(1) The Company and Summary of Significant Accounting Policies

The Company

Arena Pharmaceuticals, Inc., or Arena, was incorporated on April 14, 1997, and commenced operations in July 1997. We are a clinical-stage biopharmaceutical company with a pipeline of internally discovered small molecule drug candidates that target G protein-coupled receptors, and are being developed internally or with a collaborator. We operate in one business segment. In October 2010, the US Food and Drug Administration, or FDA, issued a Complete Response Letter, or CRL, regarding our New Drug Application, or NDA, for our most advanced drug candidate, lorcaserin, which is intended for weight management. In the CRL, the FDA stated that it completed its review of the NDA and determined that it could not approve the application in its then present form. In December 2011, we resubmitted the lorcaserin NDA, and the FDA has confirmed its acceptance of the resubmission for filing and review and assigned a new Prescription Drug User Fee Act target date of June 27, 2012.

Basis of Presentation

The accompanying consolidated financial statements reflect all of our activities, including those of our wholly owned subsidiaries. All material intercompany accounts and transactions have been eliminated in consolidation.

During the first quarter of 2011, we identified an error in our consolidated financial statements for the years ended December 31, 2003, through December 31, 2008, related to the dividends and accretion of discount on our Series B Convertible Preferred Stock, which is no longer outstanding. The error relates to dividends that were recorded to our accumulated deficit rather than to additional paid-in capital. To correct the error, we recorded a non-cash cumulative adjustment as of December 31, 2008, to reduce both our accumulated deficit and additional paid-in capital by $18.6 million. This adjustment is reflected on the accompanying consolidated balance sheets and consolidated statements of stockholders' equity and comprehensive loss. We determined that this adjustment was not material to our financial position for any previously reported period, and it had no impact on our results of operations and cash flows.

We have accumulated a large deficit since inception, and we expect that our losses will continue to be substantial for at least the short term. As of December 31, 2011, we had $57.6 million in cash and cash equivalents, which, with the additional cash we raised in January and March 2012 (see Note 17), we believe will be sufficient to fund our operations for at least the next 12 months.

Financial Statement Preparation

The preparation of financial statements in conformity with US generally accepted accounting principles, or GAAP, requires our 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. We use estimates for certain accruals including clinical and preclinical study fees and expenses, share-based compensation, and valuations of derivative liabilities, long-lived assets and contingencies, among others. Actual results could differ from those estimates.

Reclassifications

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

Cash and Cash Equivalents

Cash and cash equivalents consist of cash and highly liquid investments with remaining maturities of three months or less when purchased.

Fair Value of Financial Instruments

Cash and cash equivalents, accounts receivable, prepaid expenses and other current assets, accounts payable and accrued liabilities are carried at cost, which we believe approximates fair value due to the short-term maturity of these instruments. Short-term investments and derivative liabilities are carried at fair value. Based on borrowing rates currently available to us for loans with similar terms, we estimate the fair value of the lease financing obligations and note payable to Deerfield to be $55.5 million and $20.4 million, respectively, at December 31, 2011. As of December 31, 2010, we estimated the fair value of the lease financing obligations, note payable to Siegfried and note payable to Deerfield to be $55.9 million, $9.3 million and $54.2 million, respectively.

Concentration of Credit Risk and Major Customers

Financial instruments, which potentially subject us to concentrations of credit risk, consist primarily of cash, cash equivalents and short-term investments. We limit our exposure to credit loss by holding our cash in US dollars or placing our cash and investments in US government, agency and government-sponsored enterprise obligations and in corporate debt instruments that are rated investment grade, in accordance with our board-approved investment policy.

We manufacture drug products for Siegfried Ltd, or Siegfried, under a manufacturing services agreement, and all of our manufacturing services revenues are attributable to Siegfried.

Percentages of our total revenues derived from our manufacturing services agreement and from our most significant collaborators for the years presented are as follows:

Percentages of our total accounts receivable for the years presented are as follows:

Property and Equipment

Property and equipment are stated at cost and depreciated over the estimated useful lives of the assets (generally three to 15 years) using the straight-line method. Buildings are stated at cost and depreciated over an estimated useful life of approximately 20 years using the straight-line method. Leasehold improvements are stated at cost and amortized over the shorter of the estimated useful lives of the assets or the lease term. Capital improvements are stated at cost and amortized over the estimated useful lives of the underlying assets.

Acquired Technology and Other Intangibles

We have intangible assets in connection with certain assets we acquired from Siegfried in January 2008, including manufacturing facility production licenses and an assembled workforce, as well as our February 2001 acquisition of Bunsen Rush Laboratories, Inc., or Bunsen Rush, and its Melanophore technology. These assets are measured based on their fair value at acquisition. The useful life of our intangible assets is determined based on the period over which the asset is expected to contribute directly or indirectly to our future cash flows. We amortize our intangible assets using the straight-line method over estimated useful lives ranging from two to 20 years.

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 cash flow projections. If impairment is indicated, we measure the impairment loss by comparing the fair value of the asset, estimated using discounted cash flows expected to be generated from the asset, to the carrying value.

Deferred Rent

For financial reporting purposes, rent expense is recognized on a straight-line basis over the term of the lease. The difference between rent expense and amounts paid under lease agreements is recorded as deferred rent in the liability section of our consolidated balance sheets.

Derivative Liabilities

We account for our warrants and other derivative financial instruments as either equity or liabilities based upon the characteristics and provisions of each instrument. Warrants classified as equity are recorded as additional paid-in capital on our consolidated balance sheet and no further adjustments to their valuation are made. Some of our warrants were determined to be ineligible for equity classification because of provisions that may result in an adjustment to their exercise price. Warrants classified as derivative liabilities and other derivative financial instruments that require separate accounting as liabilities are recorded on our consolidated balance sheet at their fair value on the date of issuance and are revalued on each balance sheet date until such instruments are exercised or expire, with any changes in the fair value between reporting periods recorded as other income or expense. We estimate the fair value of these liabilities using option pricing models that are based on the individual characteristics of the warrants or instruments on the valuation date, as well as assumptions for expected volatility, expected life and risk-free interest rate.

Foreign Currency Translation

The functional currency of our wholly owned subsidiary in Switzerland is the Swiss franc. Accordingly, all assets and liabilities of this subsidiary are translated to US dollars based on the applicable exchange rate on the balance sheet date. Revenue and expense components are translated to US dollars at weighted-average exchange rates in effect during the period. Gains and losses resulting from foreign currency translation are reported as a separate component of accumulated other comprehensive income or loss in the stockholders' equity section of our consolidated balance sheets. Foreign currency transaction gains and losses are included in our results of operations and, to date, have not been material.

Share-based Compensation

Compensation expense for all share-based awards, which we recognize on a straight-line basis over the vesting period, is estimated based on the grant-date fair value using the Black-Scholes option pricing model. We estimate forfeitures at the time of grant and revise our estimate in subsequent periods if actual forfeitures differ from those estimates. Such compensation expense is included in the applicable expense line item on our consolidated statements of operations.

We recognized total share-based compensation expense for all share-based awards of $3.7 million, $5.5 million and $7.1 million during the years ended December 31, 2011, 2010 and 2009, respectively.

Revenue Recognition

Our revenues to date have been generated primarily through collaborative agreements and a manufacturing services agreement. Our collaborative agreements can include multiple elements including licenses, research services and manufacturing. Consideration we receive under these arrangements may include upfront payments, research funding and milestone payments. For our multiple element transactions, if fair value exists for the undelivered and delivered elements whereby such elements have stand-alone value, we allocate the consideration to the elements based on their relative fair values. In cases where fair value exists for the undelivered elements but does not exist for the delivered elements, we use the residual method to allocate the arrangement consideration. In cases where fair value does not exist for the undelivered elements in an arrangement, we account for the transaction as a single unit of accounting. We typically defer non-refundable upfront payments under our collaborations and recognize them over the period in which we have significant involvement or perform services, using various factors specific to each collaboration. Amounts we receive for research funding for a specified number of full-time researchers are recognized as revenue as the services are performed. Revenue from a milestone payment is recognized when earned, as evidenced by acknowledgment from our collaborator, provided that (i) the milestone event is substantive and its achievability was not reasonably assured at the inception of the agreement, (ii) the milestone represents the culmination of an earnings process, (iii) the milestone payment is non-refundable and (iv) our performance obligations after the milestone achievement will continue to be funded by our collaborator at a level comparable to the level before the milestone achievement. If all of these criteria are not met, the milestone payment is recognized over the remaining minimum period of our performance obligations under the agreement. Any advance payments we receive in excess of amounts earned are classified as deferred revenues until earned.

We manufacture drug products under a manufacturing services agreement for a single customer, Siegfried. Upon Siegfried's acceptance of drug products manufactured by us, we recognize manufacturing services revenues at agreed upon sales prices for such drug products. We have also contracted with Siegfried for them to provide us with administrative and other services in exchange for a fee. We determined that we are receiving an identifiable benefit for these services from Siegfried, and are recording such fees in the operating expense section of our consolidated statements of operations.

Research and Development Costs

Research and development expenses, which consist primarily of salaries and other personnel costs, costs associated with external clinical and preclinical study fees, manufacturing costs for non-commercial products and other related expenses, and the development of earlier-stage programs and technologies, are expensed as incurred when these expenditures have no alternative future uses.

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 the enrollment of subjects, 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 highly 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.

Patent Costs

We record costs related to filing and prosecuting patent applications in general and administrative expenses as incurred, as recoverability of such expenditures is uncertain.

Comprehensive Income (Loss)

We report all components of comprehensive income (loss), including foreign currency translation gain and loss and unrealized gains and losses on investment securities, in the financial statements in the period in which they are recognized. Comprehensive income (loss) is defined as the change in equity during a period from transactions and other events and circumstances from non-owner sources.

Net Loss Per Share

We calculate basic and diluted net loss per share allocable to common stockholders using the weighted-average number of shares of common stock outstanding during the period, less any shares subject to repurchase or forfeiture. There were no shares of our common stock subject to repurchase or forfeiture for the years ended December 31, 2011, 2010 or 2009.

Because we are in a net loss position, we have excluded outstanding unvested performance-based restricted stock unit awards, which are subject to forfeiture, warrants and stock options, as well as unvested restricted stock in our deferred compensation plan, from our calculation of diluted net loss per share because including these securities in the calculation would be antidilutive for all years presented. The table below presents our securities that would otherwise be included in our calculation of diluted net loss per share allocable to common stockholders at December 31, 2011, 2010 and 2009.

New Accounting Guidance

In June 2011, the Financial Accounting Standards Board, or FASB, issued Accounting Standards Update, or ASU, No. 2011-05, "Presentation of Comprehensive Income," which amends the presentation requirements for comprehensive income. Under ASU 2011-05, we will have the option to present the components of net income and comprehensive income as one single continuous statement or in two separate but consecutive statements. The current option to present other comprehensive income in the statement of stockholders' equity has been eliminated. ASU 2011-05 does not change the items that must be reported in comprehensive income. In December 2011, the FASB issued ASU 2011-12, "Presentation of Comprehensive Income," which defers the requirement to present reclassification adjustments on the face of the financial statements for items that are reclassified from other comprehensive income to net income in the statement(s) where the components of net income and the components of other comprehensive income are presented. These amendments are effective for us in the first quarter of 2012, and the impact will be presentation only.

In September 2011, the FASB issued ASU No. 2011-09, "Disclosures about an Employer's Participation in a Multiemployer Plan," which requires additional disclosures about an employer's participation in a multiemployer pension plan. ASU 2011-09 does not change the current measurement and recognition guidance. This guidance is effective for us for the year ended December 31, 2011. The adoption of ASU 2011-09 did not have a material impact on our consolidated financial statements (see Note 13).

(2) Fair Value Disclosures

We measure our financial assets and liabilities at fair value, which is defined as the exit price, or the amount that would be received from selling an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.

We use the following three-level valuation hierarchy that maximizes the use of observable inputs and minimizes the use of unobservable inputs to value our financial assets and liabilities:

The following table presents our valuation hierarchy for our financial assets and liabilities that are measured at fair value on a recurring basis as of December 31, 2011, in thousands:

The following table presents our valuation hierarchy for our financial assets and liabilities that are measured at fair value on a recurring basis as of December 31, 2010, in thousands:

The following table presents the activity for our derivative liabilities, which are classified as Level 3 in our valuation hierarchy, during the years ended December 31, 2011, 2010 and 2009, in thousands:

(4) Acquired Technology and Other Intangibles

In February 2001, we acquired Bunsen Rush for $15.0 million in cash and assumed $0.4 million in liabilities. We allocated $15.4 million to the patented Melanophore screening technology acquired in such transaction. We amortized this technology over its estimated useful life of 10 years.

In January 2008, we acquired from Siegfried certain drug product facility assets, including manufacturing facility production licenses and an assembled workforce originally valued at $12.1 million and $1.6 million, respectively. We amortized the acquired workforce over its estimated benefit of two years, and we are amortizing the manufacturing facility production licenses, which are necessary for us to produce and package tablets and other dosage forms in such facility, over their estimated useful life of 20 years.

Acquired technology and other intangibles, net, consisted of the following at December 31, 2011, and 2010, in thousands:

We recognized amortization expense of $0.3 million in the year ended December 31, 2011, and $1.5 million in both of the years ended December 31, 2010, and 2009 for the acquired Melanophore technology, $0.7 million, $0.6 million and $1.2 million in the years ended December 31, 2011, 2010 and 2009, respectively, for the manufacturing facility production licenses, and $0.8 million in the year ended December 31, 2009, for the acquired workforce. Using the exchange rate in effect on December 31, 2011, we expect to record amortization expense of $0.7 million per year through 2027 for the manufacturing facility production licenses.

(5) Accounts Payable and Other Accrued Liabilities

Accounts payable and other accrued liabilities consisted of the following, in thousands:

(6) Note Payable to Siegfried and Related Agreements

In January 2008, Arena Pharmaceuticals GmbH, or Arena GmbH, our wholly owned subsidiary, acquired from Siegfried certain drug product facility assets, including manufacturing facility production licenses, fixtures, equipment, other personal property and real estate assets in Zofingen, Switzerland, under an asset purchase agreement between Siegfried and Arena GmbH. These assets are being used to manufacture lorcaserin and certain drug products for Siegfried. In connection with this transaction, Arena GmbH and Siegfried also entered into a long-term supply agreement for the active pharmaceutical ingredient of lorcaserin, a manufacturing services agreement and a technical services agreement. The purchase price under the asset purchase agreement was CHF 31.8 million in cash and 1,488,482 shares of our common stock valued at $8.0 million, which we issued to Siegfried in January 2008. We paid CHF 21.8 million, or $19.6 million, of the cash purchase price in January 2008 and paid the remaining CHF 10.0 million, or $11.1 million, in three separate installments during 2011.

In March 2011, Arena GmbH amended its agreements with Siegfried, effective January 1, 2011, whereby, among other changes, we agreed to pay Siegfried the last two CHF 3.3 million installments that were due in January 2012 and January 2013 in June 2011 and October 2011. Also under these amended agreements, Siegfried agreed (i) to order from Arena GmbH 400 million units of drug product for manufacture by Arena GmbH in 2011, (ii) to use its reasonable commercial effort to order from Arena GmbH 200 million units of drug product for manufacture by Arena GmbH from January 1, 2012, to June 30, 2012, and (iii) to reduce its fees for providing Arena GmbH with certain technical and business services. In exchange, Arena GmbH agreed to reduce its sales prices for the manufacturing services provided to Siegfried. The sales prices under this amended manufacturing services agreement are generally below Arena GmbH's cost to provide such services and are reduced from prior years.

In December 2011, Arena GmbH further amended its agreement with Siegfried related to the manufacture of drug product whereby Siegfried agreed to order 80% of its requirements of certain drug products from Arena GmbH for the calendar year 2012 at agreed upon sales prices in exchange for Arena GmbH providing further reductions to the sales prices for certain of the manufacturing services provided to Siegfried.

We recognized a total loss of $2.6 million in 2011 since our costs under the amended manufacturing services agreement will exceed the related revenues. Of this amount, $1.4 million related to services rendered in 2011 and $1.2 million relates to services expected to be rendered in 2012. This $1.2 million loss provision for the remaining services expected to be rendered through December 31, 2012, is recorded as part of our cost of manufacturing services on our consolidated statements of operations and in accounts payable and other accrued liabilities on our consolidated balance sheet.

Pursuant to the manufacturing services agreement, we recognized revenue of $5.3 million, $7.1 million and $6.6 million in the years ended December 31, 2011, 2010 and 2009, respectively, for manufacturing drug products for Siegfried. The revenue recognized in 2011 reflects the $1.4 million reduction related to the loss incurred for services rendered under the amended manufacturing services agreement. Upon Siegfried's acceptance of drug products manufactured by us, we recognize manufacturing services revenues at agreed upon sales prices for such drug products. The related cost to manufacture the drug products was $8.1 million, $7.4 million and $6.5 million in the years ended December 31, 2011, 2010 and 2009, respectively. The cost of manufacturing services recognized in 2011 included $1.2 million representing the estimated contract loss provision for services expected to be rendered through December 31, 2012, under the amended manufacturing services agreement.

We also recognized expenses of $3.0 million, $2.5 million and $2.3 million for services incurred under the technical services agreement in the years ended December 31, 2011, 2010 and 2009, respectively. The technical services agreement provides us with administrative and other services to operate the facility.

(7) Note Payable to Deerfield

In July 2009, pursuant to a Facility Agreement we entered into in June 2009, or the Facility Agreement, with Deerfield Private Design Fund, L.P., Deerfield Private Design International, L.P., Deerfield Partners, L.P., Deerfield International Limited, Deerfield Special Situations Fund, L.P., and Deerfield Special Situations Fund International Limited, or collectively Deerfield, Deerfield provided us with a $100.0 million secured loan. We received net proceeds of $95.6 million from this loan. In connection with the loan, we issued Deerfield warrants to purchase an aggregate of 28,000,000 shares of our common stock at an exercise price of $5.42 per share. We refer to these warrants as the $5.42 Warrants. Deerfield has the right to require us to accelerate principal payments under the loan under certain circumstances, including upon certain changes of control, and at any time we may prepay any or all of the outstanding principal at par.

Deerfield previously had the right to make a one-time election, which we refer to as the Deerfield Additional Loan Election, to loan us up to an additional $20.0 million under the Facility Agreement, with the additional loan maturing on the same date as the original loan, June 17, 2013. For each additional $1.0 million that Deerfield loaned us under the Facility Agreement, we would have been required to issue Deerfield warrants for 280,000 shares of our common stock at an exercise price of $5.42 per share. In addition, Deerfield previously had an additional right to require us to accelerate payments under the loan in connection with certain equity issuances. Each of these rights was terminated in March 2011 as described below.

In accordance with relevant guidance, we separately valued four components under the Facility Agreement as of the date of the initial loan. Since that date, as discussed below in this note, we have amended the terms of the Facility Agreement, repaid certain of the debt, and exchanged certain of the warrants, which affects how we value and account for the Facility Agreement. The four components under the Facility Agreement were previously valued as of July 6, 2009 as follows:

As a result of the closing of our public offering of common stock in July 2009, which occurred after we entered into the Facility Agreement, we were required to repay Deerfield $10.0 million that was originally scheduled to be repaid in July 2010. In connection with this $10.0 million repayment, we retired a proportional share of the debt discount and issuance costs directly related to the repaid debt and recognized a non-cash loss on extinguishment of debt of $2.5 million in 2009.

In June 2010, we entered into a Purchase and Exchange Agreement, or the 2010 Purchase Agreement, with Deerfield, pursuant to which we sold Deerfield 11,000,000 shares of our common stock at a price of $3.23 per share, resulting in net proceeds to us of $35.5 million. Also pursuant to the 2010 Purchase Agreement, we exchanged a portion of the $5.42 Warrants to purchase an aggregate of 16,200,000 shares of our common stock at an exercise price of $5.42 per share for new warrants, which we refer to as the $3.45 Warrants, to purchase a like number of shares of our common stock at an exercise price of $3.45 per share. The outstanding $3.45 Warrants are exercisable until June 17, 2013. Other than the exercise price and certain provisions related to cashless exercise and early termination of the warrants, the $3.45 Warrants contain substantially the same terms as the $5.42 Warrants.

We valued the $3.45 Warrants at their June 2010 issuance date using an option pricing model and the following assumptions: expected life of 3.03 years, risk-free interest rate of 1.2%, expected volatility of 72% and no dividend yield. We determined that the incremental value of the $3.45 Warrants was $5.5 million, which was recorded as a component of the stock issuance and warrant exchange under the 2010 Purchase Agreement in the stockholders' equity section of our consolidated balance sheet. Because the $3.45 Warrants are eligible for equity classification, no adjustments to the recorded value will be made on an ongoing basis.

In August 2010, we sold 8,955,224 shares of our common stock at a price of $6.70 per share in a registered direct public offering to Deerfield. As part of this transaction, we entered into an amendment to the Facility Agreement, pursuant to which $30.0 million of the proceeds from this transaction was used to prepay the portion of the principal amount that was originally scheduled to be repaid in July 2012. Net proceeds to us from this transaction, after prepayment of the $30.0 million, were approximately $30.0 million. In connection with this $30.0 million prepayment, we retired a proportional share of the debt discount and issuance costs directly related to the repaid debt and recognized a non-cash loss on extinguishment of debt of $12.4 million in 2010.

To reduce our interest payments, in January 2011, we prepaid $20.0 million of the principal amount that was originally scheduled to be repaid to Deerfield in July 2011. In connection with this $20.0 million prepayment, we retired a proportional share of the debt discount and issuance costs directly related to the repaid debt and recognized a non-cash loss on extinguishment of debt of $2.5 million.