2. Basis of Presentation and Significant Accounting Policies

Basis of Presentation

The accompanying condensed consolidated financial statements are unaudited and have been prepared by TESARO in conformity with accounting principles generally accepted in the United States of America, or GAAP.

The Company’s condensed consolidated financial statements reflect the operations of the Company and its wholly-owned subsidiaries. All significant intercompany balances and transactions have been eliminated in consolidation. The Company currently operates in one business segment, which is the identification, acquisition, development and commercialization of oncology-related therapeutics, and has a single reporting and operating unit structure.

Certain information and footnote disclosures normally included in the Company’s annual financial statements have been condensed or omitted. These interim financial statements, in the opinion of management, reflect all normal recurring adjustments necessary for a fair presentation of the Company’s financial position and results of operations for the interim periods ended March 31, 2017 and 2018.

The results of operations for the interim periods are not necessarily indicative of the results of operations to be expected for the full fiscal year. These interim financial statements should be read in conjunction with the audited financial statements as of and for the year ended December 31, 2017 and the notes thereto, which are included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2017. The significant accounting policies used in preparation of these condensed consolidated financial statements for the three months ended March 31, 2018 are consistent with those discussed in Note 2 to the consolidated financial statements in the Company’s 2017 Annual Report on Form 10-K and are updated below as necessary.

Use of Estimates

The preparation of condensed consolidated financial statements in conformity with GAAP requires management to make certain estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses, other comprehensive income (loss) and the related disclosures. Significant estimates in these condensed consolidated financial statements include estimates made in connection with accrued research and development expenses, stock-based compensation expense, revenue, valuation of convertible notes, inventory, intangible assets and related amortization. The Company bases its estimates on historical experience, known trends and other market-specific or other relevant factors that it believes to be reasonable under the circumstances. Actual results may differ from those estimates or assumptions.

Fair Value of Financial Instruments

The Company is required to disclose information on all assets and liabilities reported at fair value that enables an assessment of the inputs used in determining the reported fair values. The fair value hierarchy prioritizes valuation inputs based on the observable nature of those inputs. The fair value hierarchy applies only to the valuation inputs used in determining the reported fair value of the investments and is not a measure of investment credit quality. The hierarchy defines three levels of valuation inputs:

Level 1 inputs Quoted prices in active markets for identical assets or liabilities

Level 2 inputs Observable inputs other than Level 1 inputs, including quoted prices in active markets for similar assets or liabilities and quoted prices for identical assets or liabilities in markets that are not active

Level 3 inputs Unobservable inputs that reflect the Company’s own assumptions about the assumptions market participants would use in pricing the asset or liability

The following table presents information about the Company’s financial assets and liabilities that have been measured at fair value as of December 31, 2017 and March 31, 2018 and indicates the fair value hierarchy of the valuation inputs utilized to determine such fair value (in thousands):


		December 31, 2017
Description	Balance Sheet Classification	Total		Level 1		Level 2		Level 3

Assets:
Money market funds	Cash and cash equivalents	$	593,955	$	593,955	$	—	$	—
Total assets		$	593,955	$	593,955	$	—	$	—


		March 31, 2018
Description	Balance Sheet Classification	Total		Level 1		Level 2		Level 3

Assets:
Money market funds	Cash and cash equivalents	$	403,121	$	403,121	$	—	$	—
Total assets		$	403,121	$	403,121	$	—	$	—

The carrying amounts of accounts payable and accrued expenses approximate their fair values due to their short-term maturities.

In September 2014, the Company issued $201.3 million aggregate principal amount of 3.00% convertible senior notes due October 1, 2021, or the Convertible Notes. Interest is payable semi-annually in arrears on April 1 and October 1 of each year. As of March 31, 2018, the carrying value of the Convertible Notes, net of unamortized discount and debt issuance costs, was $146.5 million and the estimated fair value of the principal amount was $369.0 million. As of March 31, 2018, the carrying value of the Company’s borrowing under its term loan agreement approximated its fair value. The Convertible Notes and the term loan agreement are discussed in more detail in Note 5, “Debt”.

Revenue Recognition

The Company recognizes revenue when its customer obtains control of promised goods or services, in an amount that reflects the consideration which the Company expects to receive in exchange for those goods or services. To determine revenue recognition, the Company performs the following five steps: (i) identify the contract(s) with a customer; (ii) identify the performance obligations in the contract; (iii) determine the transaction price; (iv) allocate the transaction price to the performance obligations in the contract; and (v) recognize revenue when (or as) the Company satisfies a performance obligation. The Company only applies the five-step model to contracts when it is probable that the Company will collect the consideration it is entitled to in exchange for the goods or services it transfers to the customer. For a further discussion of accounting for net product revenue and license, collaboration and other revenues, see Note 11, “Revenue Recognition”.

Intangible Assets

The Company maintains definite-lived intangible assets related to milestone payments made to third parties subsequent to regulatory approval for acquired and in-licensed product candidates. These assets are amortized over their remaining useful lives, which are generally estimated to be the remaining patent life. If the Company’s estimate of the product’s useful life is shorter than the remaining patent life, then the shorter period is used. Intangible assets are amortized using the economic consumption method if anticipated future revenues can be reasonably estimated. The straight-line method is used when future revenues cannot be reasonably estimated, with a cumulative catch-up of amortization expense for milestone payments that do not result in additional intellectual property rights and/or incremental cash flows. Amortization expense is recorded as a component of cost of sales in the condensed consolidated statements of operations and comprehensive loss.

The Company assesses its intangible assets for impairment if indicators are present or changes in circumstance suggest that impairment may exist. Events that could result in an impairment, or trigger an interim impairment assessment, include the receipt of additional clinical or nonclinical data regarding one of the Company’s drug candidates or a potentially competitive drug candidate, changes in the clinical development program for a drug candidate or new information regarding potential sales for the drug. If impairment indicators are present or changes in circumstance suggest that impairment may exist, the Company performs a recoverability test by comparing the sum of the estimated undiscounted cash flows of each intangible asset to its carrying value on the condensed consolidated balance sheet. If the undiscounted cash flows used in the recoverability test are less than the carrying value, the Company would determine the fair value of the intangible asset and recognize an impairment loss if the carrying value of the intangible asset exceeds its fair value.

Comprehensive Loss

Comprehensive 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. Comprehensive loss consists of net loss and other comprehensive loss. Other comprehensive loss includes foreign currency translation adjustments and unrealized gains and losses on pension obligations. The following table presents changes in the components of accumulated other comprehensive loss (in thousands):


		Foreign currency translation adjustments		Unrealized loss on pension liability		Total
Balance at December 31, 2016	$	(142)	$	(2,782)	$	(2,924)
Other comprehensive (loss) income		35		45		80
Balance at March 31, 2017	$	(107)	$	(2,737)	$	(2,844)

Balance at December 31, 2017	$	259	$	(6,141)	$	(5,882)
Other comprehensive (loss) income		462		63		525
Balance at March 31, 2018	$	721	$	(6,078)	$	(5,357)

New Accounting Pronouncements - Recently Adopted

In August 2016, the Financial Accounting Standards Board, or FASB, issued Accounting Standards Update, or ASU, No. 2016-15, which is intended to simplify and clarify how certain transactions are classified in the statement of cash flows, and to reduce diversity in practice for such transactions. This ASU addresses eight specific issues regarding classification of cash flows. The standard is effective for financial statements issued for fiscal years beginning after December 15, 2017, and interim periods within those fiscal years. The Company adopted this ASU effective January 1, 2018. The adoption of this guidance did not have an impact on the Company’s condensed consolidated financial statements and related disclosures.

In October 2016, the FASB issued ASU No. 2016-16, which removes the prohibition in ASC Topic 740 against the immediate recognition of the current and deferred income tax effects of intra-entity transfers of assets other than inventory. As a result, the income tax consequences from the intra-entity transfer of an asset, other than inventory, and associated changes to deferred taxes will be recognized when the transfer occurs. The Company adopted this new standard effective January 1, 2018 using the modified retrospective method. Upon adoption, the Company recorded a deferred tax asset and corresponding valuation allowance of $52.7 million. There was no cumulative effect adjustment to accumulated deficit as of the beginning of the period of adoption.

In November 2016, the FASB issued ASU No. 2016-18, which requires amounts generally described as restricted cash and restricted cash equivalents to be included with cash and cash equivalents when reconciling the total beginning and ending amounts for the periods shown on the statement of cash flows. ASU No. 2016-18 is effective for fiscal years beginning after December 15, 2017 (including interim periods within those periods) using a retrospective transition method to each period presented. The Company adopted this ASU effective January 1, 2018. The adoption of this guidance required the following changes and disclosures to the presentation of the condensed consolidated financial statements:

Cash, cash equivalents and restricted cash and cash equivalents reported on the condensed consolidated statements of cash flows now includes restricted cash and cash equivalents and totals $646.0 million and $501.9 million as of December 31, 2017 and March 31, 2018, respectively.

Restricted cash generally consists of cash balances held as collateral for the Company’s employee credit card programs.

In May 2017, the FASB issued ASU No. 2017-09, which clarifies when a change to the terms or conditions of a share-based payment award must be accounted for as a modification. The new guidance requires modification accounting if the fair value, vesting condition or classification of the award is not the same immediately before and after a change to the terms and conditions of the award. This ASU is effective on a prospective basis beginning on January 1, 2018, with early adoption permitted. The Company adopted this ASU effective January 1, 2018, and the adoption did not have an impact on the Company’s condensed consolidated financial statements and related disclosures.

New Accounting Pronouncements – Recently Issued

In February 2016, the FASB issued ASU No. 2016-02, a comprehensive new lease accounting standard, which provides revised guidance on accounting for lease arrangements by both lessors and lessees and requires lessees to recognize a lease liability and a right-of-use asset for most leases. This ASU also requires additional disclosures. The new guidance is effective for fiscal years beginning after December 15, 2018, and interim periods within those fiscal years, with early adoption permitted. The new standard must be applied using a modified retrospective transition approach that requires application of the new guidance for all periods presented. Although its assessment is not complete, the Company currently expects the adoption of this guidance to result in the addition of material balances of leased assets and corresponding lease liabilities to its consolidated balance sheets, primarily relating to leases of office space.