Note 3 – Accounting Policies and Recent Accounting Pronouncements

The consolidated financial statements and accompanying notes are prepared in accordance with accounting principles generally accepted in the United States.

Consolidation

The consolidated financial statements include all of the accounts of Discovery Laboratories, Inc. and its inactive subsidiary, Acute Therapeutics, Inc. All intercompany transactions and balances have been eliminated in consolidation.

Use of estimates

The preparation of financial statements, in conformity with accounting principles generally accepted in the United States, requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.

Cash and cash equivalents

We consider cash and cash equivalents as amounts on hand, on deposit in financial institutions and all highly liquid marketable securities purchased with a maturity of three months or less.

Inventory

Inventories are determined at the lower of cost or market value with cost determined under the specific identification method. In connection with the FDA approval of SURFAXIN and the registration of our initial AFECTAIR device in the U.S., we assessed the potential capitalization of inventory and the timing of when the related costs are expected to be recoverable through the commercialization of our products. Costs incurred prior to receipt of marketing authorization have been recorded in our statement of operations as research and development expense. As a result, inventory balances and cost of revenue may reflect a lower average per-unit cost of materials for several quarters after we launch our products. As of December 31, 2012, inventories were valued at $0.2 million and consisted of raw materials used in the production of SURFAXIN.

Fair value of financial instruments

Our financial instruments consist principally of cash and cash equivalents and restricted cash. The fair values of our cash equivalents are based on quoted market prices. The carrying amount of cash equivalents is equal to their respective fair values at December 31, 2012 and 2011, respectively. Other financial instruments, including accounts payable and accrued expenses, are carried at cost, which we believe approximates fair value.

Property and equipment

Property and equipment are recorded at cost and depreciated using the straight-line method over the estimated useful lives of the assets (generally three to ten years). Leasehold improvements are amortized over the shorter of the estimated useful lives or the remaining term of the lease. Repairs and maintenance costs are charged to expense as incurred.

Long-lived assets

Our long-lived assets, primarily consisting of equipment, are reviewed for impairment when events or changes in circumstances indicate the carrying amount of an asset may not be recoverable, or its estimated useful life has changed significantly. When the undiscounted cash flows of an asset are less than its carrying value, an impairment is recorded and the asset is written down to estimated value. No impairment was recorded during the years ended December 31, 2012, 2011 and 2010 as management believes there are no circumstances that indicate the carrying amount of the assets will not be recoverable.

Grant Revenue

We recognize grant revenue when persuasive evidence of an arrangement exists, delivery has occurred or services have been rendered, the price is fixed and determinable, and collectability is reasonably assured.

For the year ended December 31, 2012, we recognized $195,093 of grant revenue for funds received and expended under a Small Business Innovation Research (SBIR) Phase I award to Discovery Labs from National Institute of Health's (NIH) National Institute of Allergy and Infectious Diseases (NIAID) Center for Medical Counter Measures Against Radiation and Nuclear Threats to assess the ability of KL4 surfactant to mitigate the effects of acute radiation exposure to the lung, including acute pneumonitis and delayed lung injury. The total amount of the award is $600,000 and the remainder of the award is expected to be received and expended in 2013.

For the year ended December 31, 2011, grant revenue represents funds received and expended under a $581,839 Fast Track Small Business Innovation Research Grant (SBIR) from the National Institutes of Health to support the development of aerosolized KL4 surfactant for RDS.

For the year ended December 31, 2010, we received grant proceeds, recorded as other income, of $244,480 under the Patient Protection and Affordable Care Act of 2010 to reimburse costs incurred in 2009 to advance our aerosolized KL4 surfactant program for the prevention of neonatal RDS.

Research and development

We track research and development expense by activity, as follows: (a) product development and manufacturing, (b) medical and regulatory operations, and (c) direct preclinical and clinical programs. Research and development expense includes personnel, facilities, manufacturing and quality operations, pharmaceutical and device development, research, clinical, regulatory, other preclinical and clinical activities and medical affairs. Research and development costs are charged to operations as incurred.

Stock-based compensation

Stock-based compensation is accounted for under the fair value recognition provisions of Accounting Standards Codification (ASC) Topic 718 "Stock Compensation" (ASC Topic 718). See, Note 11 – Stock Options and Stock-based Employee Compensation, for a detailed description of our recognition of stock-based compensation expense. The fair value of stock option grants is recognized evenly over the vesting period of the options or over the period between the grant date and the time the option becomes non-forfeitable by the employee, whichever is shorter. Stock option expense is generally included in research and development and selling, general and administrative expenses in the accompanying Consolidated Statements of Operations.

Warrant accounting

We account for common stock warrants in accordance with applicable accounting guidance provided in ASC Topic 815 "Derivatives and Hedging – Contracts in Entity's Own Equity" (ASC Topic 815), as either derivative liabilities or as equity instruments depending on the specific terms of the warrant agreement. We classify derivative warrant liabilities on the consolidated balance sheet as a current liability, which is revalued at each balance sheet date subsequent to the initial issuance. We use the Black-Scholes or trinomial pricing models, depending on the applicable terms of the warrant agreement, to value the derivative warrant liabilities. Changes in the fair value of the warrants are reflected in the consolidated statement of operations as "Change in the fair value of common stock warrant liability." See, Note 8 – Common Stock Warrant Liability, for a detailed description of our accounting for derivative warrant liabilities.

Income taxes

We account for income taxes in accordance with ASC Topic 740, "Accounting for Income Taxes." ASC Topic 740 requires the recognition of deferred tax liabilities and assets for the expected future tax consequences of temporary differences between financial statement carrying amounts and the tax basis of assets and liabilities.

We use a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. Because we have never realized a profit, management has fully reserved the net deferred tax asset since realization is not assured.

Net loss per common share

Basic net loss per share is computed by dividing net loss by the weighted average number of common shares outstanding for the period. For the years ended December 31, 2012, 2011 and 2010, the number of shares of common stock potentially issuable upon the exercise of certain stock options and warrants was 11.9 million, 15.4 million and 5.3 million shares, respectively. As a result of the Company's net losses for all periods presented, all potentially dilutive securities were anti-dilutive and therefore have been excluded from the computation of diluted net loss per share.

Concentration of Suppliers

We currently obtain the active pharmaceutical ingredients (APIs) of our KL4 surfactant drug products from single-source suppliers. In addition, we rely on a number of third-party institutions and laboratories that perform various studies as well as quality control release and stability testing and other activities related to our KL4 surfactant development and manufacturing activities. Among these, our fetal rabbit biological activity test (BAT, an important quality control release and stability test for SURFAXIN) is conducted at a laboratory owned by the University of California, San Diego, School of Medicine, Department of Pediatrics. At the present time, several of these laboratories are single source providers. The loss of one or more of our single-source suppliers or testing laboratories could have a material adverse effect upon our operations.

Business segments

We currently operate in one business segment, which is the research and development of products focused on surfactant replacement therapies for respiratory disorders and diseases, and the manufacture and commercial sales of approved products. We are managed and operated as one business. A single management team that reports to the Chief Executive Officer comprehensively manages the entire business. We do not operate separate lines of business with respect to our product candidates.

Recent Accounting Pronouncements

In May 2011, the FASB issued Accounting Standards Update (ASU)2011-04, for fair value to develop common requirements between U.S. Generally Accepted Accounting Principles and International Financial Reporting Standards. The amendments, which are effective for interim and annual periods beginning after December 15, 2011, require entities to (i) provide information about valuation techniques and unobservable inputs used in Level 3 fair value measurements, and (ii) provide a narrative description of the sensitivity of Level 3 measurements to changes in unobservable inputs. The adoption of this update did not have a material impact on our consolidated financial statements.

In June 2011, the FASB issued ASU 2011-05, for accounting guidance related to the presentation of comprehensive income. The guidance, which is effective for interim and annual periods beginning after December 15, 2011, require entities to present all components of comprehensive income in either (i) a single continuous statement of comprehensive income or (ii) in a statement of net income and statement of other comprehensive income. The adoption of this update did not have a material impact on our consolidated financial statements because we do not have any material components of other comprehensive income (loss).