Significant Accounting Policies

Business

Ligand is a biopharmaceutical company with a business model based on developing or acquiring assets which generate royalty, milestone or other passive revenue for the Company and using a lean corporate cost structure. We operate in one business segment: development and licensing of biopharmaceutical assets.

Principles of Consolidation

The accompanying condensed consolidated financial statements include Ligand and its wholly-owned subsidiaries. All significant intercompany accounts and transactions have been eliminated in consolidation.

Basis of Presentation

The Company’s accompanying unaudited condensed consolidated financial statements have been prepared in accordance with GAAP for interim financial information. In the opinion of management, all adjustments (consisting of normal recurring adjustments) considered necessary for a fair presentation of the financial position and results of operations of the Company and its subsidiaries, have been included. Interim financial results are not necessarily indicative of the results that may be expected for the full year. These financial statements should be read in conjunction with the consolidated financial statements and notes therein included in the Company’s annual report on Form 10-K for the year ended December 31, 2015 filed on November 14, 2016.

Upon the occurrence of certain circumstances, holders of the 2019 Convertible Senior Notes may require us to purchase all or a portion of their notes for cash, which may require the use of a substantial amount of cash. If such cash is not available, we may be required to sell other assets or enter into alternate financing arrangements at terms that may or may not be desirable. The existence of the 2019 Convertible Senior Notes and the obligations that we incurred by issuing them may restrict our ability to take advantage of certain future opportunities, such as engaging in future debt or equity financing activities.

Restatement

The Company is restating its previously issued consolidated financial statements as of and for the year ended December 31, 2015 and the condensed consolidated financial statements as of and for the three and nine months ended September 30, 2015 to correct errors relating to the Company's net operating loss (NOL) carryforward benefits in the United States which resulted in an overstatement of deferred tax assets (DTA). In connection with three acquisitions that were completed prior to February 2010, the Company recognized DTAs for a portion of the NOLs, which included capitalized research and development expenses, obtained from the acquired businesses. From the time of the acquisitions until September 2015, there was a full valuation allowance against all of the Company’s NOLs, including those obtained from the entities acquired. In September 2015, the Company concluded that it was more likely than not that a substantial portion of it deferred tax assets would be realized through future taxable income. As a result, the Company released the majority of its DTA valuation allowance, including $27.5 million related to NOLs recognized as part of the businesses acquired prior to February of 2010.

During the quarter ended September 30, 2016, the Company concluded that for accounting purposes the approximately $27.5 million of DTAs that were obtained upon acquiring the businesses prior to February of 2010 did not meet the more likely-than-not criterion for recognition in 2015 and that the related valuation allowance should not have been reversed.

As a result, the Company's income tax benefit and net income for the year ended December 31, 2015 and the three and nine month periods ended September 30, 2015 were overstated by $27.5 million each.

The Company also recorded adjustments to the consolidated financial statements as part of this restatement relating to the classification of our 2019 Convertible Senior Notes. As of December 31, 2015, the Company's last reported sale price exceeded the 130% threshold described in Note 5 - "Financing Arrangements" and accordingly the 2019 Convertible Senior Notes have been reclassified as a current liability as of December 31, 2015. As a result, the related unamortized discount of $39.6 million previously classified within stockholders' equity was reclassified as temporary equity component of currently redeemable convertible notes on our Consolidated Balance Sheet.

The account balances labeled As Reported in the following tables as of December 31, 2015 and as of and for the three and nine months ended September 30, 2015 represent the previously reported amounts as presented in the Company's Annual Report on Form 10-K for the year ended December 31, 2015 and the Quarterly Report on Form 10-Q for the three months ended September 30, 2015, respectively.

The effects of these prior period corrections on the statement of operations and comprehensive income are as follows (in thousands except for per share data):



	Nine months ended September 30, 2015
	As Reported		Adjustments			As Restated
Income tax benefit	$	219,083	$	(27,481	)	$	191,602
Net income	250,964		(27,481		)	223,483
Comprehensive income	251,351		(27,481		)	223,870
Basic earnings per share	12.71		(1.39		)	11.32
Diluted earnings per share data	11.88		(1.30		)	10.58
Basic	19,741		—			19,741
Diluted	21,122		—			21,122



	Three months ended September 30, 2015
	As Reported		Adjustments			As Restated
Income tax benefit (expense)	$	219,362	$	(27,481	)	$	191,881
Net income	226,646		(27,481		)	199,165
Comprehensive income	222,981		(27,481		)	195,500
Basic earnings per share	11.40		(1.39		)	10.01
Diluted earnings per share data	10.56		(1.28		)	9.28

The effects of these prior period corrections on the consolidated balance sheet is as follows:



	As of December 31, 2015
	As Reported			Adjustments			As Restated
Deferred income taxes	$	216,564		$	(27,481	)	$	189,083
Total assets⁽¹⁾	530,542			(27,481		)	503,061
2019 convertible senior notes, net - current	—			201,985			201,985
Total current liabilities	20,836			201,985			222,821
2019 convertible senior notes, net - long term⁽¹⁾	201,985			(201,985		)	—
Equity component of currently redeemable convertible notes (Note 5)	—			39,628			39,628
Additional paid-in capital	701,478			(39,628		)	661,850
Accumulated deficit	(402,010		)	(27,481		)	(429,491		)
Total stockholders' equity	304,391			(67,109		)	237,282
Total liabilities and stockholders' equity⁽¹⁾	530,542			(27,481		)	503,061
(1) $3.4 million of unamortized issuance cost was reclassified to debt discount in the concurrently filed 2015 10-K/A form that it is filed after the Company's retrospective adoption of ASU 2015-03, Interest-Imputation of Interest: Simplifying the Presentation of Debt Issuance Costs in Q1 2016.

The effects of these prior period corrections on the condensed consolidated balance sheet is as follows:



	As of September 30, 2015
	As Reported			Adjustments			As Restated
Deferred income taxes	$	208,530		$	(27,481	)	$	181,049
Total assets	523,807			(27,481		)	496,326
Accumulated deficit	(408,351		)	(27,481		)	(435,832		)
Total stockholders' equity	294,288			(27,481		)	266,807
Total liabilities and stockholders' equity	523,807			(27,481		)	496,326

The corrections did not have any impact on the company's cash flow statements for any period.

Significant Accounting Policies

We describe our significant accounting policies in Note 1 to the financial statements in Item 8 of our Annual Report on Form 10-K for the year ended December 31, 2015. There have been no changes to our significant accounting policies during the first nine months of fiscal 2016.

Use of Estimates

The preparation of condensed consolidated financial statements in conformity with GAAP requires the use of estimates and assumptions that affect the amounts reported in the condensed consolidated financial statements and the accompanying notes. Actual results may differ from those estimates.

Reclassifications

Certain prior period amounts have been reclassified to conform to the current period presentation.

Recent Accounting Pronouncements

During the first quarter of 2016, we adopted a new accounting standard, ASU 2015-03, Interest-Imputation of Interest: Simplifying the Presentation of Debt Issuance Costs that amends the presentation for debt issuance costs. see Note 5 for details.

In May 2014, the Financial Accounting Standards Board (FASB) issued a new accounting standard that amends the guidance for the recognition of revenue from contracts with customers to transfer goods and services. The FASB has subsequently issued additional clarifying standards to address issues arising from implementation of the new revenue recognition standard. The new revenue recognition standard and clarifying standards are effective for interim and annual periods beginning January 1, 2018, and may be adopted earlier, but not before January 1, 2017. The revenue standards are required to be adopted by taking either a full retrospective or a modified retrospective approach. We are currently evaluating the impact that the revenue standards will have on our consolidated financial statements and determining the transition method that we will apply.

In February 2016, the FASB issued a new accounting standard that amends the guidance for the accounting and disclosure of leases. This new standard requires that lessees recognize the assets and liabilities that arise from leases on the balance sheet and disclose qualitative and quantitative information about their leasing arrangements. The new standard is effective for interim and annual periods beginning on January 1, 2019. We are currently evaluating the impact that this new standard will have on our consolidated financial statements.

In March 2016, the FASB issued ASU 2016-09, Compensation – Stock Compensation, which identifies areas for simplification involving several aspects of accounting for stock-based payment transactions, including the income tax consequences, classification of awards as either equity or liabilities, an option to recognize gross stock compensation expense with actual forfeitures recognized as they occur, as well as certain classifications on the statement of cash flows. ASU No. 2016-09 is effective for reporting periods beginning after December 31, 2016. Early adoption is permitted. We are currently assessing the potential impact that the adoption of ASU No. 2016-09 will have in our condensed consolidated financial statements.

In June 2016, the FASB issued ASU No. 2016-13, Financial Instruments - Credit Losses: Measurement of Credit Losses on Financial Instruments which requires that expected credit losses relating to financial assets measured on an amortized cost basis and available-for-sale debt securities be recorded through an allowance for credit losses. ASU 2016-13 limits the amount of credit losses to be recognized for available-for-sale debt securities to the amount by which carrying value exceeds fair value and also requires the reversal of previously recognized credit losses if fair value increases. The new standard will be effective for us on January 1, 2020. Early adoption will be available on January 1, 2019. We are currently evaluating the effect that the updated standard will have on our consolidated financial statements.

In August 2016 the FASB issued ASU No. 2016-15 Statement of Cash Flows (Topic 230), Classification of Certain Cash Receipts and Cash Payments. The guidance addresses the classification of cash flows related to (1) debt prepayment or extinguishment costs, (2) settlement of zero-coupon debt instruments or other debt instruments with coupon rates that are insignificant in relation to the effective interest rate of the borrowing, (3) contingent consideration payments made after a business combination, (4) proceeds from the settlement of insurance claims, (5) proceeds from the settlement of corporate-owned life insurance, including bank-owned life insurance, (6) distributions received from equity method investees and (7) beneficial interests in securitization transactions. The guidance also clarifies how the predominance principle should be applied when cash receipts and cash payments have aspects of more than one class of cash flows. The new guidance will be effective for fiscal years beginning after 15 December 2017, and interim periods within those fiscal years. Early adoption is permitted. We are currently evaluating the effect that the updated standard will have on our consolidated financial statements.

Income (Loss) Per Share

Basic income (loss) per share is calculated by dividing net income by the weighted-average number of common shares outstanding during the period. Diluted income (loss) per share is computed based on the sum of the weighted average number of common shares and potentially dilutive common shares outstanding during the period.

Potentially dilutive common shares consist of shares issuable under 2019 convertible senior notes, stock options and restricted stock. 2019 convertible senior notes have a dilutive impact when the average market price of the Company’s common stock exceeds the applicable conversion price of the respective notes. Potentially dilutive common shares from stock options and restricted stock are determined using the average share price for each period under the treasury stock method. In addition, the following amounts are assumed to be used to repurchase shares: proceeds from exercise of stock options; the average amount of unrecognized compensation expense for restricted stock; and estimated tax benefits that will be recorded in additional paid-in capital when expenses related to equity awards become deductible. In loss periods, basic net loss per share and diluted net loss per share are identical because the otherwise dilutive potential common shares become anti-dilutive and are therefore excluded.

The following table presents the calculation of weighted average shares used to calculate basic and diluted earnings per share (in thousands):



	Three months ended		Nine months ended
	September 30,		September 30,
	2016	2015	2016	2015
Weighted average shares outstanding:	20,886,705	19,886,877	20,805,604	19,741,081
Dilutive potential common shares:
Restricted stock	134,008	63,324	102,282	55,899
Stock options	792,474	763,856	788,106	922,051
2019 convertible senior notes	1,184,092	745,591	1,046,257	402,941
Shares used to compute diluted income per share	22,997,279	21,459,648	22,742,249	21,121,972
Potentially dilutive shares excluded from calculation due to anti-dilutive effect	3,540,806	3,343,719	3,522,063	3,803,007

Subsequent to September 30, 2016, the Company repurchased 20,000 shares of its common stock for $1.9 million in the aggregate.

Cash Equivalents

Cash equivalents consist of all investments with maturities of three months or less from the date of acquisition.

Short-term Investments

Short-term investments primarily consist of investments in debt securities that have effective maturities greater than three months and less than twelve months from the date of acquisition. The Company classifies its short-term investments as "available-for-sale". Such investments are carried at fair value, with unrealized gains and losses included in the statement of comprehensive income (loss). The Company determines the cost of investments based on the specific identification method.

The following table summarizes the various investment categories at September 30, 2016 and December 31, 2015 (in thousands):



	Amortized cost		Gross unrealized gains		Gross unrealized losses			Estimated fair value
September 30, 2016
Short-term investments
Bank deposits	$	11,999	$	9	$	(2	)	$	12,006
Corporate bonds	6,014		31		—			6,045
Commercial paper	13,096		4		(9		)	13,091
Asset backed securities	63		—		—			63
Municipal Bonds	1,778		13		—			1,791
Corporate equity securities	1,578		2,961		—			4,539
	$	34,528	$	3,018	$	(11	)	$	37,535
December 31, 2015
Short-term investments
Bank deposits	$	43,043	$	—	$	(4	)	$	43,039
Corporate bonds	41,238		—		(35		)	41,203
Commercial paper	1,747		—		—			1,747
Asset backed securities	10,020		—		(5		)	10,015
Corporate equity securities	1,843		4,944		—			6,787
	$	97,891	$	4,944	$	(44	)	$	102,791

Inventory

Inventory, which consists of finished goods, is stated at the lower of cost or market value. The Company determines cost using the first-in, first-out method. Inventory levels are analyzed periodically and written down to net realizable value if it has become obsolete, has a cost basis in excess of its expected net realizable value or is in excess of expected requirements. There were no write downs related to obsolete inventory recorded for the three and nine months ended September 30, 2016 and 2015.

Goodwill and Other Identifiable Intangible Assets

Goodwill and other identifiable intangible assets consist of the following (in thousands):



	September 30,			December 31,
	2016			2015
Indefinite lived intangible assets
Acquired IPR&D	$	12,246		$	12,556
Goodwill	72,359			12,238
Definite lived intangible assets
Complete technology	182,577			15,267
Less: Accumulated amortization	(10,465		)	(3,762		)
Trade name	2,642			2,642
Less: Accumulated amortization	(751		)	(652		)
Customer relationships	29,600			29,600
Less: Accumulated amortization	(8,414		)	(7,304		)
Total goodwill and other identifiable intangible assets, net	$	279,794		$	60,585

The Company tests the carrying value of goodwill in accordance with accounting rules on impairment of goodwill, which require that the Company estimate the fair value of the reporting unit annually, or when impairment indicators exist, and compare such amounts to their respective carrying values to determine if an impairment is required. The Company performed its annual assessment for goodwill impairment for the year ended December 31, 2015, noting no impairment.

Commercial License Rights

Commercial License Rights consist of the following (in thousands):



	September 30,			December 31,
	2016			2015
CorMatrix	$	17,696		$	—
Selexis	8,601			8,602
	26,297			8,602
Less: accumulated amortization	(312		)	(48		)
Total commercial rights, net	$	25,985		$	8,554

Commercial license rights represent a portfolio of future milestone and royalty payment rights acquired from Selexis in April 2013 and April 2015 and CorMatrix in May 2016. Individual commercial license rights acquired are carried at allocated cost and approximate fair value. The carrying value of the license rights will be reduced on a pro-rata basis as revenue is realized over the term of the agreement. Declines in the fair value of individual license rights below their carrying value that are deemed to be other than temporary are reflected in earnings in the period such determination is made. As of September 30, 2016, management does not believe there have been any events or circumstances indicating that the carrying amount of its commercial license rights may not be recoverable.

Relationships between the CorMatrix Parties

As previously disclosed in Ligand’s filings, Jason Aryeh is a director of both Ligand and CorMatrix. Mr. Aryeh beneficially owns equity of CorMatrix representing less than 1% of CorMatrix’s outstanding equity. Mr. Aryeh recused himself from all of the board’s consideration of the purchase agreement between the Company and CorMatrix, including any financial analysis, the terms of the purchase agreement and the vote to approve the Purchase Agreement and the related transactions.

Property and Equipment

Property and equipment is stated at cost and consists of the following (in thousands):



	September 30,			December 31,
	2016			2015
Lab and office equipment	$	1,068		$	2,248
Leasehold improvements	1,686			273
Computer equipment and software	568			632
	3,322			3,153
Less accumulated depreciation and amortization	(1,496		)	(2,781		)
Total property and equipment, net	$	1,826		$	372

Depreciation of equipment is computed using the straight-line method over the estimated useful lives of the assets, which range from three to ten years. Leasehold improvements are amortized using the straight-line method over the shorter of the estimated useful lives or the related lease term. Depreciation expense of $0.1 million was recognized for each of the nine months ended September 30, 2016 and 2015, which is included in operating expenses.

Accrued Liabilities

Accrued liabilities consist of the following (in thousands):



	September 30,		December 31,
	2016		2015
Compensation	$	2,150	$	1,711
Professional fees	640		726
Amounts owed to former licensees	980		915
Royalties owed to third parties	1,028		823
Other	1,877		1,222
Total accrued liabilities	$	6,675	$	5,397

Contingent Liabilities

In connection with the Company’s acquisition of CyDex in January 2011, the Company recorded a contingent liability, for amounts potentially due to holders of the CyDex CVRs and former license holders. The liability is periodically assessed based on events and circumstances related to the underlying milestones, royalties and material sales. Any change in fair value is recorded in the Company’s consolidated statement of operations. The carrying amount of the liability may fluctuate significantly and actual amounts paid under the CVR agreements may be materially different than the carrying amount of the liability. The fair value of the liability at September 30, 2016 and December 31, 2015 was $6.7 million and $9.5 million, respectively. The Company recorded a fair-value adjustment to increase the liability by $1.2 million and $1.6 million for the three and nine months ended September 30, 2016, respectively. The Company paid CyDex CVR holders $1.4 million and $4.4 million for the three and nine months ended September 30, 2016. The Company recorded a fair-value adjustment to increase the liability by $0.9 million and $3.1 million for the three and nine months ended September 30, 2015, respectively. The Company paid CyDex CVR holders $0.8 million and $3.9 million during the three and nine months ended September 30, 2015, respectively.

In connection with the Company’s acquisition of Metabasis in January 2010, the Company issued to Metabasis stockholders four tradable CVRs, one CVR from each of four respective series of CVR, for each Metabasis share. The CVRs will entitle Metabasis stockholders to potential cash payments as frequently as every six months as cash is received by the Company from proceeds from the sale or partnering of any of the Metabasis drug development programs, among other triggering events. The fair values of the CVRs are remeasured at each reporting date through the term of the related agreement. Any change in fair value is recorded in the Company’s consolidated statement of operations. The carrying amount of the liability may fluctuate significantly based upon quoted market prices and actual amounts paid under the agreements may be materially different than the carrying amount of the liability. The fair value of the liability was estimated to be $2.3 million and $4.0 million as of September 30, 2016 and December 31, 2015, respectively. The Company recorded a decrease in the liability for Metabasis-related CVRs of $0.2 million and an increase of $1 million for the three and nine months ended September 30, 2016. The Company paid Metabasis CVR holders $2.6 million for the nine months ended September 30, 2016. No payments were made to Metabasis CVR holders for the three months ended September 30, 2016. The Company recorded a decrease in the liability of Metabasis-related CVRs of $3.2 million and an increase of $1.9 million for the three and nine months ended September 30, 2015, respectively. The Company paid Metabasis CVR holders $0.5 million and $0.8 million during the three and nine months ended September 30, 2015.

Stock-Based Compensation

Stock-based compensation expense for awards to employees and non-employee directors is recognized on a straight-line basis over the vesting period until the last tranche vests. The following table summarizes stock-based compensation expense recorded as components of research and development expenses and general and administrative expenses for the periods indicated (in thousands):



	Three months ended				Nine months ended
	September 30,				September 30,
	2016		2015		2016		2015
Stock-based compensation expense as a component of:
Research and development expenses	$	2,845	$	957	$	6,112	$	3,131
General and administrative expenses	2,486		1,879		7,578		6,380
	$	5,331	$	2,836	$	13,690	$	9,511

The fair-value for options that were awarded to employees and directors was estimated at the date of grant using the Black-Scholes option valuation model with the following weighted-average assumptions:



	Three months ended		Nine months ended
	September 30,		September 30,
	2016	2015	2016	2015
Risk-free interest rate	1.3%	2%	1.5%	1.7%-2.0%
Dividend yield	—	—	—	—
Expected volatility	49%	50%	50%	50%-58%
Expected term	6.7	6.5	6.6	6.6
Forfeiture rate	5.0%	8.5%	5.0%	8.5%

Lease Obligations

We describe our operating lease obligations in Note 4 to the financial statements in Item 8 of our Annual Report on Form 10-K for the year ended December 31, 2015. As of December 31, 2015, the Company had lease exit obligations of $0.9 million. As of September 30, 2016, the Company no longer records a lease obligation with respect to it's vacated space expiring in June of 2019 as the sublease proceeds offset the estimated lease exist obligation. There were no other significant changes in our operating lease commitments during the first nine months of 2016.

Convertible Debt

In August 2014, the Company completed a $245.0 million offering of 2019 Convertible Senior Notes, which bear interest at 0.75%. The Company accounted for the 2019 Convertible Senior Notes by separating the liability and equity components of the instrument in a manner that reflects the Company's nonconvertible debt borrowing rate. As a result, the Company assigned a value to the debt component of the 2019 Convertible Senior Notes equal to the estimated fair value of similar debt instruments without the conversion feature, which resulted in the Company recording the debt instrument at a discount. The Company is amortizing the debt discount over the life of the 2019 Convertible Senior Notes as additional non-cash interest expense utilizing the effective interest method.