Accounting Policies

Principles of Consolidation

The accompanying unaudited condensed consolidated financial statements include the accounts of Heron Therapeutics, Inc. and its wholly owned subsidiary, Heron Therapeutics, B.V., which was organized in the Netherlands in

March

2015.

Heron Therapeutics, B.V. has no operations and no material assets or liabilities, and there have been no significant transactions related to Heron Therapeutics, B.V. since its inception.

Use of Estimates

The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the amounts reported in the financial statements and disclosures made in the accompanying notes to the financial statements. Our critical accounting policies that involve significant judgment and estimates include revenue recognition, inventory, accrued clinical liabilities, income taxes and stock-based compensation. Actual results could differ materially from those estimates.

Cash, Cash Equivalents and Short-Term Investments

Cash and cash equivalents consist of cash and highly liquid investments with original maturities from purchase date of

three

months or less.

Short-term investments consist of securities with contractual maturities of

one

year or less. We have classified our short-term investments as available-for-sale securities in the accompanying unaudited condensed consolidated financial statements. Available-for-sale securities are stated at fair market value, with unrealized gains and losses reported in other comprehensive loss and realized gains and losses included in interest expense, net. The cost of securities sold is based on the specific-identification method. Interest and dividends on securities classified as available-for-sale are included in interest income.

The following is a summary of our short-term, available-for-sale securities (in thousands):

	March 31, 2017
			Gross		Gross
	Amortized		Unrealized		Unrealized			Estimated
	Cost		Gains		Losses			Fair Value
United States government and agency	$	24,971	$	—	$	—		$	24,971
United States corporate debt		35,052		—		(29	)		35,023
Foreign corporate debt		8,301		—		(1	)		8,300
United States commercial paper		36,897		—		—			36,897
Foreign commercial paper		16,933		—		—			16,933
Total	$	122,154	$	—	$	(30	)	$	122,124

	December 31, 2016
			Gross		Gross
	Amortized		Unrealized		Unrealized			Estimated
	Cost		Gains		Losses			Fair Value
United States corporate debt	$	12,048	$	—	$	(9	)	$	12,039
Foreign corporate debt		14,065		—		(8	)		14,057
United States commercial paper		8,635		—		—			8,635
Foreign commercial paper		2,993		—		—			2,993
Total	$	37,741	$	—	$	(17	)	$	37,724

The amortized cost of debt securities is adjusted for amortization of premiums and accretion of discounts to maturity. We regularly monitor and evaluate the realizable value of our marketable securities. We did

not

recognize any impairment losses for each of the

three

months ended

March

31,

2017

and

2016.

Realized gains and losses associated with our investments, if any, are reported in the statement of comprehensive loss. There were

realized gains or losses for each of the

three

months ended

March

31,

2017

and

2016.

Our bank and investment accounts have been placed under control agreements in accordance with our Senior Secured Convertible Notes (the “Convertible Notes”) and Subordinated Secured Promissory Note (the

“Promissory Note”) (see Note

6).

Concentration of Risk

Cash, cash equivalents and short-term investments are financial instruments that potentially subject us to concentrations of credit risk. We deposit our cash in financial institutions. At times, such deposits

may

be in excess of insured limits. We

may

also invest our excess cash in money market funds, U.S. government and agencies, corporate debt securities and commercial paper. We have established guidelines relative to our diversification of our cash investments and their maturities in an effort to maintain safety and liquidity. These guidelines are periodically reviewed and modified to take advantage of trends in yields and interest rates.

Sales of SUSTOL to ASD Specialty Healthcare, Inc. and Cardinal Health, Inc. each accounted for

10%

or more of our net revenues for the quarter ended

March

31,

2017.

The loss of either of these customers could materially and adversely affect our business, results of operations, financial condition and cash flows.

Inventory

Inventory is stated at the lower of cost or estimated net realizable value, on a

first

-in,

first

-out, or FIFO, basis. We periodically analyze our inventory levels, and write down inventory that has become obsolete, inventory that has a cost basis in excess of its estimated realizable value and inventory quantities that are in excess of expected sales requirements as cost of product sales. The determination of whether inventory costs will be realizable requires estimates by management. If actual market conditions are less favorable than projected by management, additional write-downs of inventory

may

be required, which would be recorded as a cost of product sales.

As of

March

31,

2017,

inventory totaled

$4.6

million and consisted of raw materials of

$1.6

million and finished goods of

$3.0

million. For the

three

months ended

March

31,

2017,

we recognized cost of product sales of

$0.3

million for sales of SUSTOL, which primarily included raw materials, labor and overhead related to the manufacturing of SUSTOL, as well as shipping and distribution costs. In addition, cost of product sales for the

first

quarter of

2017

included a

one

-time charge of

$0.9

million resulting from the write-off of short-dated inventory.

Revenue Recognition

Product Sales

SUSTOL is distributed in the U.S. through a limited number of specialty distributors (“Customers”) that resell SUSTOL to healthcare providers, the end users of SUSTOL. Product sales are recorded net of sales allowances and estimated rebates, chargebacks, distributor fees, and other deductions.

Product sales are recognized as revenue when there is persuasive evidence that an arrangement exists, delivery has occurred and title has passed, the price is fixed or determinable and we are reasonably assured of collecting the resulting receivable. Product sales are recorded net of sales allowances and estimated rebates, chargebacks, distributor fees and other deductions. At this point in the SUSTOL commercial launch, we do not yet have sufficient historical data regarding the

third

-party payor mix and resulting rebates related to shipments of SUSTOL to our Customers. In addition, we do not currently have the data necessary to provide sufficient visibility into the ultimate utilization of SUSTOL, which inhibits our ability to determine a reasonable estimate of potential returns. As a result, we are not yet able to make reliable estimates necessary to meet certain of the key recognition criteria to recognize product sales as revenue with respect to shipments of SUSTOL to our Customers. Accordingly, revenue related to shipments to our Customers is deferred, except to the extent that our Customers have resold SUSTOL to healthcare providers (sell-through approach). As of

March

31,

2017,

product sales of

$5.2

million to our Customers have been deferred and are recorded as deferred revenue on our unaudited condensed consolidated balance sheet.

Product Sales Allowances

We recognize product sales allowances as a reduction of product sales in the same period the related revenue is recognized. Product sales allowances are based on amounts owed or to be claimed on the related sales. These estimates take into consideration the terms of our agreements with Customers, historical product returns, rebates or discounts taken, the shelf life of the product, and specific known market events, such as competitive pricing and new product introductions. If actual future results vary from our estimates, we

may

need to adjust these estimates, which could have an effect on product sales and earnings in the period of adjustment. Our product sales allowances include:

●

Product Returns — We allow our Customers to return product for credit

months after its product expiration date. As such, there

may

be a significant period of time between the time the product is shipped and the time the credit is issued on returned product.

●

Distributor Fees — We offer contractually determined discounts to our Customers. These discounts are paid on a quarterly basis within

two

months after the quarter in which product was shipped.

●

Group Purchasing Organization (“GPO”) Discounts and Rebates — We offer cash discounts to GPO members. These discounts are taken when the GPO members purchase SUSTOL from our Customers, who then charge back to us the discount amount. Additionally, we offer volume and contract-tier rebates to GPO members. Rebates are estimated based on actual purchase levels during the quarterly or semi-annual rebate purchase period.

●

GPO Administrative Fees — We pay administrative fees to GPO’s for services and access to data. These fees are based on contracted terms and are paid after the quarter in which the product was purchased by the GPO’s members.

●

Medicaid Rebates — We participate in Medicaid rebate programs, which provide assistance to certain low-income patients based on each individual state's guidelines regarding eligibility and services. Under the Medicaid rebate programs, we pay a rebate to each participating state, generally within

three

months after the quarter in which SUSTOL was sold.

We believe our estimated allowance for product returns requires a high degree of judgment and is subject to change based on our experience and certain quantitative and qualitative factors. We believe our estimated allowances for distributor fees, GPO discounts, rebates and administrative fees, and Medicaid rebates do not require a high degree of judgement because the amounts are settled within a relatively short period of time.

Our product sales allowances and related accruals are evaluated each reporting period and adjusted when trends or significant events indicate that a change in estimate is appropriate. Changes in sales allowance estimates could materially affect our results of operations and financial position.

The following provides a summary of activity with respect to our accrued distributor fees, rebates and chargebacks and product returns for the quarter ended

March

31,

2017

(in thousands):

	Product Returns		Distributor Fees			Rebates and Chargebacks			Total

Balance at December 31, 2016	$	49	$	72		$	221		$	342
Provision		153		215			1,114			1,482
Payments/credits		—		(119	)		(243	)		(362	)
Balance at March 31, 2017	$	202	$	168		$	1,092		$	1,462

Comprehensive Income (Loss)

Comprehensive income (loss) is defined as the change in equity during a period from transactions and other events and circumstances from non-owner sources.

Unrealized gains and losses on available-for-sale securities are included in other comprehensive loss and represent the difference between our net loss and comprehensive loss for both periods presented.

Earnings per Share

Basic earnings per share (“EPS”) is calculated by dividing the net loss by the weighted-average number of common shares outstanding for the period, without consideration of common share equivalents. Diluted EPS is computed by dividing the net loss by the weighted-average number of common shares and common share equivalents outstanding for the period determined using the treasury stock method. For purposes of this calculation, stock options, warrants and common stock underlying Convertible Notes are considered to be common stock equivalents and are included in the calculation of diluted EPS only when their effect is dilutive.

Because we have incurred a net loss for all periods presented in the unaudited condensed consolidated statements of comprehensive loss, stock options, warrants and shares of common stock underlying Convertible Notes are not included in the computation of net loss per share because their effect would be anti-dilutive.

The following table includes the number of stock options, warrants and shares of common stock underlying Convertible Notes not included in the computation as of the dates shown below (in thousands):

	As of March 31,
	2017		2016

Stock options outstanding		11,849		8,961
Warrants outstanding		625		3,565
Shares of common stock underlying Convertible Notes outstanding		7,634		7,193

Recent Accounting Pronouncements

Recently Adopted

March

2016,

the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No.

2016

09,

Compensation – Stock Compensation: Improvements to Employee Share-Based Payment Accounting

(“ASU

2016

09”).

ASU

2016

addresses several aspects of the accounting for share-based payment award transactions, including: (a) income tax consequences; (b) classification of awards as either equity or liabilities; and (c) classification on the statement of cash flows. We adopted the provisions of ASU

2016

in the

first

quarter of

2017.

We have elected to continue to estimate forfeitures based on the estimated number of awards expected to vest. In addition, the adoption of ASU

2016

will result in the recognition of

$3.6

million of previously unrecognized excess tax benefits in deferred tax assets, fully offset by a valuation allowance. All tax-related cash flows resulting from stock-based compensation, including the excess tax benefits related to the settlement of stock-based awards, will be classified as cash flows from operating activities on our consolidated statements of cash flows. The adoption of ASU

2016

did not have a material impact on our results of operations or financial condition.

July

2015,

FASB issued ASU No.

2015

11,

Inventory (Topic

330)

(“ASU

2015

11”).

ASU

2015

requires entities to measure inventory at the lower of cost or net realizable value. Net realizable value is the estimated selling price in the ordinary course of business, less reasonably predicable costs of completion, disposal and transportation. Subsequent measurements are unchanged for inventory measured using LIFO or the retail inventory method. We adopted the provisions of ASU

2015

in the

first

quarter of

2017,

which did not have a material impact on our results of operations or financial condition.

Not Yet Adopted

February

2016,

FASB issued ASU No.

2016

02,

Leases

(“ASU

2016

02”).

ASU

2016

requires a lessee to record on the balance sheet the assets and liabilities for the rights and obligations created by leases with lease terms of more than

months. In addition, ASU

2016

requires both lessees and lessors to disclose certain key information about lease transactions. ASU

2016

is effective for fiscal years beginning after

December

15,

2018,

including interim periods within those fiscal years. We plan to adopt the provisions of ASU

2016

in the

first

quarter of

2019,

and we are currently evaluating the impact on our results of operations and financial condition.

May

2014,

FASB issued ASU No.

2014

09,

Revenue from Contracts with Customers (Topic

606)

(“ASU

2014

09”).

ASU

2014

is based on the principle that revenue should be recognized to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. ASU

2014

is effective for fiscal years beginning after

December

15,

2017,

including interim periods within those fiscal years. The provisions of ASU

2014

allow for either a full retrospective or a modified retrospective adoption approach. We plan to adopt the provisions of ASU

2014

in the

first

quarter of

2018.

Although we are currently evaluating our method of adoption and the guidance in ASU

2014

09,

including the evaluation of our contracts with our customers and the impact on prior period financial statements, we expect the adoption of ASU

2014

to have a material impact on our consolidated financial statements and related disclosures. Specifically, as disclosed above in our revenue recognition policy, we recognize revenue using the sell-through approach through

March

31,

2017.

Under ASU

2014

we will be required to estimate our sales allowances at the time of sale, resulting in earlier recognition of revenue.