Note 3 – Summary of Significant Accounting Policies

Basis of Presentation

The accompanying interim unaudited consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the U.S. for interim financial information in accordance with the instructions to Form10‑Q. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States for complete consolidated financial statements. In the opinion of management, all adjustments (consisting of normally recurring accruals) considered for fair presentation have been included. Operating results for the three and six months ended June 30, 2014 are not necessarily indicative of the results that may be expected for the year ending December 31, 2014. There have been no changes to our critical accounting policies since December 31, 2013. For a discussion of our accounting policies, see, Note 3, “Accounting Policies and Recent Accounting Pronouncements,” to the consolidated financial statements in our 2013 Form 10-K. Readers are encouraged to review those disclosures in conjunction with this Quarterly Report on Form 10-Q.

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. We capitalize inventories produced in preparation for commercial launch when the related product candidates receive regulatory approval and the related costs will be recoverable through the commercial sale of the product. Costs incurred prior to FDA approval of drug products and registration of medical devices are recorded in our statement of operations as research and development expense. Inventories are 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.

Accrued Severance and Retention Costs

A liability for employee severance and retention benefits is recognized when (1) management has committed to a plan of termination; (2) the plan provides sufficient details, such as the employees affected, amounts to be paid, and expected dates of termination and payment; (3) it is unlikely that significant changes to the plan will be made or that the plan will be withdrawn; and (4) the plan has been communicated to employees. The cost of such benefits are accrued over the remaining service period.

In September 2013, we implemented an employee severance and retention plan for employees at our Totowa Facility to minimize employee turnover and encourage employees to remain with us through any potential plant closing. The plan provides for severance for non-union employees and retention bonuses for management. If we succeed in our efforts to secure longer-term utilization of the Totowa Facility, the severance plan and retention bonuses will remain in effect. The total cash amount expected to be paid for severance and retention under this plan through June 2016, assuming a June 2015 plant closing, is approximately $1.1 million. The plan-related expense for the three and six months ended June 30, 2014 was $0.1 million and $0.3 million, respectively, and is included in research and development expense. The related accrued liability is $0.4 million as of June 30, 2014.

In addition, at the Totowa Facility, there are 13 employees who are subject to a collective bargaining agreement under which they would be eligible to receive severance payments if the Totowa Facility were closed. The related accrued liability is $0.4 million as of June 30, 2014.

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 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 a hospital, the risk of material returns is significantly mitigated. 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 Group Purchasing Organizations member hospitals, 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 periodically adjusted on a prospective basis based upon the customer’s 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 six months subsequent to its expiry date. Product that has been administered to patients is no longer subject to any right of return.

Research and development expense

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.

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. Diluted net loss per common share is computed by giving effect to all potentially dilutive securities outstanding for the period. For the quarters ended June 30, 2014 and 2013, the number of shares of common stock potentially issuable upon the exercise of certain stock options and warrants was 20.9 million and 15.8 million shares, respectively.

In accordance with Accounting Standards Codification (ASC) Topic 260, “Earnings per Share,” when calculating diluted net loss per common share, a gain associated with the decrease in the fair value of certain warrants classified as derivative liabilities results in an adjustment to the net loss; and the dilutive impact of the assumed exercise of the warrants results in an adjustment to the weighted average common shares outstanding. We utilize the treasury stock method to calculate the dilutive impact of the assumed exercise of the warrants. For the three and six months ended June 30, 2014 and 2013, the effect of the adjustments for warrants issued in February 2011 was dilutive.

The table below provides information pertaining to the calculation of diluted net loss per common share for the periods presented:

(in thousands)	Three Months Ended June 30,						Six Months Ended June 30,
	2014			2013			2014			2013

Numerator:
Net loss as reported	$	(10,623	)	$	(8,627	)	$	(22,099	)	$	(21,263	)
Less: income from change in fair value of warrant liability		(1,447	)		(2,494	)		(1,820	)		(2,584	)
Numerator for diluted net loss per common share	$	(12,070	)	$	(11,121	)	$	(23,919	)	$	(23,847	)

Denominator:
Basic weighted average common shares outstanding		85,061			49,135			84,766			46,411
Dilutive common shares from assumed warrant exercises		821			731			1,345			1,362
Diluted weighted average common shares outstanding		85,882			49,866			86,111			47,773

As of June 30, 2014 and 2013, 16.4 million and 10.8 million shares of common stock potentially issuable upon the exercise of certain stock options and warrants were excluded from the computation of diluted net loss per common share because their impact would have been anti-dilutive.

We do not have any components of other comprehensive income (loss).

Recent accounting pronouncements

In May 2014, the FASB issued ASU No. 2014-09, Revenue from Contracts with Customers, which requires an entity to recognize revenue at an amount that reflects the consideration to which the entity expects to be entitled in exchange for transferring goods or services to customers. The ASU will replace most existing revenue recognition guidance in U.S. generally accepted accounting principles (GAAP) when it becomes effective. The new standard is effective for us in our fiscal year 2017. Early application is not permitted. We are evaluating the effect that ASU 2014-09 will have on our consolidated financial statements and related disclosures. The standard permits the use of either the retrospective or cumulative effect transition method. We have not yet selected a transition method nor determined the effect of the standard on our financial reporting.