Note 3 - Significant Accounting Policies

6 Months Ended

Jun. 30, 2013

Significant Accounting Policies [Text Block]

Significant Accounting Policies [Text Block]

3. Summary of Significant Accounting Policies

Consolidation

The accompanying consolidated financial statements include the accounts of EpiCept Corporation and the Company’s 100%-owned subsidiaries, Maxim Pharmaceuticals, Inc., Cytovia, Inc. and EpiCept GmbH (in liquidation). All inter-company transactions and balances have been eliminated.

Use of Estimates

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America (the “U.S.”) requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements. Estimates also affect the reported amounts of revenues and expenses during the reporting period, including stock –based compensation. Actual results could differ from those estimates.

Revenue Recognition

The Company recognizes revenue relating to its collaboration agreements in accordance with the SEC Staff Accounting Bulletin No. 104, Revenue Recognition, Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) 605-25, “Revenue Recognition - Multiple Element Arrangements” (“ASC 605-25”), and Accounting Standards Update (“ASU”) 2009-13, "Multiple Revenue Arrangements - a Consensus of the FASB Emerging Issues Task Force" (“ASU 2009-13”). ASU 2009-13 supersedes certain guidance in ASC 605-25, and requires an entity to allocate arrangement consideration to all of its deliverables at the inception of an arrangement based on their relative selling prices (i.e., the relative-selling-price method). The Company adopted the provisions of ASU 2009-13 beginning on January 1, 2011. The adoption of ASU 2009-13 did not have a material effect on the Company’s financial statements.

Revenue under collaborative arrangements may result from license fees, milestone payments, research and development payments and royalty payments. The Company’s application of these standards requires subjective determinations and requires management to make judgments about the value of the individual elements and whether they are separable from the other aspects of the contractual relationship. The Company evaluates its collaboration agreements to determine units of accounting for revenue recognition purposes. For collaborations containing a single unit of accounting, the Company recognizes revenue when the fee is fixed or determinable, collectibility is reasonably assured and the contractual obligations have occurred or been rendered. For collaborations involving multiple elements, the Company’s application requires management to make judgments about value of the individual elements and whether they are separable from the other aspects of the contractual relationship. To date, the Company has determined that its upfront non-refundable license fees cannot be separated from its ongoing collaborative research and development activities and, accordingly, does not treat them as a separate element. The Company recognizes revenue from non-refundable, upfront licenses and related payments, not specifically tied to a separate earnings process, either on the proportional performance method with respect to the Company’s license with Endo, or ratably over either the development period in which the Company is obligated to participate on a continuing and substantial basis in the research and development activities outlined in the contract, or the later of 1) the conclusion of the royalty term on a jurisdiction by jurisdiction basis or 2) the expiration of the last EpiCept licensed patent as we do with respect to our license with DURECT, Myrexis and GNI, Ltd.

Proportional performance is measured based on costs incurred compared to total estimated costs to be incurred over the development period which approximates the proportion of the value of the services provided compared to the total estimated value over the development period. The proportional performance method currently results in revenue recognition at a slower pace than the ratable method as many of the Company’s costs are incurred in the latter stages of the development period. The Company periodically reviews its estimates of cost and the length of the development period and, to the extent such estimates change, the impact of the change is recorded at that time. The Company increased the estimated development period with respect to its license with Endo by an additional twelve months to reflect additional time required to obtain clinical data from our partner during each of the years 2012 and 2011.

EpiCept recognizes milestone payments as revenue upon achievement of the milestone only if (1) it represents a separate unit of accounting as defined in ASC 605-25; (2) the milestone payments are nonrefundable; (3) substantive effort is involved in achieving the milestone; and (4) the amount of the milestone is reasonable in relation to the effort expended or the risk associated with the achievement of the milestone. If any of these conditions is not met, EpiCept will recognize milestones as revenue in accordance with its accounting policy in effect for the respective contract. For current agreements, EpiCept recognizes revenue for milestone payments based upon the portion of the development services that are completed to date and defers the remaining portion and recognizes it over the remainder of the development services on the proportional or ratable method, whichever is applicable. When payments are specifically tied to a separate earnings process, revenue will be recognized when the specific performance obligation associated with the payment has been satisfied. Deferred revenue represents the excess of cash received compared to revenue recognized to date under licensing agreements.

Revenue from the sale of product is recognized when title and risk of loss of the product is transferred to the customer. Provisions for discounts, early payments, rebates, sales returns and distributor chargebacks under terms customary in the industry, if any, are provided for in the same period the related sales are recorded.

Royalty revenue is recognized in the period in which the sales occur, provided that the royalty amounts are fixed or determinable, collection of the related receivable is reasonably assured and the Company has no remaining performance obligations under the arrangement providing for the royalty. If royalties are received when the Company has remaining performance obligations, they would be attributed to the services being provided under the arrangement and, therefore, recognized as such obligations are performed under either the proportionate performance or ratable methods, as applicable.

Share-Based Payments

The Company records stock-based compensation expense at fair value in accordance with the FASB issued ASC 718-10, “Compensation – Stock Compensation” (“ASC 718-10”). The Company utilizes the Black-Scholes valuation method to recognize compensation expense over the vesting period. Certain assumptions need to be made with respect to utilizing the Black-Scholes valuation model, including the expected life, volatility, risk-free interest rate and anticipated forfeiture of the stock options. The expected life of the stock options was calculated using the method allowed by the provisions of ASC 718-10. In accordance with ASC 718-10, the simplified method for “plain vanilla” options may be used where the expected term is equal to the vesting term plus the original contract term divided by two. The risk-free interest rate is based on the rates paid on securities issued by the U.S. Treasury with a term approximating the expected life of the options. Estimates of pre-vesting option forfeitures are based on the Company’s experience. The Company will adjust its estimate of forfeitures over the requisite service period based on the extent to which actual forfeitures differ, or are expected to differ, from such estimates. Changes in estimated forfeitures will be recognized through a cumulative catch-up adjustment in the period of change and will also impact the amount of compensation expense to be recognized in future periods.

The Company accounts for stock-based transactions with non-employees in which services are received in exchange for the equity instruments based upon the fair value of the equity instruments issued, in accordance with ASC 718-10 and ASC 505-50, “Equity-Based Payments to Non-Employees.” The two factors that most affect charges or credits to operations related to stock-based compensation are the estimated fair market value of the common stock underlying stock options for which stock-based compensation is recorded and the estimated volatility of such fair market value. The value of such options is periodically remeasured and income or expense is recognized during the vesting terms.

Accounting for stock-based compensation granted by the Company requires fair value estimates of the equity instrument granted or sold. If the Company’s estimate of the fair value of stock-based compensation is too high or too low, it will have the effect of overstating or understating expenses. When stock-based grants are granted in exchange for the receipt of goods or services, the Company estimates the value of the stock-based compensation based upon the value of its common stock.

Foreign Exchange Gains and Losses

EpiCept’s 100%-owned subsidiary in Germany, EpiCept GmbH, is currently in in the process of liquidating its assets and liabilities. EpiCept GmbH performed certain commercialization activities on the Company’s behalf and has generally been unprofitable since its inception. Its functional currency is the euro. The process by which EpiCept GmbH’s financial results are translated into U.S. dollars is as follows: income statement accounts are translated at average exchange rates for the period and balance sheet asset and liability accounts are translated at end of period exchange rates. Translation of the balance sheet in this manner affects the stockholders’ deficit account, referred to as the cumulative translation adjustment account. This account exists only in EpiCept GmbH’s U.S. dollar balance sheet and is necessary to keep the foreign balance sheet stated in U.S. dollars in balance.

Research and Development Expenses

The Company expects that a large percentage of its future research and development expenses will be incurred in support of current and future preclinical and clinical development programs. These expenditures are subject to numerous uncertainties in timing and cost to completion. The Company tests its product candidates in numerous preclinical studies for toxicology, safety and efficacy. The Company then conducts early stage clinical trials for each drug candidate. As the Company obtains results from clinical trials, it may elect to discontinue or delay clinical trials for certain product candidates or programs in order to focus resources on more promising product candidates or programs. Completion of clinical trials may take several years but the length of time generally varies according to the type, complexity, novelty and intended use of a drug candidate. The cost of clinical trials may vary significantly over the life of a project as a result of differences arising during clinical development, including:

● the number of sites included in the trials;

● the length of time required to enroll suitable patients;

● the number of patients that participate in the trials;

● the number of doses that patients receive;

● the duration of follow-up with the patient;

● the product candidate’s phase of development; and

● the efficacy and safety profile of the product.

Expenses related to clinical trials are based on estimates of the services received and efforts expended pursuant to contracts with multiple research institutions and clinical research organizations that conduct clinical trials on the Company’s behalf. The financial terms of these agreements are subject to negotiation and vary from contract to contract and may result in uneven payment flows. If timelines or contracts are modified based upon changes in the clinical trial protocol or scope of work to be performed, estimates of expenses are modified accordingly on a prospective basis.

Other than Ceplene^®, none of the Company’s drug candidates has received FDA or foreign regulatory marketing approval. In order to grant marketing approval, the FDA or foreign regulatory agencies must conclude that its clinical data and that of its collaborators establish the safety and efficacy of our drug candidates. Furthermore, the Company’s strategy includes entering into collaborations with third parties to participate in the development and commercialization of its products. In the event that third parties have control over the preclinical development or clinical trial process for a product candidate, the estimated completion date would largely be under control of that third party rather than under the Company’s control. The Company cannot forecast with any degree of certainty which of its drug candidates will be subject to future collaborations or how such arrangements would affect its development plan or capital requirements.

Income Taxes

The Company accounts for income taxes in accordance with ASC 740, “Income Taxes.” The Company files income tax returns in the U.S. federal jurisdiction, New York, California and Germany. The Company’s income tax returns for tax years after 2008 are still subject to review. Since the Company incurred losses in the past, all prior years that generated losses are open and subject to audit examination in relation to the losses generated from those years.

The Company accounts for its income taxes under the asset and liability method. Under the asset and liability method, deferred tax assets and liabilities are recognized based upon the differences arising from carrying amounts of the Company’s assets and liabilities for tax and financial reporting purposes using enacted tax rates in effect for the year in which the differences are expected to reverse. The effect on the deferred tax assets and liabilities of a change in tax rates is recognized in the period when the change in tax rates is enacted. A valuation allowance is established when it is determined that it is more likely than not that some portion or all of the deferred tax assets will not be realized. A full valuation allowance has been applied against the Company’s net deferred tax assets at June 30, 2013 and December 31, 2012, because it is not more likely than not that the Company will realize future benefits associated with these deferred tax assets. Upon completion of the merger with Immune, the Company’s deferred tax assets and net operating loss carry-forwards  will be reevaluated to determine any limitations due to change in control under Internal Revenue Code Section 382.

The Company’s policy is to recognize interest and penalties accrued on any unrecognized tax benefits as a component of operating expense. The Company did not have any liabilities, accrued interest or penalties associated with any unrecognized tax benefits, nor was any interest expense recognized during the quarters ended June 30, 2013 and 2012. Income tax expense for the three and six months ended June 30, 2013 and 2012 is primarily due to minimum state and local income taxes.

Income (loss) per Share:

Basic and diluted loss per share is computed by dividing loss attributable to common stockholders by the weighted average number of shares of common stock outstanding during the period. Diluted weighted average shares outstanding for the three months ended June 30, 2013 and the six months ended June 30, 2013 and 2012 excludes shares underlying convertible preferred stock, stock options, restrictive stock and warrants, since the effects would be anti-dilutive. Accordingly, basic and diluted loss per share is the same. Diluted weighted average shares outstanding for the three months ended June 30, 2012 excludes shares underlying stock options, restrictive stock and warrants, because these shares were out of the money. Such excluded shares are summarized as follows:

	Three Months Ended June 30,				Six Months Ended June 30,
	2013		2012		2013		2012
Common stock options		2,277,989		4,316,436		2,277,989		4,316,436
Restricted stock units		—		2,325,000		—		2,730,000
Shares issuable upon conversion of preferred stock		—		—		—		7,444,706
Warrants		21,718,914		31,088,705		21,718,914		34,221,058
Total shares excluded from calculation		23,996,903		37,730,141		23,996,903		48,712,200

Basic and diluted earnings per share (EPS) were computed using the following data (in thousands, except share and per share amounts):

	Three Months Ended June 30,					Six Months Ended June 30,
	2013			2012		2013			2012
EPS Numerator – Basic:
Net income (loss)	$	(1,684	)	$	2,209	$	(2,784	)	$	(2,495	)
EPS Numerator – Diluted:
Net income (loss)	$	(1,684	)	$	2,959	$	(2,784	)	$	(2,495	)
EPS Denominator:
Weighted-average common shares outstanding––Basic		113,639,424			83,772,960		110,158,277			80,414,692
Common stock equivalents: convertible preferred stock, restricted stock units and warrants		—			7,818,933		—			—
Weighted-average common shares outstanding––Diluted		113,639,424			91,591,893		110,158,277			80,414,692

Interest Expense:

Interest expense consisted of the following for the three and six months ended June 30, 2013 and 2012:

	Three Months Ended June 30,						Six Months Ended June 30,
	2013			2012			2013			2012
	(in $000s)						(in $000s)
Interest expense	$	(125	)	$	(208	)	$	(247	)	$	(447	)
Amortization of debt issuance costs and discount		(50	)		(172	)		(116	)		(296	)
Interest and amortization of debt discount and expense	$	(175	)	$	(380	)	$	(363	)	$	(743	)

Amortization of debt issuance costs in 2013 and 2012 was primarily related to issuance costs in connection with the Company’s senior secured term loan that was entered into in May 2011.

Cash and Cash Equivalents 

The Company considers all highly liquid investments with a maturity of 90 days or less when purchased to be cash equivalents.

Restricted Cash 

The Company has lease agreements for the premises it occupies. A letter of credit in lieu of a lease deposit for leased facilities totaling $0.1 million was secured by restricted cash in the same amount at December 31, 2012. The letter of credit was not renewed in 2013, resulting in the release of restricted cash totaling $0.1 million. The Company has failed to make payments on its lease agreement for the premises located in San Diego, California since April 2012. As a result, the landlord applied approximately $0.1 million to unpaid rent in 2012 (see Deferred Rent and Other Noncurrent Liabilities). The Company also has a restricted cash balance of $0.6 million being held by Midcap Financial, LLC., (“Midcap”) at June 30, 2013 (see Note 8).

Prepaid Expenses and Other Current Assets: 

As of June 30, 2013 and December 31, 2012, prepaid expenses and other current assets consist of the following:

	June 30,		December 31,
	2013		2012
	(in thousands)
Prepaid expenses	$	30	$	43
Prepaid insurance		64		53
Other		5		20
Total prepaid expenses and other current assets	$	99	$	116

Property and Equipment

Property and equipment consists of furniture, office and laboratory equipment, and leasehold improvements stated at cost. Furniture and office and laboratory equipment are depreciated on a straight-line basis over their estimated useful lives ranging from five to seven years. Leasehold improvements are amortized on a straight-line basis over the shorter of the lease term or the estimated useful life of the asset. Maintenance and repairs are charged to expense as incurred.

Deferred Financing Costs

Deferred financing costs represent legal and other costs and fees incurred to negotiate and obtain debt financing. Deferred financing costs are capitalized and amortized using the effective interest method over the life of the applicable financing. Deferred financing costs were approximately $24,000 and $0.1 million at June 30, 2013 and December 31, 2012, respectively. Amortization expense was $0.1 million for each of the six months ended June 30, 2013 and 2012, respectively.

Beneficial Conversion Feature of Certain Instruments

The convertible feature of certain financial instruments provided for a rate of conversion that was below market value at the commitment date. Such feature is normally characterized as a beneficial conversion feature (“BCF”). Pursuant to ASC 470-20, Debt with Conversion and Other Options (“ASC 470-20”), the estimated fair value of the BCF is recorded as a dividend if it is related to preferred stock. Our Series A 0% Convertible Preferred Stock and Series B 0% Convertible Preferred Stock were each immediately convertible and contained a BCF. Therefore, the Company initially recorded a BCF of approximately $1.9 million as a deemed dividend in 2012. As the result of the Reset Offer in September 2012, the Company recorded an additional BCF of $1.6 million. (see Note 8).

Deferred Rent and Other Noncurrent Liabilities

Deferred rent and other noncurrent liabilities represents deferred rent expense on the Company’s facilities in Tarrytown, NY and San Diego, CA. In accordance with accounting principles generally accepted in the U.S., the Company recognizes rental expense, including tenant improvement allowances, on a straight-line basis over the life of the leases or useful life, whichever is shorter, irrespective of the timing of payments to or from the lessor. The Company ceased use of its discovery research facility in San Diego, CA as a result of the Company’s decision to discontinue its drug discovery activities in 2009. In accordance with ASC 420-10, “Exit or Disposal Cost Activities” (“ASC 420-10”), the Company recorded a liability of $0.8 million, included in research and development expense on the consolidated statements of operations and comprehensive loss, on the cease-use date based on the fair value of the costs that are expected to be incurred under the lease of the facility. The fair value of the liability at the cease-use date was determined based on the remaining rental payments, reduced by estimated sublease rental income that could be reasonably obtained for the property. The Company had deferred rent of zero and $0.3 million at June 30, 2013 and December 31, 2012, respectively. The Company accrued $1.5 million payable under this lease at June 30, 2013.

Impairment of Long-Lived Assets

The Company performs impairment tests on its long-lived assets when circumstances indicate that their carrying amounts may not be recoverable. If required, recoverability is tested by comparing the estimated future undiscounted cash flows of the asset or asset group to its carrying value. If the carrying value is not recoverable, the asset or asset group is written down to fair value. No such impairments have been identified with respect to the Company’s long-lived assets, which consist primarily of property and equipment at June 30, 2013.

Derivatives

The Company accounts for its derivative instruments in accordance with ASC 815-10, “Derivatives and Hedging” (“ASC 815-10”). ASC 815-10 establishes accounting and reporting standards requiring that derivative instruments, including derivative instruments embedded in other contracts, be recorded on the balance sheet as either an asset or liability measured at its fair value. ASC 815-10 also requires that changes in the fair value of derivative instruments be recognized currently in results of operations unless specific hedge accounting criteria are met. The Company does not have derivatives in the current quarter and has not entered into hedging activities to date.

Accumulated Other Comprehensive Loss

The Company’s only element of accumulated other comprehensive loss was foreign currency translation adjustments of ($1.1) million at June 30, 2013 and December 31, 2012.

Fair Value of Financial Instruments

The Company applies ASC 820, Fair Value Measurements and Disclosures (“ASC 820”) to all financial instruments that are being measured and reported on a fair value basis, non-financial assets and liabilities measured and reported at fair value on a non-recurring basis, and disclosures of fair value of certain financial assets and liabilities.

The following fair value hierarchy is used in selecting inputs for those instruments measured at fair value that distinguishes between assumptions based on market data (observable inputs) and the Company’s assumptions (unobservable inputs). The hierarchy consists of three levels:

● Level 1 — Quoted prices in active markets for identical assets or liabilities.

● Level 2 — Inputs other than Level 1 that are observable for similar assets or liabilities either directly or indirectly.

● Level 3 — Prices or valuation techniques that require inputs that are both significant to the fair value measurement and unobservable.

The financial instruments recorded in the Company’s consolidated balance sheets consist primarily of cash and cash equivalents, accounts payable and the Company’s debt obligations. The carrying amounts of the Company’s cash and cash equivalents and accounts payable approximate fair value due to their short-term nature. The fair market value of the Company’s convertible and non-convertible loans is based on the present value of their cash flows discounted at a rate that approximates current market returns for issues of similar risk.

The carrying amount and estimated fair values of the Company’s debt instruments are as follows:

	June 30, 2013				December 31, 2012
	Carrying Amount		Level 2 Fair Value		Carrying Amount		Level 2 Fair Value
	(In millions)
Non-convertible loans	$	4.1	$	4.0	$	4.1	$	4.0

Recent Accounting Pronouncements

In June 2011, the FASB issued ASU 2011-05, "Comprehensive Income (Topic 220) – Presentation of Comprehensive Income" which amends ASC 220, “Comprehensive Income”. ASU 2011-05 gives an entity the option to present the total comprehensive income, the components of net income, and the components of other comprehensive income either in a single continuous statement of comprehensive income or in two separate but consecutive statements. ASU 2011-05 is effective for fiscal years, and interim periods within those years, beginning after December 15, 2011. The Company adopted the provisions of ASU 2011-05 on a retrospective basis in the year ended December 31, 2011. The adoption of ASU 2011-05 did not have a material impact on the Company’s consolidated financial statements. In December 2011, the FASB issued ASU 2011-12 “Deferral of the Effective Date for Amendments to the Presentation of Reclassifications of Items out of Accumulated Other Comprehensive Income in Accounting Standards Update No. 2011-05.” This update stated that the specific requirement to present items that are reclassified from other comprehensive income to net income alongside their respective components of net income and other comprehensive income will be deferred. In February 2013, the FASB issued ASU 2013-02 “Reporting of Amounts Reclassified Out of Accumulated Other Comprehensive Income”. This update requires companies to present the effects on the line items of net income of significant reclassifications out of accumulated other comprehensive income if the amount being reclassified is required under U.S. generally accepted accounting principles to be reclassified in its entirety to net income in the same reporting period.  ASU 2013-02 is effective prospectively for the Company for fiscal years, and interim periods within those years, beginning after December 15, 2012. The adoption of ASU 2013-02 did not have a material impact on the Company’s consolidated financial statements.