1.                                      Basis of Presentation

The unaudited interim condensed consolidated financial statements for the three and six month periods ended June 30, 2010 and 2009 have been prepared on the same basis as the audited financial statements for the year ended December 31, 2009. The financial statements include all normal recurring adjustments, which we consider necessary for a fair presentation of the financial position at such dates and the operating results and cash flows for those periods. Results for the interim periods are not necessarily indicative of the results for the entire year. For more complete financial information, these financial statements, and notes thereto, should be read in conjunction with the audited financial statements for the year ended December 31, 2009 included in our Annual Report on Form 10-K filed with the Securities and Exchange Commission ( 7;SEC”).

The condensed consolidated financial statements include the accounts of Isis Pharmaceuticals, Inc. (“we”, “us” or “our”) and our wholly owned subsidiaries, Isis USA Ltd. and Symphony GenIsis, Inc.  In addition to our wholly owned subsidiaries, our condensed consolidated financial statements include our equity investment in Regulus Therapeutics Inc., an entity we identified as a variable interest entity.  Beginning in the first quarter of 2010, as a result of adopting a new accounting standard for identifying which enterprise has the power to direct activities of a variable interest entity, we concluded that we are no longer the primary beneficiary of Regulus. As such we have presented our share of Regulus’ operating results on a separate line in our condensed con solidated statement of operations called “Equity in net loss of Regulus Therapeutics Inc.”  On our condensed consolidated balance sheet, we have presented our investment in Regulus on a separate line in the non-current liabilities section called “Investment in Regulus Therapeutics Inc.”  Prior to the adoption of the new accounting standard, we were the primary beneficiary of Regulus and as such we consolidated Regulus’ financial results on a line-by-line basis.  We have not reclassified amounts in the prior period financial statements to conform to the current period presentation.  As a result of completing the sale of Ibis Biosciences, Inc. to Abbott Molecular Inc., or AMI, in January 2009, we presented Ibis’ financial position and results of operations separately as discontinued operations in our condensed consolidated financial statements.  All significant intercompany balances and transact ions have been eliminated in consolidation.

2.                                      Significant Accounting Policies

Revenue Recognition

We generally recognize revenue when we have satisfied all contractual obligations and are reasonably assured of collecting the resulting receivable. We are often entitled to bill our customers and receive payment from our customers in advance of recognizing the revenue under current accounting rules. In those instances where we have received payment from our customers in advance of recognizing revenue, we include the amounts in deferred revenue on our condensed consolidated balance sheet.

Research and development revenue under collaborative agreements

We often enter into collaborations under which we receive non-refundable upfront payments for prior or future expenditures. We recognize revenue related to upfront payments ratably over our period of performance relating to the term of the contractual arrangements. Occasionally, we are required to estimate our period of performance when the agreements we enter into do not clearly define such information.  The revenue we recognize could be materially different if different estimates prevail. To date, we have not had to make material adjustments to our estimates. We have made estimates of our continuing obligations on several agreements. Our collaborative agreements typically include a research and/or development project plan that includes the activities the agreement requires each party to perform during the collaboration and the party responsible for performing them. We estimate the period of time over which we will complete the activities for which we are responsible and use that period of time as our period of performance for purposes of revenue recognition and amortize revenue over such period. When our collaborators have asked us to continue performing work in a collaboration beyond the initial period of performance, we have extended our amortization period to correspond to the new extended period of performance. In no case have adjustments to performance periods and related adjustments to revenue amortization periods had a material impact on our revenue.

Our collaborations often include contractual milestones. When we achieve these milestones, we are entitled to payment, according to the underlying agreements. We generally recognize revenue related to milestone payments upon completion of the milestone’s substantive performance requirement, as long as we are reasonably assured of collecting the resulting receivable, the amounts are not refundable and we have no future performance obligations related to the achievement of the milestone.

We often enter into revenue arrangements that contain multiple deliverables. In these cases, we recognize revenue from each element of the arrangement as long as we are able to determine a separate fair value for each element, we have completed our obligation to deliver or perform on that element and we are reasonably assured of collecting the resulting receivable.

As part of our Genzyme strategic alliance, in February 2008 Genzyme Corporation made a $150 million equity investment in us by purchasing five million shares of our common stock at $30 per share. The price Genzyme paid for our common stock represented a significant premium over the fair value of our stock.  Using a Black-Scholes option valuation model, we determined that the value of the premium was $100 million, which represented value Genzyme gave to us to help fund the companies’ research collaboration, which began in January 2008.  We accounted for this premium as deferred revenue and are amortizing it along with the $175 million licensing fee that we received in June 2008 ratably into revenue until June 2012, which represents the end of our performance obligation based on the current research and development pla n.

Licensing and royalty revenue

We often enter into agreements to license our proprietary patent rights on an exclusive or non-exclusive basis in exchange for license fees and/or royalties. We generally recognize as revenue immediately those licensing fees and royalties for which we have no significant future performance obligations and are reasonably assured of collecting the resulting receivable.

Short-term investments

We consider all liquid investments with maturities of 90 days or less when purchased to be cash equivalents. Our short-term investments have initial maturities of greater than 90 days from date of purchase. We classify our short-term investments as “available-for-sale” and carry them at fair market value based upon prices for identical or similar items on the last day of the fiscal period. We record unrealized gains and losses as a separate component of stockholders’ equity and include net realized gains and losses in gain (loss) on investments in the condensed consolidated statement of operations. We use the specific identification method to determine the cost of securities sold.

We have equity investments in privately- and publicly-held biotechnology companies.  We hold ownership interests of less than 20 percent in each of the respective companies except Regulus, our majority owned subsidiary, which we began accounting for using the equity method in the first quarter of 2010.  Prior to 2010, we consolidated Regulus’ financial results on a line-by-line basis. In determining if and when a decrease in market value below our cost in our equity positions is temporary or other-than-temporary, we examine historical trends in the stock price, the financial condition of the company, near term prospects of the company and our current need for cash.  We record unrealized gains and losses related to temporary declines in the publicly-held companies as a separate component of stockholders’ equity and account for securiti es in the privately-held companies, except for Regulus, under the cost method of accounting because we own less than 20 percent and do not have significant influence in their operations. When we determine that a decline in value in either a public or private investment is other-than-temporary, we recognize an impairment loss in the period in which the other-than-temporary decline occurs.  During the first six months of 2010, we recognized a $1.1 million loss on investments primarily consisting of an $880,000 non-cash loss related to the other-than-temporary impairment of our equity investment in Antisense Therapeutics Limited and $349,000 of valuation allowances we recorded related to the investments we made in Excaliard Pharmaceuticals, Inc. and Achaogen, Inc.  Because realization of our Excaliard and Achaogen investments is uncertain we recorded a full valuation allowance.  During the first six months of 2009, we recognized a $2.7 million gain on investments primarily co nsisting of a $2.5 million gain when we sold all of the common stock of OncoGenex Pharmaceuticals Inc. that we owned.  We determined that there were no other-than-temporary declines in value of our investments during the first six months of 2009.

Inventory valuation

We capitalize the costs of raw materials that we purchase for use in producing our drugs because until we use these raw materials they have alternative future uses. We include in inventory raw material costs for drugs that we manufacture for our partners under contractual terms and that we use primarily in our clinical development activities and drug products. We can use each of our raw materials in multiple products and, as a result, each raw material has future economic value independent of the development status of any single drug. For example, if one of our drugs failed, we could use the raw materials allocated for that drug to manufacture our other drugs. We expense these costs when we deliver the drugs to our partners, or as we provide these drugs for our own clinical trials. We reflect our inventory on the balance sheet at the lower of cost or market value under the first - -in, first-out method. We review inventory periodically and reduce the carrying value of items we consider to be slow moving or obsolete to their estimated net realizable value. We consider several factors in estimating the net realizable value, including shelf life of raw materials, alternative uses for our drugs and clinical trial materials and historical write-offs.  We did not record any inventory write-offs during the first six months of 2010 and 2009.  Total inventory, which consisted of raw materials, was $2.8 million as of June 30, 2010 and December 31, 2009.

Patents

We capitalize costs consisting principally of outside legal costs and filing fees related to obtaining patents. We review our capitalized patent costs regularly to ensure that they include costs for patent applications that have future value. We evaluate costs related to patents that we are not actively pursuing and write off any of these costs. We amortize patent costs over their estimated useful lives of ten years, beginning with the date the United States Patent and Trademark Office issues the patent. For the first six months of 2010 and 2009, we recorded a non-cash charge of $385,000 and $351,000, respectively, which we included in research and development expenses, related to the write-down of our patent costs to their estimated net realizable values.

Long-lived assets

We evaluate long-lived assets, which include property, plant and equipment, patent costs, and licenses acquired from third parties, for impairment on at least a quarterly basis and whenever events or changes in circumstances indicate that the carrying amount of such assets may not be recoverable.

Equity method of accounting

On January 1, 2010, we adopted an accounting standard, which replaced the quantitative-based risks and rewards calculation for determining which enterprise, if any, has a controlling financial interest in a variable interest entity.  The new approach focuses on identifying which enterprise has the power to direct the activities of a variable interest entity that most significantly impacts the variable interest entity’s economic performance and (1) the obligation to absorb losses of the variable interest entity or (2) the right to receive benefits from the variable interest entity.  As a result of adopting this new accounting standard, we were required to change the way we account for our variable interest in Regulus.  Since we and Alnylam Pharmaceuticals, Inc. share the ability to impact Regulus’ ec onomic performance, we are no longer the primary beneficiary of Regulus.  We adopted the new standard on a prospective basis; therefore, beginning in the first quarter of 2010, we deconsolidated Regulus from our condensed consolidated financial statements and began to account for our ownership interest in Regulus using the equity method of accounting.  This means that we no longer include Regulus’ revenue and operating expenses in our operating results.  Instead we include our share of Regulus’ operating results on a separate line in our condensed consolidated statement of operations called “Equity in net loss of Regulus Therapeutics Inc.”  On our condensed consolidated balance sheet, we present our investment in Regulus on a separate line in the non-current liabilities section called “Investment in Regulus Therapeutics Inc.”  We have not reclassified amounts in the prior period financial statements to conform to the current period presentation.  For additional information, see Note 3, Investment in Regulus Therapeutics Inc.

Use of estimates

The preparation of condensed consolidated financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the amounts reported in the condensed consolidated financial statements and accompanying notes. Actual results could differ from those estimates.  Historically, our estimates have been accurate as we have not experienced any material differences between our estimates and our actual results.

Basic and diluted net income (loss) per share

We compute basic net income (loss) per share by dividing the net income (loss) by the weighted-average number of common shares outstanding during the period. As we incurred a loss from continuing operations for the three and six months ended June 30, 2010 and 2009, we did not include the following diluted common equivalent shares in the computation of diluted net loss from continuing operations per share because the effect would have been anti-dilutive:

·                  25/8% convertible subordinated notes;

·                  GlaxoSmithKline convertible promissory notes;

·                  Dilutive stock options; and

·                  Warrants issued to Symphony GenIsis Holdings LLC

Consolidation of variable interest entities

We identify entities as variable interest entities either: (1) that do not have sufficient equity investment at risk to permit the entity to finance its activities without additional subordinated financial support, or (2) in which the equity investors lack an essential characteristic of a controlling financial interest.  As of June 30, 2010, we had collaborative arrangements with eight entities that we consider to be variable interest entities.  We are not the primary beneficiary for any of these entities.  For the six months ended June 30, 2009, our condensed consolidated financial statements included one variable interest entity, Regulus, for which we were the primary beneficiary.  As a result of adopting the new accounting standard related to our investment in Regulus in the first quarter of 2010, we deco nsolidated Regulus because we are no longer the primary beneficiary of Regulus.  See Note 3, Investment in Regulus Therapeutics Inc., for additional details.

Comprehensive income (loss)

We report, in addition to net income (loss) attributable to Isis Pharmaceuticals, Inc. common stockholders, comprehensive income (loss) and its components as follow (in thousands):

Convertible debt

We account for our 25/8% convertible notes by separating the liability and equity components of the instruments in a manner that reflects our nonconvertible debt borrowing rate when we recognize interest expense in subsequent periods.  As a result, we assigned a value to the debt component of our 25/8% convertible notes equal to the estimated fair value of a similar debt instrument without the conversion feature, which resulted in us recording the debt at a discount.  We are amortizing the resulting debt discount over the life of the debt as additional non-cash interest expense.  At June 30, 2010, the principal and accrued interest payable on our 25/8% convertible notes was $162.5 million and $1.6 million, respectively, and the fair value using quoted market prices was $154.1 million.  At December 31, 2009, the principal and accrued interest payable on the notes was $162.5 million and $1.6 million, respectively, and the fair value using quoted market prices was $165.8 million.

Stock-based compensation expense

We account for our stock-based compensation expense related to employee stock options and employee stock purchases by estimating the fair value of each employee stock option grant and the employee stock purchase plan (“ESPP”) purchase rights on the date of grant using the Black-Scholes model.  The expected term of stock options granted represents the period of time that they are expected to be outstanding.  We estimated the expected term of options granted based on historical exercise patterns.

For the six months ended June 30, 2010 and 2009, we used the following weighted-average assumptions in our Black-Scholes calculations:

Employee Stock Options:

ESPP:

Stock-based compensation expense (in thousands, except per share data) was allocated as follows:

As part of our Regulus joint venture, both we and Alnylam issued our own company’s stock options to members of Regulus’ Board of Directors, Scientific Advisory Board and employees of Regulus. In January 2009 as part of Regulus’ conversion to a C-Corporation both we and Alnylam modified our own company’s stock options issued to Regulus’ employees, members of Regulus’ Board of Directors and Scientific Advisory Board to stop vesting in these stock awards before the awards were fully vested.  Additionally, in February 2009, Regulus issued options to purchase its own common stock to Regulus’ employees, members of Regulus’ Board of Directors and members of Regulus’ Scientific Advisory Board.

As of June 30, 2010, total unrecognized compensation cost related to non-vested stock-based compensation plans was $13.6 million.  We will adjust total unrecognized compensation cost for future changes in estimated forfeitures.  We expect to recognize this cost over a weighted average period of 1.4 years.

Impact of recently issued accounting standards

In October 2009, the FASB issued a new accounting standard for revenue arrangements with multiple deliverables. This new standard requires companies to separate multiple-deliverable arrangements and at inception allocate arrangement consideration using a selling price hierarchy.  The new standard also requires additional disclosures about multiple-deliverable arrangements.  This guidance is effective prospectively for revenue arrangements entered into or materially modified in fiscal years beginning on or after June 15, 2010 and is effective for our fiscal year 2011.  We do not expect this new standard to have a material impact on our financial statements.

In March 2010, the FASB issued a new accounting standard that establishes a revenue recognition method for milestone payments in research and development agreements.  Under the new standard, entities can make an accounting policy election to recognize a payment that is contingent upon the achievement of a substantive milestone in its entirety in the period in which the milestone is achieved.  We have historically applied a revenue recognition method for milestone payments that is consistent with this new standard.  Therefore when we adopt this new standard in 2011, the only change required is to provide additional information about the substantive nature of the milestones in our research and development agreements.

3.                                      Investment in Regulus Therapeutics Inc.

In September 2007, we and Alnylam established Regulus as a company focused on the discovery, development, and commercialization of microRNA-based therapeutics.  Regulus combines the strengths and assets of our and Alnylam’s technologies, know-how, and intellectual property relating to microRNA-based therapeutics.

We and Alnylam each granted Regulus exclusive licenses to our respective intellectual property for microRNA therapeutic applications, as well as certain early fundamental patents in the microRNA field, including the “Tuschl III”, “Sarnow” and “Esau” patent series.  Alnylam made an initial investment of $10 million in Regulus to balance venture ownership. We own 51 percent of Regulus and Alnylam owns the remaining 49 percent. Regulus operates as an independent company with a separate board of directors, scientific advisory board and management team. We and Alnylam retain rights to develop and commercialize on pre-negotiated terms microRNA therapeutic products that Regulus decides not to develop either itself or with a partner.

We and Alnylam provide Regulus research and development and general and administrative services under the terms of a services agreement.

In January 2009, Regulus completed a legal reorganization from a limited liability company to a C-Corporation.  In March 2009, Regulus raised $20 million in a Series A preferred equity financing, in which we and Alnylam were the sole and equal investors.

Regulus Collaborations

sanofi-aventis

In June 2010, Regulus entered into a global, strategic alliance with sanofi-aventis to discover, develop, and commercialize microRNA therapeutics. The alliance includes $750 million of potential milestone payments in addition to a $25 million upfront fee, a $10 million future equity investment and annual research support for three years with the option to extend two additional years. In addition, Regulus is eligible to receive royalties on microRNA therapeutic products commercialized by sanofi-aventis.  Sanofi-aventis also received an option for a broader technology alliance that provides Regulus certain rights to participate in development and commercialization of resulting products. If exercised, this three-year option is worth up to an additional $50 million to Regulus. We and Alnylam are each eligible to receive 7.5% of the upfront payment and all potential mileston e payments, in addition to royalties on product sales.  As a result, in July 2010 we received a payment of $1.9 million from Regulus.

GlaxoSmithKline

In April 2008, Regulus entered into a strategic alliance with GlaxoSmithKline, or GSK, to discover, develop and commercialize novel microRNA-targeted therapeutics to treat inflammatory diseases such as rheumatoid arthritis and inflammatory bowel disease. The alliance utilizes Regulus’ expertise and intellectual property position in the discovery and development of microRNA-targeted therapeutics and provides GSK with an option to license drug candidates directed at four different microRNA targets with relevance in inflammatory disease. Regulus will be responsible for the discovery and development of the microRNA antagonists through completion of clinical proof of concept, unless GSK chooses to exercise its option earlier. After exercise of the option, GSK will have an exclusive license to drugs Regulus develops under each program for the relevant microRNA targe t for further development and commercialization on a worldwide basis. Regulus will have the right to further develop and commercialize any microRNA therapeutics which GSK chooses not to develop or commercialize.

In 2008, Regulus received $20 million in upfront payments from GSK, including a $15 million option fee and a $5 million note. The note plus interest will convert into Regulus stock in the future if Regulus achieves a minimum level of financing with institutional investors. In addition, we and Alnylam are guarantors of the note, and if the note does not convert or if Regulus does not repay the note in cash by April 2011, we, Alnylam and Regulus may elect to repay the note plus interest with shares of each company’s common stock or cash.  Regulus is eligible to receive from GSK up to $144.5 million in development, regulatory and sales milestone payments for each of the four microRNA-targeted drugs discovered and developed as part of the alliance. In May 2009, Regulus received a $500,000 discovery milestone payment from its collaboration with GSK for demonstrating a pharmacological effect in immune cells by specific microRNA inhibition.  In addition, Regulus would receive from GSK tiered royalties up to double digits on worldwide sales of drugs resulting from the alliance.

In February 2010, Regulus announced the establishment of a new worldwide strategic alliance with GSK to develop and commercialize microRNA therapeutics targeting microRNA 122, or miR-122, for the treatment of hepatitis C virus, or HCV, infection.  The new HCV alliance expands the ongoing GSK-Regulus immuno-inflammatory disease alliance formed in 2008.  Under the terms of this HCV collaboration, Regulus received $8 million from GSK, including a $3 million license fee and a second $5 million note (guaranteed by Isis and Alnylam) that will convert into Regulus stock in the future if Regulus achieves a minimum level of financing with institutional investors.  In addition, Regulus is eligible to receive several near-term significant payments associated with the advancement of an HCV drug, plus additional milestone payments with the potential to ear n more than $150 million in miR-122-related combined payments and double-digit royalties consistent with the existing immuno-inflammatory diseases alliance terms established in April 2008.  Because GSK has selected Regulus’ miR-122 for the new collaboration, the number of immuno-inflammatory programs GSK has an option to license under the 2008 immuno-inflammatory alliance has been reduced from four to three.

As part of the HCV collaboration, Regulus granted GSK a limited license to develop and commercialize the miR-122 antagonist SPC 3649, if GSK acquires rights to this compound.  Regulus will receive development and regulatory milestones as well as royalties if GSK develops and commercializes SPC 3649.

Equity method of accounting

On January 1, 2010, as a result of adopting the new accounting standard for identifying which enterprise has the power to direct activities of a variable interest entity, we prospectively changed the way we account for our variable interest in Regulus.  Since we and Alnylam share the ability to impact Regulus’ economic performance, we are no longer the primary beneficiary of Regulus.  Beginning in the first quarter of 2010, we deconsolidated Regulus from our condensed consolidated financial statements and began to account for our ownership interest in Regulus using the equity method of accounting.  Below is a table summarizing the accounting impact to our balance sheet as of January 1, 2010 as a result of adopting the equity method of accounting (in thousands):

Under the equity method of accounting, we are required to suspend losses if our share of Regulus’ net loss exceeds the amount of funding we were required to provide.  Since we and Alnylam are guarantors of both of the convertible notes that Regulus issued to GSK, we continued to recognize losses in excess of our net investment in Regulus up to the $5 million we guaranteed.  If we had been applying the equity method from inception, we would have suspended recognizing our share of Regulus’ losses in 2008 because it would have exceeded the amount we guaranteed under the first GSK convertible note.  When we made the $10 million investment in March 2009 we would have recognized all of the suspended losses.

4.                                      Discontinued Operations

In January 2009, AMI completed its acquisition of Ibis for a total purchase price of $215 million.  Since we sold Ibis to AMI and Ibis met the criteria for a component of an entity, we reflect Ibis as a discontinued operation.  Accordingly, we have presented the operating results of Ibis in our condensed consolidated statements of operations as discontinued operations.  Net income from discontinued operations for the first six months of 2009 primarily consisted of the $202.5 million gain related to the sale of Ibis to AMI less $15.4 million of income tax expense.  The components of discontinued operations for the six months ended June 30, 2009 are as follows (in thousands):

We do not have any remaining assets and liabilities from discontinued operations in our accompanying condensed consolidated balance sheets at June 30, 2010 and December 31, 2009.  We have not separately classified cash flows from discontinued operations in our condensed consolidated statement of cash flows.

5.                                      Investments

As of June 30, 2010, our excess cash was primarily invested in commercial paper and debt instruments with strong credit ratings of financial institutions, corporations, U.S. government agencies and the U.S. Treasury. We have established guidelines relative to diversification and maturities that maintain safety and liquidity. We periodically review and modify these guidelines to maximize trends in yields and interest rates without compromising safety and liquidity.

The following table summarizes the contract maturity of the available-for-sale securities we held as of June 30, 2010:

At June 30, 2010, we had an ownership interest of less than 20% in each of five private companies and two public companies with which we conduct business.  The companies are Santaris Pharma A/S, Achaogen, Atlantic Pharmaceuticals Limited, Altair Therapeutics Inc. and Excaliard, which are privately-held and ATL and iCo Therapeutics Inc., which are publicly-traded.  We account for securities in the privately-held companies under the cost method of accounting.  During the first six months of 2010, we recognized a $1.1 million loss on investments primarily consisting of an $880,000 non-cash loss related to the other-than-temporary impairment of our equity investment in ATL and $349,000 of valuation allowances we recorded related to the investments we made in Excaliard and Achaogen.  Because realization of our Excaliard and Achaogen investments is uncertain we recorded a full valuation allowance.

Beginning in the first quarter of 2010, we deconsolidated Regulus from our condensed consolidated financial statements and began to account for our ownership interest in Regulus using the equity method of accounting.  As a result, our short-term investments balance at June 30, 2010 did not include Regulus’ short-term investments, compared to $14.5 million at December 31, 2009.  The following is a summary of our investments (in thousands):