of operations data:                                      |         | 2004                             |             | 2003       |  | 2002 |             | 2001       |  | 2000
|                                                                   |         |                                  |             |            |  |      |             |            |  |     
|Revenues                                                           |         | $                                | 3,589,317   |            |  | $    | 2,438,733   |            |  | $    | 8,853,742   |            |  | $ | 12,678,602 |            |  | $ | 10,252,818 |           
|Net income (loss)                                                  |         | $                                | (28,154,853 | )          |  | $    | (23,236,348 | )          |  | $    | (10,249,512 | )          |  | $ | 233,122    |            |  | $ | (582,283   | )         
|Net income (loss) attributable to common
    shareholders          |         | $                                | (28,154,853 | )          |  | $    | (23,264,293 | )          |  | $    | (10,292,798 | )          |  | $ | 189,888    |            |  | $ | (801,806   | )         
|Basic net income (loss) per share                                  |         | $                                | (0.36       | )          |  | $    | (0.39       | )          |  | $    | (0.18       | )          |  | $ | 0.00       |            |  | $ | (0.02      | )         
|Diluted net income (loss) per share                                |         | $                                | (0.36       | )          |  | $    | (0.39       | )          |  | $    | (0.18       | )          |  | $ | 0.00       |            |  | $ | (0.02      | )         
|Weighted average number of shares of common stock
    outstanding: |         |                                  |             |            |  |      |             |            |  |      |             |            |  |   |            |            |  |   |            |           
|                                                                   | Basic   |                                  |             | 77,946,413 |  |      |             | 59,896,135 |  |      |             | 58,206,969 |  |   |            | 57,475,748 |  |   |            | 51,784,214 | 
|                                                                   | Diluted |                                  |             | 77,946,413 |  |      |             | 59,896,135 |  |      |             | 58,206,969 |  |   |            | 61,130,415 |  |   |            | 51,784,214 | 

|                                      |                                                                |               |            |            |  |      |            |            |  |      |            |            |  |   |            |            |  |   |            |            | 
|------------------------------------- | -------------------------------------------------------------- | ------------- | ---------- | ---------- |  | ---- | ---------- | ---------- |  | ---- | ---------- | ---------- |  | - | ---------- | ---------- |  | - | ---------- | ---------- | 
|                                      |                                                                |              
|                                      |                                                                | September 30,
|                                      |                                                                |              
|Balance sheet data:                   |                                                                | 2004          |            | 2003       |  | 2002 |            | 2001       |  | 2000
|                                      |                                                                |               |            |            |  |      |            |            |  |     
|Cash and cash equivalents             |                                                                | $             | 13,494,083 |            |  | $    | 12,198,408 |            |  | $    | 8,630,547  |            |  | $ | 16,542,545 |            |  | $ | 19,699,768 |           
|Investments in securities             |                                                                |               | 12,412,446 |            |  |      | 5,258,881  |            |  |      | 4,538,460  |            |  |   | 5,308,691  |            |  |   | 1,568,474  |           
|                                      |                                                                |               |            |            |  |      |            |            |  |      |            |            |  |   |            |            |  |   |            |           
|                                      | Total cash, cash equivalents and investments in
    securities |               | $          | 25,906,529 |  |      | $          | 17,457,289 |  |      | $          | 13,169,007 |  |   | $          | 21,851,236 |  |   | $          | 21,268,242 | 
|Working capital                       |                                                                | $             | 16,653,621 |            |  | $    | 10,619,216 |            |  | $    | 5,918,083  |            |  | $ | 16,027,577 |            |  | $ | 18,774,423 |           
|Total assets                          |                                                                | $             | 37,403,953 |            |  | $    | 29,645,257 |            |  | $    | 20,332,929 |            |  | $ | 27,053,953 |            |  | $ | 23,519,237 |           
|Deferred revenues                     |                                                                | $             | 21,009,115 |            |  | $    | 22,742,641 |            |  | $    | 233,333    |            |  | $ | 125,000    |            |  | $ |           |           
|Notes payable, net of current portion |                                                                | $             | 703,560    |            |  | $    |           |            |  | $    |           |            |  | $ |           |            |  | $ |           |           
|Total liabilities                     |                                                                | $             | 27,206,694 |            |  | $    | 28,608,026 |            |  | $    | 5,752,259  |            |  | $ | 2,592,490  |            |  | $ | 1,922,929  |           
|Convertible preferred stock           |                                                                | $             |           |            |  | $    |           |            |  | $    | 521,189    |            |  | $ | 502,903    |            |  | $ | 465,920    |           
|Shareholders equity                  |                                                                | $             | 10,197,259 |            |  | $    | 1,037,231  |            |  | $    | 14,059,481 |            |  | $ | 23,958,560 |            |  | $ | 21,130,388 |           

20



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|                                                                   |                   |                       |            |                |  |               |            |                    |  |   |            |            |  |   |            |            | 
|------------------------------------------------------------------ | ----------------- | --------------------- | ---------- | -------------- |  | ------------- | ---------- | ------------------ |  | - | ---------- | ---------- |  | - | ---------- | ---------- | 
|                                                                   |                   |                      
|                                                                   |                   | Fiscal Quarters Ended
|                                                                   |                   |                      
|Quarterly statement of operations data for fiscal 2004:            |                   | December 31, 2003     |            | March 31, 2004 |  | June 30, 2004 |            | September 30, 2004
|                                                                   |                   |                       |            |                |  |               |            |                   
|Revenues                                                           |                   | $                     | 1,509,645  |                |  | $             | 855,837    |                    |  | $ | 591,354    |            |  | $ | 632,481    |           
|Net loss                                                           |                   | $                     | (6,280,212 | )              |  | $             | (6,690,555 | )                  |  | $ | (6,617,493 | )          |  | $ | (8,566,593 | )         
|Net loss attributable to common shareholders                       |                   | $                     | (6,280,212 | )              |  | $             | (6,690,555 | )                  |  | $ | (6,617,493 | )          |  | $ | (8,566,593 | )         
|Basic and diluted net loss per share                               |                   | $                     | (0.09      | )              |  | $             | (0.09      | )                  |  | $ | (0.08      | )          |  | $ | (0.09      | )         
|Weighted average number of shares of common stock
    outstanding: |                   |                       |            |                |  |               |            |                    |  |   |            |            |  |   |            |           
|                                                                   | Basic and diluted |                       |            | 67,804,604     |  |               |            | 71,285,690         |  |   |            | 78,256,417 |  |   |            | 94,369,912 | 

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



|        |                                                                                          
|------- | -----------------------------------------------------------------------------------------
|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 is a drug discovery and
development company focused primarily on novel treatments for
chronic diseases. AVANIR is currently developing
NeurodexTM for the treatment of pseudobulbar affect
(PBA) and for the treatment of chronic diabetic
neuropathic pain. We have successfully completed two
Phase III trials of Neurodex in the treatment of PBA in
patients with multiple sclerosis (MS) and with Lou
Gehrigs disease (amyotrophic lateral sclerosis or
ALS), and one Phase II trial for the treatment
of diabetic neuropathic pain. We also have a potential product
for allergy and asthma, AVP-13358, which is in Phase I
clinical development.

Our clinical and preclinical research and drug
discovery programs are focused primarily on small molecules that
can be taken orally as therapeutic treatments. Other small
molecule research programs include potential treatments for
atherosclerosis and inflammation, which are both in the
preclinical development stage. Using our proprietary
XenerexTM technology, we are also conducting research
to develop injectable human monoclonal antibody products for
anthrax, cytomegalovirus, and other infectious diseases.

21



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The following chart illustrates the approximate
status of research activities for our products and product
candidates that are under development.

(CLINICAL-PRECLINICAL ACTIVITIES GRAPH)

We strive to maintain a lean organizational
structure while working on a diverse product development
pipeline. We also strive to maintain flexibility in our cost
structure, by managing over outsourced functions such as
clinical trials, market research, legal counsel and portions of
chemistry, rather than maintain all of these functions in house.
While outsourcing can lead to higher costs in some cases, we
believe the benefits of being flexible, and being able to
rapidly respond to program delays, or successes, and the
availability of capital to advance our programs, far outweigh
the disadvantages. However, even with a lean, flexible
organization, the continued development of our current product
candidates and the potential launch of Neurodex will require
substantial additional capital.

We intend to partner with pharmaceutical
companies that can help fund our research and development
programs in exchange for sharing in the rights to commercialize
new drugs. We have licensed certain rights to docosanol 10%
cream and continue to seek licensees for that product and
potential products in our pipeline. Research collaborations also
represent a significant way to achieve our development goals by
sharing the risks and the opportunities that come from such
development efforts.

We expect that our development and operational
costs will continue to exceed revenues from existing sources
through at least fiscal 2006. We will have to raise significant
amounts of additional capital to continue our research and
development activities, prepare for potential product launch of
Neurodex for PBA and fund other operating activities. Our future
capital needs will depend substantially on the economic terms
and the timing of any new partnership or collaborative
arrangements with pharmaceutical companies under which they will
share the costs of such activities. If we are unable to raise
capital as needed to fund our operations, or if we are unable to
enter into any such collaborative arrangements, then we may need
to slow the rate of development of some of our programs or sell
the rights to one or more of our drug candidates.

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Critical Accounting Policies and
Estimates

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

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



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

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

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

We entered into additional agreements this year
and 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, data transfer fees, and
milestone payments and taking into consideration when the
earnings process is complete and collection is reasonably
assured.



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

We recognize royalty revenues from our licensed
products based on the reported sales by our licensees and
computed in accordance with the specific terms of the license
agreements. Since the launch of Abreva in October 2000 through
September 30, 2004, substantially all of our royalties have
come from GlaxoSmithKline. We have entered into additional
license agreements that contain royalties as a source of
revenues, and we expect to enter into additional similar license
agreements with foreign-based companies in the future.



| |                                              
| | ---------------------------------------------
| | Sale of Rights to Future Abreva
    Royalties

In fiscal 2003, we sold an undivided interest in
our license agreement with GlaxoSmithKline to Drug Royalty USA
for $24.1 million. Because of our ongoing involvement with
GlaxoSmithKline in earning future royalty revenues, we have
recorded the amounts received from Drug Royalty USA, net of
costs of the transaction and forgiveness of certain advances, as
deferred revenue. The amount recorded as deferred revenue is
being recognized as revenue under the units-of-revenue method
over the period from October 2002 through April 2014. Under this
method, the amount of deferred revenue being recognized as
revenue in each period is calculated by multiplying (i) the
ratio of the royalty payments due to Drug Royalty USA for the
period to the

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total remaining royalties that we expect SB will
pay Drug Royalty USA over the term of the agreement, by
(ii) the unamortized deferred revenue amount. The variance
in revenues from quarter-to-quarter under this method has been
as much as $191,000 in fiscal 2004. The portion of deferred
revenue classified as a current liability represents the amount
we expect to realize as revenue within the next 12 months.
(See Note 2, Summary of Significant Accounting
Policies  Deferred Revenue, in the accompanying
Notes to Consolidated Financial Statements.)




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

We may enter into research contracts or
collaborations that have 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 discussed below.

Antibody generation
services.As of September 30,
2004, we had $33,000 in deferred revenue related to a research
collaboration agreement that had research initiation fees. In
this type of agreement, the customer provides us with the target
antigens. We then perform research services to develop potential
antibodies for those antigens. If we are able to estimate the
period of service in the contract in advance of beginning the
work, then we recognize such research initiation fees ratably as
revenue over the estimated period of service. If we are unable
to identify the period of service in the contract in advance of
beginning the work, we defer research initiation fees and
recognize such fees as revenue only when we have completed our
efforts to create the antibodies. In the research phases of the
research collaboration agreement, we may receive payment either
to start a research phase or to complete a research phase
(including receipt by the customer of the deliverable). We
recognize revenue once the product has been delivered because
the earning process is complete and an exchange has been made.
Factors taken into consideration in recognizing revenues include
the following:



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

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



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

Pursuant to managements assessment of the
progress that has been made on clinical trials and services
provided in other research contracts, we recognize expenses as
the services are provided. Several of our contracts extend
across multiple reporting periods, including our largest
contract valued at approximately $3.4 million as of
September 30, 2004. A 5% variance in our estimate of the
percent completed in our largest contract could increase or
decrease our operating expenses by $173,000. Such contracts
require an assessment of the work that has been completed during
the period, including measurement of progress, analysis of data
that justifies the progress, and finally, managements
judgment.

We assess our obligations to make milestone
payments that may become due under licensed or acquired
technology to determine whether the payments should be expensed
or capitalized. We charge milestone payments to research and
development expense when:



| |   |                                                                                     
| | - | ------------------------------------------------------------------------------------
| |  | The technology is in the early stage of
    development and has no alternative uses;
|
| |  | There is substantial uncertainty of the
    technology or product being successful; 
|
| |  | There will be difficulty in completing the
    remaining development; and           
|
| |  | There is substantial cost to complete the work.                                     

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| |                                                      
| | -----------------------------------------------------
| | Capitalization and Valuation of Intangible
    Assets

We capitalize legal costs incurred in connection
with patents, patent applications pending, trademark
applications and license agreements. We amortize costs of
approved patents and license agreements over their estimated
useful lives, or terms of the agreements, whichever are shorter.
For patents pending, we amortize the costs over the shorter of a
period of twenty years from the date of filing the
application or, if licensed, the term of the license agreement.
We re-assess the useful lives of patents when they are issued,
or whenever events or changes in circumstances indicate the
useful lives may have changed. For patent and trademark
applications that we abandon, we charge the remaining
unamortized accumulated costs to expense. AVANIRs
amortizable intangible assets consist of the costs of patents,
patent applications, and licenses.

Intangible assets are evaluated for impairment
whenever events or changes in circumstances indicate that their
carrying value 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.
Factors we consider important that could trigger an impairment
review include the following:



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

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

As of September 30, 2004, our largest group
of intangible assets with finite lives was for our IgE
down-regulation technology, having net intangible assets of
approximately $1.0 million. Any setback or failure in our
IgE technology, currently in Phase I clinical development
for the treatment of allergy and asthma, could cause a
re-assessment of the value of this technology and possible
write-down of all or a portion of the costs of these assets.

Nature of Operating Expenses

AVANIRs operating expenses are influenced
substantially by the amount of spending devoted to clinical
development programs and drug discovery research. During the
past three years, we have substantially expanded our drug
development pipeline, which requires that we allocate
significant amounts of our resources to research and development
activities and professional and consulting fees related to
clinical trials programs, which also have increased
substantially over the same period. We expect research and
development expenses will represent approximately 60% of our
operating expenses for fiscal 2005, compared with 70% for fiscal
2004, as we embark on pre-launch planning and sales and
marketing programs for Neurodex.

Other than research and development, our
operating expenses are primarily related to sales and marketing
and general and administrative areas. We expect that sales and
marketing will increase as a percentage of total operating
expenses in fiscal 2005, compared to fiscal 2004. We attribute
the increased allocation to sales and marketing to our medical
education and marketing programs for Neurodex. The balance of
spending relates to general and administrative functions,
including the Companys board of directors, securities
compliance, corporate governance, human resources, finance and
investor relations. Our spending on general and administrative
support staff tends to follow trends in other areas, but to a
lesser extent. General and administrative expenses have tended
to increase since the adoption of the Sarbanes-Oxley Act of
2002. Occupancy costs, including building rent, utilities,
maintenance, operation of our laboratory and office facilities,
insurance and depreciation, are allocated to the various
departments based on headcount. Building rent amounting to
approximately $1.8 million in fiscal 2004 has scheduled
rent increases of approximately 4% a year for at least the next
three years.

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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 results of operations and
financial condition.

Effects of Inflation

We believe the impact of inflation and changing
prices on net sales revenues and on operations has been minimal
during the past three years.

Results of Operations

Comparison of Fiscal 2004 and 2003



| |                             
| | ----------------------------
| | Revenues  2004 vs.
    2003

Revenues in fiscal 2004 amounted to
$3.6 million, including $1.7 million from the
recognition of deferred revenue relating to the sale of an
undivided interest in our Abreva® license agreement to Drug
Royalty USA (See Note 2, Summary of Significant
Accounting Policies  Deferred Revenue, in the
accompanying Notes to Consolidated Financial Statements),
$787,000 in sales of the active ingredient docosanol to
licensees, $759,000 from government research grants, and
$328,000 from milestones and fees earned in license agreements.
Revenues from government research grants included preclinical
development of docosanol as a potential treatment for genital
herpes ($373,000) and preclinical research on a potential
antibody to anthrax ($265,000). Revenues for fiscal 2003
amounted to $2.4 million, including $1.8 million from
the recognition of deferred revenue relating to the sale of an
undivided interest in our Abreva license agreement, $587,000
from government research grants and $17,000 in docosanol product
sales.

During fiscal 2005, we expect to recognize
approximately $1.8 million in revenues from the recognition
of deferred revenue relating to the sale of an undivided
interest in our Abreva license agreement and $578,000 in
revenues from research being performed under government research
grants. We expect sales of the active ingredient docosanol will
be less than $100,000 in fiscal 2005. Projected fiscal 2005
revenues from new sources, such as license fees and milestone
payments, will depend substantially on our ability to enter into
additional license arrangements and achieve milestones under
those arrangements. Such arrangements could be in the form of
licensing or partnering agreements for docosanol 10% cream,
Neurodex, or for our other product development programs
including potential treatments for PBA, allergy and asthma,
inflammation and atherosclerosis. Many of our product
development programs could take years of additional development
before they reach the stage of licensing, if ever, by other
pharmaceutical companies.



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

Partnering, licensing and research collaborations
have been, and will continue to be, an important part of
AVANIRs business development strategy. We intend to
partner with pharmaceutical companies that can help fund
AVANIRs research in exchange for sharing in the rights to
commercialize new drugs resulting from this research. We have
licensed and continue to seek licensees in other countries for
docosanol 10% cream and other potential products in our
development pipeline. Research collaborations also represent an
important way to achieve our development goals, while sharing in
the risks and the opportunities that come from such development
efforts. Commercial contracts that remained active at the end of
fiscal 2004 include seven docosanol 10% cream license
agreements, one antibody license and one Neurodex sublicense.
The Abreva license arrangement has been our most significant
revenue source during the past four years, accounting for a
majority of revenues in each of those years.



| |                             
| | ----------------------------
| | Expenses  2004 vs.
    2003

Operating expenses.Total operating expenses amounted to $32.0 million in
fiscal 2004, compared to $25.9 million in fiscal 2003. The
$6.1 million or 24% increase in operating expenses was
primarily caused by a $3.9 million or 21% increase in
spending on research and development programs including a
$2.7 million charge in fiscal 2004 related to the issuance
of common stock to the Ciblex Corporation, in lieu of potential

26



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##### Table of Contents



future milestone payments related to our MIF
technology. Clinical development of Neurodex for the treatment
of PBA remained the leading research and development program for
fiscal 2004, accounting for $7.4 million or approximately
33% of all research program spending. We also incurred a
$1.1 million or 24% increase in general and administrative
expense and an $851,000 or 32% increase in sales and marketing.
Research and development programs accounted for 70% and 72% of
total operating expenses for fiscal 2004 and 2003, respectively.
The increase in general and administrative expenses, which
accounted for 18% of total operating expenses for fiscal 2004
and 2003, was primarily attributable to increases in legal,
consulting and other costs associated with corporate governance
and compliance with the Sarbanes Oxley Act of 2002. The increase
in sales and marketing, which accounted for 11% and 10% of total
operating expenses for fiscal 2004 and 2003, respectively, was
primarily because of increased medical education and marketing
activities related to Neurodex. These and other costs are more
fully described below.


Operating Expenses

|                    |                            |                          |  |               |     |      |  |      |     |   |  |    |     |   |  |    |     |  
|------------------- | -------------------------- | ------------------------ |  | ------------- | --- | ---- |  | ---- | --- | - |  | -- | --- | - |  | -- | --- | -
|                    |                            |                          |  |              
|                    |                            | Three Months             |  | Twelve Months
|                    |                            | Ended                    |  | Ended        
|                    |                            | September 30,            |  | September 30,
|                    |                            |                          |  |              
|                    |                            | 2004                     |  | 2003          |     | 2004 |  | 2003
|                    |                            |                          |  |               |     |      |  |     
|Operating expenses: |                            |                          |  |               |     |      |  |      |     |   |  |    |     |   |  |   
|                    | Research and development   |                          |  | 71            | %   |      |  | 72   | %   |   |  | 70 | %   |   |  | 72 | %  
|                    | General and administrative |                          |  | 19            | %   |      |  | 17   | %   |   |  | 18 | %   |   |  | 18 | %  
|                    | Sales and marketing        |                          |  | 10            | %   |      |  | 11   | %   |   |  | 11 | %   |   |  | 10 | %  
|                    | Costs of sales             |                          |  | 0             | %   |      |  | 0    | %   |   |  | 1  | %   |   |  | 0  | %  
|                    |                            |                          |  |               |     |      |  |      |     |   |  |    |     |   |  |   
|                    |                            | Total operating expenses |  |               | 100 | %    |  |      | 100 | % |  |    | 100 | % |  |    | 100 | %
|                    |                            |                          |  |               |     |      |  |      |     |   |  |    |     |   |  |   

Research and development (R&D)
expenses.R&D expenses totaled
$22.5 million in fiscal 2004, including the issuance of
$2.7 million in common stock in connection with the MIF
technology, compared to $18.6 million in fiscal 2003. (See
Note 2, Summary of Significant Accounting
Policies  Research and Development Expenses in
the accompanying Notes to Consolidated Financial Statements.)
Higher R&D spending for fiscal 2004, other than for the MIF
technology, was primarily related to clinical development of
Neurodex for the treatment of PBA. Neurodex had a higher number
of patients enrolled in both the Phase III clinical trial
and the open label safety study in the treatment of PBA in
fiscal 2004, which resulted in a $2.4 million or
47% increase over fiscal 2003 program spending. Costs
associated primarily with Phase I clinical trials of
AVANIRs lead compound for the treatment of allergies and
asthma accounted for 16% of total R&D spending in fiscal
2004. The balance of R&D spending was for other programs,
including pre-clinical research related to the development of
compounds for the treatment of inflammation and atherosclerosis
and antibody research programs.

In fiscal 2003, the clinical trials of Neurodex
for the treatment of PBA in patients with MS accounted for 27%
of all R&D spending. Costs associated with completion of
toxicology, submitting an IND, and initiating Phase I
clinical trials of AVANIRs lead compound for the treatment
of allergies and asthma accounted for 25% of total
R&D spending. The balance of R&D spending was for
other programs, including clinical research of Neurodex for the
treatment of neuropathic pain, pre-clinical research related to
the development of compounds for the treatment of inflammation
and atherosclerosis, and antibody research programs.

Pharmaceutical R&D programs, by their very
nature, require a substantial amount of financial and human
resources and there is no assurance that any drug candidate will
be approved for marketing by domestic and/or foreign regulatory
agencies. The later stages of clinical development typically
require substantially greater funds for development than the
earlier stages. Thus, for many of our larger development
programs, we intend to license our technology or partner with
other pharmaceutical companies that have substantially greater
financial resources. We expect that our licensees will continue
to develop and fund those projects and pay us up-front license
fees, data transfer fees, milestone payments, and royalties on
product sales if those products are successfully developed and
approved for marketing by the U.S. Food and Drug

27



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##### Table of Contents



Administration (FDA) and foreign
regulatory agencies. We caution that many of our development
efforts could experience delays, setbacks and failures, with no
assurance that any of our clinical research or our potential
licensees or partners will ever reach the stage of an NDA with
the FDA or that any NDA will be approved.


The following table sets forth the status of, and
costs attributable to, our proprietary research and clinical
development programs.

Research and Development Projects and
Expenses

|                                                                                                                                                                                         |       |                    |           |                   |  |               |           |           |  |            |           |            |  |   |           |            |  |   |            |            |  |   |      |     | 
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | ----- | ------------------ | --------- | ----------------- |  | ------------- | --------- | --------- |  | ---------- | --------- | ---------- |  | - | --------- | ---------- |  | - | ---------- | ---------- |  | - | ---- | --- | 
|                                                                                                                                                                                         |       |                    |           |                   |  |               |           |          
|                                                                                                                                                                                         |       | Three Months Ended |           | Fiscal Year Ended |  | Inception     |           | Estimated
|                                                                                                                                                                                         |       | September 30,      |           | September 30,     |  | Through       |           | Cost to  
|                                                                                                                                                                                         |       |                    |           |                   |  | September 30, |           | Complete 
|                                                                                                                                                                                         |       | 2004(1)            |           | 2003(1)           |  | 2004(1)       |           | 2003(1)   |  | 2004(1)(2) |           | Project(1)
|                                                                                                                                                                                         |       |                    |           |                   |  |               |           |           |  |            |           |           
|Company-funded Projects:                                                                                                                                                                 |       |                    |           |                   |  |               |           |           |  |            |           |            |  |   |           |            |  |   |            |            |  |   |      |    
|Develop Neurodex for FDA marketing approval in
    treating PBA. Estimated cost and timing to reach NDA decision by
    end of 2005                                                      |       | $                  | 1,112,774 |                   |  | $             | 1,719,327 |           |  | $          | 7,431,450 |            |  | $ | 5,055,929 |            |  | $ | 17,917,633 |            |  | $ | 8M   | (3)
|Develop Neurodex for neuropathic pain.
    Phase II open-label study completed. Estimated cost and
    timing to complete one Phase III trial and license the
    product: up to 2 years |       |                    | 73,667    |                   |  |               | 792,823   |           |  |            | 1,636,582 |            |  |   | 2,093,097 |            |  |   | 6,400,669  |            |  | $ | 8M   | (4)
|Development program for allergy and asthma.
    Estimated timing to complete Phase IIa and license the
    product: up to 2 years                                                        |       |                    | 624,468   |                   |  |               | 1,223,059 |           |  |            | 3,564,324 |            |  |   | 4,709,587 |            |  |   | 18,076,952 |            |  | $ | 13M  |    
|Preclinical atherosclerosis research program.
    Estimated timing to complete proof of concept and to license the
    product: up to 3 years                                            |       |                    | 514,934   |                   |  |               | 235,423   |           |  |            | 1,304,852 |            |  |   | 870,423   |            |  |   | 3,205,044  |            |  | $ | 26M  |    
|Preclinical anti-inflammatory research program
    (MIF inhibitor). Estimated timing to complete Phase IIa and
    to license the product: up to 4 years.(5)                             |       |                    | 3,659,891 |                   |  |               | 610,231   |           |  |            | 5,140,019 |            |  |   | 2,222,095 |            |  |   | 10,142,085 |            |  | $ | 21M  |    
|Other projects involving monoclonal antibodies
    and docosanol                                                                                                                         |       |                    | 510,467   |                   |  |               | 778,526   |           |  |            | 2,425,272 |            |  |   | 2,823,599 |            |  |   | 13,824,512 |            |  |   |     | (6)
|Government-funded Projects:                                                                                                                                                              |       |                    |           |                   |  |               |           |           |  |            |           |            |  |   |           |            |  |   |            |            |  |   |      |    
|Preclinical research, primarily for potential
    treatments for genital herpes, and anthrax. Estimated timing to
    complete the various projects varies from one to two years         |       |                    | 156,240   |                   |  |               | 202,866   |           |  |            | 979,182   |            |  |   | 783,287   |            |  |   | 2,064,747  |            |  | $ | 0.7M | (7)
|                                                                                                                                                                                         |       |                    |           |                   |  |               |           |           |  |            |           |            |  |   |           |            |  |   |            |            |  |   |      |    
|                                                                                                                                                                                         | Total |                    | $         | 6,652,441         |  |               | $         | 5,562,255 |  |            | $         | 22,481,681 |  |   | $         | 18,558,017 |  |   | $          | 71,631,642 |  |   |      |     | 
|                                                                                                                                                                                         |       |                    |           |                   |  |               |           |           |  |            |           |            |  |   |           |            |  |   |            |            |  |   |      |    



---



|    |                                                                                                                                                                                                  
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | Each project includes allocation of laboratory
    occupancy costs. M refers to millions. Estimated
    costs and timing to complete the projects are subject to the
    availability of funds.
|   
|(2) | Inception dates are on or after October 1,
    1998, at which time we began identifying and tracking programs
    costs.                                                                         
|   
|(3) | Total expenditures of $8.0 million include
    an additional $5.0 million in 2005 calendar year to
    complete the open label study and pay for the
    NDA submission fee.                     

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|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(4) | Licensing and co-promotion alternatives are being
    explored whereby a partner would fund a portion of clinical
    development. See Research and Development Program Status
    and Plans. Program expenditures for Neurodex for the
    treatment of neuropathic pain during each of the listed periods
    include allocated costs of certain research projects that are
    shared with Neurodex for PBA. We are in the process of
    developing our Phase III clinical study plan and estimated
    costs could change substantially.
|   
|(5) | Includes a non-cash charge of $2,733,023 related
    to the issuance of Class A common stock in connection with
    the MIF Inhibitor Technology (See Note 2, Summary of
    Significant Accounting Policies  Research and
    Development Expense in the accompanying Notes to
    Consolidated Financial Statements).                                                                                                                                                                                                                     
|   
|(6) | The costs and timing to complete these projects
    are unpredictable because of the uncertainty of outcomes of the
    research.                                                                                                                                                                                                                                                                                                                                                                                                              
|   
|(7) | Represents the remaining balance of State and
    Federal research grant awards totaling $724,000 for research
    related to genital herpes and anthrax.                                                                                                                                                                                                                                                                                                                                                                                      



| |                                                               
| | --------------------------------------------------------------
| | Status of R&D Programs and
    Plans  Company-funded Projects

Neurodex for the treatment of
PBA.We intend to begin submission of
an NDA for NeurodexTM to the FDA by December 31,
2004 and we expect to complete its submission by mid-2005. The
FDA has offered a rolling review of the NDA and has
also indicated that Neurodex would qualify for a priority review
when the submission is complete. The rolling review process will
allow us to submit the NDA in modules (reviewable units), which
can then be evaluated by the FDA as they are submitted. Once the
submission is complete, and assuming that the FDA grants us
priority review, it should take approximately six months for the
FDA to complete its review of the entire submission. In June
2004, we successfully completed the treatment phase of a
Phase III clinical trial of Neurodex for the treatment of
PBA in 150 patients with MS. Also, AVANIR has been engaged
in an open-label safety study for the treatment of PBA in a
broader pool of patients who could have PBA associated with one
of several underlying neurodegenerative diseases or conditions.
Prior to engaging in these recent and current ongoing studies,
we successfully completed the initial Phase III clinical
trial of PBA in patients with amyotrophic lateral sclerosis
(ALS), in May 2002.

Neurodex for the treatment of neuropathic
pain.We are currently developing our
Phase III clinical development plan for the use of Neurodex
in the treatment of neuropathic pain and have included the costs
to complete only one Phase III clinical trial.
Simultaneously, we are evaluating commercial development
alternatives, including continuing development on our own or
with the funding of a potential co-promotion partner or
potential licensee. In mid-2003, we successfully completed a
four-week open-label dose escalation study of Neurodex in
patients with painful diabetic neuropathy. There can be no
assurances as to the timing of a license or co-promotion
arrangement, if any.

Development program for allergy and asthma
(IgE regulator).In fiscal 2004 we
completed a Phase I clinical trial of our asthma/ allergy
drug, AVP-13358, in 54 healthy volunteers. The
placebo-controlled study was intended to assess safety,
tolerability and pharmacokinetics following single rising oral
doses. Results of the study suggest AVP-13358 was well tolerated
at all doses up through 16 milligrams. The study also
demonstrated AVP-13358 was detectable in the bloodstream at all
doses administered and remains in circulation long enough to
allow potentially once or twice daily dosing. We intend to
continue to evaluate the safety of the drug by conducting rising
multi-dose studies in healthy patients in fiscal 2005. Assuming
the successful completion of Phase I clinical trials and
adequate funds to continue development without a partner, we
intend to continue development of the drug through
Phase IIa. Assuming the results of such additional studies
are favorable, we will seek to license the drug to a larger
pharmaceutical company for further development.

Development program for
atherosclerosis.We are engaged in
preclinical research evaluating certain small, orally active
molecules as a potential treatment of atherosclerosis (the
build-up of fatty plaques in blood vessel walls). Our research
is focused on developing molecules that can enhance the
naturally occurring

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process known as reverse cholesterol transport
(RCT), whereby cholesterol is effluxed from the
fatty-plaques in blood vessel walls and transported to the liver
for elimination from the body. Preliminary studies in animal
models suggest our compounds may both reduce fatty plaques and
increase fecal cholesterol excretion.


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

AVANIR acquired the rights to the MIF Inhibitor
Technology from the Ciblex Corporation in August 2001 on the
basis that the technology could assist us in discovering a small
molecule drug capable of regulating MIF. The MIF Inhibitor
Technology included several compounds, details of their chemical
structures and method of preparation, data from in vitroexperiments and in vivotest models, and rights to
provisional patent applications filed by Ciblex regarding use of
those or similar compounds in the treatment of autoimmune and
inflammatory diseases.

In August 2004, we charged $2,733,023 to research
and development expense for the MIF inhibitor program,
representing the cost of issuing common stock to Ciblex, in lieu
of potential future milestones that would have likely been due
in the future under the technology acquisition agreement,
assuming continued successful development. Per the August 2004
amendment to the Ciblex Technology Acquisition Agreement (the
Amendment), we will no longer be obligated to make
up to $9.0 million in milestone payments to Ciblex upon the
occurrence of certain events relating to the clinical
development and/or commercialization of the MIF Inhibitor
Technology in the United States, nor will we be obligated to
share the receipt of other milestone payments outside the United
States. We will, however, be required to pay a royalty to Ciblex
if and when commercial sales under the agreement commence. In
connection with entering into the Amendment, we issued Ciblex
1,036,807 shares of Class A common stock valued at
$2,733,023. (See Note 6, Shareholders
Equity  Common Stock in the accompanying Notes
to Consolidated Financial Statements) and charged that amount to
R&D expense.

We believe that our continued research in this
area likely would have resulted in the payment of one or more
milestones to Ciblex. It is for that reason that AVANIR entered
into the Amendment. As of the date of the Amendment, the
MIF Inhibitor Technology was in the preclinical stage of
development at AVANIR, but considerably further along than it
was in August 2001 when we entered into the Technology
Acquisition Agreement. There can be no assurance that any of the
milestones under the Technology Acquisition Agreement would have
ever been reached or a payment made.



| |                                                                  
| | -----------------------------------------------------------------
| | Status of R&D Programs and
    Plans  Government-funded Projects

Government research grants have helped fund
research on docosanol-based formulations for the treatment of
genital herpes and the development of antibodies to anthrax
toxins, among other research programs. Approximately $724,000 in
funds remains to be spent for the remainder of 2004 and in 2005
under existing government research grants.

Monoclonal antibodies anthrax
toxin.Two of AVANIRs most
potent anthrax antibodies, AVP-21D9 and AVP-22G12, appear unique
both in mechanism of action and in terms of the binding site on
the anthrax toxin. AVP-21D9 is currently in preclinical
development for use as a prophylactic and therapeutic drug to
treat anthrax infections. Ultimately, AVANIR intends to submit
an IND application seeking clearance from the FDA to begin
clinical trials to evaluate the safety, tolerability, and
pharmacology of AVP-21D9 in healthy human subjects. Much of our
work targeting infectious diseases has been funded by government
research grants. Because all of our research is at a very early
preclinical stage of development and is unpredictable in terms
of the outcome, we are unable to predict the cost and timing for
development of any antibody or drug.

30



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Other government-funded
research.During fiscal 2004, we
completed two government-funded research programs 
the development of a blood donor program intended to find
high-affinity antibodies to infectious diseases and research on
potential antibodies to cytomegalovirus and continued to make
progress in developing antibodies to the anthrax toxin.

General and administrative
expenses.Our general and
administrative expenses increased to $5.9 million in fiscal
2004, compared to $4.7 million in fiscal 2003. These
increased expenses primarily relate to:



| |   |                                                                                                                                                                          
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | a $472,000 increase related to human resources,
    employee training, and other Company-wide employee programs;                                                         
|
| |  | a $436,000 increase related to legal and other
    professional services associated with corporate governance and
    compliance with the Sarbanes-Oxley Act of 2002; and
|
| |  | a $248,000 increase in building occupancy costs,
    primarily resulting from the utilization of additional office
    space in fiscal 2004.                             

These increases were partially offset by a
$183,000 reduction in outside services for investor relations.
We expect that costs associated with compliance with the
Sarbanes-Oxley Act will continue to increase.

Sales and marketing
expenses.Sales and marketing expenses
increased to $3.5 million in fiscal 2004, compared to
$2.6 million during fiscal 2003. Higher expenses in fiscal
2004 were related to the continued expansion of our medical
education and awareness programs for PBA, market research, and
pre-launch planning activities for Neurodex. We expect sales and
marketing expenses will increase from 11% of our operating
expenses in fiscal 2004 to 18% in fiscal 2005 as we continue to
increase activities in preparation for a potential launch of
Neurodex, assuming the FDA approves Neurodex.



| |                             
| | ----------------------------
| | Net Loss  2004 vs.
    2003

For fiscal 2004, the net loss attributable to
common shareholders was $28.2 million, or $0.36 per
share, compared to $23.3 million, or $0.39 per share
in fiscal 2003. A higher average number of shares was
outstanding in fiscal 2004.

We expect to continue to pursue our drug
development strategy focused on the development of Neurodex,
followed by other programs in earlier stages of development that
are in large therapeutic areas and that have significant
partnering and licensing potential. To help fund and develop our
products, we are evaluating potential alternative licensees and
partners to share the costs of development. Some of these
potential license arrangements could materially change our
outlook for future revenues and costs. However, the timing of
such potential arrangements is unpredictable. To reach the stage
of partnering or licensing our product candidates or
technologies or marketing our own products, we expect to
continue to invest primarily in our clinical development
programs, which we expect will contribute to a loss for fiscal
2005.

Comparison of Fiscal 2003 and 2002



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

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



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

Operating expenses.Our total operating expenses increased to $25.9 million in
fiscal 2003, compared to $19.5 million in fiscal 2002. The
33% increase in operating expenses was primarily caused by a 36%
increase in spending on research and development programs.
Research and development programs accounted for 72% and

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70% of total operating expenses for fiscal 2003
and 2002, respectively. General and administrative expenses
accounted for 18% and 22% of total operating expenses for fiscal
2003 and 2002, respectively. Sales and marketing expenses
accounted for 10% and 8% of total operating expenses for fiscal
2003 and 2002, respectively. These and other costs are more
fully described below.


Research and development
expenses.R&D expenses totaled
$18.6 million in fiscal 2003, compared to
$13.6 million in fiscal 2002. We had four clinical trials
and studies under way throughout most of fiscal 2003, compared
to only one clinical trial in fiscal 2002. The Phase III
clinical trial and open label study of Neurodex in the treatment
of PBA accounted for $5.1 million, or 27%, of total R&D
spending. Completion of toxicology, submitting an
investigational new drug (IND) application to the FDA, and
completion of the initial dose levels in Phase I clinical
trials of our lead compound for the treatment of allergy and
asthma accounted for $4.7 million, or 25%, of total R&D
spending. An additional 11% of R&D spending was devoted
to the development of Neurodex in the treatment of neuropathic
pain, in Phase II clinical development at that time.
Approximately 12% of spending was focused on research on a group
of compounds targeting MIF as a potential treatment for
inflammatory diseases.

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

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



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

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

Liquidity and Capital Resources

As of September 30, 2004, we had cash, cash
equivalents and investments in securities totaling
$25.9 million, including cash and cash equivalents of
$13.5 million, short- and long-term investments of
$11.6 million and restricted investments of $857,000. Our
net working capital balance as of September 30, 2004 was
$16.7 million. As of September 30, 2003, we had cash,
cash equivalents and investments in securities of
$17.5 million, including cash and cash equivalents of
$12.2 million, short- and long-term investments of
$4.4 million and restricted investments of $857,000. Our
net working capital balance as of September 30, 2003

32



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was $10.6 million. Explanations of the
changes in net cash provided by or used for operating, investing
and financing activities are provided below.


|                                                         |  |               |            |                 |  |               |           |  |  |   |            | 
|-------------------------------------------------------- |  | ------------- | ---------- | --------------- |  | ------------- | --------- |  |  | - | ---------- | 
|                                                         |  | September 30, |            | Increase During |  | September 30,
|                                                         |  | 2004          |            | Fiscal 2004     |  | 2003         
|                                                         |  |               |            |                 |  |              
|Cash and cash equivalents                                |  | $             | 13,494,083 |                 |  | $             | 1,295,675 |  |  | $ | 12,198,408 | 
|Cash, cash equivalents and investments in
    securities |  | $             | 25,906,529 |                 |  | $             | 8,449,240 |  |  | $ | 17,457,289 | 
|Net working capital                                      |  | $             | 16,653,621 |                 |  | $             | 6,034,405 |  |  | $ | 10,619,216 | 

|                                                         |  |               |             |               |  |               |             |   |  |   |            |  
|-------------------------------------------------------- |  | ------------- | ----------- | ------------- |  | ------------- | ----------- | - |  | - | ---------- | -
|                                                         |  | Year Ended    |             |               |  | Year Ended   
|                                                         |  | September 30, |             | Change During |  | September 30,
|                                                         |  | 2004          |             | Fiscal 2004   |  | 2003         
|                                                         |  |               |             |               |  |              
|Net cash provided by (used for) operating
    activities |  | $             | (25,265,811 | )             |  | $             | (26,406,446 | ) |  | $ | 1,140,635  |  
|Net cash used for investing activities                   |  |               | (8,590,823  | )             |  |               | (1,736,890  | ) |  |   | (6,853,933 | )
|Net cash provided by financing activities                |  |               | 35,152,309  |               |  |               | 25,871,150  |   |  |   | 9,281,159  |  
|                                                         |  |               |             |               |  |               |             |   |  |   |            |  
|Net increase in cash and cash equivalents                |  | $             | 1,295,675   |               |  | $             | (2,272,186  | ) |  | $ | 3,567,861  |  
|                                                         |  |               |             |               |  |               |             |   |  |   |            |  

AVANIR has contracted obligations for long-term
debt, capital (finance) lease obligations and operating
lease obligations, as summarized in the table that follows. We
anticipate being able to satisfy the obligations described below
out of cash, cash equivalents and investments in securities held
by the Company as of September 30, 2004 and proceeds from
additional sales of Class A Common Stock under a shelf
registration that we filed with the SEC in April 2004 (See
Financing Activities below). See also Note 4,
Commitments and Contingencies, and Note 5,
Notes Payable in the accompanying Notes to
Consolidated Financial Statements filed with this report.

|                                    |       |                        |            |            |  |           |           |           |  |         |           |           |  |   |           |           |  |   |           |           | 
|----------------------------------- | ----- | ---------------------- | ---------- | ---------- |  | --------- | --------- | --------- |  | ------- | --------- | --------- |  | - | --------- | --------- |  | - | --------- | --------- | 
|                                    |       |                       
|                                    |       | Payments Due by Period
|                                    |       |                       
|                                    |       |                        |            | Less than  |  |           |           | More than
|Contractual Obligations             |       | Total                  |            | 1 Year     |  | 1-3 Years |           | 3-5 Years |  | 5 Years
|                                    |       |                        |            |            |  |           |           |           |  |        
|Long-term debt obligations          |       | $                      | 1,080,879  |            |  | $         | 284,691   |           |  | $       | 616,404   |           |  | $ | 179,784   |           |  | $ |          |          
|Capital (finance) lease obligations |       |                        | 208,097    |            |  |           | 169,772   |           |  |         | 38,325    |           |  |   |          |           |  |   |          |          
|Operating lease obligations         |       |                        | 12,113,206 |            |  |           | 1,702,298 |           |  |         | 3,602,595 |           |  |   | 2,920,584 |           |  |   | 3,887,729 |          
|                                    |       |                        |            |            |  |           |           |           |  |         |           |           |  |   |           |           |  |   |           |          
|                                    | Total |                        | $          | 13,402,182 |  |           | $         | 2,156,761 |  |         | $         | 4,257,324 |  |   | $         | 3,100,368 |  |   | $         | 3,887,729 | 
|                                    |       |                        |            |            |  |           |           |           |  |         |           |           |  |   |           |           |  |   |           |          

Operating
activities.Net cash used for
operating activities amounted to $25.3 million in fiscal
2004, compared to net cash provided by operating activities of
$1.1 million in fiscal 2003. The net loss of
$28.2 million, reflecting the high levels of spending on
our R&D programs (described earlier), combined with low
revenues from existing sources, primarily accounted for the cash
used for operating activities in fiscal 2004. Depreciation and
amortization of $1.8 million in fiscal 2004 was $815,000
higher than in fiscal 2003. The additional depreciation in
fiscal 2004 represents the full-year effect of depreciation on
$4.1 million in tenant improvements on approximately 30,400
square feet of additional office and laboratory space that was
completed in May 2003. During fiscal 2004, the Company was able
to reduce the accounts payable balance by $892,000, or from
$2.9 million at September 30, 2003 to
$2.0 million at September 30, 2004. During the course
of fiscal 2004, the Company made payments on various contracts
for services, including work performed by others on our clinical
trials. Also during fiscal 2004, inventory declined by $202,000,
representing the cost of docosanol sold to various licensees. We
intend to replenish our docosanol inventory in early fiscal 2005.

The net cash provided by operating activities in
fiscal 2003 includes $24.1 million in cash, net of
transaction costs, received from Drug Royalty USA on
December 24, 2002, from the sale of an undivided interest
in our Abreva® license agreement with GlaxoSmithKline. The
sale of rights to future Abreva royalties was recorded as
deferred revenue on the date of sale. (See Note 2,
Summary of Significant Accounting Policies 
Deferred Revenue, in the accompanying Notes to
Consolidated Financial Statements.) Also in fiscal 2003 we
received a royalty payment of $876,000 from GlaxoSmithKline that
contributed substantially to

33



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the $827,000 reduction in receivables. Cash
receipts were partially offset by high levels of R&D
spending (described earlier), combined with low revenues and an
$846,000 increase in prepaid expenses and other assets.


Investing
activities.Net cash used for
investing activities in fiscal 2004 amounted to
$8.6 million, including investments in securities totaling
$9.4 million, patent costs of $1.2 million, and
purchases of property and equipment of $202,000, partially
offset by sales and maturities of investments totaling
$2.2 million. Patent costs of $1.2 million in fiscal
2004 were higher than fiscal 2003 by approximately $541,000,
reflecting our continuing investment in our intellectual
property, particularly in domestic and foreign patent
applications pending for the MIF inhibitor technology and
advances that we have made in atherosclerosis research. Capital
expenditures were substantially lower in fiscal 2004, compared
to fiscal 2003 when the Company was engaged in making leasehold
improvements to additional office and laboratory space.

Net cash used for investing activities during the
fiscal 2003 amounted to $6.9 million, including capital
expenditures related to purchases of capital equipment and
leasehold improvements totaling $5.5 million, patent costs
of $616,000, and investments in securities totaling
$3.7 million, partially offset by sales and maturities of
investments totaling $3.0 million. The leasehold
improvements were related to completion of construction of
laboratory and office space at our three leased buildings in
San Diego. In May 2003, we completed construction on
approximately 30,400 square feet of existing leased
laboratory and office space, located at 11404 and 11408 Sorrento
Valley Road, San Diego, California. The facilities at 11404
and 11408 Sorrento Valley Road are subject to a lease between
the Company and Sorrento Plaza, a California limited
partnership, effective May 20, 2002. Leasehold improvements
to the Sorrento Plaza facilities were necessary before we could
take occupancy. The Company also made leasehold improvements to
laboratory and office space at 11388 Sorrento Valley Road to
accommodate the relocation of several departments. The
expenditures at all three facilities are intended to accommodate
current as well as potential future expanded business
operations, and capacity to accommodate up to 100 employees.
(See Note 2, Summary of Significant Accounting
Policies  Property and Equipment in the
accompanying Notes to Consolidated Financial Statements.)

Financing
activities.Net cash provided by
financing activities amounted to $35.2 million during
fiscal 2004, consisting primarily of $26.5 million in net
cash received from the sale of Class A common stock in June
2004, and $7.5 million received from the sale of
Class A common stock and warrants in December 2003 (see
Note 6, Shareholders Equity in the
accompanying Notes to Consolidated Financial Statements). Net
cash provided by financing activities in fiscal 2003 amounted to
$9.3 million, including $9.4 million in net proceeds
from a private placement in common stock, after taking into
effect $644,000 in costs related to the transaction, and
$418,000 in payments on notes and capital lease obligations.

On December 5, 2003, we sold and issued
5,382,316 shares of Class A common stock and five-year
warrants to purchase an additional 3,229,389 shares of
Class A common stock to several accredited investors and
received approximately $8.0 million in gross proceeds. The
exercise price of the warrants is $1.75 per share. The
financing transaction was made pursuant to the terms of a
securities purchase agreement that provided each investor with a
five-year warrant to purchase six-tenths of a share of
Class A common stock for every share of Class A common
stock purchased under the agreement. The effect of the financing
transaction was an increase in cash and shareholders
equity in the amount of approximately $7.5 million, after
taking into effect the costs of the transaction. In connection
with this transaction and its costs, the placement agent was
paid $415,000 in fees and expenses, and was issued a five-year
warrant to purchase 161,470 shares of the
Companys Class A common stock at $1.75 per share.

In April 2004, the Company filed a shelf
registration statement on Form S-3 with the SEC that
enables the Company to sell an aggregate of up to
$50.0 million in Class A common stock from time to
time over a period of two years. The Companys sale of
Class A common stock in June 2004, representing
$28.8 million in gross proceeds ($26.5 million net of
underwriting discount and costs of the financing transaction)
was the first transaction for the sale of Class A common
stock under the existing shelf registration. In
December 2004, we issued an additional $7.0 million in
Class A common stock to an institutional investor at $3.00
per share. (See Note 11, Subsequent Event, in
the accompanying Notes to the Consolidated Financial
Statements.) The

34



---



##### Table of Contents



balance of Class A common stock available
for sale under the existing shelf registration is approximately
$14.2 million.


In September 2004, AVANIR entered into an
equipment line of credit with GE Healthcare Financial Services
(GE Capital) for financing of up to
$1.4 million. As of September 30, 2004 the Company had
$914,652 in borrowed funds on hand under the line of credit. For
further details concerning the financial terms with GE Capital,
please see Note 5, Notes Payable, in the
accompanying Notes to Consolidated Financial Statements.

Management Outlook

The substantial progress in research programs in
fiscal 2004 has set the stage for continued development of all
of our programs in fiscal 2005, including the anticipated
submission of an NDA for Neurodex in the treatment of PBA. We
believe that cash, cash equivalents, and investments in
securities totaling $25.9 million at September 30,
2004, the December 2004 financing, plus anticipated future
revenues, should be sufficient to sustain our planned level of
operations for at least the next 12 months. However, to
continue to fund the development of our new drug candidates and
technology platforms and potential product launch of Neurodex
during the next two years (assuming that Neurodex is approved
for marketing by the FDA), we expect to continue to pursue
various alternatives for raising capital during this two-year
period. 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 one or more
of our platform technologies or new drug candidates.

Recent Accounting Pronouncements

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



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

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

Interest Rate Sensitivity

Our investment portfolio consists primarily of
fixed income instruments with an average duration of
1.2 years as of September 30, 2004 (2.0 years as
of September 30, 2003). The primary objective of our
investments in debt securities is to preserve principal while
achieving attractive yields, without significantly increasing
risk. We classify our investments in securities as of
September 30, 2004 as available-for-sale and our restricted
investments in securities as held-to-maturity. These
available-for-sale securities are subject to interest rate risk.
In general, we would expect that the volatility of this
portfolio would decrease as its duration decreases.

35



---



##### Table of Contents





|        |                                                
|------- | -----------------------------------------------
|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

None.



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

With the participation of the principal executive
officer and principal financial officer of AVANIR
Pharmaceuticals (the Registrant), the
Registrants management has evaluated the effectiveness of
the Companys disclosure controls and procedures (as
defined in the Securities Exchange Act of 1934,
Rules 13a-15(e) and 15(d)-15(e)), as of the end of the
period covered by this report. Based on that evaluation, the
Registrants principal executive officer and principal
financial officer have concluded that:



| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                 
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | Information required to be disclosed by the
    Registrant in this Annual Report on Form 10-K and the other
    reports that the Registrant files or submits under the Exchange
    Act would be accumulated and communicated to the
    Registrants management, including its principal executive
    officer and principal financial officer, as appropriate to allow
    timely decisions regarding required disclosure;    
|
| |  | Information required to be disclosed by the
    Registrant in this Annual Report on Form 10-K and the other
    reports that the Registrant files or submits under the Exchange
    Act would be recorded, processed, summarized and reported within
    the time periods specific in the SECs rules and
    forms; and                                                                                                        
|
| |  | The Registrants disclosure controls and
    procedures are effective as of the end of the period covered by
    this Annual Report on Form 10-K to ensure that material
    information relating to the Registrant and its consolidated
    subsidiary is made known to them, particularly during the period
    in which the Registrants periodic reports, including this
    Annual Report on Form 10-K, are being prepared.

Additionally, there were no changes in the
Registrants internal control over financial reporting (as
defined in Rule 13a-15(f) under the Exchange Act) that
occurred during the Registrants fiscal quarter ended
September 30, 2004, that have materially affected, or are
reasonably likely to materially affect, the Registrants
internal control over financial reporting.



|         |                  
|-------- | -----------------
|Item 9B. | Other Information

None.

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 in 2005.

36



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##### Table of Contents



Executive Officers of the Registrant

The names of our executive officers and their
ages as of December 7, 2004 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.  |  |     | 62 |          |  | President and Chief Executive Officer                             
|James E. Berg             |  |     | 53 |          |  | Vice President, Clinical and Regulatory Affairs                   
|R. Martin Emanuele, Ph.D. |  |     | 50 |          |  | Vice President, Licensing and Business Development                
|Gus Fernandez, Pharm.D    |  |     | 47 |          |  | Vice President, Commercial Development                            
|Gregory P. Hanson, CMA    |  |     | 58 |          |  | Vice President, Finance; Chief Financial Officer
    and Secretary
|J. David Hansen           |  |     | 53 |          |  | Senior Vice President, Corporate Development                      
|Jagadish C. Sircar, Ph.D. |  |     | 69 |          |  | Vice President, Drug Discovery                                    
|Victoria Smith            |  |     | 56 |          |  | Vice President, Administration                                    

Gerald J.
Yakatan, Ph.D.Dr. Yakatan
has served as President and Chief Executive Officer since March
1998 and as Vice President of Drug Development from July 1995 to
February 1998. Dr. Yakatan also has served as a director of
the Company since February 1998. Dr. Yakatan has extensive
executive management experience in the pharmaceutical industry.
In 1996, he founded IriSys Research & Development, LLC,
a privately held company (IriSys) where he served as
President and Chief Executive Officer until joining AVANIR. He
still serves as Chairman of IriSys. (See Note 8,
Related Party Transactions, in the accompanying
Notes to Consolidated Financial Statements.) Dr. Yakatan
also founded Tanabe Research Laboratories, USA, Inc., in 1990
and served as President and Chief Executive Officer until 1995.
Earlier in his career, Dr. Yakatan held various executive
positions over a seven-year period at Warner-Lambert
Co./Parke-Davis, including Vice President of worldwide product
development, and as a member of the Parke-Davis pharmaceutical
research management team and the Executive Committee where he
had significant exposure to all stages of R&D and the sales
and marketing processes. Prior to joining
Warner-Lambert/Parke-Davis, Dr. Yakatan was a tenured
faculty member of the University of Texas at the Austin College
of Pharmacy where he was Chair of the Department of
Pharmaceutics and Assistant Director of the Drug Dynamics
Institute. He is a Fellow of the American Association of
Pharmaceutical Scientists and the American College of Clinical
Pharmacology. Dr. Yakatan received his B.S. degree in
Pharmacy in 1963 and M.S. degree in Pharmaceutical Chemistry in
1965 from Temple University. In 1971, Dr. Yakatan received
his Ph.D. degree in Pharmaceutical Sciences from the University
of Florida.

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

R. Martin
Emanuele, Ph.D.Dr. Emanuele
has served as Vice President, Licensing and Business
Development, since August 2002. Dr. Emanuel is responsible
for AVANIRS partnering, licensing and related business
development activities. From May 1988 to July 2002,
Dr. Emanuele was employed by CytRx Corporation, where he
held a number of R&D and business development positions and
attained the position of

37



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##### Table of Contents



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. degree from Colorado State University, an M.S.
degree from Northern Illinois University, and a Ph.D. degree in
Pharmacology & Experimental Therapeutics from Loyola
University of Chicago.


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

Gregory P. Hanson,
CMA.Mr. Hanson has served as
Vice President, Finance and Chief Financial Officer
(CFO) and Corporate Secretary since July 1998.
Mr. Hanson also serves as the Corporate Compliance Officer.
From September 1995 to July 1998, he was the Chief Financial
Officer of XXsys Technologies Inc., a composite materials
technology company; and from May 1993 to September 1995, he held
a number of financial positions within The Titan Corporation, a
diversified telecommunications and information technology
company, including acting CFO and acting Controller for its
subsidiary, Titan Information Systems. Earlier in his career,
Mr. Hanson held various management positions at Ford Motor
Company over a 14-year span and at Solar Turbines Incorporated,
a subsidiary of Caterpillar Inc., over a three-year span.
Mr. Hanson has a B.S. degree in Mechanical Engineering
from Kansas State University and an M.B.A. degree with
honors from the University of Michigan. He is a Certified
Management Accountant and has passed the examination for
Certified Public Accountants. In March 2004, Mr. Hanson was
selected to be member of the Financial Accounting Standards
Boards Small Business Advisory Committee
(SBAC). He also serves on the SBACs Agenda
Committee.

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

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

38



---



##### Table of Contents



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



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

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



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

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



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

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



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

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

PART IV



|         |                                                 
|-------- | ------------------------------------------------
|Item 15. | Exhibits, Financial Statements and
    Schedules

(a) Financial Statements and Schedules



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

(b) Exhibits

| |   |    |  |                                                                                                                                     
| | - | -- |  | ------------------------------------------------------------------------------------------------------------------------------------
| | 3 | .1 |  | Restated Articles of Incorporation of the
    Registrant, dated April 1, 2004(13)                                                   
| | 3 | .2 |  | Amended and Restated Bylaws of the Registrant,
    dated August 26, 2004 (14)                                                       
| | 4 | .1 |  | Form of Class A Common Stock Certificate(1)                                                                                         
| | 4 | .2 |  | Certificate of Determination with respect to
    Series C Junior Participating Preferred Stock of the
    Registrant(2)             
| | 4 | .3 |  | Rights Agreement, dated as of March 5, 1999,
    with American Stock Transfer & Trust Company(2)                                    
| | 4 | .4 |  | Form of Rights Certificate with respect to the
    Rights Agreement, dated as of March 5, 1999(2)                                   
| | 4 | .5 |  | Form of Class J Stock Purchase Warrant
    issued in connection with Series D redeemable convertible
    preferred stock(3)         
| | 4 | .6 |  | Amendment No. 1 to Rights Agreement, dated
    November 30, 1999, with American Stock Transfer &
    Trust Company(4)               
| | 4 | .7 |  | Form of Class A Stock Purchase Warrant,
    issued in connection with the Securities Purchase Agreement
    dated July 21, 2003 (10)

39



---



##### Table of Contents



| |    |     |  |                                                                                                                                                                                            
| | -- | --- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | 4  | .8  |  | Form of Class A Stock Purchase Warrant,
    issued in connection with the Securities Purchase Agreement
    dated November 25, 2003 (11)                                                   
| | 4  | .9  |  | Class G Stock Purchase Warrant
    (12)                                                                                                                                                    
| | 10 | .1  |  | License Agreement, dated March 31, 2000, by
    and between AVANIR Pharmaceuticals and SB Pharmco Puerto Rico, a
    Puerto Rico Corporation(5)                                            
| | 10 | .2  |  | Standard Industrial Net Lease by and between
    AVANIR Pharmaceuticals and BC Sorrento, LLC, effective
    September 1, 2000(6)                                                           
| | 10 | .3  |  | License Agreement, dated August 1, 2000, by
    and between AVANIR Pharmaceuticals (Licensee) and
    Irisys Research and Development, LLC, a California limited
    liability company(6)
| | 10 | .4  |  | Amended and Restated 1998 Stock Option Plan(7)                                                                                                                                             
| | 10 | .5  |  | Amended and Restated 1994 Stock Option Plan(7)                                                                                                                                             
| | 10 | .6  |  | Employment Agreement with Gerald J. Yakatan,
    dated November 29, 2001(7)                                                                                                                
| | 10 | .7  |  | Standard Industrial Net Lease by and between
    AVANIR Pharmaceuticals (Tenant) and Sorrento Plaza,
    a California limited partnership (Landlord),
    effective May 20, 2002(8)    
| | 10 | .8  |  | Amended and Restated 2000 Stock Option Plan(9)                                                                                                                                             
| | 10 | .9  |  | Form of Restricted Stock Grant Notice for use
    with Amended and Restated 2000 Stock Option Plan(9)                                                                                      
| | 10 | .10 |  | 2003 Equity Incentive Plan(9)                                                                                                                                                              
| | 10 | .11 |  | Form of Non-qualified Stock Option Award Notice
    for use with 2003 Equity Incentive Plan(9)                                                                                             
| | 10 | .12 |  | Form of Restricted Stock Grant for use with 2003
    Equity Incentive Plan(9)                                                                                                              
| | 10 | .13 |  | Form of Restricted Stock Grant Notice (cash
    consideration) for use with 2003 Equity Incentive Plan(9)                                                                                  
| | 10 | .14 |  | Form of Indemnification Agreement with certain
    Directors and Executive Officers of the Registrant
    (12)                                                                             
| | 10 | .15 |  | Form of Retention Agreement with various members
    of management of the Company (15)                                                                                                     
| | 21 | .1  |  | List of Subsidiaries                                                                                                                                                                       
| | 23 | .1  |  | Consent of Independent Registered Public
    Accounting Firm                                                                                                                               
| | 24 | .1  |  | Power of Attorney (contained on signature page)                                                                                                                                            
| | 31 | .1  |  | Certification pursuant to Section 302 of
    Sarbanes-Oxley Act of 2002                                                                                                                    
| | 31 | .2  |  | Certification pursuant to Section 302 of
    Sarbanes-Oxley Act of 2002                                                                                                                    
| | 32 | .1  |  | Certification pursuant to Section 906 of the
    Sarbanes-Oxley Act of 2002                                                                                                                
| | 32 | .2  |  | Certification pursuant to Section 906 of the
    Sarbanes-Oxley Act of 2002                                                                                                                



---



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

40



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##### Table of Contents





|    |                                                                                                                                                          
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------------------
|(7) | Incorporated by reference to the similarly
    described exhibit included with the Registrants Annual
    Report on Form 10-K, filed December 21, 2001. 
|   
|(8) | Incorporated by reference to the similarly
    described exhibit included with the Registrants Quarterly
    Report on Form 10-Q, filed August 13, 2002.
|   
|(9) | Incorporated by reference to the similarly
    described exhibit included with the Registrants Quarterly
    Report on Form 10-Q, filed May 13, 2003.   



|     |                                                                                                                                                                                                                
|---- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(10) | Incorporated by reference to the similarly
    described exhibit included with the Registrants
    Registration on From S-3, File No. 333-107820, declared
    effective by the Commission on August 19, 2003.
|    
|(11) | Incorporated by reference to the similarly
    described exhibit included with the Registrants Current
    Report on Form 8-K, filed December 11, 2003.                                                       
|    
|(12) | Incorporated by reference to the similarly
    described exhibit included with the Registrants Annual
    Report on Form 10-K, filed December 23, 2003.                                                       
|    
|(13) | Incorporated by reference to the similarly
    described exhibit included with the Registrants Current
    Report on Form 8-K, filed on April 6, 2004.                                                        
|    
|(14) | Incorporated by reference to the similarly
    described exhibit included with the Registrants Current
    Report on Form 8-K, filed September 1, 2004.                                                       
|    
|(15) | Incorporated by reference to the similarly
    described exhibit included with the Registrants Current
    Report on Form 8-K, filed September 21, 2004.                                                      

41



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##### Table of Contents



SIGNATURES

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



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



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

| | 
| | 
| | 



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

Date: December 13, 2004

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 13, 2004
|                                                              
|/s/ GREGORY P. HANSON, CMAGregory P. Hanson, CMA               |  | Vice President, Finance, Chief Financial Officer
    (Principal
    Financial and Accounting Officer) |  | December 13, 2004
|                                                              
|/s/ JAMES B. GLAVINJames B. Glavin                             |  | Chairman of the Board                                                                                 |  | December 13, 2004
|                                                              
|/s/ STEPHEN G. AUSTIN, CPAStephen G. Austin, CPA               |  | Director                                                                                              |  | December 13, 2004
|                                                              
|/s/ DENNIS J. CARLO, PH.D.Dennis J. Carlo, Ph.D.               |  | Director                                                                                              |  | December 13, 2004
|                                                              
|/s/ SUSAN GOLDINGSusan Golding                                 |  | Director                                                                                              |  | December 13, 2004
|                                                              
|/s/ CHARLES A. MATHEWSCharles A. Mathews                       |  | Director                                                                                              |  | December 13, 2004
|                                                              
|/s/ HAROLD F. OBERKFELLHarold F. Oberkfell                     |  | Director                                                                                              |  | December 13, 2004
|                                                              
|/s/ KENNETH E. OLSONKenneth E. Olson                           |  | Director                                                                                              |  | December 13, 2004
|                                                              
|/s/ JONATHAN T. SILVERSTEIN, J.D.Jonathan T. Silverstein, J.D. |  | Director                                                                                              |  | December 13, 2004

42



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##### Table of Contents



AVANIR Pharmaceuticals

INDEX TO CONSOLIDATED FINANCIAL
STATEMENTS

|                                                            |  |      |     | 
|----------------------------------------------------------- |  | ---- | --- | 
|                                                            |  | Page
|                                                            |  |     
|Report of Independent Registered Public
    Accounting Firm |  |      | F-2 | 
|CONSOLIDATED FINANCIAL STATEMENTS                           |  |      |     | 
|Consolidated Balance Sheets                                 |  |      | F-3 | 
|Consolidated Statements of Operations                       |  |      | F-4 | 
|Consolidated Statements of Shareholders
    Equity         |  |      | F-5 | 
|Consolidated Statements of Cash Flows                       |  |      | F-6 | 
|Notes to Consolidated Financial Statements                  |  |      | F-7 | 

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##### Table of Contents



REPORT OF INDEPENDENT REGISTERED PUBLIC
ACCOUNTING FIRM

To the Board of Directors and Shareholders of

AVANIR Pharmaceuticals


We have audited the accompanying consolidated
balance sheets of AVANIR Pharmaceuticals and subsidiary (the
Company) as of September 30, 2004 and 2003, and
the related consolidated statements of operations,
shareholders equity and cash flows for each of the three
years in the period ended September 30, 2004. 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 the
standards of the Public Company Accounting Oversight Board
(United States). Those standards require that we plan and
perform the audit to obtain reasonable assurance about whether
the financial statements are free of material misstatement. An
audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An
audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating
the overall financial statement presentation. We believe that
our audits provide a reasonable basis for our opinion.

In our opinion, such consolidated financial
statements present fairly, in all material respects, the
financial position of the Company as of September 30, 2004
and 2003, and the results of its operations and its cash flows
for each of the three years in the period ended
September 30, 2004, in conformity with accounting
principles generally accepted in the United States of America.

DELOITTE & TOUCHE LLP

San Diego, California

December 13, 2004


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AVANIR Pharmaceuticals

CONSOLIDATED BALANCE SHEETS

|                                                   |                                                                                                                                     |                                                                                                                                                                                                                                                     |           |              |             |  |           |             |            | 
|-------------------------------------------------- | ----------------------------------------------------------------------------------------------------------------------------------- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | --------- | ------------ | ----------- |  | --------- | ----------- | ---------- | 
|                                                   |                                                                                                                                     |                                                                                                                                                                                                                                                    
|                                                   |                                                                                                                                     | September 30,                                                                                                                                                                                                                                      
|                                                   |                                                                                                                                     |                                                                                                                                                                                                                                                    
|                                                   |                                                                                                                                     | 2004                                                                                                                                                                                                                                                |           | 2003        
|                                                   |                                                                                                                                     |                                                                                                                                                                                                                                                     |           |             
|                                                  
|ASSETS                                            
|Current assets:                                    |                                                                                                                                     |                                                                                                                                                                                                                                                     |           |              |             |  |           |            
|                                                   | Cash and cash equivalents                                                                                                           |                                                                                                                                                                                                                                                     | $         | 13,494,083   |             |  | $         | 12,198,408  |           
|                                                   | Short-term investments in securities                                                                                                |                                                                                                                                                                                                                                                     |           | 8,803,982    |             |  |           | 3,888,798   |           
|                                                   | Receivables, net                                                                                                                    |                                                                                                                                                                                                                                                     |           | 239,879      |             |  |           | 271,681     |           
|                                                   | Inventory                                                                                                                           |                                                                                                                                                                                                                                                     |           | 9,302        |             |  |           | 210,854     |           
|                                                   | Prepaid expenses                                                                                                                    |                                                                                                                                                                                                                                                     |           | 1,526,282    |             |  |           | 1,564,315   |           
|                                                   |                                                                                                                                     |                                                                                                                                                                                                                                                     |           |              |             |  |           |            
|                                                   |                                                                                                                                     | Total current assets                                                                                                                                                                                                                                |           |              | 24,073,528  |  |           |             | 18,134,056 | 
|Investments in securities                          |                                                                                                                                     |                                                                                                                                                                                                                                                     | 2,751,867 |              |             |  | 513,486   |            
|Restricted investments in securities               |                                                                                                                                     |                                                                                                                                                                                                                                                     | 856,597   |              |             |  | 856,597   |            
|Property and equipment, net                        |                                                                                                                                     |                                                                                                                                                                                                                                                     | 6,390,964 |              |             |  | 7,742,005 |            
|Intangible assets, net                             |                                                                                                                                     |                                                                                                                                                                                                                                                     | 3,035,024 |              |             |  | 2,131,209 |            
|Other assets                                       |                                                                                                                                     |                                                                                                                                                                                                                                                     | 295,973   |              |             |  | 267,904   |            
|                                                   |                                                                                                                                     |                                                                                                                                                                                                                                                     |           |              |             |  |           |            
|                                                   |                                                                                                                                     | TOTAL ASSETS                                                                                                                                                                                                                                        |           | $            | 37,403,953  |  |           | $           | 29,645,257 | 
|                                                   |                                                                                                                                     |                                                                                                                                                                                                                                                     |           |              |             |  |           |            
|                                                  
|LIABILITIES AND SHAREHOLDERS
    EQUITY          
|Current liabilities:                               |                                                                                                                                     |                                                                                                                                                                                                                                                     |           |              |             |  |           |            
|                                                   | Accounts payable                                                                                                                    |                                                                                                                                                                                                                                                     | $         | 1,961,938    |             |  | $         | 2,853,604   |           
|                                                   | Accrued expenses and other liabilities                                                                                              |                                                                                                                                                                                                                                                     |           | 2,418,209    |             |  |           | 1,806,058   |           
|                                                   | Accrued compensation and payroll taxes                                                                                              |                                                                                                                                                                                                                                                     |           | 710,368      |             |  |           | 626,154     |           
|                                                   | Current portion of deferred revenue                                                                                                 |                                                                                                                                                                                                                                                     |           | 1,961,530    |             |  |           | 1,841,865   |           
|                                                   | Current portion of notes payable                                                                                                    |                                                                                                                                                                                                                                                     |           | 211,092      |             |  |           | 244,805     |           
|                                                   | Current portion of capital lease obligations                                                                                        |                                                                                                                                                                                                                                                     |           | 156,770      |             |  |           | 142,354     |           
|                                                   |                                                                                                                                     |                                                                                                                                                                                                                                                     |           |              |             |  |           |            
|                                                   |                                                                                                                                     | Total current liabilities                                                                                                                                                                                                                           |           |              | 7,419,907   |  |           |             | 7,514,840  | 
|                                                   | Deferred revenue, net of current portion                                                                                            |                                                                                                                                                                                                                                                     |           | 19,047,585   |             |  |           | 20,900,776  |           
|                                                   | Notes payable, net of current portion                                                                                               |                                                                                                                                                                                                                                                     |           | 703,560      |             |  |           |            |           
|                                                   | Capital lease obligations, net of current portion                                                                                   |                                                                                                                                                                                                                                                     |           | 35,642       |             |  |           | 192,410     |           
|                                                   |                                                                                                                                     |                                                                                                                                                                                                                                                     |           |              |             |  |           |            
|                                                   |                                                                                                                                     | Total liabilities                                                                                                                                                                                                                                   |           |              | 27,206,694  |  |           |             | 28,608,026 | 
|                                                   |                                                                                                                                     |                                                                                                                                                                                                                                                     |           |              |             |  |           |            
|COMMITMENTS AND CONTINGENCIES(Notes 4, 5, 7 and 8) |                                                                                                                                     |                                                                                                                                                                                                                                                     |           |              |             |  |           |            
|SHAREHOLDERS EQUITY:                              |                                                                                                                                     |                                                                                                                                                                                                                                                     |           |              |             |  |           |            
|                                                   | Preferred stock  no par value,
    10,000,000 and 9,999,500 shares authorized as of
    September 30, 2004 and 2003, respectively: |                                                                                                                                                                                                                                                     |           |              |             |  |           |             |           
|                                                   |                                                                                                                                     | Series C Junior Participating 
    1,000,000 shares authorized; no shares issued or outstanding                                                                                                                                                    |           |              |            |  |           |             |           | 
|                                                   | Common stock  no par value:                                                                                                        |                                                                                                                                                                                                                                                     |           |              |             |  |           |             |           
|                                                   |                                                                                                                                     | Class A  200,000,000 and
    99,288,000 shares authorized as of September 30, 2004
    and 2003, respectively; 95,305,757 and 65,816,434 shares
    issued and outstanding as of September 30, 2004 and 2003,
    respectively                     |           |              | 134,687,535 |  |           |             | 97,286,433 | 
|                                                   |                                                                                                                                     | Class B  None and
    712,000 shares authorized as of September 30, 2004 and
    2003, respectively; none and 13,500 shares issued and
    outstanding as of September 30, 2004 and 2003, respectively
    (convertible into Class A common stock) |           |              |            |  |           |             | 8,395      | 
|                                                   | Accumulated deficit                                                                                                                 |                                                                                                                                                                                                                                                     |           | (124,405,902 | )           |  |           | (96,251,049 | )         
|                                                   | Accumulated other comprehensive loss                                                                                                |                                                                                                                                                                                                                                                     |           | (84,374      | )           |  |           | (6,548      | )         
|                                                   |                                                                                                                                     |                                                                                                                                                                                                                                                     |           |              |             |  |           |            
|                                                   |                                                                                                                                     | Total shareholders equity                                                                                                                                                                                                                          |           |              | 10,197,259  |  |           |             | 1,037,231  | 
|                                                   |                                                                                                                                     |                                                                                                                                                                                                                                                     |           |              |             |  |           |            
|                                                   | TOTAL LIABILITIES AND SHAREHOLDERS EQUITY                                                                                          |                                                                                                                                                                                                                                                     | $         | 37,403,953   |             |  | $         | 29,645,257  |           
|                                                   |                                                                                                                                     |                                                                                                                                                                                                                                                     |           |              |             |  |           |            

See notes to consolidated financial statements.

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##### Table of Contents



AVANIR Pharmaceuticals

CONSOLIDATED STATEMENTS OF
OPERATIONS

|                                                          |                                                                             |                           |             |             |            |      |             |             |            |   |             |             |            | 
|--------------------------------------------------------- | --------------------------------------------------------------------------- | ------------------------- | ----------- | ----------- | ---------- | ---- | ----------- | ----------- | ---------- | - | ----------- | ----------- | ---------- | 
|                                                          |                                                                             |                          
|                                                          |                                                                             | Years Ended September 30,
|                                                          |                                                                             |                          
|                                                          |                                                                             | 2004                      |             | 2003        |            | 2002
|                                                          |                                                                             |                           |             |             |            |     
|REVENUES:                                                 |                                                                             |                           |             |             |            |      |             |             |            |   |             |            
|                                                          | Royalties and sale of royalty rights (Note 2)                               |                           | $           | 1,715,152   |            |      | $           | 1,780,893   |            |   | $           | 3,426,403   |           
|                                                          | Government research grants                                                  |                           |             | 758,827     |            |      |             | 587,440     |            |   |             | 160,412     |           
|                                                          | Product sales                                                               |                           |             | 787,338     |            |      |             | 17,400      |            |   |             | 40,760      |           
|                                                          | Research contracts and licenses                                             |                           |             | 328,000     |            |      |             | 53,000      |            |   |             | 5,226,167   |           
|                                                          |                                                                             |                           |             |             |            |      |             |             |            |   |             |            
|                                                          |                                                                             | Total revenues            |             |             | 3,589,317  |      |             |             | 2,438,733  |   |             |             | 8,853,742  | 
|                                                          |                                                                             |                           |             |             |            |      |             |             |            |   |             |            
|OPERATING EXPENSES:                                       |                                                                             |                           |             |             |            |      |             |             |            |   |             |            
|                                                          | Research and development                                                    |                           |             | 22,481,681  |            |      |             | 18,558,017  |            |   |             | 13,602,484  |           
|                                                          | General and administrative                                                  |                           |             | 5,868,208   |            |      |             | 4,736,791   |            |   |             | 4,243,829   |           
|                                                          | Sales and marketing                                                         |                           |             | 3,472,052   |            |      |             | 2,621,320   |            |   |             | 1,640,812   |           
|                                                          | Cost of product sales                                                       |                           |             | 213,192     |            |      |             | 3,102       |            |   |             | 4,731       |           
|                                                          |                                                                             |                           |             |             |            |      |             |             |            |   |             |            
|                                                          |                                                                             | Total operating expenses  |             |             | 32,035,133 |      |             |             | 25,919,230 |   |             |             | 19,491,856 | 
|                                                          |                                                                             |                           |             |             |            |      |             |             |            |   |             |            
|LOSS FROM OPERATIONS                                      |                                                                             |                           | (28,445,816 | )           |            |      | (23,480,497 | )           |            |   | (10,638,114 | )          
|                                                          | Interest income                                                             |                           |             | 290,067     |            |      |             | 265,874     |            |   |             | 663,588     |           
|                                                          | Other income                                                                |                           |             | 38,068      |            |      |             | 26,801      |            |   |             | 129,514     |           
|                                                          | Interest expense                                                            |                           |             | (34,508     | )          |      |             | (44,927     | )          |   |             | (60,560     | )         
|                                                          |                                                                             |                           |             |             |            |      |             |             |            |   |             |            
|LOSS BEFORE INCOME TAXES                                  |                                                                             |                           | (28,152,189 | )           |            |      | (23,232,749 | )           |            |   | (9,905,572  | )          
|                                                          | Provision for income taxes                                                  |                           |             | (2,664      | )          |      |             | (3,599      | )          |   |             | (343,940    | )         
|                                                          |                                                                             |                           |             |             |            |      |             |             |            |   |             |            
|NET LOSS                                                  |                                                                             | $                         | (28,154,853 | )           |            | $    | (23,236,348 | )           |            | $ | (10,249,512 | )          
|                                                          |                                                                             |                           |             |             |            |      |             |             |            |   |             |            
|NET LOSS ATTRIBUTABLE TO COMMON
    SHAREHOLDERS:         |                                                                             |                           |             |             |            |      |             |             |            |   |             |            
|                                                          | Net loss                                                                    |                           | $           | (28,154,853 | )          |      | $           | (23,236,348 | )          |   | $           | (10,249,512 | )         
|                                                          | Dividends on redeemable convertible preferred
    stock                     |                           |             |            |            |      |             | (16,122     | )          |   |             | (25,000     | )         
|                                                          | Accretion of discount related to redeemable
    convertible preferred stock |                           |             |            |            |      |             | (11,823     | )          |   |             | (18,286     | )         
|                                                          |                                                                             |                           |             |             |            |      |             |             |            |   |             |            
|NET LOSS ATTRIBUTABLE TO COMMON SHAREHOLDERS              |                                                                             | $                         | (28,154,853 | )           |            | $    | (23,264,293 | )           |            | $ | (10,292,798 | )          
|                                                          |                                                                             |                           |             |             |            |      |             |             |            |   |             |            
|NET LOSS PER SHARE:                                       |                                                                             |                           |             |             |            |      |             |             |            |   |             |            
|                                                          | BASIC AND DILUTED                                                           |                           | $           | (0.36       | )          |      | $           | (0.39       | )          |   | $           | (0.18       | )         
|                                                          |                                                                             |                           |             |             |            |      |             |             |            |   |             |            
|WEIGHTED AVERAGE NUMBER OF COMMON SHARES
    OUTSTANDING: |                                                                             |                           |             |             |            |      |             |             |            |   |             |            
|                                                          | BASIC AND DILUTED                                                           |                           |             | 77,946,413  |            |      |             | 59,896,135  |            |   |             | 58,206,969  |           
|                                                          |                                                                             |                           |             |             |            |      |             |             |            |   |             |            

See notes to consolidated financial statements.

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##### Table of Contents



AVANIR Pharmaceuticals

CONSOLIDATED STATEMENTS OF SHAREHOLDERS
EQUITY

|                                                                                                                                |                                                                    |              |            |            |  |             |             |               |  |               |        |               |   |        |        |         |   |   |              |   |  |   |         |   |  |   |             |            |  |   |             |   | 
|------------------------------------------------------------------------------------------------------------------------------- | ------------------------------------------------------------------ | ------------ | ---------- | ---------- |  | ----------- | ----------- | ------------- |  | ------------- | ------ | ------------- | - | ------ | ------ | ------- | - | - | ------------ | - |  | - | ------- | - |  | - | ----------- | ---------- |  | - | ----------- | - | 
|                                                                                                                                |                                                                    |              |            |            |  |             |             |               |  |              
|                                                                                                                                |                                                                    | Common Stock |            |            |  |             |             |               |  |              
|                                                                                                                                |                                                                    |              |            |            |  | Accumulated |             |               |  |              
|                                                                                                                                |                                                                    |              |            |            |  |             |             | Other         |  |               |        |              
|                                                                                                                                |                                                                    | Class A      |            | Class B    |  |             |             | Comprehensive |  | Total         |        |              
|                                                                                                                                |                                                                    |              |            |            |  | Accumulated |             | Income        |  | Shareholders |        | Comprehensive
|                                                                                                                                |                                                                    | Shares       |            | Amount     |  | Shares      |             | Amount        |  | Deficit       |        | (Loss)        |   | Equity |        | Loss   
|                                                                                                                                |                                                                    |              |            |            |  |             |             |               |  |               |        |               |   |        |        |        
|BALANCE, OCTOBER 1, 2001                                                                                                        |                                                                    |              | 57,976,381 |            |  | $           | 86,626,355  |               |  |               | 36,500 |               |   | $      | 19,895 |         |   | $ | (62,735,080  | ) |  | $ | 47,390  |   |  | $ | 23,958,560  |            |  |   |             |  
|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                                          |              |            | 191,152    |  |             |             | 170,574       |  |               |        |               |   |        |        |         |   |   |              |   |  |   |         |   |  |   |             | 170,574    |  |   |             |   | 
|                                                                                                                                | Conversions of Class B common stock                                |              |            | 23,000     |  |             |             | 11,500        |  |               |        | (23,000       | ) |        |        | (11,500 | ) |   |              |   |  |   |         |   |  |   |             |           |  |   |             |   | 
|Dividends on preferred stock                                                                                                    |                                                                    |              |            |            |  |             | (25,000     | )             |  |               |        |               |   |        |        |         |   |   |              |   |  |   |         |   |  |   | (25,000     | )          |  |   |             |  
|Accretion of discount related to Series D
    redeemable convertible preferred stock                                            |                                                                    |              |            |            |  |             |             |               |  |               |        |               |   |        |        |         |   |   | (18,286      | ) |  |   |         |   |  |   | (18,286     | )          |  |   |             |  
|Compensation expense related to valuation of
    stock options granted to employees and non-employees for
    services rendered |                                                                    |              |            |            |  |             | 179,828     |               |  |               |        |               |   |        |        |         |   |   |              |   |  |   |         |   |  |   | 179,828     |            |  |   |             |  
|Unrealized losses on investments in securities                                                                                  |                                                                    |              |            |            |  |             |             |               |  |               |        |               |   |        |        |         |   |   |              |   |  |   | (46,683 | ) |  |   | (46,683     | )          |  |   | (46,683     | )
|                                                                                                                                |                                                                    |              |            |            |  |             |             |               |  |               |        |               |   |        |        |         |   |   |              |   |  |   |         |   |  |   |             |            |  |   |             |  
|BALANCE, SEPTEMBER 30, 2002                                                                                                     |                                                                    |              | 58,270,533 |            |  |             | 87,053,257  |               |  |               | 13,500 |               |   |        | 8,395  |         |   |   | (73,002,878  | ) |  |   | 707     |   |  |   | 14,059,481  |            |  | $ | (10,296,195 | )
|                                                                                                                                |                                                                    |              |            |            |  |             |             |               |  |               |        |               |   |        |        |         |   |   |              |   |  |   |         |   |  |   |             |            |  |   |             |  
|Net loss                                                                                                                        |                                                                    |              |            |            |  |             |             |               |  |               |        |               |   |        |        |         |   |   | (23,236,348  | ) |  |   |         |   |  |   | (23,236,348 | )          |  | $ | (23,236,348 | )
|Issuance of Class A common stock in
    connection with:                                                                        |                                                                    |              |            |            |  |             |             |               |  |               |        |               |   |        |        |         |   |   |              |   |  |   |         |   |  |   |             |            |  |   |             |  
|                                                                                                                                | Exercise of warrants                                               |              |            | 53,200     |  |             |             | 59,850        |  |               |        |               |   |        |        |         |   |   |              |   |  |   |         |   |  |   |             | 59,850     |  |   |             |   | 
|                                                                                                                                | Exercise of stock options                                          |              |            | 24,000     |  |             |             | 25,500        |  |               |        |               |   |        |        |         |   |   |              |   |  |   |         |   |  |   |             | 25,500     |  |   |             |   | 
|                                                                                                                                | Restricted stock granted to directors                              |              |            | 80,000     |  |             |             | 92,800        |  |               |        |               |   |        |        |         |   |   |              |   |  |   |         |   |  |   |             | 92,800     |  |   |             |   | 
|                                                                                                                                | Sale of stock and warrants                                         |              |            | 6,728,396  |  |             |             | 9,381,317     |  |               |        |               |   |        |        |         |   |   |              |   |  |   |         |   |  |   |             | 9,381,317  |  |   |             |   | 
|                                                                                                                                | Conversions of Series D Redeemable
    convertible preferred stock |              |            | 660,305    |  |             |             | 536,630       |  |               |        |               |   |        |        |         |   |   |              |   |  |   |         |   |  |   |             | 536,630    |  |   |             |   | 
|Dividends on preferred stock                                                                                                    |                                                                    |              |            |            |  |             | (16,120     | )             |  |               |        |               |   |        |        |         |   |   |              |   |  |   |         |   |  |   | (16,120     | )          |  |   |             |  
|Accretion of discount related to Series D
    redeemable convertible preferred stock                                            |                                                                    |              |            |            |  |             |             |               |  |               |        |               |   |        |        |         |   |   | (11,823      | ) |  |   |         |   |  |   | (11,823     | )          |  |   |             |  
|Compensation expense related to valuation of
    stock options granted to employees and non-employees for
    services rendered |                                                                    |              |            |            |  |             | 153,199     |               |  |               |        |               |   |        |        |         |   |   |              |   |  |   |         |   |  |   | 153,199     |            |  |   |             |  
|Unrealized losses on investments in securities                                                                                  |                                                                    |              |            |            |  |             |             |               |  |               |        |               |   |        |        |         |   |   |              |   |  |   | (7,255  | ) |  |   | (7,255      | )          |  |   | (7,255      | )
|                                                                                                                                |                                                                    |              |            |            |  |             |             |               |  |               |        |               |   |        |        |         |   |   |              |   |  |   |         |   |  |   |             |            |  |   |             |  
|BALANCE, SEPTEMBER 30, 2003                                                                                                     |                                                                    |              | 65,816,434 |            |  |             | 97,286,433  |               |  |               | 13,500 |               |   |        | 8,395  |         |   |   | (96,251,049  | ) |  |   | (6,548  | ) |  |   | 1,037,231   |            |  | $ | (23,243,603 | )
|                                                                                                                                |                                                                    |              |            |            |  |             |             |               |  |               |        |               |   |        |        |         |   |   |              |   |  |   |         |   |  |   |             |            |  |   |             |  
|Net loss                                                                                                                        |                                                                    |              |            |            |  |             |             |               |  |               |        |               |   |        |        |         |   |   | (28,154,853  | ) |  |   |         |   |  |   | (28,154,853 | )          |  | $ | (28,154,853 | )
|Issuance of Class A common stock in
    connection with:                                                                        |                                                                    |              |            |            |  |             |             |               |  |               |        |               |   |        |        |         |   |   |              |   |  |   |         |   |  |   |             |            |  |   |             |  
|                                                                                                                                | Exercise of warrants                                               |              |            | 294,895    |  |             |             | 448,671       |  |               |        |               |   |        |        |         |   |   |              |   |  |   |         |   |  |   |             | 448,671    |  |   |             |   | 
|                                                                                                                                | Exercise of stock options                                          |              |            | 124,009    |  |             |             | 160,823       |  |               |        |               |   |        |        |         |   |   |              |   |  |   |         |   |  |   |             | 160,823    |  |   |             |   | 
|                                                                                                                                | Sale of stock and warrants                                         |              |            | 28,020,112 |  |             |             | 34,015,320    |  |               |        |               |   |        |        |         |   |   |              |   |  |   |         |   |  |   |             | 34,015,320 |  |   |             |   | 
|                                                                                                                                | Research milestone obligation of MIF technology                    |              |            | 1,036,807  |  |             |             | 2,733,023     |  |               |        |               |   |        |        |         |   |   |              |   |  |   |         |   |  |   |             | 2,733,023  |  |   |             |   | 
|                                                                                                                                | Conversions of Class B common stock                                |              |            | 13,500     |  |             |             | 8,395         |  |               |        | (13,500       | ) |        |        | (8,395  | ) |   |              |   |  |   |         |   |  |   |             |           |  |   |             |   | 
|Compensation expense related to valuation of
    stock options granted to employees and non-employees for
    services rendered |                                                                    |              |            |            |  |             | 34,870      |               |  |               |        |               |   |        |        |         |   |   |              |   |  |   |         |   |  |   | 34,870      |            |  |   |             |  
|Unrealized losses on investments in securities                                                                                  |                                                                    |              |            |            |  |             |             |               |  |               |        |               |   |        |        |         |   |   |              |   |  |   | (77,826 | ) |  |   | (77,826     | )          |  |   | (77,826     | )
|                                                                                                                                |                                                                    |              |            |            |  |             |             |               |  |               |        |               |   |        |        |         |   |   |              |   |  |   |         |   |  |   |             |            |  |   |             |  
|BALANCE, SEPTEMBER 30, 2004                                                                                                     |                                                                    |              | 95,305,757 |            |  | $           | 134,687,535 |               |  |               |       |               |   | $      |       |         |   | $ | (124,405,902 | ) |  | $ | (84,374 | ) |  | $ | 10,197,259  |            |  | $ | (28,232,679 | )
|                                                                                                                                |                                                                    |              |            |            |  |             |             |               |  |               |        |               |   |        |        |         |   |   |              |   |  |   |         |   |  |   |             |            |  |   |             |  

See notes to consolidated financial statements.

F-5



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##### Table of Contents



AVANIR Pharmaceuticals

CONSOLIDATED STATEMENTS OF CASH
FLOWS

|                                                                                               |                                                                                            |                                                          |             |            |             |      |             |            |            |   |             |            |            |  
|---------------------------------------------------------------------------------------------- | ------------------------------------------------------------------------------------------ | -------------------------------------------------------- | ----------- | ---------- | ----------- | ---- | ----------- | ---------- | ---------- | - | ----------- | ---------- | ---------- | -
|                                                                                               |                                                                                            |                                                         
|                                                                                               |                                                                                            | Years Ended September 30,                               
|                                                                                               |                                                                                            |                                                         
|                                                                                               |                                                                                            | 2004                                                     |             | 2003       |             | 2002
|                                                                                               |                                                                                            |                                                          |             |            |             |     
|OPERATING ACTIVITIES:                                                                          |                                                                                            |                                                          |             |            |             |      |             |            |            |   |             |           
|Net loss                                                                                       |                                                                                            | $                                                        | (28,154,853 | )          |             | $    | (23,236,348 | )          |            | $ | (10,249,512 | )         
|Adjustments to reconcile net loss to net cash
    provided by (used for) operating activities: |                                                                                            |                                                          |             |            |             |      |             |            |            |   |             |           
|                                                                                               | Depreciation and amortization                                                              |                                                          |             | 1,826,372  |             |      |             | 1,011,802  |            |   |             | 602,803    |           
|                                                                                               | Compensation paid with common stock, stock
    options and warrants                        |                                                          |             | 34,870     |             |      |             | 245,999    |            |   |             | 179,828    |           
|                                                                                               | Research milestone obligation paid with common
    stock                                   |                                                          |             | 2,733,023  |             |      |             |           |            |   |             |           |           
|                                                                                               | Loss on disposal of assets                                                                 |                                                          |             | 162        |             |      |             | 7,193      |            |   |             | 782        |           
|                                                                                               | Intangible assets abandoned                                                                |                                                          |             |           |             |      |             | 74,432     |            |   |             |           |           
|Changes in assets and liabilities:                                                             |                                                                                            |                                                          |             |            |             |      |             |            |            |   |             |           
|                                                                                               | Receivables                                                                                |                                                          |             | 31,802     |             |      |             | 827,273    |            |   |             | (200,278   | )         
|                                                                                               | Inventory                                                                                  |                                                          |             | 201,552    |             |      |             | 27,272     |            |   |             | (15,541    | )         
|                                                                                               | Prepaid expenses and other assets                                                          |                                                          |             | (9,912     | )           |      |             | (845,761   | )          |   |             | (297,024   | )         
|                                                                                               | Accounts payable                                                                           |                                                          |             | (891,666   | )           |      |             | 147,998    |            |   |             | 1,970,905  |           
|                                                                                               | Accrued expenses and other liabilities                                                     |                                                          |             | 612,151    |             |      |             | 207,431    |            |   |             | 871,136    |           
|                                                                                               | Accrued compensation and payroll taxes                                                     |                                                          |             | 84,214     |             |      |             | 164,036    |            |   |             | 100,090    |           
|                                                                                               | Deferred revenue                                                                           |                                                          |             | (1,733,526 | )           |      |             | 22,509,308 |            |   |             | 108,333    |           
|                                                                                               |                                                                                            |                                                          |             |            |             |      |             |            |            |   |             |           
|                                                                                               |                                                                                            | Net cash provided by (used for) operating
    activities |             |            | (25,265,811 | )    |             |            | 1,140,635  |   |             |            | (6,928,478 | )
|                                                                                               |                                                                                            |                                                          |             |            |             |      |             |            |            |   |             |           
|INVESTING ACTIVITIES:                                                                          |                                                                                            |                                                          |             |            |             |      |             |            |            |   |             |           
|                                                                                               | Investments in securities                                                                  |                                                          |             | (9,381,391 | )           |      |             | (3,727,676 | )          |   |             | (9,019,464 | )         
|                                                                                               | Proceeds from sales and maturities of investments
    in securities                        |                                                          |             | 2,150,000  |             |      |             | 3,000,000  |            |   |             | 9,743,012  |           
|                                                                                               | Patent costs                                                                               |                                                          |             | (1,156,975 | )           |      |             | (615,627   | )          |   |             | (537,903   | )         
|                                                                                               | Purchases of property and equipment                                                        |                                                          |             | (202,457   | )           |      |             | (5,510,630 | )          |   |             | (1,391,382 | )         
|                                                                                               |                                                                                            |                                                          |             |            |             |      |             |            |            |   |             |           
|                                                                                               |                                                                                            | Net cash used for investing activities                   |             |            | (8,590,823  | )    |             |            | (6,853,933 | ) |             |            | (1,205,737 | )
|                                                                                               |                                                                                            |                                                          |             |            |             |      |             |            |            |   |             |           
|FINANCING ACTIVITIES:                                                                          |                                                                                            |                                                          |             |            |             |      |             |            |            |   |             |           
|                                                                                               | Proceeds from issuances of common stock and
    warrants, net                              |                                                          |             | 34,624,814 |             |      |             | 9,466,667  |            |   |             | 260,574    |           
|                                                                                               | Dividends paid on preferred stock                                                          |                                                          |             |           |             |      |             | (12,500    | )          |   |             | (25,000    | )         
|                                                                                               | Proceeds from issuances of notes payable                                                   |                                                          |             | 1,074,570  |             |      |             | 244,805    |            |   |             | 287,371    |           
|                                                                                               | Payments on notes and capital lease obligations                                            |                                                          |             | (547,075   | )           |      |             | (417,813   | )          |   |             | (300,728   | )         
|                                                                                               |                                                                                            |                                                          |             |            |             |      |             |            |            |   |             |           
|                                                                                               |                                                                                            | Net cash provided by financing activities                |             |            | 35,152,309  |      |             |            | 9,281,159  |   |             |            | 222,217    |  
|                                                                                               |                                                                                            |                                                          |             |            |             |      |             |            |            |   |             |           
|Net increase (decrease) in cash and cash
    equivalents                                       |                                                                                            |                                                          | 1,295,675   |            |             |      | 3,567,861   |            |            |   | (7,911,998  | )         
|Cash and cash equivalents at beginning of year                                                 |                                                                                            |                                                          | 12,198,408  |            |             |      | 8,630,547   |            |            |   | 16,542,545  |           
|                                                                                               |                                                                                            |                                                          |             |            |             |      |             |            |            |   |             |           
|Cash and cash equivalents at end of year                                                       |                                                                                            | $                                                        | 13,494,083  |            |             | $    | 12,198,408  |            |            | $ | 8,630,547   |           
|                                                                                               |                                                                                            |                                                          |             |            |             |      |             |            |            |   |             |           
|SUPPLEMENTAL DISCLOSURES OF CASH FLOW
    INFORMATION:                                         |                                                                                            |                                                          |             |            |             |      |             |            |            |   |             |           
|                                                                                               | Interest paid                                                                              |                                                          | $           | 34,508     |             |      | $           | 44,927     |            |   | $           | 60,560     |           
|                                                                                               | Income taxes paid                                                                          |                                                          | $           | 2,664      |             |      | $           | 3,599      |            |   | $           | 343,940    |           
|SUPPLEMENTAL DISCLOSURES OF NON-CASH INVESTING
    AND FINANCING ACTIVITIES:                   |                                                                                            |                                                          |             |            |             |      |             |            |            |   |             |           
|                                                                                               | Acquisition of equipment under capital leases                                              |                                                          | $           |           |             |      | $           |           |            |   | $           | 122,662    |           
|                                                                                               | Conversions of Series D redeemable
    convertible preferred stock to Class A common stock |                                                          | $           |           |             |      | $           | 536,630    |            |   | $           |           |           

See notes to consolidated financial statements.

F-6



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##### Table of Contents



AVANIR Pharmaceuticals






NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS




|   |                        
|-- | -----------------------
|1. | Description of Business

AVANIR Pharmaceuticals (AVANIR,
we, or the Company) is a drug discovery
and development company focused primarily on novel treatments
for chronic diseases. AVANIRs lead product candidate,
NeurodexTM, has successfully completed two pivotal
Phase III clinical trials in patients with pseudobulbar
affect (PBA) and should be ready for submission as a
new drug application (NDA) to the U.S. Food and
Drug Administration (FDA) by December 31, 2004.
Under normal FDA review timelines and assuming the drug is
approved, Neurodex should be available for marketing in the
United States in 2006. The Company is also engaged in research
and development of several other drugs in various phases of
clinical and preclinical development, including potential
treatments of neuropathic pain, allergy and asthma, inflammation
and atherosclerosis. The Company also conducts research in
developing human antibody products for various infectious
diseases. AVANIRs first product, Abreva® (chemical
name of docosanol 10% cream), is sold by North American
licensee, GlaxoSmithKline, as an over-the-counter product in the
United States.

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 license arrangements,
the timing and success of reaching development milestones and in
obtaining regulatory approvals. 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 intercompany accounts and transactions have
been eliminated. Certain amounts from prior years have been
reclassified to conform to the current year presentation. The
Companys fiscal year ends on September 30 of each
year. The years ended September 30, 2004, 2003, and 2002
may be referred to as fiscal 2004, fiscal 2003, and fiscal 2002,
respectively.



| |                                            
| | -------------------------------------------
| | Accounting for stock-based
    compensation

In December 2002, the Financial Accounting
Standards Board (FASB) issued Statement of Financial
Accounting Standards No. 148
(SFAS No. 148), Accounting for
Stock-based Compensation  Transition and Disclosure,
an Amendment of FASB Statement No. 123.
SFAS No. 148 amends the disclosure requirements of
SFAS No. 123 to require prominent disclosures in both
annual and interim financial reports about the method of
accounting for stock-based compensation and the effect of the
method used on reported results. SFAS No. 123, as
amended, encourages, but does not require, companies to record
compensation cost for stock-based employee compensation at fair
value.

On March 31, 2004, the FASB issued its
Exposure Draft, Share-based Payment, which is a
proposed amendment to SFAS No. 123. Generally, the
approach in the Exposure Draft is similar to the approach
described in SFAS No. 123. The Exposure Draft would
require all share-based payments to employees, including grants
of employee stock options and stock appreciation rights, to be
recognized in the income statement based on their fair values.
Companies would no longer have the option to account for their
share-based awards to employees using Accounting Principles
Board (APB) Opinion No. 25, Accounting
for Stock Issued to Employees, and related interpretations
(the intrinsic value model) or SFAS No. 123 (the fair
value model).

F-7



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##### Table of Contents



AVANIR Pharmaceuticals


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS   (Continued)

Until such time as there has been a final
determination and implementation by the FASB regarding
Share-based Payment, the Company has chosen to continue to
account for stock-based compensation using the intrinsic value
method prescribed in APB Opinion No. 25, and related
interpretations, for all periods presented. Accordingly,
compensation costs for stock options is measured as the excess,
if any, of the fair value of the Companys stock at the
date of the grant over the amount an employee must pay to
acquire the stock.

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

|                                                                                                                    |                                 |                                                            |             |       |             |      |             |       |             |   |             |       |             |  
|------------------------------------------------------------------------------------------------------------------- | ------------------------------- | ---------------------------------------------------------- | ----------- | ----- | ----------- | ---- | ----------- | ----- | ----------- | - | ----------- | ----- | ----------- | -
|                                                                                                                    |                                 |                                                           
|                                                                                                                    |                                 | Year Ended September 30,                                  
|                                                                                                                    |                                 |                                                           
|                                                                                                                    |                                 | 2004                                                       |             | 2003  |             | 2002
|                                                                                                                    |                                 |                                                            |             |       |             |     
|Net loss attributable to common shareholders, as
    reported                                                       |                                 | $                                                          | (28,154,853 | )     |             | $    | (23,264,293 | )     |             | $ | (10,292,798 | )    
|Add: Stock-based employee compensation included
    in reported net loss attributable to common shareholders        |                                 |                                                            | 24,069      |       |             |      | 234,638     |       |             |   | 172,071     |      
|Deduct: Total stock-based employee compensation
    expense determined under fair value based method for all awards |                                 |                                                            | (1,026,844  | )     |             |      | (1,788,674  | )     |             |   | (2,348,203  | )    
|                                                                                                                    |                                 |                                                            |             |       |             |      |             |       |             |   |             |      
|                                                                                                                    |                                 | Pro forma net loss attributable to common
    shareholders |             | $     | (29,157,628 | )    |             | $     | (24,818,329 | ) |             | $     | (12,468,930 | )
|                                                                                                                    |                                 |                                                            |             |       |             |      |             |       |             |   |             |      
|Net loss per share:                                                                                                 |                                 |                                                            |             |       |             |      |             |       |             |   |             |      
|                                                                                                                    | Basic and diluted  as reported |                                                            | $           | (0.36 | )           |      | $           | (0.39 | )           |   | $           | (0.18 | )          
|                                                                                                                    | Basic and diluted  pro forma   |                                                            | $           | (0.37 | )           |      | $           | (0.41 | )           |   | $           | (0.21 | )          

We estimate the weighted average fair values per
share of the options granted during fiscal 2004, 2003 and 2002
to be $1.81, $0.96, and $2.49, respectively, using the
Black-Scholes option-pricing model and the following assumptions:

|                        |  |                           |      |      |  |      |      |   |  |  |      |  
|----------------------- |  | ------------------------- | ---- | ---- |  | ---- | ---- | - |  |  | ---- | -
|                        |  |                          
|                        |  | Years Ended September 30,
|                        |  |                          
|                        |  | 2004                      |      | 2003 |  | 2002
|                        |  |                           |      |      |  |     
|Risk free interest rate |  |                           | 2.4  | %    |  |      | 2.7  | % |  |  | 4.4  | %
|Expected life (years)   |  |                           | 3.4  |      |  |      | 4.6  |   |  |  | 4.2  |  
|Expected volatility     |  |                           | 133  | %    |  |      | 125  | % |  |  | 128  | %
|Expected dividends      |  |                           | None |      |  |      | None |   |  |  | None |  



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

We compute basic net loss per common share by
dividing the net loss attributable to common shareholders by the
weighted-average number of common shares outstanding during the
period (Basic EPS Method). We compute diluted net
loss per common share by dividing the 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. In the accompanying consolidated statements of
operations, we have presented our net loss per share for fiscal
2004, 2003 and 2002 using the Basic EPS Method and the Diluted
EPS Method. The shares of common stock issuable upon exercise of
stock options and warrants under the Diluted EPS Method were
excluded from fiscal 2004, 2003 and 2002, as the inclusion of
such shares would have been antidilutive.

F-8



---



##### Table of Contents



AVANIR Pharmaceuticals


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS   (Continued)

A reconciliation of the basic EPS to the diluted
EPS computations for fiscal 2004, 2003 and 2002 is shown in the
following table:

|                                     |                                                                      |                                                                             |                                                                                           |             |   |             |       |             |         |             |       |             |         |             |  
|------------------------------------ | -------------------------------------------------------------------- | --------------------------------------------------------------------------- | ----------------------------------------------------------------------------------------- | ----------- | - | ----------- | ----- | ----------- | ------- | ----------- | ----- | ----------- | ------- | ----------- | -
|                                     |                                                                      |                                                                            
|                                     |                                                                      | Years Ended September 30,                                                  
|                                     |                                                                      |                                                                            
|                                     |                                                                      | 2004                                                                        |                                                                                           | 2003        |   | 2002       
|                                     |                                                                      |                                                                             |                                                                                           |             |   |            
|Numerator:                           |                                                                      |                                                                             |                                                                                           |             |   |             |       |             |         |             |       |            
|                                     | Net loss                                                             |                                                                             | $                                                                                         | (28,154,853 | ) |             | $     | (23,236,348 | )       |             | $     | (10,249,512 | )      
|Less:                                |                                                                      |                                                                             |                                                                                           |             |   |             |       |             |         |             |       |            
|                                     |                                                                      | Dividends on redeemable convertible preferred
    stock                     |                                                                                           |             |  |             |       |             | (16,122 | )           |       |             | (25,000 | )          
|                                     |                                                                      | Accretion of discount related to redeemable
    convertible preferred stock |                                                                                           |             |  |             |       |             | (11,823 | )           |       |             | (18,286 | )          
|                                     |                                                                      |                                                                             |                                                                                           |             |   |             |       |             |         |             |       |            
|                                     |                                                                      |                                                                             | Net loss attributable to common shareholders for
    basic earnings per share computation |             | $ | (28,154,853 | )     |             | $       | (23,264,293 | )     |             | $       | (10,292,798 | )
|                                     |                                                                      |                                                                             |                                                                                           |             |   |             |       |             |         |             |       |            
|Denominator:                         |                                                                      |                                                                             |                                                                                           |             |   |             |       |             |         |             |       |            
|                                     | Weighted average shares for basic and diluted net
    loss per share |                                                                             |                                                                                           | 77,946,413  |   |             |       | 59,896,135  |         |             |       | 58,206,969  |        
|                                     |                                                                      |                                                                             |                                                                                           |             |   |             |       |             |         |             |       |            
|Basic and diluted net loss per share |                                                                      | $                                                                           | (0.36                                                                                     | )           |   | $           | (0.39 | )           |         | $           | (0.18 | )          
|                                     |                                                                      |                                                                             |                                                                                           |             |   |             |       |             |         |             |       |            

For fiscal 2002, preferred stock that was
convertible into 520,648 shares of common stock was
excluded from the computation of diluted net loss per share, as
the inclusion of such shares would be antidilutive. For fiscal
2004, 2003, and 2002, the following options and warrants to
purchase shares of common stock were excluded from the
computation of diluted net loss per share, as the inclusion of
such shares would be antidilutive:

|               |  |                           |           |      |  |      |           |  |  |  |           | 
|-------------- |  | ------------------------- | --------- | ---- |  | ---- | --------- |  |  |  | --------- | 
|               |  |                          
|               |  | Years Ended September 30,
|               |  |                          
|               |  | 2004                      |           | 2003 |  | 2002
|               |  |                           |           |      |  |     
|Stock options  |  |                           | 5,253,593 |      |  |      | 5,308,604 |  |  |  | 5,739,306 | 
|Stock warrants |  |                           | 5,322,106 |      |  |      | 2,289,900 |  |  |  | 1,084,550 | 



| |                          
| | -------------------------
| | 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.



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

The Company has restricted investments in two
securities totaling $856,597 as of both September 30, 2004
and 2003. These restricted investments represent amounts pledged
to our bank as collateral for letters of credit issued in
connection with our real estate lease agreements, and are
classified as held-to-maturity. The restrictions apply to the
terms of the leases as follows:

|                                                    |       |                     |         |            |  |  |          |  | 
|--------------------------------------------------- | ----- | ------------------- | ------- | ---------- |  |  | -------- |  | 
|                                                    |       | Restricted Amount   |         |           
|                                                    |       | as of September 30, |         | Lease Term
|Property Location                                   |       | 2004                |         | Expires on
|                                                    |       |                     |         |           
|11388 Sorrento Valley Road, San Diego               |       | $                   | 388,122 |            |  |  | 08/31/08 | 
|11404 and 11408 Sorrento Valley Road,
    San Diego |       |                     | 468,475 |            |  |  | 08/31/12 | 
|                                                    |       |                     |         |            |  |  |          | 
|                                                    | Total |                     | $       | 856,597    |  |  |          |  | 
|                                                    |       |                     |         |            |  |  |          | 

F-9



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##### Table of Contents



AVANIR Pharmaceuticals


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS   (Continued)



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

Investments are comprised of marketable
securities consisting primarily of certificates of deposit,
U.S. state and municipal government obligations, corporate
bonds, and an investment in a mutual fund that invests primarily
in asset-backed and mortgage-backed securities. All marketable
securities are held in the Companys name and primarily
under the custodianship of two major financial institutions. The
Companys policy is to protect the value of its investment
portfolio and minimize principal risk by earning returns based
on current interest rates. Short-term investments are marketable
securities with maturities of less than one year from the
balance sheet date.

Statement of Financial Accounting Standards
No. 115 (SFAS No. 115), Accounting for Certain
Investments in Debt and Equity Securities, addresses the
accounting and reporting for investments in equity securities
that have readily determinable fair values and for all
investments in debt securities. Those investments are to be
classified in three categories and accounted for as follows:



| |   |                                                                                                                                                                                                                                                                                                                                                            
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | Debt securities that the Company has the positive
    intent and ability to hold to maturity are classified as
    held-to-maturity securities and reported at amortized
    cost.                                                                                                                                                                         
|
| |  | Debt and equity securities that are bought and
    held principally for the purpose of selling them in the near
    term are classified as trading securities and reported at
    fair value, with unrealized gains and losses included in the
    Companys Consolidated Statement of Operations.                                                         
|
| |  | Debt and equity securities not classified as
    either held-to-maturity securities or trading securities are
    classified as available-for-sale securities and reported
    at fair value, with unrealized gains and losses excluded from
    the Consolidated Statement of Operations and reported in a
    separate component of shareholders equity.

SFAS No. 115 also 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 No. 115
requires the carrying value of the debt or equity security to be
permanently written down to its fair value.

The following tables summarize the Companys
investments in securities, all of which are classified as
available-for-sale except for restricted investments, which are
classified as held-to-maturity. The Company does not have any
investments that are impaired.

|                          |                                |                                  |                       |            |           |            |            |            |  |   |       |         |   |   |         |           |  |   |            | 
|------------------------- | ------------------------------ | -------------------------------- | --------------------- | ---------- | --------- | ---------- | ---------- | ---------- |  | - | ----- | ------- | - | - | ------- | --------- |  | - | ---------- | 
|                          |                                |                                  |                       | Gross      |           | Gross      |            |           
|                          |                                | Amortized                        |                       | Unrealized |           | Unrealized |            |           
|                          |                                | Cost                             |                       | Gains(1)   |           | Losses(1)  |            | Fair Value
|                          |                                |                                  |                       |            |           |            |            |           
|As of September 30, 2004: |                                |                                  |                       |            |           |            |            |            |  |   |       |         |   |   |         |          
|                          | Certificates of deposit        |                                  | $                     | 1,356,597  |           |            | $          | 3,558      |  |   | $     |        |   |   | $       | 1,360,155 | 
|                          | Adjustable rate mutual fund(2) |                                  |                       | 3,014,365  |           |            |            |           |  |   |       | (68,650 | ) |   |         | 2,945,715 | 
|                          | Government debt securities     |                                  |                       | 8,125,858  |           |            |            | 6,186      |  |   |       | (25,468 | ) |   |         | 8,106,576 | 
|                          |                                |                                  |                       |            |           |            |            |            |  |   |       |         |   |   |         |          
|                          |                                |                                  |                       | Total      |           | $          | 12,496,820 |            |  | $ | 9,744 |         |   | $ | (94,118 | )         |  | $ | 12,412,446 | 
|                          |                                |                                  |                       |            |           |            |            |            |  |   |       |         |   |   |         |          
|Reported as:              |                                |                                  |                       |            |           |            |            |            |  |   |       |         |   |   |         |          
|                          | Short-term investments:        |                                  |                       |            |           |            |            |            |  |   |       |         |   |   |         |           | 
|                          |                                | Classified as available-for-sale |                       | $          | 8,803,982 |            |            |            |  |   |       |         |   |   |         |           |  |  
|                          |                                |                                  |                       |            |           |            |            |            |  |   |       |         |   |   |         |          
|                          | Long-term investments:         |                                  |                       |            |           |            |            |            |  |   |       |         |   |   |         |           | 
|                          |                                | Classified as available-for-sale |                       |            | 2,751,867 |            |            |            |  |   |       |         |   |   |         |           |  |  
|                          |                                | Restricted investments(3)        |                       |            | 856,597   |            |            |            |  |   |       |         |   |   |         |           |  |  
|                          |                                |                                  |                       |            |           |            |            |            |  |   |       |         |   |   |         |          
|                          |                                |                                  | Long-term investments |            |           | 3,608,464  |            |            |  |   |       |         |   |   |         |           |  |   |           
|                          |                                |                                  |                       |            |           |            |            |            |  |   |       |         |   |   |         |          
|                          |                                |                                  |                       | Total      |           | $          | 12,412,446 |            |  |   |       |         |   |   |         |           |  |   |            | 
|                          |                                |                                  |                       |            |           |            |            |            |  |   |       |         |   |   |         |          

F-10



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##### Table of Contents



AVANIR Pharmaceuticals


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS   (Continued)

|                          |                                |                                  |                       |            |           |            |           |            |  |   |        |         |   |   |         |           |  |   |           | 
|------------------------- | ------------------------------ | -------------------------------- | --------------------- | ---------- | --------- | ---------- | --------- | ---------- |  | - | ------ | ------- | - | - | ------- | --------- |  | - | --------- | 
|                          |                                |                                  |                       | Gross      |           | Gross      |           |           
|                          |                                | Amortized                        |                       | Unrealized |           | Unrealized |           |           
|                          |                                | Cost                             |                       | Gains(4)   |           | Losses(4)  |           | Fair Value
|                          |                                |                                  |                       |            |           |            |           |           
|As of September 30, 2003: |                                |                                  |                       |            |           |            |           |            |  |   |        |         |   |   |         |          
|                          | Certificates of deposit        |                                  | $                     | 2,056,597  |           |            | $         | 15,575     |  |   | $      |        |   |   | $       | 2,072,172 | 
|                          | Adjustable rate mutual fund(2) |                                  |                       | 3,014,365  |           |            |           |           |  |   |        | (18,723 | ) |   |         | 2,995,642 | 
|                          | Government debt securities     |                                  |                       | 194,467    |           |            |           |           |  |   |        | (3,400  | ) |   |         | 191,067   | 
|                          |                                |                                  |                       |            |           |            |           |            |  |   |        |         |   |   |         |          
|                          |                                |                                  |                       | Total      |           | $          | 5,265,429 |            |  | $ | 15,575 |         |   | $ | (22,123 | )         |  | $ | 5,258,881 | 
|                          |                                |                                  |                       |            |           |            |           |            |  |   |        |         |   |   |         |          
|Reported as:              |                                |                                  |                       |            |           |            |           |            |  |   |        |         |   |   |         |          
|                          | Short-term investments:        |                                  |                       |            |           |            |           |            |  |   |        |         |   |   |         |           | 
|                          |                                | Classified as available-for-sale |                       | $          | 3,888,798 |            |           |            |  |   |        |         |   |   |         |           |  |  
|                          |                                |                                  |                       |            |           |            |           |            |  |   |        |         |   |   |         |          
|                          | Long-term investments:         |                                  |                       |            |           |            |           |            |  |   |        |         |   |   |         |           | 
|                          |                                | Classified as available-for-sale |                       |            | 513,486   |            |           |            |  |   |        |         |   |   |         |           |  |  
|                          |                                | Restricted investments(3)        |                       |            | 856,597   |            |           |            |  |   |        |         |   |   |         |           |  |  
|                          |                                |                                  |                       |            |           |            |           |            |  |   |        |         |   |   |         |          
|                          |                                |                                  | Long-term investments |            |           | 1,370,083  |           |            |  |   |        |         |   |   |         |           |  |   |          
|                          |                                |                                  |                       |            |           |            |           |            |  |   |        |         |   |   |         |          
|                          |                                |                                  |                       | Total      |           | $          | 5,258,881 |            |  |   |        |         |   |   |         |           |  |   |           | 
|                          |                                |                                  |                       |            |           |            |           |            |  |   |        |         |   |   |         |          



---



|    |                                                                                                                                                                                                                                                                                                                                                                    
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | Gross unrealized gains of $9,744 and gross
    unrealized losses of $94,118 on government securities, the
    adjustable rate mutual fund, and certificates of deposit
    represent an accumulated net unrealized loss of $84,374, which
    is reported as accumulated other comprehensive loss
    on the consolidated balance sheet as of September 30, 2004.
|   
|(2) | Represents an investment in a mutual fund that
    invests primarily in adjustable rate mortgage-backed securities.                                                                                                                                                                                                                                                
|   
|(3) | Restricted investments amounting to $856,597 as
    of September 30, 2004 and 2003, represent amounts pledged
    to our bank as collateral for letters of credit issued in
    connection with our leases of office and laboratory space.                                                                                                                         
|   
|(4) | Gross unrealized gains of $15,575 and gross
    unrealized losses of $22,123 on government securities, the
    adjustable rate mutual fund, and certificates of deposit
    represent an accumulated net unrealized loss of $6,548, which is
    reported as accumulated other comprehensive loss on
    the consolidated balance sheet as of September 30, 2003.



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

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

F-11



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##### Table of Contents



AVANIR Pharmaceuticals


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS   (Continued)



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

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

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

The Companys income from fiscal 2002 to
2004 was derived substantially from its license agreement with
GlaxoSmithKline and the sale of rights to royalties under that
agreement. 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.



| |                       
| | ----------------------
| | Property and equipment

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.

Property and equipment as of September 30,
2004 and 2003 consist of the following:

|                                          |                              |                    |           |                    |  |       |            |            |   |              |           |           |  |   |           |            |  |   |            |            |   |   |           |           | 
|----------------------------------------- | ---------------------------- | ------------------ | --------- | ------------------ |  | ----- | ---------- | ---------- | - | ------------ | --------- | --------- |  | - | --------- | ---------- |  | - | ---------- | ---------- | - | - | --------- | --------- | 
|                                          |                              |                    |           |                   
|                                          |                              | September 30, 2004 |           | September 30, 2003
|                                          |                              |                    |           |                   
|                                          |                              | Gross              |           |                    |  | Gross |            |           
|                                          |                              | Carrying           |           | Accumulated        |  |       |            | Carrying   |   | Accumulated  |           |          
|                                          |                              | Value              |           | Depreciation       |  | Net   |            | Value      |   | Depreciation |           | Net      
|                                          |                              |                    |           |                    |  |       |            |            |   |              |           |          
|Research and development equipment        |                              | $                  | 3,701,461 |                    |  | $     | (2,021,193 | )          |   | $            | 1,680,268 |           |  | $ | 3,544,343 |            |  | $ | (1,331,544 | )          |   | $ | 2,212,799 |          
|Computer equipment and related software   |                              |                    | 999,073   |                    |  |       | (545,953   | )          |   |              | 453,120   |           |  |   | 1,000,206 |            |  |   | (383,512   | )          |   |   | 616,694   |          
|Leasehold improvements                    |                              |                    | 5,032,605 |                    |  |       | (1,048,184 | )          |   |              | 3,984,421 |           |  |   | 5,000,147 |            |  |   | (445,435   | )          |   |   | 4,554,712 |          
|Office equipment, furniture, and fixtures |                              |                    | 558,970   |                    |  |       | (285,815   | )          |   |              | 273,155   |           |  |   | 549,864   |            |  |   | (192,064   | )          |   |   | 357,800   |          
|                                          |                              |                    |           |                    |  |       |            |            |   |              |           |           |  |   |           |            |  |   |            |            |   |   |           |          
|                                          | Total property and equipment |                    | $         | 10,292,109         |  |       | $          | (3,901,145 | ) |              | $         | 6,390,964 |  |   | $         | 10,094,560 |  |   | $          | (2,352,555 | ) |   | $         | 7,742,005 | 
|                                          |                              |                    |           |                    |  |       |            |            |   |              |           |           |  |   |           |            |  |   |            |            |   |   |           |          



| |                  
| | -----------------
| | Intangible assets

Effective October 1, 2002, the Company
adopted Statement of Financial Accounting Standards
No. 142, Goodwill and Other Intangible Assets
(SFAS No. 142), which requires goodwill
and other intangible assets that have indefinite useful lives to
no longer be amortized; however, these assets must be reviewed
at least annually for impairment. Intangible assets with
indefinite useful lives consist of costs of trademarks for
AVANIR and Xenerex and similar names intended for use or
potential use in the United States and the rest of the world.
Intangible assets with finite lives continue to be amortized
over their useful lives for the fiscal year ended
September 30, 2004, and are evaluated for impairment
whenever events or changes in circumstances

F-12



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##### Table of Contents



AVANIR Pharmaceuticals


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS   (Continued)

indicate that their carrying value may not be
recoverable under SFAS No. 144, Accounting for
Impairment or Disposal of Long-lived Assets. 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 carried no goodwill on its books at either
September 30, 2004 or 2003. The adoption of
SFAS No. 142 did not have a material effect on the
Company.

We capitalize legal costs incurred in connection
with patents, patent applications pending, trademark
applications and license agreements. We amortize costs of
approved patents and license agreements over their estimated
useful lives, or terms of the agreements, whichever are shorter.
For patents pending, we amortize the costs over the shorter of a
period of twenty years from the date of filing the application
or, if licensed, the term of the license agreement. We re-assess
the useful lives of patents when they are issued, or whenever
events or changes in circumstances indicate the useful lives may
have changed. For patent and trademark applications that we
abandon, we charge the remaining unamortized accumulated costs
to expense. AVANIRs amortizable intangible assets consist
of the costs of patents, patent applications, and licenses.

Intangible assets, consisting of both intangible
assets with finite and indefinite useful lives as of
September 30, 2004 and 2003, are as follows:

|                                               |                             |                         |           |                    |           |       |          |          |          |              |           |           |           |  |           |           |           |  |          |          |          |   |           |           |           | 
|---------------------------------------------- | --------------------------- | ----------------------- | --------- | ------------------ | --------- | ----- | -------- | -------- | -------- | ------------ | --------- | --------- | --------- |  | --------- | --------- | --------- |  | -------- | -------- | -------- | - | --------- | --------- | --------- | 
|                                               |                             |                         |           |                   
|                                               |                             | September 30, 2004      |           | September 30, 2003
|                                               |                             |                         |           |                   
|                                               |                             | Gross                   |           |                    |           | Gross |          |         
|                                               |                             | Carrying                |           | Accumulated        |           |       |          | Carrying |          | Accumulated  |           |          
|                                               |                             | Value                   |           | Amortization       |           | Net   |          | Value    |          | Amortization |           | Net      
|                                               |                             |                         |           |                    |           |       |          |          |          |              |           |          
|Intangible assets with finite lives:           |                             |                         |           |                    |           |       |          |          |          |              |           |           |           |  |           |           |           |  |          |          |          |   |           |          
|                                               | Patent applications pending |                         | $         | 2,462,704          |           |       | $        | (166,000 | )        |              | $         | 2,296,704 |           |  | $         | 1,464,859 |           |  | $        |         |          |   | $         | 1,464,859 |          
|                                               | Patents                     |                         |           | 1,010,097          |           |       |          | (339,552 | )        |              |           | 670,545   |           |  |           | 855,799   |           |  |          | (254,657 | )        |   |           | 601,142   |          
|                                               | Licenses                    |                         |           | 42,461             |           |       |          | (15,647  | )        |              |           | 26,814    |           |  |           | 42,461    |           |  |          | (13,383  | )        |   |           | 29,078    |          
|                                               |                             |                         |           |                    |           |       |          |          |          |              |           |           |           |  |           |           |           |  |          |          |          |   |           |          
|Total intangible assets with finite lives      |                             |                         | 3,515,262 |                    |           |       | (521,199 | )        |          |              | 2,994,063 |           |           |  | 2,363,119 |           |           |  | (268,040 | )        |          |   | 2,095,079 |          
|Intangible assets with indefinite useful lives |                             |                         | 40,961    |                    |           |       |         |          |          |              | 40,961    |           |           |  | 36,130    |           |           |  |         |          |          |   | 36,130    |          
|                                               |                             |                         |           |                    |           |       |          |          |          |              |           |           |           |  |           |           |           |  |          |          |          |   |           |          
|                                               |                             | Total intangible assets |           | $                  | 3,556,223 |       |          | $        | (521,199 | )            |           | $         | 3,035,024 |  |           | $         | 2,399,249 |  |          | $        | (268,040 | ) |           | $         | 2,131,209 | 
|                                               |                             |                         |           |                    |           |       |          |          |          |              |           |           |           |  |           |           |           |  |          |          |          |   |           |          

Amortization expense related to amortizable
intangible assets was $253,159, $69,405, and $53,413 for fiscal
years 2004, 2003, and 2002, respectively. During fiscal 2004
there were $4,831 in additional intangible assets with
indefinite useful lives for legal costs in connection with our
trademarks. During fiscal 2003, there were additions of $23,781
and an abandonment of $74,432 in intangible assets with
indefinite useful lives. Based solely on the amortizable
intangible assets as of September 30, 2004, the estimated
annual amortization expense of intangible assets for the fiscal
years ending September 30 is as shown in the following
table. Actual

F-13



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##### Table of Contents



AVANIR Pharmaceuticals


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS   (Continued)

amortization expense to be reported in future
periods could differ from these estimates as a result of
acquisitions, divestitures, asset impairments, and other
relevant factors.

|                                 |       |   |           |           | 
|-------------------------------- | ----- | - | --------- | --------- | 
|Amortization Expense             |       |  
|                                 |       |  
|Fiscal year ending September 30: |       |   |           |          
|2005                             |       | $ | 125,960   |          
|2006                             |       |   | 124,650   |          
|2007                             |       |   | 87,270    |          
|2008                             |       |   | 87,111    |          
|2009                             |       |   | 83,159    |          
|Thereafter                       |       |   | 2,485,913 |          
|                                 |       |   |           |          
|                                 | Total |   | $         | 2,994,063 | 
|                                 |       |   |           |          



| |                    
| | -------------------
| | 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 licensed products when earned in
accordance with the terms of the license agreements and reported
by the licensees. Net sales figures used for calculating
royalties due to 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.

Revenues from sale of royalty
rights.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. For example, in the sale of an undivided
interest of our Abreva license agreement to Drug Royalty USA,
revenue recognition is being determined under the
units-of-revenue method. Under this method, the amount of
deferred revenue to be recognized as revenue in each period is
calculated by multiplying (i) the ratio of the royalty
payments due to Drug Royalty USA for the period to the total
remaining royalties that we expect SB will pay Drug Royalty USA
over the term of the agreement, by (ii) the unamortized
deferred revenue amount.

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

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

F-14



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##### Table of Contents



AVANIR Pharmaceuticals


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS   (Continued)



| |                 
| | ----------------
| | Deferred revenue

We have several license agreements with
additional or continuing obligations to perform under the
agreements. In such arrangements, certain revenues have been
deferred until the performance obligations have been met or
ratably achieved. In our largest license agreement, AVANIR sold
an undivided interest in its Abreva® license agreement with
SB Pharmco Puerto Rico, Inc. (SB or
GlaxoSmithKline) to Drug Royalty USA, Inc.
(Drug Royalty USA) on December 24, 2002 for
$24.1 million. We recorded the net proceeds of the
transaction as deferred revenue, to be recognized as revenue
over the life of the license agreement, because of our ongoing
involvement in earning future revenues under our license
agreement with SB. The following table sets forth as of
September 30, 2004 the deferred revenue balances for the
Drug Royalty USA agreement and other agreements. The portion of
deferred revenue classified as a current liability represents
the amount AVANIR expects to realize as revenue within the next
12 months.

|                                          |                                          |                        |            |            |            |       |         |          |         |   |            |            |            | 
|----------------------------------------- | ---------------------------------------- | ---------------------- | ---------- | ---------- | ---------- | ----- | ------- | -------- | ------- | - | ---------- | ---------- | ---------- | 
|                                          |                                          | Drug Royalty           |            | Other      |            |      
|                                          |                                          | USA Agreement          |            | Agreements |            | Total
|                                          |                                          |                        |            |            |            |      
|Deferred revenue as of September 30, 2003 |                                          | $                      | 22,509,308 |            |            | $     | 233,333 |          |         | $ | 22,742,641 |           
|                                          |                                          |                        |            |            |            |       |         |          |         |   |            |           
|Changes during the year:                  |                                          |                        |            |            |            |       |         |          |         |   |            |           
|                                          | Additions to deferred revenue(1)         |                        |            |           |            |       |         | 300,000  |         |   |            | 300,000    |           
|                                          | Recognized as revenue during the year    |                        |            | (1,708,526 | )          |       |         | (325,000 | )       |   |            | (2,033,526 | )         
|                                          |                                          |                        |            |            |            |       |         |          |         |   |            |           
|Deferred revenue as of September 30, 2004 |                                          | $                      | 20,800,782 |            |            | $     | 208,333 |          |         | $ | 21,009,115 |           
|                                          |                                          |                        |            |            |            |       |         |          |         |   |            |           
|Classified as:                            |                                          |                        |            |            |            |       |         |          |         |   |            |           
|                                          | Current portion of deferred revenue      |                        | $          | 1,828,197  |            |       | $       | 133,333  |         |   | $          | 1,961,530  |           
|                                          | Deferred revenue, net of current portion |                        |            | 18,972,585 |            |       |         | 75,000   |         |   |            | 19,047,585 |           
|                                          |                                          |                        |            |            |            |       |         |          |         |   |            |           
|                                          |                                          | Total deferred revenue |            | $          | 20,800,782 |       |         | $        | 208,333 |   |            | $          | 21,009,115 | 
|                                          |                                          |                        |            |            |            |       |         |          |         |   |            |           



---



|    |                                                                                                                                                                                                                                                                                                                                                        
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | In May 2004, we entered into a license agreement
    with The Gerolymatos Group of Companies to manufacture and sell
    docosanol 10% cream in Greece, Cyprus, Turkey and Romania. In
    September 2004, we entered into a license agreement with ACO HUD
    to manufacture and sell docosanol 10% cream in Sweden, Norway,
    Denmark and Finland.



| |              
| | -------------
| | Deferred rent

We account for rent expense by accumulating total
minimum rent payments over the lives of the lease agreements and
recognize the rent as expense on a straight-line basis. The
difference in actual amount paid and amount recorded as rent
expense in the fiscal year has been credited to deferred rent.
The amount classified as deferred rent as of September 30,
2004 and 2003 is $557,481 and $400,204, respectively.



| |                                      
| | -------------------------------------
| | Research and development
    expenses

We charge to research and development expense
costs related to drug discovery and clinical development as they
are incurred. We also charge to research and development expense
up-front payments made by the Company, in exchange for the
avoidance of potential future milestone payments on licensed
technology when the technology is in the early stages of
development and concurrently has no alternative uses.

Expenses related to the MIF Inhibitor
Technology.In August 2004, AVANIR
entered into an amendment to a certain Technology Acquisition
Agreement with the Ciblex Corporation dated August 8, 2001
(the Amendment). Under the Amendment, the Company
will no longer be obligated to make up to $9 million in
milestone payments to Ciblex upon the occurrence of certain
events relating to the clinical development and/or
commercialization of the MIF Inhibitor Technology in the United
States and will no longer have to

F-15



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##### Table of Contents



AVANIR Pharmaceuticals


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS   (Continued)

share any other milestone payments received from
potential licenses outside the United States. In exchange for
the elimination of obligations to pay milestones or share in the
receipt of milestones, the Company issued Ciblex
1,036,807 shares of Class A common stock. For the
purposes of determining the fair market price for the common
stock for the financial statements, we used the 5-day average
closing sales price of AVANIRs common stock, beginning two
days before and ending two days after the date of the Amendment,
or $2.636 per share, establishing a value of the common
stock of $2,733,023. We recorded the value of the common stock
as research and development expense.

The MIF Inhibitor Technology includes certain
compounds, any and all patents and patent applications, any
divisions, continuations, reexaminations or reissues thereof and
any foreign counterparts which may be issued or issuing on any
of the foregoing regarding the use of those compounds in the
treatment of auto immune and inflammatory diseases, and all
preclinical data related to those compounds, and all technology
and know-how relating to the foregoing, including laboratory
data and previous experimental results.

In accounting for the cost of the Amendment, we
used a number of factors to determine the allocation of costs
between research and development expense and other intangible
assets, which might have a useful life or indefinite life. Such
determining factors included the stage of completion of the
technology, the complexity of the work completed to date, the
projected difficulty of completing the remaining development,
and the expected cost to complete the project. Because of the
early stage of development of the MIF inhibitor technology,
uncertainty of successfully completing toxicology studies and
clinical trials that are necessary to show evidence of safety
and efficacy of the compounds among other requirements, and no
alternative future uses without further development, we
allocated 100% of the cost of the transaction as research and
development expense.



| |                     
| | --------------------
| | Management estimates

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



| |                                     
| | ------------------------------------
| | Recent accounting
    pronouncements

Financial Accounting Standards Board
(FASB) Interpretation
No. 46-R.In December 2003, the
FASB issued FASB Interpretation Number 46-R
(FIN 46-R), Consolidation of Variable
Interest Entities. FIN 46-R, which modified certain
provisions and extended the effective date of FIN 46 to the
first quarter of 2004, sets forth criteria to be used in
determining whether an investment in a variable interest entity
should be consolidated. These provisions are based on the
general premise that if a company controls another entity
through interests other than voting interests, that company
should consolidate the controlled entity. AVANIR adopted the
revised guidance on January 1, 2004. Management has
evaluated whether the provisions of FIN 46-R are applicable
to its investments, as well as to other arrangements, and
believes that there are currently no arrangements that meet the
definition of a variable interest entity that would require
consolidation.

Emerging Issues Task Force (EITF)
Issue 03-01.The EITF deliberated
Issue 03-01, The Meaning of Other-Than-Temporary
Impairment and Its Application to Certain Investments. The
issue was intended to address the meaning of
other-than-temporary impairment and its application to certain
investments. A consensus was reached regarding disclosure
requirements concerning unrealized losses on available-for-sale
debt and equity securities accounted for under
SFAS No. 115, Accounting for Certain Investments
in Debt and Equity Securities. The application of certain
paragraphs covering the measurement provisions of EITF 03-1
have been deferred pending the issuance of a final FASB Staff
Position providing implementation guidance on EITF 03-1.
The disclosures are effective in annual financial statements for
fiscal years ending

F-16



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##### Table of Contents



AVANIR Pharmaceuticals


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS   (Continued)

after December 15, 2003, for investments
accounted for under SFAS No. 115. The application of
the effective paragraphs of EITF Issue 03-01 did not have a
material impact on the Companys financial statements.

EITF
Issue 03-6.In March 2004, the
EITF ratified the consensus on EITF Issue 03-6,
Participating Securities and the Two 
Class Method under FASB Statement No. 128. The
consensus requires the use of a two-class method of calculating
earnings per share under FASB Statement No. 128,
Earnings Per Share, when a company has participating
securities. A participating security is defined as a security
that may participate with common stock in undistributed
earnings, whether that participation is conditioned upon the
occurrence of a specified event or not. AVANIR does not
currently have any participating securities, and although this
guidance was adopted in the third fiscal quarter of 2004, it did
not have any impact on the Companys results of operations.

EITF
Issue 04-8.In September 2004,
the EITF reached consensus on EITF Issue 04-8, The
Effect of Contingently Convertible Debt on Diluted Earnings per
Share, which provides guidance on when the dilutive effect
of contingently convertible debt securities with a market price
trigger should be included in diluted Earnings Per Share. The
guidance is effective for all periods ending after
December 15, 2004. We expect that the guidance of EITF
Issue 04-8 will not have a material impact on AVANIRs
earnings per share calculation for either the first fiscal
quarter or the full fiscal year 2005 results.

Financial Accounting Standards Board
(FASB) Staff Position
No. FAS 106-2.On
May 19, 2004, the FASB issued FASB Staff Position
No. FAS 106-2, Accounting and Disclosure
Requirements Related to the Medicare Prescription Drug,
Improvement and Modernization Act of 2003 (FSP
No. 106-2), in response to a new law regarding
prescription drug benefits under Medicare (Medicare
Part D) and a Federal subsidy to sponsors of retiree
health care benefit plans that provide a benefit that is at
least actuarially equivalent to Medicare Part D. Currently,
Statement of Financial Accounting Standard No. 106,
Employers Accounting for Postretirement Benefits
Other Than Pensions (SFAS No. 106),
requires that changes in relevant law be considered in current
measurement of postretirement benefit costs. FSP No. 106-2
will be effective for financial statements of companies for the
first interim or annual period beginning after June 15,
2004. The Company does not currently provide any postretirement
benefits and therefore, the adoption of FSA No. 106-2,
which would have been required in the fourth quarter of fiscal
2004, has not had, and the Company anticipates will not in the
foreseeable future have, any impact on the Companys
results of operations, cash flows, or financial condition.

Financial Accounting Standards Board
(FASB)
SFAS No. 132.In December
2003, the FASB revised SFAS No. 132 (Revised 2003),
Employers Disclosures about Pensions and other
Postretirement Benefits
(SFAS No. 132(R)), establishing additional
annual disclosures about plan assets, investment strategy,
measurement date, plan obligations and cash flows. In addition,
the revised standard established interim disclosure requirements
related to the net periodic benefit cost recognized and
contributions paid or expected to be paid during the current
fiscal year. The new annual disclosures are effective for
financial statements of companies with fiscal years ending after
December 15, 2003 and the interim-period disclosures are
effective for interim periods beginning after December 15,
2003. The Company does not currently provide any postretirement
benefits, and therefore, has not adopted the disclosure
obligations, nor has it had any impact on the results of
operations or financial condition.

Financial Accounting Standards Board
(FASB)
SFAS No. 150.In May 2003,
the FASB issued SFAS No. 150, Accounting for
Certain Financial Instruments with Characteristics of both
Liabilities and Equity. SFAS No. 150 establishes
standards for how an issuer classifies and measures in its
statement of financial position certain financial instruments
with characteristics of both liabilities and equity. It requires
that an issuer classify a financial instrument that is within
its scope as a liability (or an asset in some circumstances)
because that financial instrument embodies an obligation of the
issuer. Many of such instruments were previously classified as
equity. The statement is effective for financial instruments
entered into or modified after May 31, 2003, and otherwise
is effective at the beginning of the first interim period

F-17



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##### Table of Contents



AVANIR Pharmaceuticals


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS   (Continued)

beginning after June 15, 2003, except for
mandatory redeemable financial instruments of nonpublic
entities. On November 7, 2003, the FASB deferred the
classification and measurement provisions of
SFAS No. 150 as they apply to certain mandatory
redeemable non-controlling interests. This deferral is expected
to remain in effect while these provisions are further evaluated
by the FASB. We do not have any financial instruments covered by
this statement. Therefore, the adoption of this standard did not
have a material impact on our consolidated financial statements
or results of operations.



|   |                 
|-- | ----------------
|3. | Receivables, Net

Receivables as of September 30, 2004 and
2003 consist of the following:

|                  |                                 |               |         |         |   |   |         |   | 
|----------------- | ------------------------------- | ------------- | ------- | ------- | - | - | ------- | - | 
|                  |                                 |              
|                  |                                 | Years Ended  
|                  |                                 | September 30,
|                  |                                 |              
|                  |                                 | 2004          |         | 2003   
|                  |                                 |               |         |        
|Total receivables |                                 | $             | 257,379 |         |   | $ | 271,681 |  
|                  | Allowance for doubtful accounts |               |         | (17,500 | ) |   |         |  | 
|                  |                                 |               |         |         |   |   |         |  
|Receivables, net  |                                 | $             | 239,879 |         |   | $ | 271,681 |  
|                  |                                 |               |         |         |   |   |         |  



|   |                              
|-- | -----------------------------
|4. | Commitments and Contingencies

Operating lease
commitments.On March 20, 2000,
the Company signed an eight-year lease for 27,047 square feet of
office and lab space in a building located at 11388 Sorrento
Valley Road, Suite 200, San Diego, California,
commencing on September 1, 2000. On February 1, 2001,
the Company signed an amendment to the lease for an additional
165 square feet of office and lab space. The lease has
scheduled rent increases each year and expires on
August 31, 2008. As of September 30, 2004, the
financial commitment for the remainder of the term of the lease
is $3,176,732. We delivered an irrevocable standby letter of
credit to the lessor in the amount of $388,122, to secure our
performance under the lease.

On May 20, 2002, we signed a ten-year lease
for approximately 26,770 square feet of office and lab
space in buildings adjacent to our existing facilities,
commencing on January 15, 2003. On April 2, 2003, we
signed an amendment to the lease for an additional 3,600 square
feet of storage space in the building located at 11408 Sorrento
Valley Road. The storage space is capable of being converted
into either office or lab space, if needed in the future. The
lease has scheduled rent increases each year and expires on
January 14, 2013. As of September 30, 2004, the
financial commitment for the remainder of the term of the lease
is $8,936,474. We delivered an irrevocable standby letter of
credit to the lessor in the amount of $468,475, to secure our
performance under the lease.

Lease expenses for fiscal 2004, 2003 and 2002
were $1,797,324, $1,724,403, and $818,557, respectively. We have
included $557,481 and $400,204 of deferred rent in accrued
expenses and other liabilities as of

F-18



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##### Table of Contents



AVANIR Pharmaceuticals


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS   (Continued)

September 30, 2004 and 2003, respectively.
Future minimum payments under non-cancelable operating leases as
of September 30, 2004 are as follows:

|                          |       |          |           |            | 
|------------------------- | ----- | -------- | --------- | ---------- | 
|                          |       | Minimum 
|Year Ending September 30, |       | Payments
|                          |       |         
|2005                      |       | $        | 1,702,298 |           
|2006                      |       |          | 1,768,703 |           
|2007                      |       |          | 1,833,892 |           
|2008                      |       |          | 1,830,121 |           
|2009                      |       |          | 1,090,463 |           
|Thereafter                |       |          | 3,887,729 |           
|                          |       |          |           |           
|                          | Total |          | $         | 12,113,206 | 
|                          |       |          |           |           

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

Future minimum payments under the capital leases
as of September 30, 2004 are as follows:

|                                    |       |                                   |         |         |          |  
|----------------------------------- | ----- | --------------------------------- | ------- | ------- | -------- | -
|                                    |       | Minimum                          
|Year Ending September 30,           |       | Payments                         
|                                    |       |                                  
|2005                                |       | $                                 | 169,772 |        
|2006                                |       |                                   | 28,742  |        
|2007                                |       |                                   | 9,583   |        
|                                    |       |                                   |         |        
|                                    | Total |                                   |         | 208,097 |         
|                                    |       | Less amount representing interest |         |         | (15,685  | )
|                                    |       |                                   |         |        
|Present value of net lease payments |       |                                   | 192,412 |        
|                                    |       | Less current portion              |         |         | (156,770 | )
|                                    |       |                                   |         |        
|Long-term portion of obligation     |       | $                                 | 35,642  |        
|                                    |       |                                   |         |        

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.



|   |              
|-- | -------------
|5. | Notes Payable

In September 2004, the Company entered into a
finance agreement with GE Healthcare Financial Services
(GE Capital) that provides for loans to
purchase equipment, secured by the equipment purchased. The
amount of capital equipment financed and subject to lien at
September 30, 2004 under the GE Capital finance
agreement is approximately $915,000. The initial loan was for a
term of 42 months at an interest rate

F-19



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##### Table of Contents



AVANIR Pharmaceuticals


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS   (Continued)

of 9.5% per year with fixed monthly payments.
Future minimum payments under the GE Capital finance
agreement as of September 30, 2004, are as follows:

|                                |       |                                   |         |           |          |  
|------------------------------- | ----- | --------------------------------- | ------- | --------- | -------- | -
|                                |       | Minimum                          
|Year Ending September 30,       |       | Payments                         
|                                |       |                                  
|2005                            |       | $                                 | 284,691 |          
|2006                            |       |                                   | 308,202 |          
|2007                            |       |                                   | 308,202 |          
|2008                            |       |                                   | 179,784 |          
|                                |       |                                   |         |          
|                                | Total |                                   |         | 1,080,879 |         
|                                |       | Less amount representing interest |         |           | (166,227 | )
|                                |       |                                   |         |          
|Present value of payments       |       |                                   | 914,652 |          
|                                |       | Less current portion              |         |           | (211,092 | )
|                                |       |                                   |         |          
|Long-term portion of obligation |       | $                                 | 703,560 |          
|                                |       |                                   |         |          

Other notes payable.The Company obtained approximately $160,000 from a third party
in fiscal 2004 to facilitate annual payments on certain
insurance premiums. The financing was for a term of nine months
at an interest of approximately 3.1% per year. The monthly
payments were approximately $18,000, with the final payment
being made in August 2004.



|   |                     
|-- | --------------------
|6. | Shareholders Equity

On April 1, 2004, we amended and restated
our Articles of Incorporation, pursuant to the authority granted
us by our shareholders at our 2004 Annual Meeting of
Shareholders. Upon the filing of our Amended and Restated
Articles of Incorporation, we eliminated all classes and series
of stock that were no longer outstanding and increased our
authorized Class A common stock to 200 million shares.
As of September 30, 2004, we have authorized
200 million shares of Class A common stock and
10 million shares of preferred stock, of which
1 million shares have be designated Class C Junior
Participating Preferred.



| |                
| | ---------------
| | Preferred Stock

On March 2, 1999, our Board of Directors
approved a shareholder rights plan (the Plan) that
provides for the issuance to each of our shareholders
Series C junior participating preferred stock under certain
circumstances. None of the Series C junior participating
preferred stock was outstanding on September 30, 2004 and
2003. The Plan features a dividend distribution of one preferred
share purchase right (the Right) on each outstanding
share of our Class A and Class B common stock, payable
to shareholders of record on March 25, 1999. Subject to
limited exceptions, the Rights would be exercisable if a person
or group acquires 15% or more of our common stock or announces a
tender offer for 15% or more of our common stock (a
Trigger Event).

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

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

F-20



---



##### Table of Contents



AVANIR Pharmaceuticals


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS   (Continued)



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

Class A common
stock.In December 2003, we sold and
issued 5,382,316 shares of Class A common stock and
warrants to purchase an additional 3,229,389 shares of
Class A common stock to several accredited investors and
received approximately $8,020,000 in gross proceeds. The warrant
exercise price is $1.75 per share. The financing transaction was
made pursuant to the terms of a securities purchase agreement
that provided each investor with a warrant to purchase
six-tenths of a share of Class A common stock for every
share of Class A common stock purchased under the
agreement. The effect of the financing transaction was an
increase in cash and shareholders equity in the amount of
approximately $7.5 million after taking into effect the
costs of the transaction. In connection with this transaction
and its costs, the placement agent was paid $415,000 in fees and
expenses, and issued a warrant to purchase 161,470 shares
of the Companys Class A common stock at $1.75 per
share.

In June 2004, we completed an underwritten public
offering of 19,685,040 shares of Class A common stock
at $1.27 per share ($1.18 per share after underwriters
discount). The financing transaction was made pursuant to the
terms of an underwriting agreement with Lazard Freres &
Co. On June 10, 2004, the underwriter exercised its option
to purchase from the Company an additional 2,952,756 shares
of Class A common stock at the public offering price of
$1.27 per share ($1.18 per share after underwriters
discount) to cover over-allotments. This offering generated net
proceeds of approximately $26.5 million after
underwriters discount of $2.0 million and issuance
costs of approximately $267,000.

In August 2004, we issued the Ciblex Corporation
1,036,807 shares of Class A common stock in connection
with an amendment to that certain Technology Acquisition
Agreement with Ciblex dated August 2001 (the
Amendment). In exchange for the shares issued under
the Amendment, we were no longer obligated to pay up to
$9.0 million in future potential milestones under the
agreement.

Also during fiscal 2004, we issued an aggregate
of 418,904 shares of Class A common stock in
connection with the exercise of stock purchase warrants
(294,895 shares) and employee stock options
(124,009 shares) for cash in the aggregate amount of
approximately $609,000, representing a weighted average price
per share of $1.45.

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

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

F-21



---



##### Table of Contents



AVANIR Pharmaceuticals


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS   (Continued)

Details of common stock transactions during
fiscal 2004 and 2003 are shown in the tables that follow.

|                                      |                                                |       |  |              |  |             |  |               |            |  |   |            |            |  |   |      |  | 
|------------------------------------- | ---------------------------------------------- | ----- |  | ------------ |  | ----------- |  | ------------- | ---------- |  | - | ---------- | ---------- |  | - | ---- |  | 
|Common Stock Issued and Warrants      |                                                |       |  | Class A      |  | Amount      |  | Average Price
|and Stock Options Exercised           |                                                | Date  |  | Common Stock |  | Received(1) |  | Per Share(2) 
|                                      |                                                |       |  |              |  |             |  |              
|Fiscal year ended September 30, 2004: |                                                |       |  |              |  |             |  |               |            |  |   |            |            |  |   |     
|                                      | Underwritten public offering(3)                |       |  | 6/1/04       |  |             |  | 22,637,796    |            |  | $ | 26,737,500 |            |  | $ | 1.18 | 
|                                      | Private placement of common stock and warrants |       |  | 12/5/03      |  |             |  | 5,382,316     |            |  |   | 8,019,652  |            |  | $ | 1.49 | 
|                                      | Stock options                                  |       |  | Various      |  |             |  | 124,009       |            |  |   | 160,823    |            |  | $ | 1.30 | 
|                                      | Warrants(4)                                    |       |  | Various      |  |             |  | 294,895       |            |  |   | 448,671    |            |  | $ | 1.59 | 
|                                      |                                                |       |  |              |  |             |  |               |            |  |   |            |            |  |   |     
|                                      |                                                | Total |  |              |  |             |  |               | 28,439,016 |  |   | $          | 35,366,646 |  |   |      |  | 
|                                      |                                                |       |  |              |  |             |  |               |            |  |   |            |            |  |   |     
|Fiscal year ended September 30, 2003: |                                                |       |  |              |  |             |  |               |            |  |   |            |            |  |   |     
|                                      | Private placement of common stock and warrants |       |  | 7/23/03      |  |             |  | 6,728,396     |            |  | $ | 10,025,320 |            |  | $ | 1.49 | 
|                                      | Restricted stock grants to directors           |       |  | 3/13/03      |  |             |  | 80,000        |            |  |   | 92,800     |            |  | $ | 1.16 | 
|                                      | Stock options                                  |       |  | 11/13/02     |  |             |  | 24,000        |            |  |   | 25,500     |            |  | $ | 1.06 | 
|                                      | Warrants                                       |       |  | 2/12/03      |  |             |  | 53,200        |            |  |   | 59,850     |            |  | $ | 1.13 | 
|                                      |                                                |       |  |              |  |             |  |               |            |  |   |            |            |  |   |     
|                                      |                                                | Total |  |              |  |             |  |               | 6,885,596  |  |   | $          | 10,203,470 |  |   |      |  | 
|                                      |                                                |       |  |              |  |             |  |               |            |  |   |            |            |  |   |     



---



|    |                                                                                                                                                                  
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | Amount received represents the amount before the
    cost of financing and after underwriters discount, if any.                                                 
|   
|(2) | Average price per share has been rounded to two
    decimal places.                                                                                              
|   
|(3) | Price per share of $1.18 in the underwritten
    public offering is after underwriters discount of
    $2.0 million, representing approximately $0.09 per share.
|   
|(4) | Includes 19,119 shares issued on a
    cashless exercise basis at an average exercise price
    of $1.05 per share.                                            

In December 2004, we issued an additional
$7.0 million in Class A common stock to an
institutional investor at $3.00 per share. (See Note 11,
Subsequent Event.)

Class B common stock
conversions.As of September 30,
2004 and 2003 there were none and 13,500 shares of
Class B common stock outstanding, respectively. During
fiscal 2004, 13,500 shares of Class B common stock
were converted to 13,500 shares of Class A common
stock. In March 2004, our shareholders voted on, and approved an
amendment to our articles of incorporation that eliminated the
Companys Class B common stock.



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

Class A
warrants.As of September 30,
2004, Class A warrants to purchase 1,345,673 and
3,169,383 shares at $2.23 per share and $1.75 per
share, respectively, remained outstanding. See
Class A common stock above for a description of
new issuances in fiscal 2004. Also during fiscal 2004,
Class A warrant holders exercised their rights to purchase
an aggregate of 221,476 shares of class A common stock
for total cash of $387,583.

Class G
warrants.As of September 30,
2004, a Class G warrant to purchase 757,050 shares of
Class A common stock at an exercise price of $1.375 per
share remained outstanding. The holder of the Class G
warrant did not exercise any rights to purchase Class A
common stock during fiscal 2004 or 2003. The Class G
warrant was issued in connection with the conversion of a
convertible note payable issued on February 26,

F-22



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##### Table of Contents



AVANIR Pharmaceuticals


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS   (Continued)

1997, which is no longer outstanding. The
Class G warrant expires 60 days following the date of
effectiveness of a registration statement with the Securities
and Exchange Commission (SEC) that registers the resale of
shares purchasable upon exercise of the warrant. The
757,050 shares underlying the Class G warrant have not
been registered with the SEC for resale in public markets.

Class J
warrants.As of September 30,
2004, Class J warrants to purchase 50,000 shares
of Class A common stock at $2.715 per share remained
outstanding. During fiscal 2004, a Class J warrant holder
exercised his rights to acquire 19,119 shares of
Class A common stock using a cashless exercise
option. The market price on the date of exercise of the
Class J warrant was $1.70 per share. The market price was
$0.65 per share greater than the $1.05 per share exercise price
of the warrant. Accordingly, the holder surrendered to the
Company the warrant to purchase 30,881 shares that had an
aggregate value of approximately $20,075 based on the difference
in the market price on the tender date and the exercise price,
times the number of shares purchasable under the warrant. The
Class J warrants were issued in connection with
Series D redeemable convertible preferred stock that was
issued in fiscal 2000 and 1999. The expiration date for the
remaining warrant is February 18, 2005.

Class K
warrants.As of September 30,
2004, none of the Class K warrants remained outstanding. On
January 20, 2004, the Class K warrant holder exercised
its right to purchase 54,300 shares of Class A common
stock at $1.125 per share, for cash in the amount of $61,088.

Class N
warrants.On January 31, 2004,
the Class N warrant to purchase 32,877 shares of
Class A common stock at an exercise price of $2.44 per
share expired.

The following table summarizes all warrant
activity for fiscal 2004, 2003 and 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, 2001    |             |                      | 1,264,550 |                |   | $               | 1.48 |      |  | $ | 0.91-$2.72 |           
|                                  | Expired     |                      |           | (100,000       | ) |                 | $    | 2.40 |  |   | $          | 2.40       | 
|                                  | Exercised   |                      |           | (80,000        | ) |                 | $    | 1.13 |  |   | $          | 1.13       | 
|                                  |             |                      |           |                |   |                 |      |      |  |   |            |           
|Outstanding at September 30, 2002 |             |                      | 1,084,550 |                |   | $               | 1.42 |      |  | $ | 0.91-$2.72 |           
|                                  | Issued      |                      |           | 1,345,673      |   |                 | $    | 2.23 |  |   | $          | 2.23       | 
|                                  | Expired     |                      |           | (87,123        | ) |                 | $    | 1.28 |  |   | $          | 1.28       | 
|                                  | Exercised   |                      |           | (53,200        | ) |                 | $    | 1.13 |  |   | $          | 1.13       | 
|                                  |             |                      |           |                |   |                 |      |      |  |   |            |           
|Outstanding at September 30, 2003 |             |                      | 2,289,900 |                |   | $               | 1.91 |      |  | $ | 0.91-$2.72 |           
|                                  | Issued      |                      |           | 3,390,859      |   |                 | $    | 1.75 |  |   | $          | 1.75       | 
|                                  | Tendered(1) |                      |           | (30,881        | ) |                 | $    | 1.05 |  |   | $          | 1.05       | 
|                                  | Expired     |                      |           | (32,877        | ) |                 | $    | 2.44 |  |   | $          | 2.44       | 
|                                  | Exercised   |                      |           | (294,895       | ) |                 | $    | 1.59 |  |   | $          | 1.05-$1.75 | 
|                                  |             |                      |           |                |   |                 |      |      |  |   |            |           
|Outstanding at September 30, 2004 |             |                      | 5,322,106 |                |   | $               | 1.83 |      |  | $ | 1.38-$2.72 |           
|                                  |             |                      |           |                |   |                 |      |      |  |   |            |           



---



|    |                                                                                                                                                          
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | Warrant shares tendered represent 30,881 in the
    amount of warrant shares given up, in lieu of cash, for warrants
    exercised (cashless exercise).



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

Stock options to
employees.On March 17, 2004 we
issued incentive stock options under our 2000 Stock Option Plan
to nonofficer employees of the Company for the purchase of
an aggregate of 103,000 shares of

F-23



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##### Table of Contents



AVANIR Pharmaceuticals


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS   (Continued)

Class A common stock at an exercise price of
$1.84 per share. On April 6, 2004, we issued incentive
stock options under our 2000 Stock Option Plan to the officers
of the Company for the purchase of an aggregate of
100,000 shares of Class A common stock at an exercise
price of $1.78 per share. The option price for each of these
transactions represents the closing market prices for the common
stock on the dates of the grants.

Stock options to non-employee
directors.On April 6, 2004, we
issued to our non-employee directors stock options to purchase
an aggregate of 40,000 shares of Class A common stock
at an exercise price of $1.78 per share. The exercise price of
each option represents the closing market price for the common
stock on the date of grant.

2003 Equity Incentive
Plan.On March 13, 2003, the
board of directors approved the adoption of a 2003 equity
incentive plan (the 2003 Equity Incentive Plan) that
provides for the issuance of up to 2,500,000 shares of
Class A common stock. The 2003 Equity Incentive Plan allows
us to grant options, restricted stock awards and stock
appreciation rights to our directors, officers, employees and
consultants. As of September 30, 2004 and 2003,
2,500,000 shares of Class A common stock remained
available for issuance under the 2003 Equity Incentive Plan.

2000 Stock Option
Plan.On March 23, 2000, our
shareholders approved the adoption of the 2000 Stock Option Plan
(the 2000 Plan), pursuant to which an aggregate of
2,300,000 shares of our Class A common stock have been
reserved for issuance. On March 14, 2002, our shareholders
approved an amendment to the Plan to increase the number of
shares of Class A common stock issuable under the Plan by
1,000,000 shares, for an aggregate of
3,300,000 shares. On March 13, 2003, we amended the
2000 Plan to allow for the issuance of restricted stock awards.
As of September 30, 2004 and 2003, 517,701 and
666,240 shares of Class A common stock, respectively,
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 provides for the
issuance of up to 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, 2004 and 2003, options to purchase
7,303 and 47,303 shares of Class A common stock,
respectively, were available for grant under the 1998 Plan.

1994 Stock Option
Plan.The 1994 Stock Option Plan
terminated on January 14, 2004. As of September 30,
2004 and 2003, none and 10,076 shares of Class A
common stock , respectively, were available for grant under the
1994 Plan.

Canceled stock
options.During fiscal 2004, options
to purchase an aggregate of 99,540 shares of Class A
common stock at prices ranging from $2.50 to $2.75 per share
were canceled following their expiration dates. Also, options to
purchase 74,462 shares at prices ranging from $1.16 to
$4.85 per share were canceled due to voluntary and involuntary
terminations. The weighted average price per share for all
canceled options was $2.64.

The following table summarizes all common stock
option activity for fiscal 2004, 2003 and 2002:

|                               |           |                    |           |                 |   |   |      |      | 
|------------------------------ | --------- | ------------------ | --------- | --------------- | - | - | ---- | ---- | 
|                               |           | Number of Shares   |           | Weighted       
|                               |           | Underlying Class A |           | Average Option 
|                               |           | Stock Options      |           | Price Per Share
|                               |           |                    |           |                
|Outstanding at October 1, 2001 |           |                    | 5,294,994 |                 |   | $ | 2.13 |     
|                               | Granted   |                    |           | 650,000         |   |   | $    | 2.91 | 
|                               | Exercised |                    |           | (191,152        | ) |   | $    | 0.89 | 
|                               | Canceled  |                    |           | (14,536         | ) |   | $    | 3.37 | 
|                               |           |                    |           |                 |   |   |      |     

F-24



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##### Table of Contents



AVANIR Pharmaceuticals


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS   (Continued)

|                                  |           |                    |           |                 |   |   |      |      | 
|--------------------------------- | --------- | ------------------ | --------- | --------------- | - | - | ---- | ---- | 
|                                  |           | Number of Shares   |           | Weighted       
|                                  |           | Underlying Class A |           | Average Option 
|                                  |           | Stock Options      |           | Price Per Share
|                                  |           |                    |           |                
|Outstanding at September 30, 2002 |           |                    | 5,739,306 |                 |   | $ | 2.25 |     
|                                  | Granted   |                    |           | 737,500         |   |   | $    | 1.15 | 
|                                  | Exercised |                    |           | (24,000         | ) |   | $    | 1.06 | 
|                                  | Canceled  |                    |           | (1,144,202      | ) |   | $    | 2.93 | 
|                                  |           |                    |           |                 |   |   |      |     
|Outstanding at September 30, 2003 |           |                    | 5,308,604 |                 |   | $ | 1.96 |     
|                                  | Granted   |                    |           | 243,000         |   |   | $    | 1.81 | 
|                                  | Exercised |                    |           | (124,009        | ) |   | $    | 1.30 | 
|                                  | Canceled  |                    |           | (174,002        | ) |   | $    | 2.64 | 
|                                  |           |                    |           |                 |   |   |      |     
|Outstanding at September 30, 2004 |           |                    | 5,253,593 |                 |   | $ | 1.95 |     
|                                  |           |                    |           |                 |   |   |      |     
|Exercisable at September 30, 2004 |           |                    | 4,656,411 |                 |   | $ | 1.99 |     
|                                  |           |                    |           |                 |   |   |      |     
|Exercisable at September 30, 2003 |           |                    | 4,303,092 |                 |   | $ | 1.99 |     
|                                  |           |                    |           |                 |   |   |      |     
|Exercisable at September 30, 2002 |           |                    | 4,780,299 |                 |   | $ | 2.09 |     
|                                  |           |                    |           |                 |   |   |      |     

The following table summarizes information
concerning outstanding and exercisable Class A stock
options as of September 30, 2004:

|                |  |                     |           |                     |  |          |      |             |  |          |      |  |  |  |           |  |  |   |      | 
|--------------- |  | ------------------- | --------- | ------------------- |  | -------- | ---- | ----------- |  | -------- | ---- |  |  |  | --------- |  |  | - | ---- | 
|                |  |                     |           |                    
|                |  | Options Outstanding |           | Options Exercisable
|                |  |                     |           |                    
|                |  |                     |           | Weighted            |  |          |      |            
|                |  |                     |           | Average             |  | Weighted |      |             |  | Weighted
|                |  |                     |           | Remaining           |  | Average  |      |             |  | Average 
|Range of        |  | Number              |           | Contractual         |  | Exercise |      | Number      |  | Exercise
|Exercise Prices |  | Outstanding         |           | Life in Years       |  | Price    |      | Exercisable |  | Price   
|                |  |                     |           |                     |  |          |      |             |  |         
|$0.30  $0.72   |  |                     | 909,474   |                     |  |          | 4.45 |             |  | $        | .68  |  |  |  | 909,474   |  |  | $ | 0.68 | 
|$0.78           |  |                     | 15,000    |                     |  |          | 4.79 |             |  | $        | .78  |  |  |  | 15,000    |  |  | $ | 0.78 | 
|$1.00  $1.16   |  |                     | 909,514   |                     |  |          | 7.43 |             |  | $        | 1.13 |  |  |  | 608,943   |  |  | $ | 1.11 | 
|$1.28  $2.31   |  |                     | 1,688,914 |                     |  |          | 5.30 |             |  | $        | 1.67 |  |  |  | 1,448,807 |  |  | $ | 1.65 | 
|$2.47  $2.94   |  |                     | 526,631   |                     |  |          | 4.94 |             |  | $        | 2.56 |  |  |  | 526,631   |  |  | $ | 2.53 | 
|$3.00  $3.57   |  |                     | 879,055   |                     |  |          | 6.69 |             |  | $        | 3.35 |  |  |  | 822,551   |  |  | $ | 3.35 | 
|$4.00  $6.44   |  |                     | 325,005   |                     |  |          | 4.82 |             |  | $        | 4.52 |  |  |  | 325,005   |  |  | $ | 4.52 | 
|                |  |                     |           |                     |  |          |      |             |  |          |      |  |  |  |           |  |  |   |      | 
|                |  |                     | 5,253,593 |                     |  |          | 5.69 |             |  | $        | 1.95 |  |  |  | 4,656,411 |  |  | $ | 1.99 | 
|                |  |                     |           |                     |  |          |      |             |  |          |      |  |  |  |           |  |  |   |      | 



|   |                             
|-- | ----------------------------
|7. | License and Other Agreements

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

Boryung Pharmaceuticals Company Ltd
(Boryung).In March 1994,
we entered into a 12-year exclusive license and supply agreement
with Boryung, giving the company the rights to manufacture and
sell

F-25



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##### Table of Contents



AVANIR Pharmaceuticals


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS   (Continued)

docosanol 10% cream in the Republic of Korea.
Under the terms of the agreement, Boryung is responsible for
manufacturing, marketing, sales and distribution of docosanol
10% cream, and paying a royalty to AVANIR on product sales. The
agreement includes a supply provision under which Boryung
purchases from AVANIR its entire requirement of active
ingredient for use in the manufacture of topical docosanol 10%
cream. Boryung launched the product, Herepair, in June 2002.

GlaxoSmithKline Subsidiary, SB Pharmco
Puerto Rico, Inc.
(GlaxoSmithKline).On
March 31, 2000, we signed an exclusive license agreement
with GlaxoSmithKline (NYSE: GSK) for rights to manufacture and
sell Abreva® (docosanol 10% cream) as an over-the-counter
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 provide for AVANIR to earn royalties on
product sales. In October 2000, GlaxoSmithKline launched Abreva
in the United States. All milestones under the agreement were
earned and paid prior to fiscal 2003. During fiscal 2003, we
sold an undivided interest in the GlaxoSmithKline license
agreement to Drug Royalty USA with a term until the later of
December 13, 2003 or until the expiration of the patent for
Abreva. (See Note 2, Summary of Significant
Accounting Policies  Deferred Revenue.)

Bruno Farmaceutici
(Bruno).In July 2002, we
entered into an agreement with Bruno giving the company the
rights to manufacture and sell 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. Bruno is responsible for
obtaining regulatory approval in Italy. This agreement will
continue until the fifteenth anniversary of the first shipment
date.

P.N. Gerolymatos SA.
(Gerolymatos).In May
2004, AVANIR signed an exclusive agreement with Gerolymatos
giving the company the rights to manufacture and sell docosanol
10% cream as a treatment for cold sores in Greece, Cyprus,
Turkey and Romania. Under the terms of the agreement,
Gerolymatos will be responsible for all sales and marketing
activities, as well as manufacturing and distribution of the
product. The terms of the agreement provide for AVANIR to
receive a license fee, royalties on product sales and milestones
related to product approvals in Greece, Cyprus, Turkey and
Romania. This agreement will continue until the latest of the
12th anniversary of the first commercial sale in each of those
respective countries, or the date that the patent expires, or
the last date of the expiration of any period of data
exclusivity in those countries. Gerolymatos is also responsible
for regulatory submissions to obtain marketing approval of the
product in the licensed territories.

ACO HUD.In
September 2004, AVANIR signed an exclusive agreement with ACO
HUD giving ACO HUD the rights to manufacture and sell docosanol
10% cream as a treatment for cold sores in Sweden, Norway,
Denmark and Finland. Stockholm-based ACO HUD is the Scandinavian
market leader in sales of cosmetic and medicinal skincare
products. ACO HUD plans to launch the product in 2005. Under the
terms of the agreement, ACO HUD will be responsible for all
sales and marketing activities, as well as manufacturing and
distribution of the product. The terms of the agreement provide
for AVANIR to receive a license fee, royalties on product sales
and milestones related to product approvals in Norway, Denmark
and Finland. This agreement will continue until either:
15 years from the anniversary of the first commercial sale
in each of those respective countries, or, until the date that
the patent expires, or, the last date of the expiration of any
period of data exclusivity in those countries, whichever occurs
last. ACO HUD is also responsible for regulatory submissions to
obtain marketing approval of the product in the licensed
territories.

Government research
grants.AVANIR is also engaged in
various research programs funded by government research grants.
The balance remaining under the research grants as of
September 30, 2004 was approximately $724,000. The
government research grants are to be used for conducting
research on various

F-26



---



##### Table of Contents



AVANIR Pharmaceuticals


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS   (Continued)

docosanol-based formulations for a potential
genital herpes product and development of antibodies to anthrax
toxins.



|   |                           
|-- | --------------------------
|8. | Related Party Transactions



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

License agreement.On August 1, 2000, we entered into an agreement with IriSys
Research and Development, LLC (IriSys) to sublicense
the exclusive worldwide rights to a patented drug formulation,
Neurodex, to treat multiple central nervous system disorders.
Our sublicense agreement includes rights to the patented
technology and know-how for the development and potential
marketing of products for treatments of PBA, neuropathic pain,
symptoms of chronic and intractable cough, and patients being
weaned from narcotics. If either (i) the FDA accepts the
submission of a new drug application (NDA) or (ii) the FDA
approves the NDA for marketing, we will be required to make
milestone payments to IriSys. We are currently developing
Neurodex for the treatment of PBA and neuropathic pain. To date,
we have not made any payments to IriSys, nor have any been due
under this agreement.

We expect to begin submission of an NDA to the
FDA by December 31, 2004 for Neurodex in the treatment of
PBA and to pay IriSys $150,000 upon achieving the milestone. If
the FDA accepts our NDA, we will be required to pay IriSys an
additional milestone payment of $150,000. If we market the
product ourselves, we will also pay IriSys a patent royalty
based on a percent of annual net sales revenue. If we sublicense
the product to a third party, we are required to share any
royalties that we receive from third parties equally with
IriSys. The agreement calls for certain minimum sales levels to
be achieved in order for AVANIR to maintain exclusivity of the
marketing rights in the sublicensed territories.

Dr. Yakatan, president and chief executive
officer of AVANIR, is a founder, chairman and the majority
shareholder of IriSys. IriSys is the exclusive licensee of
certain patents as set forth under an Exclusive Patent License
Agreement between IriSys and the Center for Neurologic Study,
dated as of April  2, 1997.

Research and
development.In June 2003, the Company
engaged IriSys to continue Neurodex stability studies previously
being carried out for AVANIR by another company that is no
longer in the business of providing such services. The service
arrangement was transferred to IriSys following termination with
the other company because IriSys was already familiar with the
stability protocol. During fiscal 2004 and 2003, AVANIR paid
IriSys $4,200 and $18,840, respectively, related to continuation
of the stability testing.



|   |             
|-- | ------------
|9. | Income Taxes

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

|                                                              |  |      |             |      |  |      |             |   |  |   |            |  
|------------------------------------------------------------- |  | ---- | ----------- | ---- |  | ---- | ----------- | - |  | - | ---------- | -
|                                                              |  | 2004 |             | 2003 |  | 2002
|                                                              |  |      |             |      |  |     
|Current:                                                      |  |      |             |      |  |      |             |   |  |   |            |  
|State and foreign                                             |  | $    | (2,664      | )    |  | $    | (3,599      | ) |  | $ | (343,940   | )
|                                                              |  |      |             |      |  |      |             |   |  |   |            |  
|Deferred:                                                     |  |      |             |      |  |      |             |   |  |   |            |  
|Federal                                                       |  |      | 10,900,106  |      |  |      | 8,676,371   |   |  |   | 4,113,560  |  
|State                                                         |  |      | 246,528     |      |  |      | 3,892,419   |   |  |   | 296,424    |  
|                                                              |  |      |             |      |  |      |             |   |  |   |            |  
|                                                              |  |      | 11,146,634  |      |  |      | 12,568,790  |   |  |   | 4,409,984  |  
|                                                              |  |      |             |      |  |      |             |   |  |   |            |  
|Increase in deferred income tax asset valuation
    allowance |  |      | (11,146,634 | )    |  |      | (12,568,790 | ) |  |   | (4,409,984 | )
|                                                              |  |      |             |      |  |      |             |   |  |   |            |  
|Total income tax provision                                    |  | $    | (2,664      | )    |  | $    | (3,599      | ) |  | $ | (343,940   | )
|                                                              |  |      |             |      |  |      |             |   |  |   |            |  

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##### Table of Contents



AVANIR Pharmaceuticals


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS   (Continued)

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

|                                                              |  |      |     |      |  |      |     |    |  |  |     |   
|------------------------------------------------------------- |  | ---- | --- | ---- |  | ---- | --- | -- |  |  | --- | --
|                                                              |  | 2004 |     | 2003 |  | 2002
|                                                              |  |      |     |      |  |     
|Federal statutory rate                                        |  |      | (34 | )%   |  |      | (34 | )% |  |  | (34 | )%
|Increase in deferred income tax asset valuation
    allowance |  |      | 40  |      |  |      | 54  |    |  |  | 42  |   
|State income taxes, net of federal effect                     |  |      | (6  | )    |  |      | (6  | )  |  |  | (6  | ) 
|Research and development credits                              |  |      | (4  | )    |  |      | (5  | )  |  |  | (2  | ) 
|Foreign tax credit                                            |  |      |    |      |  |      |    |    |  |  | (3  | ) 
|State net operating loss limitations                          |  |      | 1   |      |  |      | (1  | )  |  |  | 3   |   
|Other                                                         |  |      | 3   |      |  |      | (8  | )  |  |  | 3   |   
|                                                              |  |      |     |      |  |      |     |    |  |  |     |   
|Effective income tax rate                                     |  |      | 0   | %    |  |      | 0   | %  |  |  | 3   | % 
|                                                              |  |      |     |      |  |      |     |    |  |  |     |   

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,
|                                                                |  |              
|                                                                |  | 2004          |             | 2003
|                                                                |  |               |             |     
|Net operating loss carryforwards                                |  | $             | 36,718,417  |      |  | $ | 27,144,360  |  
|Deferred revenue                                                |  |               | 8,368,855   |      |  |   | 9,742,947   |  
|Research credit carryforwards                                   |  |               | 8,720,996   |      |  |   | 6,975,107   |  
|Capitalized research and development costs                      |  |               | 2,449,685   |      |  |   | 2,165,757   |  
|Capitalized license fees                                        |  |               | 626,822     |      |  |   | 741,529     |  
|Foreign tax credits                                             |  |               | 590,342     |      |  |   | 595,912     |  
|Other                                                           |  |               | 887,461     |      |  |   | (149,668    | )
|                                                                |  |               |             |      |  |   |             |  
|Net deferred income tax assets                                  |  |               | 58,362,578  |      |  |   | 47,215,944  |  
|Less valuation allowance for net deferred income
    tax assets |  |               | (58,362,578 | )    |  |   | (47,215,944 | )
|                                                                |  |               |             |      |  |   |             |  
|                                                                |  | $             |            |      |  | $ |            |  
|                                                                |  |               |             |      |  |   |             |  

We have provided a full valuation allowance
against the net deferred income tax assets recorded as of
September 30, 2004 and 2003 due to uncertainties as to
their ultimate realization. The net operating loss and research
credit carryforwards expire on various dates through 2024. In
the event of certain ownership changes, the Tax Reform Act of
1986 imposes certain restrictions on the amount of net operating
loss carry forwards that we may use in any year. As of
September 30, 2004, we had $104,790,155 and $18,678,260 of
Federal and California net operating loss carryforwards,
respectively. As of September 30, 2004, we had $5,059,401
and $3,661,595 of Federal and California research and
development credit carryforwards, respectively.



|    |                      
|--- | ---------------------
|10. | 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 up to 50% of their salary, subject
to annual limits. We are not required to make matching
contributions under the plan. However, in fiscal 2004 and 2003,
we voluntarily contributed $56,480 and $70,753, respectively, to
the plan. We did not make a contribution in fiscal 2002.

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##### Table of Contents



AVANIR Pharmaceuticals


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS   (Continued)



|    |                 
|--- | ----------------
|11. | Subsequent Event

On December 10, 2004, pursuant to
AVANIRs shelf registration on Form S-3 filed on
April 9, 2004, the Company entered into a Stock Purchase
Agreement with CDIB Capital Investment America Ltd., a
wholly-owned subsidiary of China Development Industrial Bank
Inc., pursuant to which the Company issued and sold
2,333,333 shares of Class A common stock at a price of
$3.00 per share, for aggregate offering proceeds of
approximately $7 million.

* * * *

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