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

Cash and cash equivalents are held in U.S. banks and consist of liquid investments and money market funds with a maturity from date of purchase of 90 days or less that are readily convertible into cash.

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, 2013 and 2012, respectively. Other financial instruments, including accounts payable and accrued expenses, are carried at cost, which we believe approximates fair value.

Accounts receivable

Trade accounts receivable are recorded net of allowances for prompt payment discounts and doubtful accounts.

Inventory

Inventories, which are recorded at the lower of cost or market, include materials, labor, and other direct and indirect costs and are valued at cost using the first-in, first-out method. The Company capitalizes inventories produced in preparation for commercial launches when the related product candidates receive regulatory approval and that the related costs will be recoverable through the commercial sale of the product. Costs incurred prior to FDA approval of SURFAXIN drug product and registration of our initial AFECTAIR device have been recorded in our statement of operations as research and development expense. Inventory is evaluated for impairment through consideration of factors such as the net realizable value, lower of cost or market, obsolescence, and expiry. Inventories do not have carrying values that exceed either cost or net realizable value.

We evaluate our expiry risk by evaluating current and future product demand relative to product shelf life. We build demand forecasts by considering factors such as, but not limited to, overall market potential, market share, market acceptance and hospital ordering practices.

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.

Restricted cash

Restricted cash consists of a certificate of deposit held by our bank as collateral for a letter of credit in the same notional amount held by our landlord to secure our obligations under our Lease Agreement dated May 26, 2004 and amended January 3, 2013 for our headquarters location in Warrington, Pennsylvania (See, Note 14 – Commitments, for further discussion on our leases). Under terms of the lease agreement, the required restricted cash balance was reduced to $325,000 in October 2013.

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, 2013, 2012, and 2011 as management believes there are no circumstances that indicate the carrying amount of the assets will not be recoverable.

Financing costs related to long-term debt

Costs associated with obtaining long-term debt, including the fair value of warrants issued in connection with the debt and transaction fees, are amortized over the term of the related debt using the effective interest method.

Deferred revenue

Deferred revenue reflects amounts related to SURFAXIN sales to our specialty distributor, which are deferred and recognized as revenue once product has been sold through to the hospital and all revenue recognition criteria have been met.

Product Sales

Revenues from product sales are recognized when (1) persuasive evidence of an arrangement exists, (2) delivery has occurred or services have been rendered, (3) the price is fixed or determinable and (4) collectability is reasonably assured.

Our products are distributed in the U.S. using a specialty distributor. Under this model, the specialty distributor purchases and takes physical delivery and title of product, and then sells to hospitals. We began the commercial introduction of SURFAXIN in the fourth quarter of 2013 and, for that reason, we currently cannot make a reasonable estimate of future product returns when product is delivered to the specialty distributor. Therefore, we currently do not recognize revenue upon product shipment to the specialty distributor, even though the distributor is invoiced upon product shipment. Instead, we recognize revenue once product has been sold through to the hospital and all revenue recognition criteria have been met. Once product has been delivered to the hospital, the risk of material returns is significantly mitigated. As of December 31, 2013, we have deferred revenue recognition on all product sales since the inception of the commercial launch of SURFAXIN in November 2013. We will recognize those revenues at the point in time when all revenue recognition criteria have been met.

We will begin to recognize revenue at the time of shipment of product to our specialty distributor when we can reasonably estimate expected distributor sales deductions and returns. In developing estimates for sales returns, we consider the shelf life of the product, expected demand based on market data and return rates of other surfactant products.

Product sales are recorded net of accruals for estimated chargebacks, discounts, specialty distributor deductions and returns.

Chargebacks. Chargebacks are discounts that occur when contracted customers purchase directly from our specialty distributor. Contracted customers, which currently consist primarily of member hospitals of Group Purchasing Organizations, generally purchase the product at a discounted price. Our specialty distributor, in turn, charges back the difference between the price initially paid by the specialty distributor and the discounted price paid to the specialty distributor by the customer. The allowance for specialty distributor chargebacks is based on known sales to contracted customers.

Sales discounts: Sales discounts are offered to certain contracted customers based upon a customer’s historical volume of surfactant product purchases. Customers must enter into a Letter of Participation (LOP) with us to receive sales discounts. Sales discounts are calculated on a quarterly basis based upon the customer’s quarterly purchases of SURFAXIN, as provided in the LOP. The allowance for sales discounts is based on known sales to contracted customers.

Specialty distributor deductions. Our specialty distributor is offered various forms of consideration including allowances, service fees and prompt payment discounts. Specialty distributor allowances and service fees are provided in our contractual agreement and are generally a percentage of the purchase price paid by the specialty distributor. The specialty distributor is offered a prompt pay discount for payment within a specified period.

Returns. Sales of our products are not subject to a general right of return; however, we will accept product that is damaged or defective when shipped or for expired product up to 6 months subsequent to its expiry date. Product that has been administered to patients is no longer subject to any right of return.

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.

We recognized $0.4 million and $0.2 million of grant revenue for the years ended December 31, 2013 and 2012, respectively, for funds received and expended under a $0.6 million 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 KL4surfactant to mitigate the effects of acute radiation exposure to the lung, including acute pneumonitis and delayed lung injury.

For the year ended December 31, 2011, grant revenue represents funds received and expended under a $0.6 million Fast Track SBIR from the NIH to support the development of aerosolized KL4 surfactant for 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 12 – 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 current liabilities, which are 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, 2013, 2012, and 2011, the number of shares of common stock potentially issuable upon the exercise of certain stock options and warrants was 20.2 million, 11.9 million and 15.4 million shares, respectively. As a result of the 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. We do not have any components of other comprehensive income (loss).

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. 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.

Major customer and concentration of credit risk

We currently sell our products to one exclusive pharmaceutical specialty distributor in the U.S. We periodically assess the financial strength of our specialty distributor and establish allowances for anticipated uncollectible amounts, if necessary. As of December 31, 2013, we have not recorded an allowance for doubtful accounts.

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

The Company did not adopt any new accounting pronouncements during 2013 that had a material effect on the Company’s consolidated financial statements.