ARENA PHARMACEUTICALS You should read the following discussion and analysis in conjunction with "Item 8. Financial Statements and Supplementary Data" included below in this Annual Report on Form 10-K, or Annual Report. Operating results are not necessarily indicative of results that may occur in future periods.
This discussion and analysis contains forward-looking statements that involve a number of risks, uncertainties and assumptions. Actual events or results may differ materially from our expectations. Important factors that could cause actual results to differ materially from those stated or implied by our forward-looking statements include, but are not limited to, those set forth in "Item 1A. Risk Factors" in this Annual Report. All forward-looking statements included in this Annual Report are based on information available to us as of the time we file this Annual Report and, except as required by law, we undertake no obligation to update publicly or revise any forward-looking statements. In addition, statements that "we believe" and similar statements reflect our beliefs and opinions on the relevant subject. These statements are based upon information available to us as of the date of this Annual Report, and while we believe such information forms a reasonable basis for such statements, such information may be limited or incomplete, and our statements should not be read to indicate that we have conducted an exhaustive inquiry into, or review of, all potentially available relevant information. These statements are inherently uncertain.
OVERVIEW AND RECENT DEVELOPMENTS
We are a biopharmaceutical company focused on delivering novel, transformational medicines with optimized pharmacology and pharmacokinetics to patients globally. Our internally-developed pipeline includes multiple potentially first- or best-in-class assets with broad clinical utility.
Our most advanced investigational clinical programs include:
• Etrasimod, which we are evaluating in a Phase 3 program for ulcerative
colitis, or UC, a Phase 2b/3 program for Crohn's disease, or CD, and a
Phase 2b program in atopic dermatitis, or AD. We also plan to evaluate
etrasimod in a Phase 2b program for eosinophilic esophagitis, or EOE, and
a Phase 2 program in alopecia areata, or AA.
• Olorinab, which we are evaluating for a broad range of visceral pain
conditions associated with gastrointestinal diseases and is currently in
a Phase 2b trial for treatment of abdominal pain associated with
irritable bowel syndrome, or IBS.
• APD418, which we are evaluating in a Phase 1 trial for acute heart
failure, or AHF.
We continue to leverage our two decades of world-class G-protein-coupled
receptor, or GPCR, target discovery research to develop breakthrough drugs and
ultimately deliver these to patients with large unmet needs. Our long-term
pipeline prospects include an enhanced collaboration with Beacon Discovery
across a broad range of immune-mediated inflammatory targets and compounds and
the buildout of Arena Neuroscience to focus on treating neurological conditions
with microglial neuroinflammation.
We have license agreements or collaborations with various companies, including:
• United Therapeutics (ralinepag in a Phase 3 program for pulmonary
arterial hypertension),
• Everest Medicines Limited (etrasimod in Greater China and select
countries in Asia ),
• Beacon Discovery (early research platform for GPCR targets),
• Boehringer Ingelheim International GmbH (undisclosed orphan GPCR program
for central nervous system - preclinical), and
• Eisai Co., Ltd. and
Program development update.
In
InDecember 2019 , we initiated our Phase 2/3 program to evaluate etrasimod in Crohn's disease. The program consists of a Phase 2 dose ranging trial that is intended to provide an operationally seamless transition into the Phase 3. CULTIVATE is a Phase 2b dose-ranging multicenter, randomized, double-blinded, placebo-controlled study to assess the safety and efficacy of once-daily etrasimod in subjects with moderate to severely active Crohn's disease. The primary efficacy endpoint in the CULTIVATE trial will be endoscopic response at Week 14, in addition to a variety of scales of Crohn's disease activity, including abdominal pain and stool 48 --------------------------------------------------------------------------------
frequency. The CULTIVATE trial aims to enroll approximately 225 patients in study sites globally. The Phase 3 will include two induction trials with re-randomization of clinical responders into a single maintenance trial.
InOctober 2019 , we announced that the first subject has been dosed in the Phase 2 ADVISE trial evaluating two dose levels etrasimod in development for the treatment of AD. ADVISE is a multicenter, randomized, double-blinded, placebo-controlled 16-week study (with a 52-week open-label extension) to assess the safety and efficacy of once-daily etrasimod in approximately 120 subjects with moderate-to-severe AD. InJuly 2019 , we announced the first subject dosed in the Phase 2 CAPTIVATE trial evaluating olorinab in development for the treatment of visceral pain associated with IBS. The trial will evaluate the efficacy and safety of three dose levels of olorinab for 12-weeks in approximately 240 subjects experiencing abdominal pain associated with IBS, including IBS with constipation or IBS with diarrhea. CAPTIVATE is a Phase 2, multi-center, randomized, double-blind, placebo-controlled, 12-week study. We expect data in the second half of 2020. InJune 2019 , we announced that the first subject has been dosed in ELEVATE UC 52, the first of two planned pivotal trials within the Phase 3 ELEVATE UC registrational program evaluating etrasimod 2 mg in subjects with moderately to severely active ulcerative colitis. ELEVATE UC 52 is a treat-through trial with a 12-week induction period followed by 40 weeks of maintenance.
Collaborations and license agreement update.
In
Other corporate events.
In
In general, developing drugs and obtaining marketing approval is a long, uncertain and expensive process, and our ability to execute on our plans and achieve our goals depends on numerous factors, many of which we do not control. To date, we have generated limited revenues. We expect to continue to incur substantial net losses for at least the short term as we advance our clinical development programs and support our collaborators.
See the above "Business" section for a more complete discussion of our business.
RESULTS OF OPERATIONS
We are providing the following summary of our revenues, research and development expenses and general and administrative expenses to supplement the more detailed discussion below. This summary excludes our revenues, research and development expenses and general and administrative expenses associated with our Manufacturing Operations, which are reported within loss from discontinued operations for the year endedDecember 31, 2018 . See Note 5 to our consolidated financial statements included in this Annual Report for additional information regarding the Manufacturing Operations. The dollar values in the following tables are in millions. For our discussion of the year endedDecember 31, 2018 , compared to the year endedDecember 31, 2017 , please read Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations located in our 2018 Form 10-K.
Research and development expenses
Years ended December 31 , % change from
Type of expense 2019
2018 2018 to 2019
External clinical and preclinical study fees
*
Salary and other personnel costs (excluding
non-cash
share-based compensation) 48.3 28.4 69.9 %
Non-cash share-based compensation 27.4 8.4 *
Facility and equipment costs 6.2 5.2 20.3 %
Other 8.5 3.3 *
Total research and development expenses
*
49
--------------------------------------------------------------------------------* The change is more than 100%.
General and administrative expenses
Years ended December 31, % change from
Type of expense 2019 2018 2018 to 2019
Non-cash share-based compensation $ 25.7 $ 11.2 *
Legal, accounting and other professional fees 21.8 14.4 52.1 %
Salary and other personnel costs (excluding
non-cash
share-based compensation) 20.8 13.3 56.1 %
Facility and equipment costs 5.9 4.5 29.3 %
Other 3.4 1.9 82.2 %
Total general and administrative expenses
71.5 %
* The change is more than 100%.
YEAR ENDED
Revenues. We recognized revenues of$806.4 million for the year endedDecember 31, 2019 , compared to$18.0 million for the year endedDecember 31, 2018 . This increase resulted primarily from the revenue associated with the upfront payment of$800.0 million we received inJanuary 2019 pursuant to the collaboration and license agreement with United Therapeutics. In connection with the United Therapeutics transaction we incurred transaction expenses of$17.0 million , consisting of$14.6 million incurred in the first quarter of 2019 and$2.4 million incurred in the fourth quarter of 2018, which are presented as transaction costs in our consolidated statements of operations.
Absent any new collaborations, we expect our 2020 revenues will primarily consist of potential milestone payments from our existing collaborations and license agreements.
Revenues from milestones and royalties are difficult to predict, and our overall revenues will likely continue to vary from quarter to quarter and year to year. In the short term, we expect the amount of revenue we earn to fluctuate. Research and development expenses. Research and development expenses, which account for the majority of our expenses, consist primarily of clinical trial costs (including payments to contract research organizations, or CROs), salaries and other personnel costs, preclinical study fees, manufacturing costs for non-commercial products, research supply costs and facility and equipment costs. We expense research and development costs as they are incurred when these expenditures have no alternative future uses. We generally do not track our earlier-stage, internal research and development expenses by project; rather, we track such expenses by the type of cost incurred. Research and development expenses increased by$116.5 million to$231.5 million for the year endedDecember 31, 2019 , from$115.0 million for the year endedDecember 31, 2018 . This increase was primarily due to an increase of$71.4 million in external clinical and preclinical study fees,$19.9 million in salary and other personnel costs, and$19.0 million in non-cash share-based compensation expense. The increases in compensation costs are primarily due to an increase in the number of research and development employees, and an incremental expense associated with performance-based restricted stock units granted in the first quarter of 2019, which is reflected in the non-cash share-based compensation expense. We expect to incur substantial research and development expenses in 2020 and for the aggregate amount in 2020 to be greater than the amount incurred in 2019. We expect our internal costs to be higher primarily due to higher external clinical trial costs and increasing headcount in connection with advancing the etrasimod and olorinab programs. Our actual expenses may be higher or lower than anticipated due to various factors, including our progress and results. For example, patient enrollment in our Phase 3 clinical program for etrasimod is expected to be competitive and challenging, and could take longer than originally projected, which may result in our related external expenses being lower in 2020 than anticipated (but which might increase the overall costs for completing this multi-year program). 50 -------------------------------------------------------------------------------- Included in the$141.1 million of total external clinical and preclinical study fees noted in the table above in this section for the year endedDecember 31, 2019 , were the following: •$108.6 million related to etrasimod, and •$17.8 million related to olorinab. Included in the$69.7 million of total external clinical and preclinical study fees noted in the table above in this section for the year endedDecember 31, 2018 , were the following: •$31.4 million related to ralinepag, •$25.7 million related to etrasimod, and •$3.9 million related to olorinab. Cumulatively from our inception throughDecember 31, 2019 , we have recognized (i) external clinical and preclinical study fees of$307.8 million for lorcaserin,$196.5 million for etrasimod,$63.5 million for ralinepag,$43.8 million for nelotanserin and$31.9 million for olorinab and (ii)$53.2 million for non-commercial manufacturing and other development costs for lorcaserin and, to a lesser extent, nelotanserin. While expenditures on current and future clinical development programs are expected to be substantial, they are subject to many uncertainties, including whether we have adequate funds and develop our drug candidates with one or more collaborators or independently. As a result of such uncertainties, we cannot predict with any significant degree of certainty the duration and completion costs of our research and development projects or whether, when and to what extent we will generate revenues from the commercialization and sale of any of our drug candidates. The duration and cost of clinical trials may vary significantly over the life of a project as a result of unanticipated events arising during clinical development and a variety of factors, including: • the nature and number of trials and studies in a clinical program; • the potential therapeutic indication; • the number of patients who participate in the trials; • the number and location of sites included in the trials; • the rates of patient recruitment, enrollment and withdrawal; • the duration of patient treatment and follow-up; • the costs of manufacturing drug candidates; and
• the costs, requirements, timing of, and the ability to secure and maintain
regulatory approvals.
General and administrative expenses. General and administrative expenses increased by$32.3 million to$77.6 million for the year endedDecember 31, 2019 , from$45.3 million for the year endedDecember 31, 2018 . This increase was primarily due to increases of$14.5 million in non-cash share-based compensation expenses,$7.5 million in salary and other personnel costs, and$7.4 million in legal, accounting and other professional fees. The increases in compensation costs are primarily due to an increase in the number of general and administrative employees, and an incremental expense associated with performance-based restricted stock units granted in the first quarter of 2019, which is reflected in the non-cash share-based compensation expense. We expect that our 2020 general and administrative expenses will be higher than in 2019. Interest and other income (expense), net. Interest and other income, net, was$25.1 million for the year endedDecember 31, 2019 , compared to$5.9 million for the year endedDecember 31, 2018 . This change was primarily due to an increase of$18.1 million in interest income from our available-for-sale investments activity and a decrease of$0.9 million in interest expense. Income tax expense. Income tax provision was$110.3 million for the year endedDecember 31, 2019 , as a result of the treatment of the agreement with United Therapeutics income as a discrete item during the first quarter of 2019 and the utilization of the deferred tax assets that were recorded in the fourth quarter of 2018.
LIQUIDITY AND CAPITAL RESOURCES
We have accumulated a large deficit since inception that has primarily resulted
from the significant research and development expenditures we have made in
seeking to identify and develop compounds that could become marketed drugs. We
expect to continue to incur substantial losses for at least the short term.
51
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To date, we have obtained cash and funded our operations primarily through the
sale of common and preferred stock, the issuance of debt and related financial
instruments, payments from collaborators and customers and sale leaseback
transactions. From our inception through December 31, 2019 , we have generated
$3.5 billion in cash from these sources, of which approximately $2.0 billion was
through sales of equity, $1.4 billion was through payments from collaborators
and customers, $96.9 million was through the issuance of debt and related
financial instruments and $77.1 million was from sale and leaseback
transactions.
We believe our cash resources are sufficient to allow us to continue operations
for at least the next 12 months from the date this Annual Report is filed with
the SEC . There is no guarantee that adequate funds will be available when needed
from additional debt or equity financing, development and commercialization
partnerships or from other sources, or on terms acceptable to us. If our efforts
to obtain sufficient additional funds are not successful, we would be required
to delay, scale back, or eliminate some or all of our research or development,
manufacturing operations, administrative operations, and clinical or regulatory
activities, which could negatively affect our ability to achieve certain
corporate goals.
Short term liquidity
AtDecember 31, 2019 , we had$1.1 billion in cash and cash equivalents, and available-for-sale investments. Our potential sources of liquidity in the short term include (i) milestone and other payments from collaborators, (ii) entering into new collaboration, licensing or commercial agreements for one or more of our drug candidates or programs, (iii) the lease of our facilities or sale of other assets and (iv) sale of equity, issuance of debt or other transactions.
Long term liquidity
It will require substantial cash to achieve our objectives of discovering, developing and commercializing drugs, and this process typically takes many years and potentially several hundreds of millions of dollars for an individual drug. We may not have adequate available cash, or assets that could be readily turned into cash, to meet these objectives in the long term. We will need to obtain significant funds under our existing collaborations, under new collaboration, licensing or other commercial agreements for one or more of our drug candidates and programs or patent portfolios, or from other potential sources of liquidity, which may include the sale of equity, issuance of debt or other transactions. In addition to potential payments from our current collaborators, as well as funds from public and private financial markets, potential sources of liquidity in the long term include (i) upfront, milestone, royalty and other payments from any future collaborators or licensees and (ii) revenues from sales of any drugs we obtain regulatory approval to commercialize on our own. The length of time that our current cash and cash equivalents and any available borrowings will sustain our operations will be based on, among other things, the rate of adoption and commercial success of any drugs we or our collaborators obtain regulatory approval to market, regulatory decisions affecting our and our collaborator's drug candidates, prioritization decisions regarding funding for our programs, progress in our clinical and earlier-stage programs, the time and costs related to current and future clinical trials and nonclinical studies, our research, development, manufacturing and commercialization costs (including personnel costs), our progress in any programs under collaborations, costs associated with intellectual property, our capital expenditures, and costs associated with securing any in-licensing opportunities. Any significant shortfall in funding may result in us reducing our development and/or research activities, which, in turn, would affect our development pipeline and ability to obtain cash in the future. We evaluate from time to time potential acquisitions, in-licensing and other opportunities. Any such transaction may impact our liquidity as well as affect our expenses if, for example, our operating expenses increase as a result of such acquisition or license or we use our cash to finance the acquisition or license. Sources and uses of our cash Net cash provided in operating activities was$568.7 million in the year endedDecember 31, 2019 , compared to net cash used in operating activities of$132.2 million in the year endedDecember 31, 2018 . This increase was primarily the result of an$800.0 million upfront payment from United Therapeutics received in 2019, partially offset by an increase of$66.0 million in payments made for external clinical study fees, an increase in cash expenditures of approximately$24.4 million for personnel costs resulting primarily from an increase in the number of employees, a payment of$14.6 million for the expenses related to the United Therapeutics transaction in the first quarter of 2019, reduced by a class action litigation settlement payment of$12.0 million in the second quarter of 2018. Net cash used in investing activities increased by$245.6 million to$496.9 million in the year endedDecember 31, 2019 , compared to$251.3 million in the year endedDecember 31, 2018 . This increase was primarily due to$493.1 million in net purchases of available-for-sale investments, net of proceeds from the sales and maturity of available-for-sale investments in the year endedDecember 31, 2019 , compared to$254.0 million in net purchases of available-for-sale investments in the year endedDecember 31, 2018 . 52 -------------------------------------------------------------------------------- Net cash of$9.9 million was provided by financing activities in the year endedDecember 31, 2019 , as a result of net proceeds of$13.1 million from stock option exercises and stock award releases, partially offset by$3.3 million of principal payments on our lease financing obligations. Net cash of$385.0 million was provided by financing activities in the year endedDecember 31, 2018 , as a result of net proceeds of$383.1 million from ourMarch 2018 offering of our common stock and net proceeds of$5.9 million from stock option exercises, partially offset by$4.0 million of principal payments on our lease financing obligations. Contractual Obligations The following table summarizes our contractual obligations atDecember 31, 2019 , in thousands: Payments due by period Less than 1 1-3 3-5 More than 5 Contractual Obligations Total year years years years Financing obligations$ 65,650 $ 7,576 $ 17,133 $ 18,000 $ 22,941 Operating leases 16,804 2,236 5,037 4,864 4,667 Total$ 82,454 $ 9,812 $ 22,170 $ 22,864 $ 27,608 Our financing obligations relate to sale and leaseback transactions for certain of our properties. We have applied the financing method to these sale and leaseback transactions, which requires that the book value of the properties and related accumulated depreciation remain on our balance sheet with no sale recognized. The sales price of the properties is recorded as a financing obligation and a portion of each lease payment is recorded as interest expense. AtDecember 31, 2019 , we expect our interest expense over the remaining term of these leases to total$21.2 million . Our other properties are under operating leases and are included under operating leases above.
Off-balance sheet arrangements
We do not have and did not have at
CRITICAL ACCOUNTING POLICIES AND MANAGEMENT ESTIMATES
TheSEC defines critical accounting policies as those that are, in management's view, important to the portrayal of our financial condition and results of operations and demanding of management's judgment. Our discussion and analysis of financial condition and results of operations is based on our consolidated financial statements, which have been prepared in accordance with the US generally accepted accounting principles, or GAAP. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses and related disclosures. We base our estimates on historical experience and on various assumptions that we believe are reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ significantly from those estimates. Our significant accounting policies are more fully described in Note 1 of the consolidated financial statements included in this Annual Report. As disclosed in Note 1, the preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions about future events that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ significantly from those estimates. We believe that the following discussion addresses our most critical accounting policies, which are those that are most important to the portrayal of our financial condition and results of operations and require management's most difficult, subjective and complex judgments. Revenue recognition. Our revenues to date have been generated primarily through collaboration or license agreements. Our collaboration and license agreements frequently contain multiple types of promised goods or services including (i) intellectual property licenses, (ii) product research, development and regulatory services and (iii) product manufacturing. Consideration we receive under these arrangements may include upfront payments, research and development funding, cost reimbursements, milestone payments, payments for product sales and royalty payments. We recognize revenue when a customer obtains control of promised goods or services. The amount of revenue recognized reflects the consideration that we expect to be entitled to receive in exchange for these services and excludes sales incentives and amounts collected on behalf of third parties. We analyze the nature of these performance obligations in the context of individual collaboration and license agreements in order to assess the distinct performance obligations. We apply the following five steps to recognize revenue: 53 -------------------------------------------------------------------------------- i) Identify the contract with a customer. We consider the terms and conditions of our collaboration and license agreements to identify contracts within the scope of ASC 606. We consider that we have a contract with a customer when the contract is approved, we can identify each party's rights regarding the goods and services to be transferred, we can identify the payment terms for the goods and services, we have determined the customer has the ability and intent to pay and the contract has commercial substance. We use judgment in determining the customer's ability and intent to pay, which is based upon factors including the customer's historical payment experience or, for new customers, credit and financial information pertaining to the customers. ii) Identify the performance obligations in the contract. Performance obligations in our collaboration and license agreements are identified based on the goods and services that will be transferred to the customer that are both capable of being distinct, whereby the customer can benefit from the service either on its own or together with other resources that are readily available from third parties or from us, and are distinct in the context of the contract, whereby the transfer of the services is separately identifiable from other promises in the contract. Our performance obligations generally consist of intellectual property licenses, research, development and/or regulatory services and manufacturing and supply commitments. Determining whether a promised goods or service is a separate performance obligation requires the use of significant judgment. A change in such judgment could result in a significant change in the period in which revenue is recognized. Most of our collaboration and license agreements with customers contain multiple promised goods or services. Based on the characteristics of the promised goods and services we analyze whether they are separate or combined performance obligations. The transaction price is allocated to the separate performance obligations on a relative standalone selling price basis. We determine standalone selling price based on our overall pricing and discounting objectives, taking into consideration the type of services, estimates of hourly market rates, and stage of the research, development or clinical trials. iii) Determine the transaction price. We determine the transaction price based on the consideration to which we expect to be entitled in exchange for transferring goods and services to the customer. In determining the transaction price, any variable consideration would be considered, to the extent applicable, if, in our judgment, it is probable that a significant future reversal of cumulative revenue under the contract will not occur. In accordance with the royalty exception under ASC 606 for licenses of intellectual property, the transaction price excludes future royalty payments to be received from our customers. None of our collaboration and license agreements contain consideration payable to our customer or a significant financing component. The process for determining the transaction price involves significant judgment and includes consideration of multiple factors such as estimated revenues, market size, and development risk, among other factors contemplated in negotiating the arrangement with the customer. Our contracts with customers primarily include two types of variable consideration: (i) development and regulatory milestone payments, which are due to us upon achievement of specific development and regulatory milestones and (ii) one-time sales-based payments and sales-based royalties associated with sold or licensed intellectual property. Due to uncertainty associated with achievement of the development and regulatory milestones, the related milestone payments are excluded from the contract consideration and the corresponding revenue is not recognized until we conclude it is probable that reversal of such milestone revenue will not occur. Product sales-based royalties under licensed intellectual property and one-time payments are accounted for under the royalty exception. We recognize revenue for sales-based royalties under licensed intellectual property and one-time payments at the later of when the sales occur or the performance obligation is satisfied or partially satisfied. iv) Allocate the transaction price to performance obligations in the contract. If the contract contains a single performance obligation, the entire transaction price is allocated to that performance obligation. Contracts that contain multiple performance obligations require an allocation of the transaction price to each performance obligation based on a relative standalone selling price. v) Recognize revenue when or as we satisfy a performance obligation. Revenue is recognized at the time the related performance obligation is satisfied by transferring the promised goods or services to a customer. We recognize revenue when we transfer control of the goods or services to our customers for an amount that reflects the consideration that we expect to receive in exchange for those services. Performance Obligations.
The following is a description of principal goods and services from which we generate revenue.
Intellectual property licenses
We generate revenue from licensing our intellectual property including know-how
and development and commercialization rights. These licenses provide customers
with a term-based license to further research, develop and commercialize our
internally-
54
-------------------------------------------------------------------------------- discovered drug candidates. The consideration we receive in the form of nonrefundable upfront consideration related to the functional intellectual property licenses is recognized when we transfer such license to the customer unless the license is combined with other goods or services into one performance obligation, in which case the revenue is recognized over a period of time based on our estimated pattern in which we satisfy the combined performance obligation. Our licensing agreements are generally cancelable. Customers have the right to terminate their contracts upon notice. We have the right to terminate the contracts generally only if the customer is in breach of the contract and fails to remedy the breach in accordance with the contractual terms.
Intellectual property sales
We generate royalty revenue from sales of our intellectual property. We estimate the future royalty payments and recognize revenue with a corresponding contract asset at a point in time when we transfer the intellectual property to the customer. We periodically reassess our estimate of the future royalty payments and recognize any estimate adjustments as revenue in the current period.
Research, development and regulatory services
We generate revenue from research, development and regulatory services we provide to our customers in connection with the licensed intellectual property. The services we provide to our customers primarily include scientific research activities, preparation for and management of clinical trials, and assistance during the regulatory approval application process. Revenue associated with these services is recognized based on our estimate of total consideration to be received for such services and the pattern in which we perform the services. The pattern of performance is generally determined to be the amount of incurred expenses reimbursed by the customer as a percentage of total expected reimbursable expenses associated with the contract. Clinical trial expenses. We accrue clinical trial expenses based on work performed. In determining the amount to accrue, we rely on estimates of total costs incurred based on enrollment, the completion of trials and other events. We follow this method because we believe reasonably dependable estimates of the costs applicable to various stages of a clinical trial can be made. However, the actual costs and timing of clinical trials are uncertain, subject to risks and may change depending on a number of factors. Differences between the actual clinical trial costs and the estimated clinical trial costs that we have accrued in any prior period are recognized in the subsequent period in which the actual costs become known. Historically, these differences have not been material; however, material differences could occur in the future. Share-based compensation. Our share-based awards are measured at fair value and recognized over the requisite service or performance period. We estimate the fair value of each stock option on the date of grant using the Black-Scholes option pricing model which requires the input of subjective assumptions, including price volatility of the underlying stock, risk-free interest rate, dividend yield, and expected life of the option. Expected volatility is computed using historical volatility for a period equal to the expected term. The expected term of options is determined based on historical experience of similar awards, giving consideration to the contractual terms of the share-based awards, vesting schedules and post-vesting terminations. The risk-free interest rates are based on theUS Treasury yield curve, with a remaining term approximately equal to the expected term used in the option pricing model. We account for the forfeitures in the period they occur. The fair value of each restricted stock unit award is determined based on the market price of the underlying common stock on the date of the grant. We estimate the fair value of restricted stock unit awards that include market-based performance conditions on the date of grant using a Monte Carlo simulation model, based on the market price of the underlying common stock, expected performance measurement period, expected stock price volatility and expected risk-free interest rate. Income taxes. Significant judgment is required by management to determine our provision for income taxes, our deferred tax assets and liabilities, and the valuation allowance to record against our net deferred tax assets, which are based on complex and evolving tax regulations throughout the world. Our tax calculation is impacted by tax rates in the jurisdictions in which we are subject to tax and the relative amount of income earned in each jurisdiction. Our deferred tax assets and liabilities are determined using the enacted tax rates expected to be in effect for the years in which those tax assets are expected to be realized. The effect of an uncertain income tax position is recognized at the largest amount that is "more-likely-than-not" to be sustained under audit by the taxing authority. An uncertain income tax position will not be recognized if it has less than a 50% likelihood of being sustained. The realization of our deferred tax assets is dependent upon our ability to generate sufficient future taxable income. We establish a valuation allowance when it is more-likely-than-not that the future realization of all or some of the deferred tax assets will not be achieved. The evaluation of the need for a valuation allowance is performed on a jurisdiction-by-jurisdiction basis, and includes a review of all available evidence, both positive and negative. OnDecember 22, 2017 , the US government enacted comprehensive tax legislation referred to as the Tax Cuts and Jobs Act, or the Tax Act. Shortly after the Tax Act was enacted, theSEC staff issued Staff Accounting Bulletin No. 118, Income Tax Accounting Implications of the Tax Cuts and Jobs Act, orSAB 118, which provides guidance on accounting for the Tax Act's impact.SAB 118 55
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provides a measurement period, which should not extend beyond one year from the Tax Act enactment date, during which a company acting in good faith may complete the accounting for the impacts of the Tax Act under ASC Topic 740, Income Taxes, or ASC 740. In accordance withSAB 118, the companies are required to reflect the income tax effects of the Tax Act in the reporting period in which the accounting under ASC 740 is complete. In 2018, we completed our accounting analysis of the impacts of the Tax Act. See Note 9 to our consolidated financial statements included in this Annual Report for additional information. The above listing is not intended to be a comprehensive list of all of our accounting policies. In many cases, the accounting treatment of a particular transaction is specifically dictated by GAAP. See our audited consolidated financial statements and notes thereto included elsewhere in this Annual Report, which contain additional accounting policies and other disclosures required by GAAP.
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