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Significant Accounting Policies

9 Months Ended

Sep. 30, 2012

Significant Accounting Policies

Significant Accounting Policies

2. Significant Accounting Policies

Revenue Recognition

We generally recognize revenue when we have satisfied all contractual obligations and are reasonably assured of collecting the resulting receivable. We are often entitled to bill our customers and receive payment from our customers in advance of recognizing the revenue. In those instances in which we have received payment from our customers in advance of recognizing revenue, we include the amounts in deferred revenue on our consolidated balance sheet.

Research and development revenue under collaborative agreements

Our collaboration agreements typically contain multiple elements, or deliverables, including technology licenses or options to obtain technology licenses, research and development services, and in certain cases manufacturing services. Our collaborations may provide for various types of payments to us including upfront payments, funding of research and development, milestone payments, licensing fees, profit sharing and royalties on product sales. We evaluate the deliverables in our collaboration agreements to determine whether they meet the criteria to be accounted for as separate units of accounting or whether they should be combined with other deliverables and accounted for as a single unit of accounting. When the delivered items in an arrangement have “stand-alone value” to our customer, we account for the deliverables as separate units of accounting and we allocate the consideration to each unit of accounting based on the relative selling price of each deliverable. We use the following hierarchy of values to estimate the selling price of each deliverable: (i) vendor-specific objective evidence of fair value; (ii) third-party evidence of selling price; and (iii) best estimate of selling price, or BESP. The BESP reflects our best estimate of what the selling price would be if we regularly sold the deliverable on a stand-alone basis. We recognize the revenue allocated to each unit of accounting as we deliver the related goods or services. If we determine that we should treat the deliverables as a single unit of accounting, then we recognize the revenue ratably over our estimated period of performance.

Typically, we must estimate our period of performance when the agreements we enter into do not clearly define such information. Our collaborative agreements typically include a research and/or development project plan that includes the activities the agreement requires each party to perform during the collaboration. We estimate the period of time over which we will complete the activities for which we are responsible and use that period of time as our period of performance for purposes of revenue recognition and amortize revenue over such period. If our collaborators ask us to continue performing work in a collaboration beyond the initial period of performance, we extend our amortization period to correspond to the new extended period of performance. The revenue we recognize could be materially different if different estimates prevail. We have made estimates of our continuing obligations on several agreements. Adjustments to performance periods and related adjustments to revenue amortization periods have not had a material impact on our revenue.

From time to time, we may enter into separate agreements at or near the same time with the same customer. We evaluate such agreements to determine whether they should be accounted for individually as distinct arrangements or whether the separate agreements are, in substance, a single multiple element arrangement. We evaluate whether the negotiations are conducted jointly as part of a single negotiation, whether the deliverables are interrelated or interdependent, whether fees in one arrangement are tied to performance in another arrangement, and whether elements in one arrangement are essential to another arrangement. Our evaluation involves significant judgment to determine whether a group of agreements might be so closely related that they are, in effect, part of a single arrangement.

In January 2012, we entered into a collaboration agreement with Biogen Idec to develop and commercialize ISIS-SMNRx for Spinal Muscular Atrophy, or SMA. As part of the collaboration, we received a $29 million upfront payment and we are responsible for global development of ISIS-SMNRx through completion of Phase 2/3 registrational clinical trials. Biogen Idec has the option to license ISIS-SMNRx through completion of the first successful Phase 2/3 trial. If Biogen Idec exercises its option, it will pay us a license fee and will assume global development, regulatory and commercialization responsibilities. We evaluated the delivered item, the option to license ISIS-SMNRx, to determine if it had stand-alone value. We determined that the option did not have stand-alone value because Biogen Idec cannot pursue the development or commercialization of ISIS-SMNRx until it exercises the option. As such we considered the deliverables in this collaboration to be a single unit of accounting and we are recognizing the upfront payment over the four-year research and development term for ISIS-SMNRx, which is the estimated period of our performance.

In June 2012, we entered into a separate collaboration agreement with Biogen Idec to develop and commercialize a novel antisense drug targeting DMPK, or dystrophia myotonica-protein kinase. As part of the collaboration, we received a $12 million upfront payment and we are responsible for global development of the drug through the completion of Phase 2 clinical trials. Biogen Idec has the option to license the drug through completion of the Phase 2 trial. If Biogen Idec exercises its option, it will pay us a license fee and will assume global development, regulatory and commercialization responsibilities. We evaluated the delivered item, the option to license the drug, to determine if it had stand-alone value. We determined that the option did not have stand-alone value because Biogen Idec cannot pursue the development or commercialization of the drug until it exercises the option. As such we considered the deliverables in this collaboration to be a single unit of accounting and we are recognizing the upfront payment over the five-year research and development term, which is the estimated period of our performance.

We evaluated the SMA and DMPK agreements to determine whether we should account for them as separate agreements or as a single multiple element arrangement. We determined that we should account for the agreements separately because we conducted the negotiations independently of one another, the two agreements cover two different diseases, there are no interrelated or interdependent deliverables, there are no provisions in either agreement that are essential to the other agreement, and the payment terms and fees under each agreement are independent of each other.

Our collaborations often include contractual milestones, which typically relate to the achievement of pre-specified development, regulatory and commercialization events. These three categories of milestone events reflect the three stages of the life-cycle of our drugs, which we describe in more detail in the following paragraph.

Prior to the first stage in the life-cycle of our drugs, we perform a significant amount of work using our proprietary antisense technology to design chemical compounds which interact with specific genes that are good targets for drug discovery. From these research efforts, we hope to identify a development candidate. The designation of a development candidate is the first stage in the life-cycle of our drugs. A development candidate is a chemical compound that has demonstrated the necessary safety and efficacy in preclinical animal studies to warrant further study in humans. During the first step of the development stage, we or our partners study our drugs in IND-enabling studies, which are animal studies intended to support an Investigational New Drug, or IND, application and/or the foreign equivalent. An approved IND allows us or our partners to study our development candidate in humans. If the regulatory agency approves the IND, we or our partners initiate Phase 1 clinical trials in which we typically enroll a small number of healthy volunteers to ensure the development candidate is safe for use in patients. If we or our partners determine that a development candidate is safe based on the Phase 1 data, we or our partners initiate Phase 2 studies that are generally larger scale studies in patients with the primary intent of determining the efficacy of the development candidate. The final step in the development stage is Phase 3 studies to gather the necessary safety and efficacy data to request marketing approval from the Food and Drug Administration, or FDA and/or foreign equivalents. The Phase 3 studies typically involve large numbers of patients and can take up to several years to complete. If the data gathered during the trials demonstrates acceptable safety and efficacy results, we or our partner will submit an application to the FDA and/or its foreign equivalents for marketing approval. This stage of the drug’s life-cycle is the regulatory stage. If a drug achieves marketing approval, it moves into the commercialization stage, during which our partner will market and sell the drug to patients. Although our partner will ultimately be responsible for marketing and selling the drug, our efforts to discover and develop a drug that is safe, effective and reliable contributes significantly to our partner’s ability to successfully sell the drug. The FDA and its foreign equivalents have the authority to impose significant restrictions on an approved drug through the product label and on advertising, promotional and distribution activities. Therefore, our efforts designing and executing the necessary animal and human studies are critical to obtaining claims in the product label from the regulatory agencies that would allow our partner to successfully commercialize our drug. Further, the patent protection afforded our drugs as a result of our initial patent applications and related prosecution activities in the United States and foreign jurisdictions are critical to our partner’s ability to sell our drugs without competition from generic drugs. The potential sales volume of an approved drug is dependent on several factors including the size of the patient population, market penetration of the drug, and the price charged for the drug.

Generally, the milestone events contained in our partnership agreements coincide with the progression of our drugs from development, to regulatory approval and then to commercialization. The process of successfully discovering a new development candidate, having it approved and ultimately sold for a profit is highly uncertain. As such, the milestone payments we may earn from our partners involve a significant degree of risk to achieve. Therefore, as a drug progresses through the stages of its life-cycle, the value of the drug generally increases.

Development milestones in our partnerships may include the following types of events:

· Designation of a development candidate. Following the designation of a development candidate, IND-enabling animal studies for a new development candidate generally take 12 to 18 months to complete;

· Initiation of a Phase 1 clinical trial. Generally, Phase 1 clinical trials take one to two years to complete;

· Initiation or completion of a Phase 2 clinical trial. Generally, Phase 2 clinical trials take one to three years to complete;

· Initiation or completion of a Phase 3 clinical trial. Generally, Phase 3 clinical trials take two to four years to complete.

Regulatory milestones in our partnerships may include the following types of events:

· Filing of regulatory applications for marketing approval such as a New Drug Application, or NDA, in the United States or a Marketing Authorization Application, or MAA, in Europe. Generally, it takes six to twelve months to prepare and submit regulatory filings.

· Marketing approval in a major market, such as the United States, Europe or Japan. Generally it takes one to two years after an application is submitted to obtain approval from the applicable regulatory agency.

Commercialization milestones in our partnerships may include the following types of events:

· First commercial sale in a particular market, such as in the United States or Europe.

· Product sales in excess of a pre-specified threshold, such as annual sales exceeding $1 billion. The amount of time to achieve this type of milestone depends on several factors including but not limited to the dollar amount of the threshold, the pricing of the product and the pace at which customers begin using the product.

We assess whether a substantive milestone exists at the inception of our agreements. When a substantive milestone is achieved, we recognize revenue related to the milestone payment. For our existing licensing and collaboration agreements in which we are involved in the discovery and/or development of the related drug or provide the partner with ongoing access to new technologies we discover, we have determined that all future development, regulatory and commercialization milestones are substantive. For example, for our strategic alliance with GlaxoSmithKline, or GSK, we are using our antisense drug discovery platform to seek out and develop new drugs against targets for rare and serious diseases. Alternatively, we provide on-going access to our technology to Alnylam to develop and commercialize RNA interference, or RNAi, therapeutics. We consider milestones for both of these collaborations to be substantive. For those agreements that do not meet the following criteria, we do not consider the future milestones to be substantive. In evaluating if a milestone is substantive we consider whether:

· Substantive uncertainty exists as to the achievement of the milestone event at the inception of the arrangement;

· The achievement of the milestone involves substantive effort and can only be achieved based in whole or part on our performance or the occurrence of a specific outcome resulting from our performance;

· The amount of the milestone payment appears reasonable either in relation to the effort expended or to the enhancement of the value of the delivered items;

· There is no future performance required to earn the milestone; and

· The consideration is reasonable relative to all deliverables and payment terms in the arrangement.

If any of these conditions are not met, we will defer recognition of the milestone payment and recognize it as revenue over the estimated period of performance, if any. In 2012, the FDA accepted the NDA for KYNAMRO. In 2011, we initiated a Phase 1 clinical study on ISIS-TTRRx, the first drug selected as part of our collaboration with GSK, and we selected ISIS-AATRx as the second development candidate as part of that collaboration. We consider milestones related to progression of a drug through the development and regulatory stages of its life cycle to be substantive milestones because the level of effort and inherent risk associated with these events is high. Therefore, we recognized the entire $25 million milestone payment from Genzyme, a Sanofi Company, in the second quarter of 2012 and the two $5 million milestone payments from GSK in their entirety in 2011. Further information about our collaborative arrangements can be found in Note 7, Collaborative Arrangements and Licensing Agreements, below and Note 8 of our audited financial statements for the year ended December 31, 2011 included in our Annual Report on Form 10-K filed with the SEC.

Licensing and royalty revenue

We often enter into agreements to license our proprietary patent rights on an exclusive or non-exclusive basis in exchange for license fees and/or royalties. We generally recognize as revenue immediately those licensing fees and royalties for which we have no significant future performance obligations and are reasonably assured of collecting the resulting receivable.

Cash, cash equivalents and short-term investments

We consider all liquid investments with maturities of 90 days or less when we purchase them to be cash equivalents. Our short-term investments have initial maturities of greater than 90 days from date of purchase. We classify our short-term investments as “available-for-sale” and carry them at fair market value based upon prices for identical or similar items on the last day of the fiscal period. We record unrealized gains and losses as a separate component of stockholders’ equity and include net realized gains and losses in gain (loss) on investments. We use the specific identification method to determine the cost of securities sold.

We have equity investments in privately- and publicly-held biotechnology companies that we have received as part of a technology license or collaboration agreement. At September 30, 2012 we held ownership interests of less than 20 percent in each of the respective companies except Regulus in which we owned more than 20 percent. In October 2012, Regulus completed an IPO and we now own less than 20 percent of Regulus.

We account for our equity investments in publicly-held companies at fair value and record unrealized gains and losses related to temporary increases and decreases in the stock of these publicly-held companies as a separate component of stockholders’ equity. We account for equity investments in privately-held companies under the cost method of accounting because we own less than 20 percent and do not have significant influence over their operations. Most of the cost method investments we hold are in early stage biotechnology companies and realization of our equity position in those companies is uncertain. In those circumstances we record a full valuation allowance. In determining if and when a decrease in market value below our cost in our equity positions is temporary or other-than-temporary, we examine historical trends in the stock price, the financial condition of the company, near term prospects of the company and our current need for cash. If we determine that a decline in value in either a public or private investment is other-than-temporary, we recognize an impairment loss in the period in which the other-than-temporary decline occurs.

Inventory valuation

We capitalize the costs of raw materials that we purchase for use in producing our drugs because until we use these raw materials they have alternative future uses. We include in inventory raw material costs for drugs that we manufacture for our partners under contractual terms and that we use primarily in our clinical development activities and drug products. We can use each of our raw materials in multiple products and, as a result, each raw material has future economic value independent of the development status of any single drug. For example, if one of our drugs failed, we could use the raw materials allocated for that drug to manufacture our other drugs. We expense these costs when we deliver the drugs to our partners, or as we provide these drugs for our own clinical trials. We reflect our inventory on the balance sheet at the lower of cost or market value under the first-in, first-out method. We review inventory periodically and reduce the carrying value of items we consider to be slow moving or obsolete to their estimated net realizable value. We consider several factors in estimating the net realizable value, including shelf life of raw materials, alternative uses for our drugs and clinical trial materials and historical write-offs. We did not record any inventory write-offs for the first nine months of 2012 and 2011. Total inventory, which consisted of raw materials, was $6.7 million and $4.1 million as of September 30, 2012 and December 31, 2011, respectively.

Patents

We capitalize costs consisting principally of outside legal costs and filing fees related to obtaining patents. We review our capitalized patent costs regularly to ensure that they include costs for patents and patent applications that have future value. We evaluate patents and patent applications that we are not actively pursuing and write off any associated costs. We amortize patent costs over their useful lives, beginning with the date the United States Patent and Trademark Office, or foreign equivalent, issues the patent and ending when the patent expires or is written off. For the first nine months of 2012 and 2011, we recorded non-cash charges of $664,000 and $883,000, respectively, which we included in research and development expenses, related to the write-down of our patent costs to their estimated net realizable values.

Long-lived assets

We evaluate long-lived assets, which include property, plant and equipment, patent costs, and exclusive licenses acquired from third parties, for impairment on at least a quarterly basis and whenever events or changes in circumstances indicate that we may not be able to recover the carrying amount of such assets.

Equity method of accounting

We accounted for our ownership interest in Regulus using the equity method of accounting until Regulus’ IPO in October 2012. Under the equity method of accounting, we included our share of Regulus’ operating results on a separate line in our condensed consolidated statement of operations called “Equity in net loss of Regulus Therapeutics Inc.” On our condensed consolidated balance sheet, we presented our investment in Regulus on a separate line in the non-current liabilities section called “Investment in Regulus Therapeutics Inc.” The equity method of accounting requires us to suspend recognizing losses if the carrying amount of our investment in Regulus exceeds the amount of funding we are required to provide to Regulus. Until the completion of Regulus’ IPO, we and Alnylam were guarantors of both of the convertible notes that Regulus issued to GSK. As such, we continued to recognize losses in excess of our net investment in Regulus up to the principal plus accrued interest we guaranteed, which was $5.6 million at September 30, 2012. Because our share of Regulus’ net loss exceeded the $5.6 million we guaranteed, in the second quarter of 2012 we suspended recording our portion of Regulus’ net loss. As of September 30, 2012, we had $2.7 million of suspended net losses, which we have not recognized.

Subsequent to Regulus’ IPO, we own less than 20 percent of Regulus’ common stock and we no longer have significant influence over the operating and financial policies of Regulus. As such, beginning in the fourth quarter we will no longer use the equity method of accounting for our investment in Regulus and instead we will account for it at fair value. In the fourth quarter of 2012, we will record a significant gain to reflect the change in our ownership percentage.

Use of estimates

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

Basic and diluted net loss per share

We compute basic net loss per share by dividing the net loss by the weighted-average number of common shares outstanding during the period. As we incurred a net loss for the three and nine months ended September 30, 2012 and 2011, we did not include the following diluted common equivalent shares in the computation of diluted net loss per share because the effect would have been anti-dilutive:

· 23/4 percent convertible senior notes;

· 25/8 percent convertible subordinated notes;

· GlaxoSmithKline convertible promissory notes;

· Dilutive stock options;

· Restricted stock units; and

· Warrants issued to Symphony GenIsis Holdings LLC.

In April 2011, Symphony GenIsis Holdings LLC exercised the remaining warrants. In September 2012, we redeemed all of our 25/8 percent convertible subordinated notes.

Consolidation of variable interest entities

We identify entities as variable interest entities either: (1) that do not have sufficient equity investment at risk to permit the entity to finance its activities without additional subordinated financial support, or (2) in which the equity investors lack an essential characteristic of a controlling financial interest. We perform ongoing qualitative assessments of our variable interest entities to determine whether we have a controlling financial interest in the variable interest entity and therefore are the primary beneficiary. As of September 30, 2012 and December 31, 2011, we had collaborative arrangements with six entities that we considered to be variable interest entities. We are not the primary beneficiary for any of these entities as we do not have both the power to direct the activities that most significantly impact the economic performance of our variable interest entities and the obligation to absorb losses or the right to receive benefits from our variable interest entities that could potentially be significant to the variable interest entities. In the case of Regulus, prior to Regulus’ IPO, we and Alnylam shared the ability to impact Regulus’ economic performance. As a result, we were not the primary beneficiary of Regulus.

Comprehensive income (loss)

We report the components of comprehensive income (loss) in our condensed consolidated statements of comprehensive income (loss) in the period in which we recognize them. The components of comprehensive income (loss) include net loss and unrealized gains and losses on investment holdings.

Convertible debt

In August 2012, we completed a $201.3 million offering of convertible senior notes, which mature in 2019 and bear interest at 2¾ percent. In September 2012, we used a substantial portion of the net proceeds from the issuance of the 2¾ percent notes to redeem our 25¤8 percent convertible subordinated notes. Consistent with how we accounted for our 25¤8 percent notes, we account for our 2¾ percent notes by separating the liability and equity components of the instrument in a manner that reflects our nonconvertible debt borrowing rate. As a result, we assigned a value to the debt component of our 2¾ percent notes equal to the estimated fair value of a similar debt instrument without the conversion feature, which resulted in us recording the debt instrument at a discount. We are amortizing the debt discount over the life of these 2¾ percent notes as additional non-cash interest expense utilizing the effective interest method.

Segment information

We operate in a single segment, Drug Discovery and Development operations, because our chief decision maker reviews operating results on an aggregate basis and manages our operations as a single operating segment.

Stock-based compensation expense

We measure stock-based compensation expense for equity-classified awards, principally related to stock options, restricted stock units, or RSUs, and stock purchase rights under the Employee Stock Purchase Plan, or ESPP, at the grant date, based on the estimated fair value of the award and we recognize the expense over the employee’s requisite service period.

We use the Black-Scholes model to estimate the fair value of stock options granted and stock purchase rights under the ESPP. The expected term of stock options granted represents the period of time that we expect them to be outstanding. We estimated the expected term of options granted based on historical exercise patterns. For the nine months ended September 30, 2012 and 2011, we used the following weighted-average assumptions in our Black-Scholes calculations:

Employee Stock Options:

		Nine Months Ended September 30,
		2012		2011
Risk-free interest rate		1.0	%	2.3	%
Dividend yield		0.0	%	0.0	%
Volatility		50.65	%	52.4	%
Expected life		5.1 years		5.3 years

Board of Director Stock Options:

		Nine Months Ended September 30,
		2012		2011
Risk-free interest rate		1.3	%	2.9	%
Dividend yield		0.0	%	0.0	%
Volatility		51.3	%	52.8	%
Expected Life		7.6 years		7.8 years

ESPP:

		Nine Months Ended September 30,
		2012		2011
Risk-free interest rate		0.2	%	0.1	%
Dividend yield		0.0	%	0.0	%
Volatility		49.6	%	34.9	%
Expected life		6 months		6 months

In 2012, we began granting RSUs to our employees and the Board of Directors. The fair value of RSUs is based on the market price of our common stock on the date of grant. The weighted-average grant date fair value of RSUs granted to employees and the Board of Directors for the nine months ended September 30, 2012 was $7.97 and $12.94 per RSU, respectively.

The following table summarizes stock-based compensation expense for the three and nine months ended September 30, 2012 and 2011 (in thousands), which was allocated as follows:

		Three Months Ended September 30,						Nine Months Ended September 30,
		2012			2011			2012			2011

Research and development		$	1,720		$	2,017		$	5,728		$	6,594
General and administrative		314			347			1,033			1,002
Total		$	2,034		$	2,364		$	6,761		$	7,596

As of September 30, 2012, total unrecognized estimated non-cash stock-based compensation expense related to non-vested stock options and RSUs was $7.3 million and $1.2 million, respectively. We will adjust total unrecognized compensation cost for future changes in estimated forfeitures. We expect to recognize the cost of non-cash, stock-based compensation expense related to non-vested stock options and RSUs over a weighted average amortization period of 1.2 years and 3.3 years, respectively.

Impact of recently issued accounting standards

In May 2011, the FASB amended its authoritative guidance on the measurement and disclosure for fair value measurements. The amendment clarifies the application of certain existing fair value measurement guidance and expands the disclosures for fair value measurements that are estimated using significant unobservable (Level 3) inputs. The guidance is effective prospectively for fiscal years, and interim periods within those years, beginning after December 15, 2011 and was effective for our fiscal year beginning January 1, 2012. The adoption of this guidance did not have a material impact on our financial statements.

In June 2011, the FASB amended its authoritative guidance on the presentation of comprehensive income. Under the amendment, companies have the option to present the components of net income and other comprehensive income either in a single continuous statement of comprehensive income or in separate but consecutive statements. This amendment eliminates the option to present the components of other comprehensive income as part of the statement of changes in stockholders’ equity. The amendment does not change the items that companies must report in other comprehensive income or when companies must reclassify an item of other comprehensive income to net income. The guidance is effective retrospectively for fiscal years, and interim periods within those years, beginning after December 15, 2011 and was effective for our fiscal year beginning January 1, 2012. As this guidance relates to presentation only, the adoption of this guidance did not have any other effect on our financial statements.

The entire disclosure for all significant accounting policies of the reporting entity.

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