1. Summary of Operations and Significant Accounting Policies

Organization and Business Description

In October 2009, the Board of Directors of Pharmaceutical Product Development, Inc. ("PPD" or the "Parent Company") authorized management of PPD to proceed with preparations to spin-off its compound partnering business, previously part of the discovery science segment of PPD, from its contract research organization, or CRO, business. In order to carry out the proposed spin-off of the compound partnering business, PPD formed a new wholly-owned subsidiary, Furiex Pharmaceuticals, Inc., a Delaware corporation ("Furiex" or the "Company"), into which PPD transferred the compound partnering business, including assets, employees, intellectual property rights and liabilities comprising that business, and $100.0 million in cash, as of the closing date of the spin-off, June 14, 2010. PPD effected the spin-off through a tax-free, pro-rata dividend distribution of all of the shares of the Company to PPD shareholders. PPD does not have any ownership or other form of equity interest in the Company following the spin-off.

In connection with the spin-off, the Company and PPD entered into a series of agreements, including a separation and distribution agreement, transition services agreement, sublease and license agreements, employee matters agreement, tax sharing agreement and a master development services agreement.

Furiex is a drug development company that continues the compound partnering business started by PPD in 1998. The goal of compound partnering is to in-license from, or form strategic alliances with, pharmaceutical and biotechnology companies to develop therapeutics in which the risks and rewards are shared. The Company's operations are headquartered in Morrisville, North Carolina.

The significant accounting policies followed by the Company in this Quarterly Report on Form 10-Q are consistent with the accounting policies followed for annual financial reporting. The Company prepared these unaudited combined and consolidated financial statements in accordance with the Securities and Exchange Commission's Rule 10-01 of Regulation S-X and, in management's opinion, has included all adjustments of a normal recurring nature necessary for a fair presentation. The accompanying combined and consolidated financial statements should be read in conjunction with the combined and consolidated financial statements and notes thereto in the Company's Annual Report on Form 10-K for the year ended December 31, 2010.

The Company has incurred losses and negative cash flows from operations since the spin-off. Based on current forecasts, the Company believes it has sufficient liquidity to continue its planned operations for the next 12 months. The Company's long-term liquidity needs will largely be determined by the success of its products already in commercialization with partners, key development and regulatory events that may impact the Company's ability to out-license its development compounds and the receipt of milestone payments related to various development activities. Depending upon the success and timing of receipt of various milestone payments and royalties it may be necessary to do one or more of the following in the future: (a) raise additional capital through equity or debt financings or from other sources; (b) reduce spending on one or more research and development programs; and (c) restructure the Company's operations. The Company currently receives revenue from royalties on sales of Nesina^® and Priligy™. The Company will continue to incur operating losses until revenues from all sources reach a level sufficient to support its ongoing operations.

Basis of Accounting

The accompanying combined and consolidated financial statements, through the date of the spin-off from PPD, have been derived from the combined financial statements and accounting records of PPD from the historical cost basis of the assets and liabilities of the various activities that reflect the combined results of operations, financial condition and cash flows of the discovery sciences segment of PPD. All the business components of the discovery sciences segment have been included in the historical statements because they were managed by common segment management, and because they reflect the historical performance of PPD segment management. The discovery sciences segment of PPD included pre-clinical consulting services that are not being offered by Furiex after the spin-off. All rights and obligations related to pre-clinical consulting services and the definitive purchase agreement related to PPD Dermatology, Inc. were retained by PPD. See Note 3 for further discussion of PPD Dermatology, Inc.

The Company was allocated certain expenses from PPD, such as executive oversight, risk management, accounting, tax, legal, investor relations, human resources, information technology, stock compensation, and facilities services and depreciation, but was not allocated the underlying productive assets, such as certain information systems equipment, furniture and facilities that were not assigned to the Company but from which the Company benefited. Such expenses have been included in the combined and consolidated financial statements as expense allocations from PPD for periods prior to the spin-off. The basis of these allocations included full-time equivalent employees for the respective periods presented and square footage of occupied space. See Note 7 for further discussion of the allocations.

Management believes that the assumptions and allocations underlying the combined and consolidated financial statements are reasonable. The financial information in these combined and consolidated financial statements does not include all of the expenses that would have been incurred had the Company been a separate, stand-alone publicly traded entity prior to the spin-off. The combined and consolidated financial statements include the operations of PPD Dermatology, Inc. In addition, pre-clinical consulting services were not contributed to the Company at the time of the spin-off. As such, the financial information herein does not reflect the results of operations or cash flows of the Company had it been a separate, stand-alone entity during the periods presented prior to the spin-off.

Principles of Combination and Consolidation

The Company prepared the accompanying combined and consolidated financial statements in accordance with accounting principles generally accepted in the United States of America, or GAAP, and includes the accounts of Furiex Pharmaceuticals, Inc. and its subsidiaries. All intercompany balances and transactions have been eliminated in consolidation.

Use of Estimates in Preparation of the Financial Statements

The preparation of financial statements in conformity with 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 reporting period. Actual results could differ from those estimates.

Earnings Per Share

The Company calculates net loss per basic and diluted share by dividing net loss by the weighted-average number of shares outstanding during the reporting period. For all periods presented, the computation of net loss per basic and diluted share and the weighted-average shares outstanding are calculated based on the 9,881,340 shares issued in connection with the spin-off on June 14, 2010. The calculation of net loss per diluted share is the same as net loss per basic share since the inclusion of any potentially dilutive securities would be anti-dilutive. As discussed in Note 5, all potentially dilutive securities relate to stock options issued as part of the Company's share-based compensation plan after the spin-off from PPD.

Separation Costs

The Company incurred legal, tax and other costs specifically associated with the spin-off, which are recorded as a component of selling, general and administrative expenses. The amounts for the three and six month period ended June 30, 2010 were $1.3 million and $2.6 million, respectively.

Revenue Recognition

The Company generates revenue in the form of upfront payments, development and regulatory milestone payments, royalties and sales-based milestone payments in connection with the out-licensing of compounds. The payment of future milestones and royalties will depend on the success of the Company's compound development and the Company's collaborators' success in developing and commercializing compounds. Upfront payments are generally paid within a short period of time following the execution of an out-license or collaboration agreement. Milestone payments are typically one-time payments to the Company triggered by the collaborator's achievement of specified development and regulatory events such as the commencement of Phase III trials or regulatory submission approval. Royalties are payments received by the Company based on net product sales of a collaborator. Sales-based milestone payments are typically one-time payments to the Company triggered when aggregate net sales of product by a collaborator for a specified period (for example, an annual period) reach an agreed upon threshold amount. The Company recognizes upfront payments, development and regulatory milestone payments, royalty payments, and sales-based milestone payments from its collaborators when the event which triggers the obligation of payment has occurred, there is no further obligation on the Company's part in connection with the payment, and collection is reasonably assured.

Concentration of Credit Risk

The Company's collaborators, which are its current sources of revenue, are primarily pharmaceutical companies. Two collaborators accounted for the majority of the Company's revenue for the six month period ended June 30, 2010 and for the six month period ended June 30, 2011. A concentration of credit risk with respect to revenue exists due to the small number of collaborators. Two collaborators accounted for 100% of the Company's receivable balance as of June 30, 2011.

Research and Development Expenses

Research and development costs consist primarily of costs associated with pre-clinical studies, non-clinical studies and the clinical trials of the Company's product candidates, development materials, patent costs, labor and related benefit charges associated with personnel performing research and development work, supplies associated with this work and consulting services. The Company charges research and development costs to operations as incurred, and discloses them in the combined and consolidated statements of operations.

Research and development costs include clinical research services provided by PPD, pre-clinical testing, non-clinical testing and clinical drug manufacturing provided by third parties, the direct cost of the Company's personnel managing the programs and upfront and milestone payments to the Company's collaborators.

Income Taxes

The income tax provision for the periods prior to June 14, 2010 has been calculated using the separate return basis as if the Company had filed separate income tax returns under its existing structure. The provision for income taxes subsequent to the spin-off has been determined using the asset and liability approach of accounting for income taxes. Under this approach, deferred taxes represent the future tax consequences expected to occur when the reported amounts of assets and liabilities are recovered or paid. The provision for income taxes represents income taxes paid or payable for the year, plus the change in deferred taxes during the year. Deferred taxes result from differences between the financial reporting and tax basis of the Company's assets and liabilities. Deferred tax assets and liabilities are measured using the currently enacted tax rates that apply to taxable income in effect for the years in which those tax attributes are expected to be recovered or paid, and are adjusted for changes in tax rates and tax laws when changes are enacted.

Valuation allowances are recorded to reduce deferred tax assets when it is more likely than not that a tax benefit will not be realized. The assessment of whether or not a valuation allowance is required often requires significant judgment, including the long-range forecast of future taxable income and the evaluation of tax planning initiatives. Adjustments to the deferred tax valuation allowances are made to earnings in the period when such assessments are made. Due to the historical losses from the Company's operations, a full valuation allowance on deferred tax assets has been recorded.

For the three and six month period ended June 30, 2011, the Company has recorded an insignificant amount of income tax expense. This amount relates to the adjustment of a deferred tax liability associated with historical goodwill, which is amortized and deductible for tax purposes, but is an indefinite-lived intangible asset for financial reporting purposes. The amount reflected in the statements of operations for the three and six month period ended June 30, 2011 is the tax effect of the tax amortization of this item. Because the associated deferred tax liability relates to an indefinite-lived intangible, the Company does not consider this item in computing the valuation allowance related to the Company's net deferred tax assets. As of June 30, 2011, the deferred tax liability associated with this intangible asset, reflected in other long-term liabilities within the combined and consolidated balance sheets, was approximately $0.2 million.

Share-Based Compensation

The Company recognizes compensation expense using a fair-value based method related to stock options and other share-based compensation. The expense is measured based on the grant date fair value of the awards that are expected to vest and is recorded over the applicable requisite service period. In the absence of an observable market price for a share-based award, the fair value is based upon a valuation methodology that takes into consideration various factors, including the exercise price of the award, the expected term of the award, the current price of the underlying shares, the expected volatility of the underlying share price based on peer companies, the expected dividends on the underlying shares and the risk-free interest rate.

Goodwill

The Company assigns to goodwill the excess of the purchase price of a business acquired over the fair value of net tangible assets and identifiable intangible assets at the date of the acquisition. The Company evaluates goodwill for impairment on an annual basis at October 1 or more frequently if events or changes in circumstances indicate that goodwill might be impaired. Any impairment could have a material adverse effect on the Company's financial condition and results of operations.

Realizability of Carrying Value of Long-Lived Assets

The Company reviews the recoverability of long-lived and finite-lived intangible assets when circumstances indicate that the carrying amount of assets might not be recoverable. This evaluation is based on various analyses, including undiscounted cash flow projections. In the event undiscounted cash flow projections indicate impairment, the Company would record an impairment based on the fair value of the assets at the date of the impairment.

Recent Accounting Pronouncements

In March 2010, the Financial Accounting Standards Board, or FASB, issued a new accounting standard, the objective of which is to establish a revenue recognition model for contingent consideration that is payable upon the achievement of an uncertain future event, referred to as a milestone. The Company's adoption of this standard on January 1, 2011 did not have a material impact on the Company's combined and consolidated financial statements.

2. Spin-off from Pharmaceutical Product Development Inc.

On June 14, 2010, PPD spun off its compound partnering business through the spin-off of Furiex. PPD contributed substantially all of the compound partnering business components of the discovery sciences segment and $100.0 million of cash to Furiex. All outstanding shares of Furiex were then distributed to PPD shareholders of record on June 1, 2010 as a pro-rata, tax-free dividend of one share of Furiex common stock for every twelve shares of PPD's common stock.

In connection with the spin-off, PPD and Furiex entered into a series of agreements, including a separation and distribution agreement, transition services agreement, sublease and license agreements, employee matters agreement, tax sharing agreement and a master development services agreement.

The total amount of the Furiex contribution of $152.4 million was based on the book value of the net assets that were transferred to Furiex in connection with the spin-off, as follows:

3. Discontinued Operations

In April 2009, PPD acquired 100 percent of the outstanding equity interests of Magen BioSciences, Inc., or Magen, a biotechnology company focused on the development of dermatologic therapies. In May 2010, PPD discontinued the operations of its wholly owned subsidiary, PPD Dermatology, Inc., formerly Magen, due to unfavorable efficacy data associated with its MAG-131 program. As a result, this business unit is recorded as discontinued operations in the accompanying combined and consolidated financial statements for 2010.

None of the business assets or liabilities of Magen were contributed to the Company and all rights and liabilities remained with PPD after the spin-off on June 14, 2010. The loss from discontinued operations of this business unit is reported as discontinued operations within the combined and consolidated statements of operations.

4. Goodwill

The Company reviews goodwill for impairment annually on October 1 and whenever events or changes in circumstances indicate that the carrying amount of an asset might not be recoverable. This analysis utilizes a discounted cash flow method using the expected future inflows and outflows of the business and an appropriate discount rate. Based on the review as of October 1, 2010, the Company's calculated fair value of equity was in excess of carrying value by approximately 38%.

The fair value of goodwill could be materially impacted by adverse changes such as declines in operating results, a decline in the valuation of pharmaceutical and biotechnology company stocks, including the valuation of the Company's own common stock, a significant slowdown in the worldwide economy or the pharmaceutical and biotechnology industry, development and regulatory events that may impact the Company's ability to out-license its development compounds or which might impact the receipt of milestone payments related to various development activities, or the delay or abandonment of any research and development programs.

5. Share-Based Compensation

The Company has adopted an equity incentive plan, the Furiex Pharmaceuticals, Inc. 2010 Stock Plan, or the Plan. The Company is authorized to issue a total of 1,778,641 shares under the Plan. The Plan is intended to provide incentives to employees, directors and consultants through the issuance of common stock-based awards, including restricted stock, stock options, stock appreciation rights and other equity based awards. The Plan is administered by a committee designated by the Company's Board of Directors.

During the three and six month period ended June 30, 2011, the Company granted 304,712 stock options to employees and directors with a weighted-average exercise price of $14.83. During the year ended December 31, 2010, the Company granted 839,642 stock options to employees, directors and consultants, with a weighted-average exercise price of $9.11. All options were granted with an exercise price equal to the fair value of the Company's common stock on the grant date. The fair value of the Company's common stock on the grant date is equal to the most recent Nasdaq closing price of the Company's stock on the date of grant.

The weighted-average grant date fair value per share of options was determined using the Black-Scholes option-pricing method. The weighted-average grant date fair value per share and aggregate fair value of options granted during the three and six month period ended June 30, 2011 was $9.05 and $2.3 million, respectively, for employees, and $8.07 and $0.4 million, respectively, for directors. The weighted-average grant date fair value per share and aggregate fair value of options granted to employees and directors during the year ended December 31, 2010 was $5.95 and $3.8 million, respectively. The weighted-average grant date fair value per share and aggregate fair value of options granted to consultants during the year ended December 31, 2010, was $7.36 and $1.5 million, respectively. The amount of stock compensation expense related to consultant option grants, classified in selling, general and administrative expenses within the statements of operations, is adjusted to fair value at the end of each financial reporting period using the Black-Scholes option-pricing method until such options vest.

Expected option lives are based on the simplified method, and volatilities used in fair valuation calculations are based on a benchmark of peer companies with similar expected lives. The related expense is recognized on a straight-line basis over the vesting period. Share-based compensation expense recognized for Company employees, directors, and consultants under the Plan included in the statements of operations for the three and six month period ended June 30, 2011 was approximately $1.6 million and $2.3 million, respectively.

As of June 30, 2011, unrecognized compensation expense related to the unvested portion of the Company's stock options granted to employees, directors, and consultants was approximately $5.6 million, and will be recognized over a weighted-average period of 1.93 years for employees, 0.89 years for directors, and 1.97 years for consultants. As of June 30, 2011, the Company had options outstanding to purchase an aggregate of approximately 1,142,000 shares of its common stock.

6. Commitments and Contingencies

The Company is involved in compound development and commercialization collaborations. The Company developed a risk-sharing research and development model with pharmaceutical and biotechnology companies to advance compounds to commercialization. Through collaborative arrangements based on this model, the Company works with its collaborators by sharing the risks and potential rewards associated with the development and commercialization of drugs with its collaborators. As of June 30, 2011, the Company's four main collaborations were with Janssen Pharmaceutica, N.V., or Janssen (an affiliate of Johnson & Johnson), Ranbaxy Laboratories, Ltd., or Ranbaxy, Alza Corporation, or Alza, and Takeda Pharmaceuticals Company Limited, and relate to, respectively: the Fluoroquinolone, or JNJ-Q2, and MuDelta compounds; a novel statin compound, or PPD-10558; the product Priligy; and the product Nesina.

As of June 30, 2011, the Company had three collaborations that involve potential future expenditures. The first is its collaboration with Alza for Priligy. In connection with this collaboration, the Company has an obligation to pay a royalty to Eli Lilly and Company of 5% on annual net sales of the compound in excess of $800.0 million. If the related triggering events and product sales occur, the Company is entitled to receive from Alza future regulatory milestone payments of $15.0 million, sales-based milestone payments of up to $50.0 million, and royalties ranging from 10% to 20% for sales of patented products without generic competition and ranging from 10% to 17.5% for non-patented products without generic competition, in both cases the percentages rise as sales volume increases, and a royalty of 7.5% for patented and non-patented products with generic competition regardless of sales volume. The Company is not obligated to pay any ongoing costs of development for this compound.

The second collaboration involving future expenditures is in respect of the two compounds in-licensed from Janssen: the JNJ-Q2 and MuDelta compounds. On April 18, 2011, Janssen announced that in connection with a broad strategic review of its portfolio of infectious disease programs, it will be redirecting its research and development efforts toward antivirals and vaccines, and will not be investing in the development of new antibacterial therapies. As a result, Janssen elected not to exercise its option to continue the development of the JNJ-Q2 compound. On April 19, 2011 the Company announced it had acquired full exclusive license rights to develop and commercialize the JNJ-Q2 compound under its existing development and license agreement with Janssen. The Company plans to continue evaluating other partnering and funding opportunities, which could result in significant additional research and development expense in future periods. The Company may be obligated to pay Janssen, for the JNJ-Q2 compound, up to $50.0 million in regulatory milestone payments and, if approved for marketing, up to $75.0 million in sales-based milestone payments and sales-based royalties increasing from the mid-to upper-single digit percentages as sales volume increases.

At the completion of Phase II development, Janssen will have the option to continue development and commercialization of the MuDelta compound. In exchange, the Company may receive up to $90.0 million in regulatory milestone payments and up to $75.0 million in sales-based milestone payments, as well as sales-based royalty payments increasing from mid-single digit to low initial double digit percentages as sales volume increase. In the event Janssen elects not to continue the MuDelta program, the Company has the option to continue developing and commercializing the compound, and the Company would be obligated to pay Janssen up to $50.0 million in regulatory milestone payments and, if approved for marketing, up to $75.0 million in sales-based milestone payments and sales-based royalties increasing from the mid-to upper-single digit percentages as sales volume increases.

The Company expects expenses associated with the Phase II development of the compounds in-licensed from Janssen to be between $30.0 and $35.0 million over the next two years.

The third collaboration involving future expenditures is with Ranbaxy for a novel statin compound, PPD-10558. If the Company develops this product and it attains regulatory approval, and in addition, the product meets specific commercialization and sales milestones, the total amount of potential clinical and sales-based milestones that the Company is obligated to pay Ranbaxy would be $43.0 million. The Company would also be obligated to pay Ranbaxy sales-based royalties of a mid-single digit percentage. The Company will be solely responsible and will bear all costs and expenses for the development, manufacture, and marketing of the compound and licensed products. The Company estimates the remaining cost of Phase II development will be $8.0 to $10.0 million over the next two years. If the Company exercises its right to terminate early, other than for safety or efficacy reasons, a material product failure or Ranbaxy breach, the Company must pay Ranbaxy $1.0 million.

7. Related Party Transactions

Corporate Overhead Allocations

For the periods prior to the June 14, 2010 spin-off, the Company's operations were fully integrated with PPD, including executive services, finance, treasury, corporate income tax, human resources, information technology, facilities, legal services and investor relations services. The accompanying combined and consolidated financial statements reflect the application of estimates and allocations of operating expenses. Management believes the methods used to allocate these operating expenses were reasonable. The allocation methods included relative time devoted by executive management to the Company's business, and the related benefit received by the Company for other services.

Allocations of expense for these services were $0.3 million associated with continuing operations and $0.2 million associated with discontinued operations for the three month period ended June 30, 2010. Allocations of expense for these services were $0.6 million associated with continuing operations and $0.5 million associated with discontinued operations for the six month period ended June 30, 2010. These allocations are reflected in the accompanying combined and consolidated statements of operations.

Research and Development Services

PPD performed drug development work for the Company prior to June 14, 2010, and the expenses related to these services are included in research and development expenses in the accompanying combined and consolidated financial statements. Such amounts were $6.1 million and $8.4 million for the three and six month period ended June 30, 2010, respectively.

PPD has continued to provide the Company services after the spin-off. Two members of the Company's Board of Directors hold board positions with PPD. For the three and six month period ended June 30, 2011, the Company recognized expenses of approximately $10.2 million and $18.5 million related to PPD, respectively. As of June 30, 2011, the Company owed PPD approximately $11.5 million for services rendered.

Transfer of Proceeds from Sale of Business

During 2009, PPD disposed of Piedmont Research Center, LLC. The cash proceeds of $3.5 million received from this transaction in 2010 for the payment of an outstanding escrow account were transferred to PPD prior to the spin-off on June 14, 2010 and all rights and liabilities related to Piedmont Research Center, LLC remained with PPD after the spin-off on June 14, 2010.