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. The year-end condensed consolidated financial statements were derived from audited financial statements, but certain information and footnote disclosures required by GAAP normally included in the Company’s annual consolidated financial statements have been condensed or omitted. These interim condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements for the year ended December 31, 2012, which are contained in the Company’s Annual Report on Form 10-K filed with the Securities and Exchange Commission, or SEC, on February 27, 2013. 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. Certain reclassifications have been made to prior year amounts to conform to the current year presentation.

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

Use of Estimates

The preparation of financial statements in conformity with GAAP requires the extensive use of estimates and assumptions that affect the reported amounts of assets, liabilities, revenues, expenses and related disclosures. The most significant assumptions are employed in estimates used in determining values of: inventories; investments; acquisition-date fair value and subsequent fair value estimates used to assess 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 rebate, chargeback and return accruals; as well as in estimates used in accounting for contingencies and revenue recognition. Actual results could differ from these estimates.

Fair Value Measurements

The accounting standard for fair value measurements defines fair value, establishes a framework for measuring fair value in accordance with GAAP, and requires detailed disclosures about fair value measurements. Under this standard, fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. The valuation techniques are based on observable and unobservable inputs. Observable inputs reflect readily obtainable data from independent sources, while unobservable inputs reflect certain market assumptions. This standard classifies these inputs into the following hierarchy:

Level 1 Inputs—Quoted prices for identical instruments in active markets.

Level 2 Inputs—Quoted prices for similar instruments in active markets; quoted prices for identical or similar instruments in markets that are not active; and model-derived valuations whose inputs are observable or whose significant value drivers are observable.

Level 3 Inputs—Instruments with primarily unobservable value drivers.

The fair value hierarchy level is determined by asset class based on the lowest level of significant input. In periods of market inactivity, the observability of prices and inputs may be reduced for certain instruments. This condition could cause an instrument to be reclassified between Level 1 and Level 2 or between Level 2 and Level 3. During the three and six months ended June 30, 2013, there were no transfers between Level 1, Level 2 or Level 3.

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. Short-term and long-term investments primarily consist of available-for-sale securities as of June 30, 2013 and December 31, 2012, and are carried at fair value.

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 with several major financial institutions in the United States, or U.S. The Company’s investments are restricted, in accordance with its investment policy, to a concentration limit per institution.

Cubist’s accounts receivable as of June 30, 2013 and December 31, 2012, primarily represent amounts due to the Company from wholesalers, including AmerisourceBergen Drug Corporation, Cardinal Health, Inc. and McKesson Corporation. 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, 2013 and 2012, Cubist did not have any significant write-offs of accounts receivable, and its days sales outstanding has not significantly changed since December 31, 2012.

	Percentage of Total Accounts Receivable Balance as of
	June 30, 2013	December 31, 2012
AmerisourceBergen Drug Corporation	20%	22%
Cardinal Health, Inc.	17%	18%
McKesson Corporation	18%	20%

	Percentage of Total Net Revenues for the Three Months Ended June 30,		Percentage of Total Net Revenues for the Six Months Ended June 30,
	2013	2012	2013	2012
AmerisourceBergen Drug Corporation	20%	19%	20%	19%
Cardinal Health, Inc.	16%	19%	17%	19%
McKesson Corporation	17%	17%	18%	17%

IPR&D

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, these assets are accounted for as indefinite-lived intangible assets, subject to impairment testing. Once the project is completed, the carrying value of the IPR&D is amortized over the estimated useful life of the asset. Post-acquisition research and development expenses related to the acquired IPR&D are expensed as incurred.

IPR&D is tested for impairment on an annual basis, or more frequently if impairment indicators are present. If IPR&D 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. If the fair value of the asset becomes impaired as the result of unfavorable data from any ongoing or future clinical trial, changes in assumptions that negatively impact projected cash flows, or because of any other information regarding the prospects of successfully developing or commercializing the Company’s programs, Cubist could incur significant charges in the period in which the impairment occurs. The valuation techniques utilized in performing impairment tests incorporate significant assumptions and judgments to estimate the fair value. The use of different valuation techniques or different assumptions could result in materially different fair value estimates.

Revenue Recognition

Principal sources of revenue are (i) sales of CUBICIN® (daptomycin for injection) and ENTEREG® (alvimopan) in the U.S.; (ii) revenues derived from sales of CUBICIN by Cubist’s international distribution partners; (iii) license fees and milestone payments that are derived from collaboration, license and commercialization agreements with other biopharmaceutical companies; and (iv) service revenues derived from Cubist’s agreement with Optimer Pharmaceuticals, Inc., or Optimer, for the promotion and support of DIFICID® (fidaxomicin) in the U.S., which has been extended beyond July 2013. See Note N., “Subsequent Events,” for additional information regrading the extension of the co-promotion agreement with Optimer. 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, and collectibility of the resulting receivable is reasonably assured.

U.S. Product Revenues, net

All revenues from product sales are recorded net of applicable provisions for returns, chargebacks, Medicaid program rebates, Medicare coverage gap discount program rebates, wholesaler management fees, volume-based rebates and discounts in the same period the related sales are recorded.

Gross U.S. product revenues were offset by provisions for the three and six months ended June 30, 2013 and 2012, as follows:

	Three Months Ended June 30,						Six Months Ended June 30,
	2013			2012			2013			2012
	(in thousands)
Gross U.S. product revenues	$	272,271		$	241,900		$	518,218		$	466,025
Provisions offsetting U.S. product revenues:
Contractual adjustments	(16,014		)	(14,085		)	(30,032		)	(26,981		)
Governmental rebates	(16,754		)	(17,929		)	(35,435		)	(35,009		)
Total provisions offsetting product revenues	(32,768		)	(32,014		)	(65,467		)	(61,990		)
U.S. product revenues, net	$	239,503		$	209,886		$	452,751		$	404,035

Certain product sales qualify for rebates or discounts from standard list pricing due to government sponsored programs or other contractual agreements. Contractual adjustments in the table above include pricing and early payment discounts extended to the Company’s external customers, as well as returns, wholesaler distribution fees and volume-based rebates. Governmental rebates in the table above represent estimated amounts for Medicaid program rebates, Medicare coverage gap discount program rebates and chargebacks related to 340B/Public Health Service and Federal Supply Schedule drug pricing programs. Estimates and assumptions for reserves are analyzed quarterly. As a result of receiving claims information from certain state governments and additional data regarding the usage of CUBICIN by managed care organizations, the Company reversed approximately $6.6 million of previously reserved Medicaid program rebates during the three months ended June 30, 2013.

Basic and Diluted Net Income Per Share

Basic net income per common share has been computed by dividing net income by the weighted average number of shares outstanding during the period. Diluted net income per share has been computed by dividing diluted net income 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 which were due June 2013, or 2.25% Notes, and 2.50% convertible senior notes due 2017, 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. In 2012, Cubist retired its 2.25% Notes.

The following table sets forth the computation of basic and diluted net income per common share:

	Three Months Ended June 30,				Six Months Ended June 30,
	2013		2012		2013		2012
	(in thousands, except share and per share amounts)
Net income, basic	$	15,242	$	43,123	$	21,330	$	75,917
Effect of dilutive securities:
Interest on 2.50% Notes, net of tax	—		1,808		—		3,610
Debt issuance costs related to 2.50% Notes, net of tax	—		239		—		477
Debt discount amortization related to 2.50% Notes, net of tax	—		2,201		—		4,358
Net income, diluted	$	15,242	$	47,371	$	21,330	$	84,362

Shares used in calculating basic net income per common share	65,558,376		63,498,953		65,248,707		63,250,165
Effect of dilutive securities:
Options to purchase shares of common stock and RSUs	2,173,600		2,243,221		2,136,434		2,327,156
2.50% Notes convertible into shares of common stock	—		15,424,155		—		15,424,155
Shares used in calculating diluted net income per common share	67,731,976		81,166,329		67,385,141		81,001,476

Net income per share, basic	$	0.23	$	0.68	$	0.33	$	1.20
Net income per share, diluted	$	0.23	$	0.58	$	0.32	$	1.04

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

	Three Months Ended June 30,		Six Months Ended June 30,
	2013	2012	2013	2012
Options to purchase shares of common stock and RSUs	2,591,295	3,091,164	2,546,822	2,775,786
2.25% Notes convertible into shares of common stock	—	2,909,940	—	3,229,658
2.50% Notes convertible into shares of common stock	15,424,084	—	15,424,118	—

Accumulated Other Comprehensive Income

In February 2013, the Financial Accounting Standards Board, or FASB, issued amended accounting guidance for reporting accumulated other comprehensive income. The amendments require a company to provide information about the amounts reclassified out of accumulated other comprehensive income by component. In addition, a company is required to present, either on the face of the statement where net income is presented or in the notes, significant amounts reclassified out of accumulated other comprehensive income by the respective line items of net income. The Company adopted this guidance on January 1, 2013. The Company did not recognize any realized gains or losses from sales of its available-for-sale securities and did not reclassify any amounts out of accumulated other comprehensive income during the three and six months ended June 30, 2013.

Subsequent Events

Cubist considers events or transactions that have occurred after the balance sheet date of June 30, 2013, 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 recognition or disclosure. On July 30, 2013, Cubist entered into two separate agreements to acquire all of the outstanding shares of Trius Therapeutics, Inc., or Trius, and Optimer. The execution of each agreement occurred after June 30, 2013, and is considered a nonrecognizable subsequent event. See Note N., “Subsequent Events,” for additional information.

Recent Accounting Pronouncements

In July 2013, the FASB issued an accounting standards update clarifying the presentation of an unrecognized tax benefit when a net operating loss carryforward, a similar tax loss, or a tax credit carryforward exists. The updated guidance requires the netting of unrecognized tax benefits against a deferred tax asset for a loss or other carryforward when settlement of the liability for an unrecognized tax benefit in this manner is available. The update is effective prospectively for reporting periods beginning after December 15, 2013, and early adoption and retrospective adoption are permitted. The adoption of this guidance is not expected to have an impact on the Company’s consolidated financial statements.