Summary of Significant Accounting Policies

Business

Applied Micro Circuits Corporation (“AppliedMicro”, “APM”, “AMCC” or the “Company”) is a global leader in computing and connectivity solutions that span embedded computing, Telco, and solutions for next-generation cloud infrastructure and data centers. The Company's products include the X-Gene^TM ARM^® 64-bit Server on a Chip^TM solution, or X-Gene, designed for cloud data center and enterprise applications. Its embedded computing products are deployed in applications in markets such as control- and data-plane functionality, wireless access points, residential gateways, wireless base-stations, storage controllers, network attached storage, network switches and routing products, and multi-function printers. The Company's connectivity products address high growth segments including 10, 40, and 100Gbps solutions serving data center and service provider market opportunities. Connectivity products include framer/mapper devices for Optical Transport Network (“OTN”) equipment and physical layer devices that transmit and receive signals in a very high-speed serial format. The Company's corporate headquarters are located in Sunnyvale, California. Sales and engineering offices are located throughout the world.

Basis of Presentation

The consolidated financial statements include all the accounts of AppliedMicro, its wholly-owned subsidiaries including Veloce Technologies Inc. (“Veloce”), which was consolidated in prior accounting periods as a variable interest entity (“VIE”) since the Company was determined to be its primary beneficiary. On June 20, 2012, the Company completed the acquisition of Veloce which became a wholly owned subsidiary of the Company as of this date. See note 4 of Notes to Consolidated Financial Statements. All significant intercompany balances and transactions have been eliminated in consolidation.

Use of Estimates

The preparation of financial statements in accordance with U.S. generally accepted accounting principles 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 net revenue and expenses in the reporting period. The Company regularly evaluates estimates and assumptions related to its:


•	capitalized mask sets including its useful lives, which affects cost of goods sold and property and equipment or Research and Development ("R&D") expenses, if not capitalized;


•	inventory valuation, warranty liabilities, and revenue reserves, which affects cost of sales, gross margin, and revenues;


•	allowance for doubtful accounts, which affects operating expenses;


•	the unrealized losses or other-than-temporary impairments of short-term investments available for sale, which affects interest income (expense), net;


•	the valuation of purchased intangibles and goodwill, which affects amortization and impairments of purchased intangibles and impairments of goodwill;

•

Veloce accrued liability which considers: (i) estimating the total value of the expected Veloce consideration, (ii) determining the stage at which a milestone is deemed to be probable of attainment, (iii) the estimated progress towards achieving the milestone at the time such milestone was deemed probable of achievement, and (iv) estimating the approximate timing of the expected completion of the milestones and related payments;


•	the potential costs of litigation, which affects operating expenses;


•	the valuation of deferred income taxes, which affects income tax expense (benefit); and


•	stock-based compensation, which affects gross margin and operating expenses.

The Company bases its estimates and assumptions on historical experience and on various other factors that it believes to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. The actual results experienced by the Company may differ materially and adversely from management’s estimates. To the extent there are material differences between the estimates and the actual results, future results of operations will be affected.

Cash and Cash Equivalents

The Company considers all highly liquid investments with an original maturity from the date of purchase of 90 days or less to be cash equivalents.

Veloce Consideration

The Company periodically evaluate the progress of the development work that is being performed in connection with its contractual arrangement with Veloce. Based on such an evaluation as well as considering various other qualitative factors, the Company estimates the total value of the development work being performed, and assesses the timing and probability of attaining contractually defined performance milestones.

Upon assessing a performance milestone as probable of achievement, R&D expense is recognized based upon the estimated stage of development of that milestone and the estimated value associated with each performance milestone. The amount of R&D costs recognized in connection with the Veloce consideration excludes any value relating to Veloce common stock equivalents that have not been allocated to individuals (“Unallocated Veloce Units”). Payment of the Veloce consideration will occur based upon when a performance milestone is completed, and upon satisfaction of vesting requirements, if applicable. Significant judgment is required to estimate the total value of the Veloce development work, assess when a performance milestone is probable of achievement and estimating the timing of when the performance milestones will be completed. The Company relies on discussions with internal technical personnel and using various qualitative and quantitative factors, including, but not limited to, overall complexity, stage of development and progress made to date, results of testing, and consideration as to the nature of the remaining development work, to assess probability of attaining the performance milestones defined in the Merger Agreement. If, based on such assessment, the Company believes attainment of a performance milestone is probable, the Company will recognize expenses related to the estimated stage of development for the performance milestone, excluding the value relating to the Unallocated Veloce Units. As of March 31, 2013, the Company believes that the first two performance milestones are probable of attainment, and the third and final performance milestone is currently not yet believed to be probable of attainment.

The estimated total value of the Veloce consideration is currently based upon the benchmarks that were achieved during simulations that were performed during the third quarter of fiscal 2013 and correlating the results of the simulations to the contractual terms included in the Merger Agreement. As a result of higher than expected benchmarks achieved during simulations, the total estimated value to Veloce has been updated from a previous estimated maximum of $135 million to the contractual maximum of $178.5 million. As a result of this increase in value, the estimated value relating to the first and second performance milestone was also increased.

Total R&D expenses expected to be recognized upon completion of the first and second performance milestones is approximately $142.8 million (including the initial consideration of $60.4 million), of which approximately $126.6 million has been recognized through March 31, 2013. During the twelve months ended March 31, 2013, expenses recognized in connection with first and second performance milestones were $37.0 million and $29.2 million, respectively.

Investments

The Company holds a variety of securities that have varied underlying investments. The Company reviews its investment portfolio periodically to assess for other-than-temporary impairment. The Company assesses the existence of impairment of its investments in order to determine the classification of the impairment as “temporary” or “other-than-temporary”. The factors used to determine whether an impairment is temporary or other-than-temporary involves considerable judgment. The factors considered in determining whether any individual impairment is temporary or other-than-temporary are primarily the length of the time and the extent to which the market value has been less than amortized cost, the nature of underlying assets (including the degree of collateralization), the financial condition, credit rating, market liquidity conditions and near-term prospects of the issuer. If the fair value of a debt security is less than its amortized cost basis at the balance sheet date, an assessment would have to be made as to whether the impairment is other-than-temporary. If the Company decided to sell the security, an other-than-temporary impairment shall be considered to have occurred. However, if the Company does not intend to sell the debt security, the Company shall consider available evidence to assess whether it is more likely than not, it will be required to sell the security before the recovery of its amortized cost basis due to cash, working capital requirements, contractual or regulatory obligations indicate that the security will be required to be sold before a forecasted recovery occurs. If it is more likely than not that the Company will be required to sell the security before recovery of its amortized cost basis, an other-than-temporary impairment is considered to have occurred. If the Company does not expect to recover the entire amortized cost basis of the security, the Company would not be able to assert that it will recover its amortized cost basis even if it does not intend to sell the security. Therefore, in those situations, an other-than-temporary impairment shall be considered to have occurred. The Company uses present value cash flow models to determine whether the entire amortized cost basis of the security will be recovered. The Company will compare the present value of cash flows expected to be collected from the security with the amortized cost basis of the security. An other-than-temporary impairment is said to have occurred if the present value of cash flows expected to be collected is less than the amortized cost basis of the security. During the fiscal year ended March 31, 2013, we recorded approximately $1.1 million in other-than-temporary impairment charges. During the fiscal years ended March 31, 2012 and 2011, we did not record any other-than-temporary impairment charges. As of March 31, 2013, we did not record an impairment charge in connection with other securities in a continuous loss position (fair value less than carrying value) with unrealized losses of $48,000 as we believe that such unrealized losses are temporary. In addition, we also had $8.1 million in unrealized gains.

Fair Value of Financial Instruments

Short term investments are recorded at fair value in the Company’s consolidated balance sheets and are categorized based upon the level of judgment associated with the inputs used to measure their fair value. ASC Subtopic 820-10 defines a three-level valuation hierarchy for disclosure of fair value measurements. The Company currently classifies inputs to derive fair values for short term investments as Level 1 and 2. Instruments classified as Level 1 include highly liquid government and agency securities, money market funds and publicly traded closed end bond funds in active markets. Instruments classified as Level 2 include corporate notes, mortgage-backed securities, asset-backed securities, commercial paper and preferred stock. The Company did not have any Level 3 short term investments as of any of the periods presented.

Concentration of Credit Risk

Financial instruments, which potentially subject the Company to concentrations of credit risk, consist principally of available-for-sale securities and trade receivables. The Company believes that the credit risk in its trade receivables is mitigated by the Company’s credit evaluation process, relatively short collection terms and dispersion of its customer base. The Company generally does not require collateral and losses on trade receivables have historically been within management’s expectations.

The Company invests its excess cash in debt instruments of the U.S. Treasury, corporate bonds, mutual funds, mortgage-backed securities, asset-backed securities, preferred stocks, and closed-end bond funds primarily with investment grade credit ratings. The Company has established guidelines relative to diversification and maturities that attempt to maintain safety, yield and liquidity. These guidelines are periodically reviewed and modified to take advantage of trends in yields and interest rates.

Inventories

The Company’s policy is to value inventories at the lower of cost or market on a part-by-part basis. This policy requires the Company to make estimates regarding the market value of its inventories, including an assessment of excess or obsolete inventories. The Company determines excess and obsolete inventories based on an estimate of the future demand for its products within a specified time horizon, generally 12 months. The estimates used for future demand are also used for near-term capacity planning and inventory purchasing and are consistent with revenue forecasts. If the Company’s demand forecast is greater than its actual demand the Company may be required to take additional excess inventory charges, which would decrease gross margin and net operating results. Any inventory charges establishes a new cost basis for the underlying inventory and the cost basis for such inventory is not marked-up on changes in circumstances. This accounting is consistent with the guidance provided by SAB Topic 5-BB.

Strategic Investments

The Company has entered into certain equity investments in privately held businesses to achieve certain strategic business objectives. The Company’s investments in equity securities of privately held businesses are accounted for under the cost method. Under the cost method, strategic investments in which the Company holds less than a 20% voting interest and in which the Company does not have the ability to exercise significant influence are carried at cost reduced by other-than-temporary impairments, as appropriate. These investments are included in other assets on the Company’s consolidated balance sheets. The Company periodically reviews these investments for other-than-temporary declines in fair value based on the specific identification method and writes down investments when an other-than-temporary decline has occurred. During the fiscal year ended March 31, 2013, 2012, and 2011, the Company recorded other-than-temporary impairment charges of its strategic investments of $2.3 million, $1.0 million and zero, respectively.

Property and Equipment

Property and equipment are stated at cost and depreciated over the estimated useful lives of the assets ranging from 1 to 31.5 years using the straight line method. Leasehold improvements are stated at cost and amortized over the shorter of the term of the related lease or its estimated useful life.

The Company considers events and changes in circumstances that could indicate carrying amounts of the long-lived assets, including property and equipment and intangible assets, may not be recoverable. When such events or changes in circumstances occur, the Company assesses recoverability of long-lived assets.

Goodwill, Purchased Intangible Assets and Other Long-Lived Assets

The Company conducts a goodwill impairment analysis annually and as necessary if changes in facts and circumstances indicate that it is more likely than not that the fair value of the Company’s reporting units may be less than its carrying amount.

In accordance with ASC Topic 350-10 (“ASC 350-10”) as it relates to Goodwill and Other Intangible Assets, we perform our annual impairment review at the reporting unit level each fiscal year or more frequently if we believe that it is more likely than not that the fair value of the Company’s reporting units may be less than its carrying amount. In September 2011, the FASB issued ASU 2011-08, Intangibles, Goodwill and Other (Topic 350): Testing Goodwill for Impairment. The amendment is effective for annual impairment tests done for fiscal years that start after December 15, 2011 though early adoption is permitted. The changes to FASB ASC 350-20 permits an entity to make a qualitative assessment of whether it is more likely than not that a reporting unit’s fair value is less than its carrying amount before applying the two-step goodwill impairment test. If an entity concludes that it is not more likely than not that the fair value of a reporting unit is less than its carrying amount, it would not be required to perform the two-step impairment test for that reporting unit. During the fourth quarter of fiscal 2012, the Company early adopted ASU 2011-08. As part of its qualitative assessment, the Company evaluated and determined that its market capitalization was well in excess of its book value and based on this and other qualitative factors (such as revenue trends, design wins, continued utilization of developed technology acquired from the TPack A/S acquisition and subsequent to its sale in April 2013 - see Note 12 to the Consolidated Financial Statements for details of the TPack A/S sale), determined that there was no goodwill impairment.

The Company’s long-lived assets consist of property, plant and equipment and other acquired intangibles, excluding goodwill. Acquired intangibles with definite lives are amortized on a straight-line basis over the remaining estimated economic life of the underlying products and technologies. The Company reviews its definite-lived long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying amount of a long-lived asset may not be recoverable. Recoverability of an asset group is measured by comparison of its carrying amount to the expected future undiscounted cash flows that the asset group is expected to generate. If it is determined that an asset group is not recoverable, an impairment loss is recorded in the amount by which the carrying amount of the asset group exceeds its fair value. In addition, the Company assesses its long-lived assets for impairment if they are abandoned.

Revenue Recognition

The Company recognizes revenue based on four basic criteria: 1) there is evidence that an arrangement exists; 2) delivery has occurred; 3) the fee is fixed or determinable; and 4) collectability is reasonably assured. The Company recognizes revenue upon determination that all criteria for revenue recognition have been met. In addition, the Company does not recognize revenue until the applicable customer’s acceptance criteria have been met. The criteria are usually met at the time of product shipment. The Company’s standard terms and conditions of sale do not allow for product returns and it generally does not allow product returns other than under warranty or stock rotation agreements. Revenue from shipments to distributors is recognized upon shipment. In addition, the Company records reductions to revenue for estimated allowances such as returns not pursuant to contractual rights, competitive pricing programs and rebates. These estimates are based on our experience with stock rotations and the contractual terms of the competitive pricing and rebate programs. Royalty revenues are recognized when cash is received only when royalty amounts cannot be reasonably estimated. Royalty revenues are based upon sales of our customers' products that include our technology.

Shipping terms are generally FCA (Free Carrier) shipping point. If actual returns or pricing adjustments exceed our estimates, we would record additional reductions to revenue.

From time to time the Company generates revenue from the sale of internally developed intellectual property ("IP"). The Company generally recognizes revenue from the sale of IP when all basic criteria outlined above are met, which generally occurs upon cash receipt.

Research and Development

R&D costs are expensed as incurred. Substantially all R&D expenses are related to new product development and designing significant improvements to existing products. Please also refer to note 4 of the Notes to the Consolidated Financial Statements.

Mask Costs

The Company incurs significant costs for the fabrication of masks used by its contract manufacturers to manufacture its products. If the Company determines, at the time the costs for the fabrication of masks are incurred, that technological feasibility of the product has been achieved, it considers the nature of these costs to be pre-production costs. Accordingly, such costs are capitalized as property and equipment under machinery and equipment and are amortized as cost of sales over approximately three years, representing the estimated production period of the product. The Company periodically reassesses the estimated product production period for specific mask sets capitalized. If the Company determines, at the time fabrication mask costs are incurred, that either technological feasibility of the product has not occurred or that the mask is not reasonably expected to be used in production manufacturing or that the commercial feasibility of the product is uncertain, the related mask costs are expensed to R&D in the period in which the costs are incurred. The Company will also periodically assess capitalized mask costs for impairment. During the fiscal years ended March 31, 2013 and 2012, total mask costs capitalized were $3.1 million and $4.8 million, respectively.

Stock-Based Compensation

The Company accounts for stock-based compensation activity using the modified prospective method. This method requires companies to estimate the fair value of stock-based compensation on the date of grant using an option-pricing model. The Company uses the Black-Scholes model to value stock-based compensation, excluding Restricted Stock Units ("RSUs"), for which we use the fair market value of our common stock. The Black-Scholes model determines the fair value of share-based payment awards based on the stock price on the date of grant and is affected by assumptions regarding a number of highly complex and subjective variables. These variables include, but are not limited to, the Company’s stock price, volatility over the term of the awards and actual and projected employee stock option exercise behaviors. Option-pricing models were developed for use in estimating the value of traded options that have no vesting or hedging restrictions and are fully transferable. Although the fair value of stock options granted by the Company is estimated by the Black-Scholes model, the estimated fair value may not be indicative of the fair value observed in a willing buyer/willing seller market transaction.

The following table summarizes stock-based compensation expense related to stock options and restricted stock units for the three fiscal years ended March 31, 2013, which is as follows (in thousands, except per share data):



	Fiscal Year Ended March 31,
	2013		2012			2011
Stock-based compensation expense by type of award
Stock options (including employee stock purchase program) and warrants	$	3,469	$	5,289		$	5,600
Restricted stock units	20,620		13,148			11,062
Total stock-based compensation	24,089		18,437			16,662
Stock-based compensation expensed from (capitalized to) inventory	147		(63		)	22
Total stock-based compensation expense	$	24,236	$	18,374		$	16,684

The following table summarizes stock-based compensation expense as it relates to the Company’s statements of operations (in thousands):



	Fiscal Year Ended March 31,
	2013		2012			2011
Stock-based compensation expense by cost centers
Cost of revenues	$	545	$	495		$	628
Research and development	11,760		10,496			9,001
Selling, general and administrative	11,784		7,446			7,033
Total stock-based compensation	24,089		18,437			16,662
Stock-based compensation expensed from (capitalized to) inventory	147		(63		)	22
Total stock-based compensation expense	$	24,236	$	18,374		$	16,684

The stock based compensation expense of approximately $24.2 million for the twelve months ended March 31, 2013 does not include approximately $1.3 million expense related to the acceleration of Veloce warrants. See note 5 of Notes to Consolidated Financial Statements for further details relating to the Veloce warrants.

The fair values of the options and employee stock purchase plan awards granted are estimated as of the grant date using the Black-Scholes option-pricing model assuming the weighted-average assumptions listed in the following table:



	Employee Stock Options									Employee Stock Purchase Plans
	Fiscal Years Ended March 31,									Fiscal Years Ended March 31,
	2013			2012			2011			2013			2012			2011
Expected life (years)	4.4			3.8			4.0			0.5			0.5			0.5
Risk-free interest rate	0.7		%	1.4		%	1.6		%	—		%	0.1		%	0.2		%
Volatility	0.54			0.48			0.51			0.50			0.55			0.50
Dividend yield	—		%	—		%	—		%	—		%	—		%	—		%
Expected forfeiture rate	6.6		%	6.8		%	6.6		%	—		%	—		%	—		%
Weighted average fair value	$	2.47		$	3.83		$	4.85		$	1.77		$	2.13		$	3.09

Compensation Amortization Period. All stock-based compensation is amortized over the requisite service period of the awards, which is generally the same as the vesting period of the awards. The Company amortizes the fair value cost on a straight-line basis over the expected service periods.

Expected Life. The expected life of stock options granted represents the expected weighted average period of time from the date of grant to the estimated date that the stock option would be fully exercised. To calculate the expected term, the Company utilizes historical actual exercise data and assumes that unexercised stock options would be exercised at the midpoint of the valuation date of its analysis and the full contractual term of the option.

Expected Volatility. Expected volatility is a measure of the amount by which the stock price is expected to fluctuate. The Company estimates the expected volatility of its stock options at their grant date by equally weighting the historical volatility and the implied volatility of its stock. The historical volatility is calculated using the weekly stock price of its stock over a recent historical period equal to its expected life. The implied volatility is calculated from the implied market volatility of exchange-traded call options on its common stock.

Risk-Free Interest Rate. The risk-free interest rate is the implied yield currently available on zero-coupon government issues with a remaining term equal to the expected life.

Expected Dividends. The Company has never paid any cash dividends on its common stock and does not anticipate paying any cash dividends in the foreseeable future. Consequently, the Company uses an expected dividend yield of zero percent in valuation models.

Expected Forfeitures. As stock-based compensation expense recognized in the Consolidated Statements of Operations for the three fiscal years ended March 31, 2013 is based on awards that are ultimately expected to vest, it should be reduced for estimated forfeitures. Forfeitures are required to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. Pre-vesting forfeiture rates were based upon the average of expected forfeiture data using the Company’s current demographics and standard probabilities of employee turnover and the annual forfeiture rate based on the Company’s historical forfeiture rates.

Effective April 1, 2012, the Company revised the estimated forfeiture rate used to determine the amount of stock-based compensation from 6.8% to 6.6% as a result of a decreasing rate of forfeitures in recent periods, which the Company believes is indicative of the rate it will experience during the remaining vesting period of currently outstanding unvested grants.

The weighted average fair value per share of the restricted stock units awarded in the fiscal years ended March 31, 2013, 2012 and 2011 was $6.11, $9.00 and $10.69, respectively. The weighted average fair value per share was calculated based on the fair market value of the Company’s common stock on the respective grant dates.

The amount of unearned stock-based compensation currently estimated to be expensed from now through fiscal 2016, including time and performance based awards that are expected to vest, at March 31, 2013 is $10.3 million. The weighted-average period over which the unearned stock-based compensation is expected to be recognized is approximately 1.2 years. If there are any modifications or cancellations of the underlying unvested securities, the Company may be required to accelerate, increase or cancel any remaining unearned stock-based compensation expense. Future stock-based compensation expense and unearned stock-based compensation will increase to the extent that the Company grants additional equity awards or assumes unvested equity awards in connection with acquisitions.

Income Taxes

The Company utilizes the asset and liability method of accounting for income taxes as set forth in ASC Subtopic 740-10 (“ASC 740-10”). Under the asset and liability method, deferred taxes are determined based on the temporary differences between the financial statement and tax bases of assets and liabilities using enacted tax rates. A valuation allowance is recorded when it is more likely than not that some or all of the deferred tax assets will not be realized. During the fiscal year ended March 31, 2013, the Company recorded a tax charge of approximately $1.0 million to other comprehensive income and concurrently recorded the same amount as an income tax benefit to operations. In applying the exception to the general principle of intra-period tax allocations under ASC 740-10, the Company considered income recognized in other comprehensive income. Accordingly, the allocation of the current year tax provision included recognizing a $1.0 million tax benefit arising from the loss from operations. The offsetting tax expense was allocated to other comprehensive income for the fiscal year ended March 31, 2013.

Segments of a Business Enterprise

The Company has two operating segments — Computing and Connectivity, and under the aggregation criteria set forth in ASC 280-10 (as the two operating segments share similar economic characteristics related to the nature of their products, production processes, customers and methods of distribution), has one reportable operating segment. The Company’s Chief Operating Decision Maker, the Chief Executive Officer, evaluates performance of the Company and makes decisions regarding allocation of resources based on total Company results.

New Accounting Pronouncements

In June 2011, the Financial Accounting Standards Board (FASB) issued an amendment to its guidance regarding the presentation of comprehensive income. The amended guidance gives an entity the option to 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. The amended guidance eliminates the option to present the components of other comprehensive income as part of the statement of changes in stockholders’ equity. In December 2011, the FASB further modified the guidance by deferring until further notice the requirement of presenting the effects of reclassification adjustments on accumulated other comprehensive income as both components of net income and of other comprehensive income. This guidance is effective on a retrospective basis for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2011. The Company adopted this guidance in fiscal 2013 by opting to present this information in two separate but consecutive statements. Adoption of this guidance did not have any material impact on its financial position, results of operations or cash flows as it only impacted the presentation of the financial statements.