2.	Summary of Significant Accounting Policies

Principles of Consolidation

The accompanying 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

operations and

material assets or liabilities, and there have been

significant transactions related to Heron Therapeutics B.V. since its inception.

Use of Estimates

The preparation of financial statements in conformity with accounting principles generally accepted in the

U.S. 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 greater than

three

months to

one

year. We have classified our short-term investments as available-for-sale securities in the accompanying 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 other 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 other income.

Our bank and investment accounts have been placed under control agreements in accordance with our

Senior Secured Convertible Notes (“Convertible Notes”) and our Subordinated Secured Promissory Note (“

Promissory Note”) (see Note

Fair Value of

Financial Instruments

A company

may

elect to use fair value to measure accounts and loans receivable, available-for-sale and held-to-maturity securities, equity method investments, accounts payable, guarantees and issued debt. Other eligible items includ

e firm commitments for financial instruments that otherwise would

not

be recognized at inception and non-cash warranty obligations where a warrantor is permitted to pay a

third

-party to provide the warranty goods or services. If the use of fair value is elected, any upfront costs and fees related to the item such as debt issuance costs must be recognized in earnings and cannot be deferred. The fair value election is irrevocable and generally made on an instrument-by-instrument basis, even if a company has similar instruments that it elects

not

to measure based on fair value. Unrealized gains and losses on existing items for which fair value has been elected are reported as a cumulative adjustment to beginning retained earnings, and any changes in fair value are recognized in earnings. We have elected to

not

apply the fair value option to our financial assets and liabilities.

Financial instruments, including cash and cash equivalents, receivables,

inventory, prepaid expenses, other current assets, accounts payable and accrued expenses, are carried at cost, which is considered to be representative of their respective fair values because of the short-term maturity of these instruments.

Short-term available-for-sale investments are carried at fair value (see Note

)

. Our Convertible Notes and Promissory Note outstanding at

December

31,

2017

not

have a readily available ascertainable market value, however, the carrying value is considered to approximate its fair value.

Concentration of Credit 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 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

two

customers accounted for

10%

or more of our net product sales for the year ended

December

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 cost of product sales.

Property and Equipment

Property and equipment is stated at cost less accumulated depreciation and amortization. Depreciation is calculated on a

straight-line basis over the estimated useful lives of the assets (generally

five

years). Leasehold improvements are stated at cost and amortized on a straight-line basis over the shorter of the estimated useful life of the asset or the lease term.

Impairment of Long-Lived Assets

If indicators of impairment exist,

we assess the recoverability of the affected long-lived assets by determining whether the carrying value of such assets can be recovered through undiscounted future operating cash flows. If impairment is indicated, we measure the amount of such impairment by comparing the carrying value of the asset to the fair value of the asset and record the impairment as a reduction in the carrying value of the related asset with a corresponding charge to operating expenses. Estimating the undiscounted future operating cash flows associated with long-lived assets requires judgment and assumptions that could differ materially from actual results.

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

December 31, 2017,

product sales of

$2.8

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

Product Sales Allowances

We recognize product sales allowances as a reduction of product sales in the same period the related revenue i

s 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 based on actual purchase levels during the quarterly rebate purchase period.

●

GPO Administrative Fees — We pay administrative fees to GPOs 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 GPOs’ 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 quant

itative 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 judgment 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 materiall

y affect our results of operations and financial position.

The following

table provides a summary of activity with respect to our product returns, distributor fees and GPO fees, rebates and chargebacks for the year ended

December 31, 2017,

which are included in other accrued liabilities on the consolidated balance sheets (in thousands):

	Product Returns			Distributor Fees			GPO Fees, Rebates and Chargebacks			Total

Balance at December 31, 2016	$	49		$	72		$	221		$	342
Provision		473			2,027			16,752			19,252
Payments/credits		(1	)		(1,519	)		(8,755	)		(10,275	)
Balance at December 31, 2017	$	521		$	580		$	8,218		$	9,319

Accrued Clinical Liabilities

We accrue

clinical costs based on work performed, which relies on estimates of the progress of the trials and the related expenses incurred. Clinical trial related contracts vary significantly in duration, and

may

be for a fixed amount, based on the achievement of certain contingent events or deliverables, a variable amount based on actual costs incurred, capped at a certain limit or contain a combination of these elements. Revisions are recorded to research and development expense in the period in which the facts that give rise to the revision become known. Historically, revisions have

not

resulted in material changes to research and development expense; however, a modification in the protocol of a clinical trial or cancellation of a clinical trial could result in a material charge to our results of operations.

Research and Development Expense

All costs of research and development are expensed in the period incurred. Research and development

expense primarily consist of personnel and related costs, stock-based compensation expense, fees paid to outside service providers and consultants, facilities costs and materials used in clinical and preclinical trials and research and development.

Patent Costs

We incur

outside legal fees in connection with filing and maintaining our various patent applications. All patent costs are expensed as incurred and are included in general and administrative expense in the consolidated statements of operations and comprehensive loss.

Stock-Based Compensation Expense

We estimate

the fair value of stock-based payment awards using the Black-Scholes option pricing model. This fair value is then amortized using the straight-line single-option method of attributing the value of stock-based compensation to expense over the requisite service periods of the awards. The Black-Scholes option pricing model requires the input of complex and subjective assumptions, including each option’s expected life and price volatility of the underlying stock.

As stock-based compensation expense is based on awards ultimately expected to vest, it has been reduced for estimated forfeitures. F

orfeitures are estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. Forfeitures are estimated based on historical data.

Warrants

We have issued warrants to purchase shares of our common stock in conjunction with certain equity

financings or in exchange for services. The terms of the warrants were evaluated to determine the appropriate classification as equity or a liability.

Income Taxes

recognize the impact of a tax position in our consolidated financial statements if the position is more likely than

not

to be sustained on examination and on the technical merits of the position. The total amount of unrecognized tax benefits, if recognized, would affect other tax accounts, primarily deferred taxes in future periods, and would

not

affect our effective tax rate, since we maintain a full valuation allowance against our deferred tax assets (see Note

We recognize interest and penalties related to income tax matters in income tax expense.

Comprehensive

Loss

Comprehensive 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 net loss for all periods presented.

Net Loss

per Share

Basic

net loss per share 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 net loss per share is computed by dividing the net loss by the weighted-average number of common shares and common stock equivalents outstanding for the period determined using the treasury stock method. For purposes of this calculation, stock options, warrants and shares of common stock underlying Convertible Notes are considered to be common stock equivalents and are included in the calculation of diluted net loss per share only when their effect is dilutive.

Because we have incurred a net loss for all periods presented in the consolidated statements of

operations and 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):

	December 31 ,
	2017		2016		2015

Stock options outstanding		13,463		11,845		8,435
Warrants outstanding		620		600		3,565
Shares of c ommon stock underlying Convertible Notes outstanding		7,983		7,521		7,087

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; (c) classification on the statement of cash flows; and (d) accounting for forfeitures. 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

resulted 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 payment awards, are now 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 predictable costs of completion, disposal and transportation. Subsequent measurements are unchanged for inventory measured using last-in-

first

-out or the retail inventory method. We adopted the provisions of ASU

2015

in the

first

quarter of

2017.

The adoption did

not

have a material impact on our results of operations or financial condition.

Not

Yet Adopted

May 2017,

FASB issued ASU

No.

2017

09,

Compensation – Stock Compensation (Topic

718

): Scope of Modification Accounting

(“ASU

2017

09”

The amendments in ASU

2017

provide guidance about which changes to the terms or conditions of a stock-based payment award require an entity to apply modification accounting in Topic

718.

The amendments in ASU

2017

are effective for all entities for annual periods, and interim periods within those annual periods, beginning after

December

15,

2017.

Early adoption is permitted, including adoption in any interim period, for (

) public business entities for reporting periods for which financial statements have

not

yet been issued and (

) all other entities for reporting periods for which financial statements have

not

yet been made available for issuance. We plan to adopt the provisions of ASU

2017

in the

first

quarter of

2018.

We do

not

expect the adoption of ASU

2017

to have a material impact on our results of operations or financial condition.

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.

Under the provisions of ASU

2014

09,

we expect the timing of revenue recognition from sales to our Customers to be accelerated. We will recognize revenue at the time of sale to our Customers, net of product sales allowances, which includes product returns. We will adopt ASU

2014

using the modified retrospective approach. Under this approach, incremental disclosures will be provided to present each financial statement line item for

2018

under the prior standard. We are substantially complete with our evaluation of the effect that the adoption of ASU

2014

will have on our consolidated financial statements, and we expect to record a cumulative adjustment to retained earnings of

$1.9

million on

January 1, 2018.

This adjustment reflects the acceleration of

$2.9

million in gross product sales less

$1.0

million in product sales allowances.