BASIS OF PRESENTATION AND ACCOUNTING POLICIES

6 Months Ended

Jun. 30, 2011

BASIS OF PRESENTATION AND ACCOUNTING POLICIES

BASIS OF PRESENTATION AND ACCOUNTING POLICIES

A. BASIS OF PRESENTATION AND ACCOUNTING POLICIES

Basis of Presentation and Consolidation

The accompanying condensed consolidated financial statements are unaudited and have been prepared by Cubist Pharmaceuticals, Inc. (“Cubist” or the “Company”) in accordance with accounting principles generally accepted in the United States of America, or GAAP, and pursuant to the instructions to Form 10-Q and Article 10 of Regulation S-X. Certain information and footnote disclosures normally included in the Company’s annual consolidated financial statements have been condensed or omitted. The condensed consolidated financial statements, in the opinion of management, reflect all normal and recurring adjustments necessary for a fair statement of the Company’s financial position and results of operations.

The results of operations for the interim periods are not necessarily indicative of the results of operations to be expected for any future period or the entire fiscal year. These interim condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements for the year ended December 31, 2010, which are contained in Cubist’s Annual Report on Form 10-K filed with the Securities and Exchange Commission, or SEC, on February 23, 2011.

The accompanying condensed consolidated financial statements include the accounts of Cubist and its wholly-owned subsidiaries. All intercompany balances and transactions have been eliminated in consolidation.

Use of Estimates

The preparation of financial statements in conformity with GAAP requires the use of estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and contingent liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. The most significant assumptions are employed in estimates used in determining values of: inventories; investments; impairment of long-lived assets, including goodwill, in-process research and development, or IPR&D, and other intangible assets; accrued clinical research costs; contingent consideration; income taxes; accounting for stock-based compensation; product rebates, chargeback and return accruals; as well as in estimates used in accounting for contingencies and revenue recognition. Actual results could differ from estimated amounts.

Fair Value Measurements

The carrying amounts of Cubist’s cash and cash equivalents, accounts receivable, accounts payable, and accrued expenses approximate their fair value due to the short-term nature of these amounts. Investments are considered available-for-sale as of June 30, 2011 and December 31, 2010, and are carried at fair value. In connection with its acquisition of Calixa Therapeutics Inc., or Calixa, in December 2009, the Company recorded contingent consideration relating to potential amounts payable to Calixa’s former stockholders upon the achievement of certain development, regulatory and sales milestones. This contingent consideration is recognized at its estimated fair value.

In evaluating the fair value information, considerable judgment is required to interpret the market data used to develop the estimates. The use of different market assumptions and/or different valuation techniques may have a material effect on the estimated fair value amounts. Accordingly, the estimates of fair value presented herein may not be indicative of the amounts that could be realized in a current market exchange. See Note C., “Fair Value Measurements,” for additional information.

Investments

Short-term investments include bank deposits, corporate and municipal notes, United States, or U.S., treasury securities and U.S. government agency securities. Long-term investments include corporate notes, U.S. treasury securities and U.S. government agency securities. See Note B., “Investments,” for additional information.

Unrealized gains and temporary losses on investments are included in accumulated other comprehensive income (loss) as a separate component of stockholders’ equity. Realized gains and losses, dividends, interest income, and declines in value judged to be other-than-temporary credit losses are included in other income (expense). Amortization of any premium or discount arising at purchase is included in interest income.

Concentration of Risk

Financial instruments, which potentially subject the Company to concentrations of credit risk, consist principally of cash and cash equivalents, investments and accounts receivable. The Company’s cash and cash equivalents are held primarily with five financial institutions in the U.S. Investments are restricted, in accordance with the Company’s investment policy, to a concentration limit per institution.

Cubist’s accounts receivable at June 30, 2011 and December 31, 2010, primarily represent amounts due to the Company from wholesalers, including AmerisourceBergen Drug Corporation, Cardinal Health, Inc. and McKesson Corporation, as well as from Cubist’s international partners for CUBICIN® (daptomycin for injection). Cubist performs ongoing credit evaluations of its key wholesalers, distributors and other customers and generally does not require collateral. For the three and six months ended June 30, 2011 and 2010, Cubist did not have any significant write-offs of accounts receivable and its days sales outstanding has not significantly changed since December 31, 2010.

	Percentage of Total Accounts Receivable, Net as of
	June 30,	December 31,
	2011	2010
AmerisourceBergen Drug Corporation	25%	26%
Cardinal Health, Inc.	22%	24%
McKesson Corporation	19%	19%

	Percentage of Total Net Revenues for the Three Months Ended June 30,		Percentage of Total Net Revenues for the Six Months Ended June 30,
	2011	2010	2011	2010
AmerisourceBergen Drug Corporation	23%	25%	24%	26%
Cardinal Health, Inc.	22%	21%	22%	22%
McKesson Corporation	17%	17%	18%	17%

Acquired In-process Research and Development

IPR&D acquired in a business combination is capitalized on the Company’s condensed consolidated balance sheets at its acquisition-date fair value. Until the underlying project is completed, IPR&D is accounted for as indefinite-lived intangible assets. Once the project is completed, the carrying value of the IPR&D is amortized over the estimated useful life of the asset. If a project becomes impaired or is abandoned, the carrying value of the IPR&D is written down to its revised fair value with the related impairment charge recognized in the period in which the impairment occurs. IPR&D is tested for impairment on an annual basis, or more frequently if an indicator of impairment is present, using a projected discounted cash flow model.

On December 16, 2009, Cubist acquired 100% of the outstanding stock of Calixa for an upfront payment of $99.2 million, as adjusted, in cash and contingent consideration with an estimated fair value of $101.6 million, upon which Calixa became a wholly-owned subsidiary of Cubist. Calixa’s lead compound, CXA-201, is an intravenously administered combination of a novel anti-pseudomonal cephalosporin, CXA-101, and the beta-lactamase inhibitor tazobactam. The transaction was accounted for as a business combination using the acquisition method. Accordingly, the fair value of the purchase price, as adjusted, was allocated to the fair value of tangible assets and identifiable intangible assets acquired and liabilities assumed, with the remaining purchase price recorded as goodwill. Of the identifiable assets acquired, $194.0 million are IPR&D assets relating to CXA-201. The fair value of the IPR&D acquired was determined using an income method approach, including discounted cash flow models that are probability-adjusted for assumptions the Company believes a market participant would make relating to the development and potential commercialization of CXA-201. CXA-201 as a potential treatment for pneumonia had an estimated fair value of $174.0 million and CXA-201 as a potential treatment for complicated urinary tract infections, or cUTI, and complicated intra-abdominal infections, or cIAI, had an estimated fair value of $20.0 million as of the acquisition date. Cubist did not record any impairment charges related to the IPR&D during the three and six months ended June 30, 2011 and 2010.

Revenue Recognition

Cubist’s principal sources of revenue are: (i) sales of CUBICIN in the U.S.; (ii) revenues derived from sales of CUBICIN by Cubist’s international distribution partners; and (iii) license fees and milestone payments that are derived from collaboration, license and commercialization agreements with other biopharmaceutical companies. In all instances, revenue is recognized only when the price is fixed or determinable, persuasive evidence of an arrangement exists, delivery has occurred or services have been rendered, collectibility of the resulting receivable is reasonably assured and the Company has no further performance obligations.

U.S. Product Revenues, net

All U.S. product revenues are recognized upon delivery. All revenues from product sales are recorded net of applicable provisions for returns, chargebacks, rebates, wholesaler management fees and discounts in the same period the related sales are recorded.

Certain product sales qualify for rebates or discounts from standard list pricing due to government-sponsored programs or other contractual agreements. Reserves for Medicaid rebates and Medicare Part D coverage gap rebates are included in accrued liabilities and were $10.5 million at June 30, 2011. Reserves for Medicaid rebates included in accrued liabilities were $6.3 million at December 31, 2010. The increase in the reserve at June 30, 2011, is a result of delayed billing for Medicaid claims by state authorities. Reserves for returns, discounts, chargebacks, and wholesaler management fees are offset against accounts receivable and were $7.0 million and $6.0 million at June 30, 2011 and December 31, 2010, respectively.

In the three and six months ended June 30, 2011, provisions for sales returns, chargebacks, Medicaid rebates, Medicare Part D coverage gap rebates, wholesaler management fees and discounts that were offset against gross U.S. product revenues totaled $24.3 million and $45.1 million, respectively. In the three and six months ended June 30, 2010, provisions for sales returns, chargebacks, Medicaid rebates, wholesaler management fees and discounts that were offset against gross U.S. product revenues totaled $17.2 million and $28.8 million, respectively. The increase in the amount of the provisions that were offset against gross U.S. product revenues is primarily due to increases in pricing discounts, chargebacks and Medicaid reserves due to the 6.9% price increases in April 2010 and January 2011, and an increase in the number of vials sold of CUBICIN in the U.S. In addition, contractual rebates increased as a result of U.S. health care reform legislation enacted in March 2010, which increased the Medicaid rebate rate from 15.1% to 23.1%, the number of individuals eligible to participate in the Medicaid program and the amount of additional discounts to Medicare beneficiaries whose prescription drug costs cause them to be subject to the Medicare Part D coverage gap.

International Product Revenues

Cubist sells its product to international CUBICIN distribution partners based upon a transfer price arrangement that is generally established annually. Once Cubist’s distribution partner sells the product to a third party, Cubist may be owed an additional payment or royalty based on a percentage of the net selling price to the third party, less the initial transfer price previously paid on such product. Under no circumstances would the subsequent adjustment result in a refund to the distribution partner of the initial transfer price. Cubist recognizes the additional revenue upon receipt of royalty statements from its distribution partners.

Service Revenues

From July 2008 through June 2010, Cubist promoted and provided other support for MERREM® I.V. in the U.S. under a commercial services agreement with AstraZeneca Pharmaceuticals, LP, an indirect wholly-owned subsidiary of AstraZeneca PLC, or AstraZeneca. AstraZeneca provided marketing and commercial support for MERREM I.V. The agreement with AstraZeneca, as amended, expired in accordance with its terms on June 30, 2010. Service revenues relating to MERREM I.V. for the three and six months ended June 30, 2010, were $6.5 million and $8.5 million, respectively.

On April 5, 2011, the Company entered into a co-promotion agreement with Optimer Pharmaceuticals, Inc., or Optimer, pursuant to which Optimer engaged Cubist as its exclusive partner for the promotion of DIFICIDTM in the U.S. DIFICID was approved by the U.S. Food and Drug Administration, or FDA, in May 2011 for the treatment of Clostridium difficile-associated diarrhea. Under the terms of the co-promotion agreement, Optimer and Cubist will co-promote DIFICID to physicians, hospitals, long-term care facilities and other healthcare institutions as well as jointly provide medical affairs support for DIFICID. In addition, Optimer will be responsible for the distribution of DIFICID in the U.S. and for recording revenue from sales of DIFICID. The initial term of the co-promotion agreement is two years from the date of first commercial sale of DIFICID in the U.S. Optimer paid the Company a quarterly fee of $3.8 million in June 2011, which was recorded by the Company as short-term deferred revenue in the condensed consolidated balance sheet. The payment will be recognized as service revenue ratably over the service period commencing with the commercial launch of DIFICID in July 2011. Cubist is also eligible to receive: (a) an additional $5.0 million in the first year after first commercial sale and $12.5 million in the second year after first commercial sale if mutually agreed-upon annual sales targets are achieved; and (b) a portion of Optimer’s gross profits derived from net sales above the specified annual targets, if any. The co-promotion agreement may be renewed by mutual agreement of the parties for additional, consecutive one-year terms. Each of Optimer and Cubist may terminate the co-promotion agreement prior to expiration upon the uncured material breach of the co-promotion agreement by the other party, upon the bankruptcy or insolvency of the other party, or in the event that actual net sales during the first year of commercial sales of DIFICID in the U.S. are below specified levels, subject to certain limitations. Optimer may terminate the co-promotion agreement, subject to certain limitations, if (i) Optimer withdraws DIFICID from the market in the U.S., (ii) Cubist fails to comply with applicable laws in performing its obligations, (iii) Cubist undergoes a change of control, (iv) certain market events occur related to CUBICIN in the U.S., or (v) Cubist undertakes certain restructuring activities with respect to its sales force. Cubist may terminate the co-promotion agreement, subject to certain limitations, if (i) the first commercial sale of DIFICID in the U.S. does not occur within one year from the effective date of the co-promotion agreement, (ii) Optimer experiences certain supply failures in relation to the demand for DIFICID in the U.S., (iii) Optimer is acquired by certain types of entities, including competitors of Cubist, (iv) certain market events occur related to CUBICIN in the U.S., or (v) Optimer fails to comply with applicable laws in performing its obligations.

Other Revenues

Other revenues include revenues related to upfront license payments, license fees and milestone payments received through Cubist’s license, collaboration and commercialization agreements. The Company analyzes its multiple-deliverable arrangements to determine whether the elements can be separated and accounted for individually as separate units of accounting.

License Revenues

On January 1, 2011, the Company adopted new authoritative guidance on revenue recognition for multiple-element arrangements. The guidance, which applies to multiple-element arrangements entered into or materially modified on or after January 1, 2011, amends the criteria for separating and allocating consideration in a multiple-element arrangement by modifying the fair value requirements for revenue recognition and eliminating the use of the residual method. The fair value of deliverables under the arrangement may be derived using a “best estimate of selling price” if vendor-specific objective evidence and third-party evidence is not available. Deliverables under the arrangement will be separate units of accounting, provided (i) a delivered item has value to the customer on a standalone basis; and (ii) if the arrangement includes a general right of return relative to the delivered item, delivery or performance of the undelivered item is considered probable and substantially in the control of the Company. The Company did not enter into or materially modify any multiple-element arrangements during the three and six months ended June 30, 2011. Cubist’s existing license and collaboration agreements continue to be accounted for under previously-issued revenue recognition guidance for multiple-element arrangements.

Milestones

On January 1, 2011, the Company adopted new authoritative guidance on revenue recognition for milestone payments related to arrangements under which the Company has continuing performance obligations. Milestone payments are recognized as revenue upon achievement of the milestone only if all of the following conditions are met: (i) the milestone payments are non-refundable; (ii) there was substantive uncertainty at the date of entering into the arrangement that the milestone would be achieved; (iii) the milestone is commensurate with either the vendor’s performance to achieve the milestone or the enhancement of the value of the delivered item by the vendor; (iv) the milestone relates solely to past performance; and (v) 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 are not met, the milestone payments are not considered to be substantive and are, therefore, deferred and recognized as revenue over the term of the arrangement as the Company completes its performance obligations. Upon achievement of any future regulatory and sales milestones, as stipulated under the applicable agreements with its licensing partners, the Company will evaluate each milestone as of the arrangement date to determine whether the milestones are substantive and could be recognized as revenue in their entirety during the period of achievement. The adoption of this guidance does not materially change the Company’s previous method of recognizing milestone payments. All potential future milestones under existing arrangements with licensing partners, as specified below, and any new arrangements with milestones, will be evaluated under the new revenue recognition guidance for milestone payments.

In March 2007, Cubist entered into a license agreement with Merck & Co., Inc., or Merck, for the development and commercialization of CUBICIN in Japan. Merck will develop and commercialize CUBICIN through its wholly-owned subsidiary, MSD Japan. On July 1, 2011, Merck received regulatory approval of CUBICIN in Japan, which triggered a $6.0 million milestone payment to Cubist. Cubist may receive up to $32.5 million in additional payments upon Merck achieving certain sales milestones. See Note M., “Subsequent Events,” for additional information.

In December 2006, Cubist entered into a license agreement with AstraZeneca AB for the development and commercialization of CUBICIN in China and certain other countries in Asia (excluding Japan, Taiwan and Korea), the Middle East and Africa not yet covered by previously-existing CUBICIN international partnering agreements. Cubist may receive payments of up to $4.5 million and $14.0 million upon AstraZeneca AB achieving certain regulatory and sales milestones, respectively.

Basic and Diluted Net Income (Loss) Per Share

Basic net income (loss) per common share has been computed by dividing net income (loss) by the weighted average number of shares outstanding during the period. Diluted net income (loss) per share has been computed by dividing diluted net income (loss) by the diluted number of shares outstanding during the period. Except where the result would be antidilutive to income from continuing operations, diluted net income per share has been computed assuming the conversion of convertible obligations and the elimination of the interest expense related to the Company’s 2.25% convertible subordinated notes, or 2.25% Notes, and 2.50% convertible senior notes, or 2.50% Notes, the exercise of stock options, and the vesting of restricted stock units, or RSUs, as well as their related income tax effects.

The following table sets forth the computation of basic and diluted net income (loss) per common share (amounts in thousands, except share and per share amounts):

	Three Months Ended June 30,					Six Months Ended June 30,
	2011			2010		2011		2010
Net (loss) income, basic	$	(20,615	)	$	28,115	$	1,970	$	48,547
Effect of dilutive securities:
Interest on 2.25% Notes, net of tax	—			987		—		1,993
Debt issuance costs related to 2.25% Notes, net of tax	—			132		—		265
Debt discount amortization related to 2.25% Notes, net of tax	—			2,075		—		4,146
Net (loss) income, diluted	$	(20,615	)	$	31,309	$	1,970	$	54,951
Shares used in calculating basic net (loss) income per common share	60,517,553			58,670,728		59,991,068		58,404,418
Effect of dilutive securities:
Options to purchase shares of common stock and RSUs	—			881,948		1,837,739		921,523
2.25% Notes convertible into shares of common stock	—			9,749,430		—		9,749,430
Shares used in calculating diluted net (loss) income per common share	60,517,553			69,302,106		61,828,807		69,075,371
Net (loss) income per share, basic	$	(0.34	)	$	0.48	$	0.03	$	0.83
Net (loss) income per share, diluted	$	(0.34	)	$	0.45	$	0.03	$	0.80

Potential common shares excluded from the calculation of diluted net income (loss) per share, as their inclusion would have been antidilutive, were:

	Three Months Ended June 30,		Six Months Ended June 30,
	2011	2010	2011	2010
Options to purchase shares of common stock and RSUs	1,215,120	4,803,331	2,137,434	3,848,509
2.25% Notes convertible into shares of common stock	3,549,377	—	3,549,377	—
2.50% Notes convertible into shares of common stock	15,424,155	—	15,424,155	—

Comprehensive Income (Loss)

During the three and six months ended June 30, 2011 and 2010, comprehensive income (loss) included the Company’s net income (loss) as well as increases in unrealized losses on the Company’s available-for-sale securities.

The following table summarizes the components of comprehensive income (loss):

	Three Months Ended June 30,						Six Months Ended June 30,
	2011			2010			2011			2010
	(in thousands)						(in thousands)
Net (loss) income	$	(20,615	)	$	28,115		$	1,970		$	48,547
Increase in unrealized loss on auction rate securities	—			(1,688		)	—			(237		)
Other unrealized investment losses	(159		)	(270		)	(142		)	(38		)
Total comprehensive (loss) income	$	(20,774	)	$	26,157		$	1,828		$	48,272

Subsequent Events

Cubist considers events or transactions that have occurred after the balance sheet date of June 30, 2011, but prior to the filing of the financial statements with the SEC on this Form 10-Q to provide additional evidence relative to certain estimates or to identify matters that require additional disclosure. Subsequent events have been evaluated through the date of the filing with the SEC of this Quarterly Report on Form 10-Q. Cubist had two nonrecognizable subsequent events related to the completion of its purchase of the building and land at 45 and 55 Hayden Avenue in Lexington, Massachusetts, or 45-55 Hayden, and notification from Merck of regulatory approval of CUBICIN in Japan, both of which occurred after June 30, 2011. See Note M., “Subsequent Events,” for additional information.

Recent Accounting Pronouncements

In June 2011, the Financial Accounting Standards Board, or FASB, issued an amendment to the accounting guidance for presentation of comprehensive income. Under the amended guidance, a company may present the total of 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. In either case, a company is required to present each component of net income along with total net income, each component of other comprehensive income along with a total for other comprehensive income, and a total amount for comprehensive income. Regardless of choice in presentation, the company is required to present on the face of the financial statements reclassification adjustments for items that are reclassified from other comprehensive income to net income in the statement(s) where the components of net income and the components of other comprehensive income are presented. For public companies, the amendment is effective for fiscal years, and interim periods within those years, beginning after December 15, 2011, and shall be applied retrospectively. Early adoption is permitted. Other than a change in presentation, the adoption of this update is not expected to have a material impact on the Company’s consolidated financial statements.

In May 2011, the FASB amended the accounting guidance for fair value to develop common requirements between GAAP and International Financial Reporting Standards. The amendments clarify the FASB’s intent about the application of existing fair value measurement and disclosure requirements and in some instances change a particular principle or requirement for measuring fair value or for disclosing information about fair value measurements. Notable changes under the amended guidance include: (i) application of the highest and best use and valuation premise concepts solely for non-financial assets and liabilities; (ii) measuring the fair value of an instrument classified in a reporting entity’s shareholders’ equity; and (iii) disclosing quantitative information about unobservable inputs used in the fair value measurement within Level 3 of the fair value hierarchy. For public entities, the amendment is effective for interim and annual periods beginning after December 15, 2011. Early application is not permitted. The Company is currently evaluating the disclosure requirements related to providing quantitative information about unobservable inputs used to measure the fair value of its contingent consideration liability.