(3) Significant Accounting Policies

Basic and Diluted Income (Loss) per Common Share

The Company reports earnings per share in accordance with Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) Topic 260, Earnings Per Share (ASC 260), which establishes standards for computing and presenting earnings per share. Basic earnings per share is computed by dividing net income (loss) available to common shareholders by the weighted average number of common shares outstanding during the period. Preferred shares are not included in the calculation of net income (loss) per share until their conversion to common shares. Diluted earnings per share is computed by dividing net income available to common shareholders by the weighted-average number of common shares and dilutive common share equivalents then outstanding. Potential common share equivalents consist of the incremental common shares issuable upon the exercise of stock options and warrants. Under the treasury stock method, unexercised “in-the-money” stock options are assumed to be exercised at the beginning of the period or at issuance, if later. The assumed proceeds are then used to purchase common shares at the average market price during the period. Share-based payment awards that entitle their holders to receive non-forfeitable dividends before vesting are considered participating securities and are included in the calculation of basic and diluted earnings per share. Common share equivalents have not been included in the net loss per share computation in the three months ended June 30, 2011 and 2010 and the six months ended June 30, 2010 because their effect is anti-dilutive.

Basic and diluted earnings per share for the three and six months ended June 30, 2011 and 2010 are as follows:


	Three Months Ended June 30,						Six Months Ended June 30,
	2011			2010			2011			2010
	(in thousands, except per share data)						(in thousands, except per share data)
Basic earnings per share
Net income (loss)	$	(5,731	)	$	(15,489	)	$	79,635		$	(29,867	)
Income allocated to participating securities		—			—			(113	)		—

Income (loss) available to common stockholders		(5,731	)		(15,489	)		79,522			(29,867	)

Basic weighted average common shares outstanding		36,849			30,822			36,318			18,649
Basic earnings (loss) per share	$	(0.16	)	$	(0.50	)	$	2.19		$	(1.60	)


Diluted earnings per share
Net income (loss)	$	(5,731	)	$	(15,489	)	$	79,635		$	(29,867	)
Income allocated to participating securities		—			—			(103	)		—

Income (loss) available to common stockholders		(5,731	)		(15,489	)		79,532			(29,867	)
Weighted average common shares outstanding		36,849			30,822			36,318			18,649
Diluted potential common shares		—			—			1,802			—

Diluted weighted average common shares and potential common shares		36,849			30,822			38,120			18,649
Diluted earnings (loss) per share	$	(0.16	)	$	(0.50	)	$	2.09		$	(1.60	)

Stock-Based Compensation

The fair value of all stock-based awards is recognized in the Company’s statements of operations on a straight-line basis over their requisite service periods based on their grant date fair values as calculated using the measurement and recognition provisions of FASB ASC Topic 718, Stock Compensation. During the three and six months ended June 30, 2011 and 2010, respectively, the Company recorded the following stock-based compensation expense:


	Three Months Ended June 30,				Six Months Ended June 30,
	2011		2010		2011		2010
	(in thousands)				(in thousands)
Research and development	$	583	$	421	$	1,130	$	779
General and administrative		828		677		1,463		1,135

	$	1,411	$	1,098	$	2,593	$	1,914

Allocations to research and development expenses and general and administrative expenses are based upon the department to which the associated employee reported. No related tax benefits of the stock-based compensation expense have been recognized. Stock-based awards issued to non-employees are recorded at their fair values, and are periodically revalued as the equity instruments vest and are recognized as expense over the related service period.

Revenue Recognition

The Company’s revenues are generated primarily through collaborative research, development and commercialization agreements. The terms of these agreements generally contain multiple elements, or deliverables, which may include (i) licenses, or options to obtain licenses, to the Company’s technology, (ii) research and development activities to be performed on behalf of the collaborative partner and (iii) in certain cases, services in connection with the manufacturing of pre-clinical and clinical material. Payments to the Company under these arrangements typically include one or more of the following: non-refundable, up-front license fees; option exercise fees; funding of research and/or development efforts; milestone payments; and royalties on future product sales.

Effective January 1, 2011, the Company adopted Accounting Standards Update (“ASU”) No. 2009-13, Multiple-Deliverable Revenue Arrangements, which amends ASC Topic 605-25, Revenue Recognition – Multiple Element Arrangements. In addition, effective January 1, 2011, the Company adopted ASU No. 2010-17, Revenue Recognition – Milestone Method. Refer to “New Accounting Pronouncements” below for additional discussion of these standards and their impact on the Company’s accounting for collaborative research, development and commercialization agreements.

When evaluating multiple element arrangements, the Company considers whether the deliverables under the arrangement represent separate units of accounting. This evaluation requires subjective determinations and requires management to make judgments about the individual deliverables and whether such deliverables are separable from the other aspects of the contractual relationship. In determining the units of accounting, management evaluates certain criteria, including whether the deliverables have standalone value, based on the consideration of the relevant facts and circumstances for each arrangement. The consideration received is allocated among the separate units of accounting, and the applicable revenue recognition criteria are applied to each of the separate units.

The Company typically receives up-front, non-refundable payments when licensing its intellectual property in conjunction with a research and development agreement. When management believes the license to its intellectual property does not have stand-alone value from the other deliverables to be provided in the arrangement, the Company generally recognizes revenue attributed to the license on a straight-line basis over the Company’s contractual or estimated performance period, which is typically the term of the Company’s research and development obligations. If management cannot reasonably estimate when the Company’s performance obligation ends, then revenue is deferred until management can reasonably estimate when the performance obligation ends. When management believes the license to its intellectual property has stand-alone value, the Company generally recognizes revenue attributed to the license upon delivery. The periods over which revenue should be recognized are subject to estimates by management and may change over the course of the research and development agreement. Such a change could have a material impact on the amount of revenue the Company records in future periods.

Payments or reimbursements resulting from the Company’s research and development efforts for those arrangements where such efforts are considered as deliverables are recognized as the services are performed and are presented on a gross basis so long as there is persuasive evidence of an arrangement, the fee is fixed or determinable, and collection of the related receivable is reasonably assured. Amounts received prior to satisfying the above revenue recognition criteria are recorded as deferred revenue in the accompanying balance sheets.

At the inception of each agreement that includes milestone payments, the Company evaluates whether each milestone is substantive and at risk to both parties on the basis of the contingent nature of the milestone, specifically reviewing factors such as the scientific and other risks that must be overcome to achieve the milestone, as well as the level of effort and investment required. Revenues from milestones, if they are nonrefundable and deemed substantive, are recognized upon successful accomplishment of the milestones. Milestones that are not considered substantive are accounted for as license payments and recognized on a straight-line basis over the remaining period of performance.

Principles of Consolidation

The Company’s condensed consolidated financial statements include the Company’s accounts and the accounts of the Company’s wholly-owned subsidiary, AVEO Pharma Limited. All intercompany transactions have been eliminated.

Research and Development Expenses

Research and development expenses are charged to expense as incurred. Research and development expenses consist of costs incurred in performing research and development activities, including personnel-related costs, stock-based compensation, facilities, research-related overhead, clinical trial costs, manufacturing costs and other contracted services, license fees, and other external costs.

Nonrefundable advance payments for goods and services that will be used in future research and development activities are expensed when the activity has been performed or when the goods have been received rather than when the payment is made in accordance with the provisions of ASC Topic 730, Research and Development.

Cash and Cash Equivalents

The Company considers highly liquid investments with a maturity of three months or less when purchased to be cash equivalents. Cash equivalents at June 30, 2011 and December 31, 2010 consist of money market funds, commercial paper, corporate bonds and U.S. government agency securities.

Marketable Securities

Marketable securities at June 30, 2011 and December 31, 2010 primarily consist of U.S. treasuries, U.S. government agency securities, a foreign government agency security, commercial paper and corporate debt maintained by an investment manager. Credit risk is reduced as a result of the Company’s policy to limit the amount invested in any one issue. Marketable securities consist primarily of investments which have original maturities at the date of purchase in excess of three months, but not longer than 24 months. The Company classifies these investments as available-for-sale. Unrealized gains and losses are included in other comprehensive income as a component of stockholders’ equity until realized. The cost of securities sold is based on the specific identification method. There were no realized gains or losses recognized on the sale or maturity of securities during the three and six months ended June 30, 2011 and 2010.

Available-for-sale securities at June 30, 2011 and December 31, 2010 consist of the following:


	Amortized Cost		Unrealized Gains		Unrealized Losses			Fair Value
	(in thousands)
June 30, 2011:
Corporate debt securities (Due within 1 year)	$	138,623	$	125	$	(42	)	$	138,706
Corporate debt security (Due after 1 year through 2 years)		5,119		—		(25	)		5,094
U.S. Treasuries (Due within 1 year)		7,101		5		—			7,106
Government agency securities (Due within 1 year)		33,437		3		(1	)		33,439
Government agency securities (Due after 1 year through 2 years)		27,384		9		(11	)		27,382
Foreign government agency security (Due within 1 year)		4,043		1		—			4,044

	$	215,707	$	143	$	(79	)	$	215,771

December 31, 2010:
Corporate debt securities (Due within 1 year)	$	71,615	$	19	$	(27	)	$	71,607
U.S. Treasury (Due within 1 year)		5,178		—		(1	)		5,177
Government agency securities (Due within 1 year)		13,503		—		(6	)		13,497
Foreign government agency security (Due within 1 year)		4,131		—		(5	)		4,126

	$	94,427	$	19	$	(39	)	$	94,407

The aggregate fair value of securities in an unrealized loss position for less than 12 months at June 30, 2011 was $65.4 million, representing twenty nine securities. The aggregate fair value of securities in an unrealized loss position for greater than 12 months at June 30, 2011 was $21.5 million, representing four securities. The unrealized loss was caused by a temporary change in the market for those securities. There was no change in the credit risk of the securities. To determine whether an other-than-temporary impairment exists, the Company performs an analysis to assess whether it intends to sell, or whether it would more likely than not be required to sell, the security before the expected recovery of the amortized cost basis. Where the Company intends to sell a security, or may be required to do so, the security’s decline in fair value is deemed to be other-than-temporary and the full amount of the unrealized loss is recorded in the statement of operations as an other-than-temporary impairment charge. When this is not the case, the Company performs additional analysis on all securities with unrealized losses to evaluate losses associated with the creditworthiness of the security. Credit losses are identified where the Company does not expect to receive cash flows, based on using a single best estimate, sufficient to recover the amortized cost basis of a security and these are recognized in other income (expense), net.

Marketable securities in an unrealized loss position at June 30, 2011 and December 31, 2010 consists of the following:


	Aggregate Fair Value		Unrealized Losses
	(in thousands)
June 30, 2011:
Corporate debt securities (Due within 1 year)	$	55,666	$	(42	)
Corporate debt security (Due after 1 year through 2 years)		5,094		(25	)
Government agency securities (Due within 1 year)		9,754		(1	)
Government agency securities (Due after 1 year through 2 years)		16,372		(11	)

	$	86,886	$	(79	)


	Aggregate Fair Value		Unrealized Losses
	(in thousands)
December 31, 2010:
Corporate debt securities (Due in less than 1 year)	$	27,536	$	(27	)
U.S. Treasury (Due in less than 1 year)		5,177		(1	)
Government agency securities (Due in less than 1 year)		13,497		(6	)
Foreign government agency security (Due in less than 1 year)		4,126		(5	)

	$	50,336	$	(39	)

Based on consideration of those factors described in the previous paragraph, the Company does not believe an other-than temporary impairment exists with respect to those securities in an unrealized loss position at June 30, 2011.

Concentrations of Credit Risk

Financial instruments that potentially subject the Company to credit risk primarily consist of cash and cash equivalents and available-for-sale marketable securities. The Company maintains deposits in federally insured financial institutions in excess of federally insured limits.

Management believes that the Company is not exposed to significant credit risk due to the financial position of the depository institutions in which those deposits are held.

The Company’s credit risk related to marketable securities is reduced as a result of the Company’s policy to limit the amount invested in any one issue.

Fair Value Measurements

The carrying amounts of the Company’s financial instruments not required to be measured at fair value, which include accounts receivable, accounts payable, and loans payable, approximate their fair values at June 30, 2011 and December 31, 2010.

The Company records cash equivalents, marketable securities and warrants to purchase preferred stock at fair value. ASC Topic 820, Fair Value Measurements and Disclosures, establishes a fair value hierarchy for those instruments measured at fair value that distinguishes between fair value measurements based on market data (observable inputs) and those based on the Company’s own assumptions (unobservable inputs). The hierarchy consists of three levels:

•

Level 1—Quoted market prices in active markets for identical assets or liabilities. Assets utilizing Level 1 inputs include U.S. government securities.

•

Level 2—Inputs other than Level 1 inputs that are either directly or indirectly observable, such as quoted market prices, interest rates and yield curves. Assets utilizing Level 2 inputs include government agency securities, including direct issuance bonds, and corporate bonds. These assets are valued using third party pricing sources which generally use interest rates and yield curves observable at commonly quoted intervals of similar assets as observable inputs for pricing.

•

Level 3—Unobservable inputs developed using estimates and assumptions developed by the Company, which reflect those that a market participant would use. The Company currently has no assets or liabilities valued with Level 3 inputs.

The following tables summarize the cash equivalents and marketable securities measured at fair value on a recurring basis in the accompanying condensed consolidated balance sheets as of June 30, 2011 and December 31, 2010.


	Fair Value Measurements of Cash Equivalents and Marketable Securities as of June 30, 2011
	Level 1		Level 2		Level 3		Total
	(in thousands)
Cash equivalents	$	71,622	$	6,206	$	—	$	77,828
Marketable securities		7,105		208,666		—		215,771

	$	78,727	$	214,872	$	—	$	293,599


	Fair Value Measurements of Cash Equivalents and Marketable Securities as of December 31, 2010
	Level 1		Level 2		Level 3		Total
	(in thousands)
Cash equivalents	$	28,767	$	14,015	$	—	$	42,782
Marketable securities		5,177		89,230		—		94,407

	$	33,944	$	103,245	$	—	$	137,189

Property and Equipment

Property and equipment are stated at cost and are depreciated using the straight-line method over the estimated useful lives of the respective assets. Maintenance and repair costs are charged to expense as incurred.

Long-lived Assets

The Company reviews long-lived assets, including property and equipment, for impairment whenever changes in business circumstances indicate that the carrying amount of the asset may not be fully recoverable. The Company has not recognized any impairment losses through June 30, 2011.

Comprehensive Income (Loss)

Comprehensive income (loss) is defined as the change in equity of a business enterprise during a period from transactions and other events and circumstances from non-owner sources. Accumulated other comprehensive income (loss) as of June 30, 2011 and 2010 consists entirely of unrealized gains/(losses) on available-for-sale securities.


	Six months Ended June 30,
	2011		2010
	(in thousands)
Net income (loss)	$	79,635	$	(29,867	)
Net unrealized gains on marketable securities		84		16

Comprehensive income (loss)	$	79,719	$	(29,851	)

Income Taxes

The Company provides for income taxes using the liability method. Under this method, deferred tax assets and liabilities are determined based on differences between financial reporting and tax bases of assets and liabilities, and are measured using the enacted tax rates and laws that will be in effect when the differences are expected to reverse.

Segment and Geographic Information

Operating segments are defined as components of an enterprise engaging in business activities for which discrete financial information is available and regularly reviewed by the chief operating decision maker in deciding how to allocate resources and in assessing performance. The Company views its operations and manages its business in one operating segment and the Company operates in only one geographic segment.

Use of Estimates

The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires the Company’s 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.

New Accounting Pronouncements

Effective January 1, 2011, the Company adopted ASU 2009-13, which amends ASC Topic 605-25 to eliminate the residual method of allocation for multiple-deliverable revenue arrangements and requires that arrangement consideration be allocated at the inception of an arrangement to all deliverables using the relative selling price method. ASU 2009-13 also establishes a selling price hierarchy for determining the selling price of a deliverable, which includes: (1) vendor-specific objective evidence (“VSOE”) if available; (2) third-party evidence (“TPE”) if VSOE is not available; and (3) estimated selling price if neither VSOE nor TPE is available.

Prior to the adoption of ASU 2009-13, ASC Topic 605-25 required that the fair value of an undelivered item be determined by reference to VSOE or TPE. This was difficult to determine when a deliverable was not individually sold because of its unique features. Prior to the adoption of ASU 2009-13, if the fair value of the undelivered elements in the arrangement was not determinable, then revenue was generally deferred and recognized over the delivery period of the longest deliverable or when fair value was determined for the undelivered elements. The Company has elected to prospectively apply the provisions of ASU 2009-13 to all multiple-deliverable revenue arrangements entered into or materially modified after January 1, 2011. The adoption of ASU 2009-13 had a material impact on the Company’s financial position and results of operations for the three and six months ended June 30, 2011 as discussed in Note 4, “Collaborations and License Agreements.”

On January 1, 2011, the Company adopted ASU 2010-17, which codified a method of revenue recognition that has been common practice. This guidance concludes that the milestone method is a valid application of the proportional performance model when applied to research or development arrangements. Accordingly, an entity can make an accounting policy election to recognize a payment that is contingent upon the achievement of a substantive milestone in its entirety in the period in which the milestone is achieved. Because the Company’s revenue recognition policy for milestone payments is generally consistent with ASU 2010-17, the adoption of this standard did not have a material effect on the Company’s condensed consolidated financial position, results of operations or cash flows for the three and six months ended June 30, 2011. This standard may impact the Company’s accounting for any milestone payments received in future periods.

Subsequent Events

The Company has evaluated all events or transactions that occurred after June 30, 2011 up through the date the Company issued these financial statements.