Summary of Significant Accounting Policies

Basis of Presentation: The accompanying consolidated financial statements include the accounts of Lexicon and its wholly-owned subsidiaries. Intercompany transactions and balances are eliminated in consolidation.

Use of Estimates: The preparation of financial statements in conformity with U. S. generally accepted accounting principles (“GAAP”) requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the period. Actual results could differ from those estimates.

Cash, Cash Equivalents and Short-Term Investments: Lexicon considers all highly-liquid investments with original maturities of three months or less to be cash equivalents. As of December 31, 2018 and December 31, 2017, short-term investments consist of U.S. treasury bills and corporate debt securities. The Company’s short-term investments are classified as available-for-sale securities and are carried at fair value, based on quoted market prices of the securities. The Company views its available-for-sale securities as available for use in current operations regardless of the stated maturity date of the security. Unrealized gains and losses on such securities are reported as a separate component of stockholders’ equity. Net realized gains and losses, interest and dividends are included in interest income. The cost of securities sold is based on the specific identification method.

Accounts Receivable: Lexicon records trade accounts receivable in the normal course of business related to the sale of products or services. The allowance for doubtful accounts takes into consideration such factors as historical write-offs, the economic climate and other factors that could affect collectibility. Write-offs are evaluated on a case by case basis.

Inventory: Inventories are determined at the lower of cost or market value with cost determined under the specific identification method and may consist of raw materials, work in process and finished goods. Inventory consisted of the following as of December 31, 2018 and 2017 (in thousands):



	As of December 31,
	2018		2017
Raw materials	$	3,564	$	616
Work-in-process	232		149
Finished goods	884		1,183
Total inventory	$	4,680	$	1,948

Concentration of Credit Risk: Lexicon’s cash equivalents, investments and accounts receivable represent potential concentrations of credit risk. The Company attempts to minimize potential concentrations of risk in cash equivalents and investments by placing investments in high-quality financial instruments. The Company’s accounts receivable are unsecured and are concentrated in pharmaceutical and biotechnology companies located in Europe and the United States. The Company has not experienced any significant credit losses to date. In 2018, customers in France and the United States represented 60% and 40% of revenue, respectively. In 2017, customers in France and the United States represented 83% and 17%, respectively. In 2016, customers in France and the United States represented 99% and 1% of revenue, respectively. At December 31, 2018, management believes that the Company has no significant concentrations of credit risk.

Segment Information and Significant Customers: Lexicon operates in one business segment, which primarily focuses on the discovery, development and commercialization of pharmaceutical products for the treatment of human disease. Substantially all of the Company’s revenues have been derived from drug discovery alliances, target validation collaborations for the development and, in some cases, analysis of the physiological effects of genes altered in knockout mice, technology licenses, subscriptions to its databases, product sales, government grants and contracts and compound library sales. In 2018, Sanofi represented 53% of revenues and two independent specialty pharmacies, Biologics, Inc. and Diplomat Pharmacy, represented 25% and 14% of revenues, respectively. In 2017, Sanofi and Ipsen Pharma SAS (“Ipsen”) represented 66% and 18% of revenues, respectively. In 2016, Sanofi represented 90% of revenues.

Other Intangible Assets: Other intangible assets, net consist of in-process research and development acquired in business combinations, which are reported at fair value, less accumulated amortization. Intangible assets with finite lives are amortized using the straight-line method over their estimated useful lives. During 2017, intangible assets relating to XERMELO of $24.7 million were reclassified from indefinite-lived to finite-lived assets following the approval of XERMELO by the FDA. The Company has recorded $1.8 million and $1.5 million in amortization expense related to this asset, which is recorded as cost of sales in the accompanying consolidated statements of comprehensive loss for the years ended December 31, 2018 and 2017, respectively.

Estimated future amortization expense for intangible assets as of December 31, 2018 is as follows:



	For the Year Ending December 31
	(in thousands)
2019	$	1,766
2020	1,766
2021	1,766
2021	1,766
2023	1,766
Thereafter	12,654
	$	21,484

Property and Equipment: Property and equipment that is held and used is carried at cost and depreciated using the straight-line method over the estimated useful life of the assets which ranges from three to 40 years. Maintenance, repairs and minor replacements are charged to expense as incurred. Leasehold improvements are amortized over the shorter of the estimated useful life or the remaining lease term. Significant renewals and betterments are capitalized.

Impairment of Long-Lived Assets: Long-lived assets and certain identifiable intangible assets to be held and used are reviewed for impairment when events or changes in circumstances indicate that the carrying amount of such assets may not be recoverable. Recoverability of assets to be held and used is measured by comparison of the carrying amount of an asset to future net cash flows expected to be generated by the asset. If such assets are considered to be impaired, the impairment to be recognized is measured by the amount that the carrying amount of the assets exceeds the fair value of the assets. Assets to be disposed of are reported at the lower of the carrying amount or fair value less costs to sell. There were no impairments of long-lived assets, including finite-lived intangible assets, in 2018, 2017 or 2016.

Indefinite lived intangible assets are also tested annually for impairment and whenever indicators of impairment are present. When performing the impairment assessment, the Company first assesses qualitative factors to determine whether it is necessary to recalculate the fair value of its intangible assets. If management believes, as a result of the qualitative assessment, that it is more likely than not that the fair value of the intangible assets is less than its carrying amount, the Company calculates the asset’s fair value. If the carrying value of the asset exceeds its fair value, then the intangible asset is written down to its fair value. There were no impairments of indefinite lived intangible assets in 2018, 2017 or 2016.

Goodwill Impairment: Goodwill is not amortized, but is tested at least annually for impairment at the reporting unit level. The Company has determined that the reporting unit is the single operating segment disclosed in its current financial statements. Impairment is the condition that exists when the carrying amount of goodwill exceeds its implied fair value. The first step in the impairment process is to determine the fair value of the reporting unit and then compare it to the carrying value, including goodwill. If the fair value exceeds the carrying value, no further action is required and no impairment loss is recognized. Additional impairment assessments may be performed on an interim basis if the Company encounters events or changes in circumstances that would indicate that, more likely than not, the carrying value of goodwill has been impaired. There was no impairment of goodwill in 2018, 2017 or 2016.

Revenue Recognition:

Product Revenues

Product revenues consist of commercial sales of XERMELO in the United States and sales of bulk tablets of XERMELO to Ipsen. Product revenues are recognized when the customer obtains control of the Company’s product, which occurs upon delivery to the customer. The Company recognizes product revenue net of applicable reserves for variable consideration, including allowances for customer credits, estimated rebates, chargebacks, discounts, returns, distribution service fees, and government rebates, such as Medicare Part D coverage gap reimbursements in the United States, as discussed below. These estimates are based on the most likely amount method for relevant factors such as current contractual and statutory requirements, industry data and forecasted customer buying and payment patterns. Product shipping and handling costs are considered a fulfillment activity when control transfers to the Company’s customers and such costs are included in cost of sales.

Customer Credits: The Company’s specialty pharmacy customers are offered various forms of consideration, including allowances, service fees and prompt payment discounts. The Company expects that the specialty pharmacies will earn prompt payment discounts. As a result, the Company deducts the full amount of those discounts from total product sales when revenues are recognized. Service fees are also deducted from product sales as they are earned.

Rebates: Allowances for rebates include mandated discounts under the Medicaid Drug Rebate Program. Rebate amounts are based upon contractual agreements or legal requirements with public sector (e.g., Medicaid) benefit providers. Rebates are amounts owed after the final dispensing of the product to a benefit plan participant and are based upon contractual agreements or legal requirements with public sector benefit providers. The allowance for rebates is based on statutory discount rates and expected utilization. The Company’s estimates for expected utilization of rebates are based on third party market research data and data received from the specialty pharmacies. Rebates are generally invoiced and paid in arrears so that the accrual balance consists of an estimate of the amount expected to be incurred for the current quarter’s activity, plus an accrual balance for known unpaid rebates from the prior quarter. If actual future rebates vary from estimates, the Company may need to adjust prior period accruals, which would affect revenue in the period of adjustment.

Chargebacks: Chargebacks are discounts that occur when contracted customers purchase directly from a specialty pharmacy. Contracted customers, which currently consist primarily of Public Health Service Institutions, non-profit clinics, and federal government entities purchasing via the Federal Supply Schedule, generally purchase the product at a discounted price. The specialty pharmacies, in turn, charge back to Lexicon the difference between the price initially paid by the specialty pharmacies and the discounted price paid to the specialty pharmacies by the customer. The allowance for chargeback is based on known sales to contracted customers.

Medicare Part D Coverage Gap: The Medicare Part D prescription drug benefit mandates manufacturers to fund 50% of the Medicare Part D insurance coverage gap for prescription drugs sold to eligible patients. The Company’s estimates for the expected Medicare Part D coverage gap are based on data received from the specialty pharmacies. Funding of the coverage gap is generally invoiced and paid in arrears so that the accrual balance consists of an estimate of the amount expected to be incurred for the current quarter’s activity, plus an accrual balance for known prior quarters. If actual future funding varies from estimates, the Company may need to adjust prior period accruals, which would affect revenues in the period of adjustment.

Co-payment assistance: Patients who have commercial insurance and meet certain eligibility requirements may receive co-payment assistance. The Company accrues a liability for co-payment assistance based on actual program participation and estimates of program redemption using data provided by third-party administrators.

Collaborative Agreements

Revenues under collaborative agreements include both license revenue and contract research revenue. The Company performs the following five steps in determining the amount of revenue to recognize as it fulfills its performance obligations under each of its agreements: (i) identify the contract(s) with a customer; (ii) identify the performance obligation in the contract; (iii) determine the transaction price; (iv) allocate the transaction price to the performance obligation in the contract, and (v) recognize revenue when (or as) the Company satisfies the performance obligation. The Company applies this five-step model to contracts when it is probable that the Company will collect the consideration it is entitled to in exchange for the goods or services it transfers to the customer. At contract inception, the Company assesses the goods or services promised within each contract and determines those that are performance obligations, and assesses whether each promised good or service is distinct. The Company then recognizes as revenue the amount of the transaction price that is allocated to the respective performance obligation when (or as) the performance obligation is satisfied. The Company develops assumptions that require judgment to determine the stand-alone selling price for each performance obligation identified in the contract.

At contract inception, the Company evaluates whether development milestones are considered probable of being reached and estimates the amount to be included in the transaction price using the most likely amount method. If it is probable that a significant revenue reversal will not occur, the associated development milestone value is included in the transaction price. Development milestones that are not within the control of the Company or the licensee, including those requiring regulatory approval, are not considered probable of being achieved until those approvals are received. The transaction price is allocated to each performance obligation on a relative stand-alone selling price basis, for which the Company recognizes revenue when (or as) the performance obligation is satisfied. At the end of each reporting period, the Company re-evaluates the probability of achievement of the development milestones and any related constraint, and if necessary, adjusts its estimates of the overall transaction price. Any such adjustments are recorded on a cumulative catch-up basis, which would affect collaboration revenues in the period of adjustment.

In agreements in which a license to the Company’s intellectual property is determined distinct from other performance obligations identified in the agreement, the Company recognizes revenue when the license is transferred to the licensee and the licensee is able to use and benefit from the license.

For agreements that include sales-based royalties, including milestones based on a level of sales, the license is deemed to be the predominant item to which the royalties relate, the Company recognizes revenue at the later of (i) when the related sales occur, or (ii) when the performance obligation to which some or all of the royalty has been allocated has been satisfied (or partially satisfied).

The Company may receive payments from its licensees based on billing schedules established in each contract. Up-front payments and fees are recorded as deferred revenue upon receipt or when due, and may require deferral of revenue recognition to a future period until the Company performs its obligations under these agreements. Amounts are recorded as accounts receivable when the Company’s right to consideration is unconditional.

Cost of Sales: Cost of sales consists of third-party manufacturing costs, freight and indirect overhead costs associated with sales of XERMELO. The Company began capitalizing inventory during 2017 once the FDA approved XERMELO as the related costs were expected to be recoverable through the commercialization of the product. Costs incurred prior to approval of XERMELO have been recorded as research and development expense in the consolidated statements of comprehensive loss. As a result, cost of sales for approximately the next eighteen months will reflect a lower average per unit cost of materials. Product shipping and handling costs are included in cost of sales. Cost of sales also includes the amortization of the in-process research and development intangible asset for XERMELO using the straight-line method over the estimated useful life of 14 years.

Research and Development Expenses: Research and development expenses consist of costs incurred for company-sponsored as well as collaborative research and development activities. These costs include direct and research-related overhead expenses and are expensed as incurred. Technology license fees for technologies that are utilized in research and development and have no alternative future use are expensed when incurred. Substantial portions of the Company’s preclinical and clinical trials are performed by third-party laboratories, medical centers, contract research organizations and other vendors. For preclinical studies, the Company accrues expenses based upon estimated percentage of work completed and the contract milestones remaining. For clinical studies, expenses are accrued based upon the number of patients enrolled and the duration of the study. The Company monitors patient enrollment, the progress of clinical studies and related activities to the extent possible through internal reviews of data reported to the Company by the vendors and clinical site visits. The Company’s estimates depend on the timeliness and accuracy of the data provided by the vendors regarding the status of each program and total program spending. The Company periodically evaluates the estimates to determine if adjustments are necessary or appropriate based on information it receives.

Stock-Based Compensation: The Company recognizes compensation expense in its statements of comprehensive loss for share-based payments, including stock options and restricted stock units issued to employees, based on their fair values on the date of the grant, with the compensation expense recognized over the period in which an employee is required to provide service in exchange for the stock award. Stock-based compensation expense for awards without performance conditions is recognized on a straight-line basis. Stock-based compensation expense for awards with performance conditions is recognized over the period from the date the performance condition is determined to be probable of occurring through the time the applicable condition is met. As of December 31, 2018, stock-based compensation cost for all outstanding unvested options and restricted stock units was $22.3 million, which is expected to be recognized over a weighted-average period of 1.2 years.

The fair value of stock options is estimated at the date of grant using the Black-Scholes method. The Black-Scholes option-pricing model requires the input of subjective assumptions. Because the Company’s employee stock options have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, in management’s opinion, the existing models do not necessarily provide a reliable single measure of the fair value of its employee stock options. For purposes of determining the fair value of stock options, the Company segregates its options into two homogeneous groups, based on exercise and post-vesting employment termination behaviors, resulting in different assumptions used for expected option lives. Historical data is used to estimate the expected option life for each group. Expected volatility is based on the historical volatility in the Company’s stock price. The following weighted-average assumptions were used for options granted in the years ended December 31, 2018, 2017 and 2016, respectively:



	Expected Volatility	Risk-free Interest Rate	Expected Term	Dividend Rate
December 31, 2018:
Employees	58%	2.6%	4	0	%
Officers and non-employee directors	63%	2.8%	8	0	%
December 31, 2017:
Employees	61%	1.7%	4	0	%
Officers and non-employee directors	70%	2.2%	8	0	%
December 31, 2016:
Employees	63%	1.1%	4	0	%
Officers and non-employee directors	83%	1.6%	8	0	%

Net Loss per Common Share: Net loss per common share is computed using the weighted average number of shares of common stock outstanding. Shares associated with convertible debt, stock options and restricted stock units are not included because they are antidilutive.

Correction of errors in previously reported consolidated financial statements: During the year ended December 31, 2018, the Company identified errors in its previously issued financial statements for the interim and annual periods prior to the quarter ended December 31, 2018 related to the recognition of research and development expense and accrued liabilities for its inTandem1, inTandem2 and inTandem3 clinical trials of sotagliflozin. The Company recognized research and development expense based on its estimates of clinical trial costs, but in 2018 the Company determined that the design of controls were not sufficiently precise to prevent the overstatement of estimated pass-through costs recorded in the clinical trial expense accrual. In December 2018, the Company was notified by the third party vendor performing such clinical trials that the aggregate pass-through costs payable by the Company with respect to such clinical trials would be $19.0 million less than previously estimated. As a result, the Company’s accruals of expenses for such clinical trials were overstated by such amount.

The Company assessed the materiality of these errors in accordance with the Securities and Exchange Commission Staff Accounting Bulletins No. 99, Materiality and No. 108, Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements (“SAB 108”), using both the rollover method and the iron curtain method, as defined in SAB 108. The Company concluded that the errors, including other adjustments discussed below, were immaterial to prior years but, if corrected in the current year, would have been material to the current year. Under SAB 108, such prior year misstatements must be corrected by adjusting the prior year financial statements if such corrections would be material to the current year if made in the current year. Correcting prior year financial statements for such immaterial misstatements does not require previously filed reports to be amended.

In addition to the adjustments related to research and development expense and accrued liabilities for the inTandem1, inTandem2 and inTandem3 clinical trials, the Company recorded other adjustments related to the years ended December 31, 2016 and 2015 and the quarterly periods in the nine months ended September 30, 2016 to correct for immaterial errors related to research and development and selling, general and administrative expense. These other adjustments were not previously recorded in the appropriate periods, as the Company concluded that they were immaterial to its previously issued consolidated financial statements.

For the years ended December 31, 2017 and 2016, correction of these errors decreased the Company’s net loss by $6.1 million and $10.0 million, respectively. The cumulative effect of those adjustments increased previously reported retained earnings by $16.1 million, which included an adjustment of $0.1 million to the opening balance at December 31, 2016. The Company also corrected its financial statements for each of the interim periods in the years ended December 31, 2018 and 2017. See Note 15, Selected Quarterly Financial Data (Unaudited).

The effects of the corrections of the errors on the Company’s consolidated statements of comprehensive loss and balance sheets are presented in the tables below. The corrections of the errors had no effect on the previously reported total amounts of operating, investing, and financing cash flows on the Company’s consolidated statements of cash flows.



	Years ended December 31,
	2017									2016
	Previously reported			Adjustments			As adjusted			Previously reported			Adjustments			As adjusted
Revenues:
Net product revenue	$	15,890		$	—		$	15,890		$	—		$	—		$	—
Collaborative agreements	74,267			1,354			75,621			83,182			(4,081		)	79,101
Royalties and other revenue	178			—			178			155			—			155
Total revenues	90,335			1,354			91,689			83,337			(4,081		)	79,256
Operating expenses:
Cost of sales (including finite-lived intangible asset amortization)	1,899			—			1,899			—			—			—
Research and development, including stock-based compensation of $4,905 and $3,938, respectively	156,813			(4,590		)	152,223			178,151			(14,178		)	163,973
Increase (decrease) in fair value of Symphony Icon, Inc. purchase liability	2,101			—			2,101			(703		)	—			(703		)
Selling, general and administrative, including stock-based compensation of $4,567 and $3,514, respectively	66,203			(113		)	66,090			43,044			113			43,157
Total operating expenses	227,016			(4,703		)	222,313			220,492			(14,065		)	206,427
Loss from operations	(136,681		)	6,057			(130,624		)	(137,155		)	9,984			(127,171		)
Interest expense	(6,984		)	—			(6,984		)	(6,567		)	—			(6,567		)
Interest and other income, net	1,954			—			1,954			2,293			—			2,293
Net loss before taxes	(141,711		)	6,057			(135,654		)	(141,429		)	9,984			(131,445		)
Income tax benefit	12,661			—			12,661			—			—			—
Net loss	$	(129,050	)	$	6,057		$	(122,993	)	$	(141,429	)	$	9,984		$	(131,445	)
Net loss per common share, basic and diluted	$	(1.23	)	$	0.06		$	(1.17	)	$	(1.36	)	$	0.09		$	(1.27	)
Shares used in computing net loss per common share, basic and diluted	105,237						105,237			103,863						103,863



	December 31, 2017
	Previously reported			Adjustment			As revised
Assets
Current assets:
Cash and cash equivalents	$	61,661		$	—		$	61,661
Short-term investments	249,127			—			249,127
Accounts receivable, net of allowances of $4	4,825			—			4,825
Inventory	1,948			—			1,948
Prepaid expenses and other current assets	4,434			—			4,434
Total current assets	321,995			—			321,995
Property and equipment, net of accumulated depreciation and amortization of $58,623	17,687			—			17,687
Goodwill	44,543			—			44,543
Other intangible assets	51,885			—			51,885
Other assets	429			—			429
Total assets	$	436,539		$	—		$	436,539
Liabilities and Equity
Current liabilities:
Accounts payable	$	57,652		$	(18,890	)	$	38,762
Accrued liabilities	12,282			—			12,282
Current portion of deferred revenue	40,099			252			40,351
Current portion of long-term debt, net of deferred financing costs	14,094			—			14,094
Total current liabilities	124,127			(18,638		)	105,489
Deferred revenue, net of current portion	22,428			2,475			24,903
Long-term debt, net of deferred financing costs	231,576			—			231,576
Deferred tax liabilities	6,014			—			6,014
Other long-term liabilities	292			—			292
Total liabilities	384,437			(16,163		)	368,274

Commitments and contingencies
Equity:
Preferred stock, $.01 par value; 5,000 shares authorized; no shares issued and outstanding	—			_—			—
Common stock, $.001 par value; 225,000 shares authorized; 105,711 shares issued	106			_—			106
Additional paid-in capital	1,435,526			_—			1,435,526
Accumulated deficit	(1,381,404		)	16,163			(1,365,241		)
Accumulated other comprehensive loss	(222		)	—			(222		)
Treasury stock, at cost, 122 shares, respectively	(1,904		)	—			(1,904		)
Total (deficit) equity	52,102			16,163			68,265
Total liabilities and (deficit) equity	$	436,539		$	—		$	436,539