Note 1. Summary of Significant Accounting Policies

Scanners and CAD/CAM Services

We recognize revenues from the sales of iTero and iOC scanners and CAD/CAM services.  CAD/CAM services include scanning services, extended warranty for the scanners, a range of iTero restorative services and OrthoCAD services, such as OrthoCAD iCast, OrthoCAD iQ, and OrthoCAD iRecord.  We sell scanners and services through both our direct sales force and distributors.  The scanner sales price includes one year of warranty, and for additional fees, the customer may select an unlimited scanning service agreement over a fixed period of time or extended warranty periods.  When scanners are sold with either an unlimited scanning service agreement and/or extended warranty, we allocate revenue based on each element's relative selling price.  We estimate the selling price of each element, as if it is sold on a stand-alone basis, taking into consideration historical prices as well as our pricing and discounting strategies.  We will continue to review our estimates as we continue to integrate Cadent into our business.

Revenues for unlimited scanning service agreements and extended warranty are recognized ratably over the service periods.  If a customer selects a pay per use basis for scanning service fees, the revenue is recognized as the service is provided.

For direct sales and sales to certain distributors, scanner revenue is recognized once the scanner has been installed and on-site training is completed.  For other distributors who provide training to the customer, we recognize scanner revenue when the scanner is shipped to the distributor assuming all of the other revenue recognition criteria have been met.

Revenues from iTero restorative services and OrthoCAD services are recognized as the services are provided

.

Note 2. Marketable Securities and Fair Value Measurements

Our short-term and long-term marketable securities as of June 30, 2011 and December 31, 2010 are as follows (in thousands):

Short-term

Long-term

Short-term

Long-term

For the three and six months ended June 30, 2011 and 2010, no significant gains or losses were realized on the sale of marketable securities.

Fair Value Measurements

We measure the fair value of our cash equivalents and marketable securities as the price 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 GAAP fair value hierarchy that prioritizes the inputs to valuation techniques used to measure fair value.  This hierarchy requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value.  The three levels of inputs that may be used to measure fair value:

Level 1—Quoted (unadjusted) prices in active markets for identical assets or liabilities.

Our Level 1 assets consist of money market funds.  We did not hold any Level 1 liabilities as of June 30, 2011.

Level 2—Observable inputs other than quoted prices included in Level 1, such as quoted prices for similar assets or liabilities in active markets; quoted prices for identical or similar assets or liabilities in markets that are not active; or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the asset or liability.

Our Level 2 assets consist of corporate bonds, foreign bonds, agency bonds, and discount notes.  We did not hold any Level 2 liabilities as of June 30, 2011.

Level 3—Unobservable inputs to the valuation methodology that are supported by little or no market activity and that are significant to the measurement of the fair value of the assets or liabilities.  Level 3 assets and liabilities include those whose fair value measurements are determined using pricing models, discounted cash flow methodologies or similar valuation techniques, as well as significant management judgment or estimation.

We did not hold any Level 3 assets or liabilities as of June 30, 2011.  The following table summarizes our financial assets measured at fair value on a recurring basis as of June 30, 2011 (in thousands):

Note 3. Balance Sheet Components

Inventories

Inventories are comprised of (in thousands):

Work in process includes costs to produce the Invisalign and scanner products.  Finished goods primarily represent our scanners and ancillary products that support the Invisalign system.

Accrued liabilities

Accrued liabilities consist of the following (in thousands):

Note 4. Business Combination

On April 29, 2011, we completed the acquisition of Cadent Holdings, Inc. ("Cadent") pursuant to the Agreement and Plan of Merger (the "Merger Agreement").  Cadent is a provider of 3D digital scanning solutions for the orthodontic and dental industry.  We expect the acquisition of Cadent to strengthen our ability to drive the adoption of Invisalign by integrating Invisalign treatment more fully with mainstream tools and procedures in doctors' practices.

Pursuant to the terms and subject to the conditions set forth in the Merger Agreement, we acquired Cadent, which became a wholly owned subsidiary of Align, for an aggregate cash purchase price of approximately $187.0 million.

The following table summarizes the allocation of the preliminary purchase price as of April 29, 2011 (in thousands):

The preliminary allocation is based on estimates, assumptions, valuations and other studies which have not progressed to a stage where there is sufficient information to make a definitive allocation.  Accordingly, the allocation will remain preliminary until we have all information to finalize the allocation of the purchase price.  We have incurred direct transaction costs of approximately $6.4 million that include investment banking, legal and accounting fees, and other external costs directly related to the acquisition.  These costs were expensed as incurred as part of our operating expenses.

Goodwill of $135.3 million represents the excess of the purchase price over the fair value of the underlying net tangible and identifiable intangible assets, and represents the expected synergistic benefits of the transaction and the knowledge and experience of the workforce in place. None of this goodwill will be deductible for tax purposes.  Under the applicable accounting guidance, goodwill will not be amortized but will be tested for impairment on an annual basis or more frequently if certain indicators are present.  As of June 30, 2011, we are still in the process of assessing the assignment of this goodwill to the appropriate reporting units.

During the period of May 2011 through June 2011, Cadent contributed revenues of approximately $6.4 million and net loss of approximately $3.1 million.

The following table presents the results of Align and Cadent for three and six months ended June 30, 2011 and 2010, on a pro forma basis, as though the companies had been combined as of the beginning of January 1, 2011 and 2010.  The pro forma financial information is presented for informational purposes only and is not indicative of the results of operations that would have been achieved if the acquisition had taken place at the beginning of January 1, 2011 and 2010 or of results that may occur in the future (in thousands):

Note 5. Goodwill

The change in the carrying value of goodwill for the six months ended June 30, 2011 is as follows (in thousands):

Goodwill of $135.3 million as a result of the Cadent acquisition represents the excess of the purchase price over the fair value of the underlying net tangible and identifiable intangible assets, and represents the expected synergistic benefits of the transaction and the knowledge and experience of the workforce in place.  Under the applicable accounting guidance, goodwill will not be amortized but will be tested for impairment on an annual basis or more frequently if certain indicators are present.

Note 6. Intangible Assets

Acquired intangible assets

Information regarding our intangible assets as a direct result from the Cadent acquisition is being amortized as follows (in thousands):

Amortization of the acquired existing technology is recorded in cost of revenue, while the amortization of acquired trademarks and customer relationships are included in operating expenses.  The following table summarizes the amortization expense of acquired intangible assets for the periods indicated (in thousands):

The total estimated annual future amortization expense for these acquired intangible assets as of June 30, 2011 is as follows (in thousands):

Non-compete Agreements

The non-compete intangible assets represent agreements received in conjunction with the October 2006 OrthoClear Agreement at gross value of $14.0 million.  These assets are amortized on a straight-line basis over the expected useful life of five years.  As of June 30, 2011 and December 31, 2010, the net carrying value of these non-compete agreements was $0.8 million (net of $13.2 million of accumulated amortization) and $2.2 million (net of $11.8 million of accumulated amortization), respectively.

The total estimated annual future amortization expense for these intangible assets as of June 30, 2011 is $0.8 million.  These non-compete intangible assets will be fully amortized by the end of third quarter of 2011.

Impairment assessment

We perform an impairment test whenever events or changes in circumstances indicate that the carrying value of such assets may not be recoverable.  Examples of such events or circumstances include significant underperformance relative to historical or projected future operating results, significant changes in the manner of use of acquired assets or the strategy for its business, significant negative industry or economic trends, and/or a significant decline in our stock price for a sustained period.  Impairments are recognized based on the difference between the fair value of the asset and its carrying value, and fair value is generally measured based on discounted cash flow analyses.  There were no impairments of intangible assets during the periods presented.

Note 7. Legal Proceedings

Weber

On May 18, 2007, Debra A. Weber filed a consumer class action lawsuit against us, OrthoClear, Inc. and OrthoClear Holdings, Inc. (d/b/a OrthoClear, Inc.) in Syracuse, New York, U.S. District Court.  The complaint alleges two causes of action against the OrthoClear defendants and one cause of action against us for breach of contract.  The cause of action against us titled "Breach of Third Party Benefit Contract" references our agreement to make Invisalign treatment available to OrthoClear patients, alleging that we failed "to provide the promised treatment to Plaintiff or any of the class members."  On June 2, 2010, the Court granted our motion for summary judgment and dismissed us from the action.

On June 29, 2010, Weber requested that the Court enter final judgment as to Align pursuant to Federal Rule of Civil Procedure 54(b) in order to certify Align's dismissal for immediate appeal.  We filed an opposition to Weber's request on July 19, 2010, on the grounds that Weber failed to show that exceptional circumstances warranted the entry of a final judgment where fewer than all claims or parties had been dismissed.  On August 20, 2010, the Court denied Weber's motion.  On October 29, 2010, the Court dismissed the action against OrthoClear and OrthoClear Holdings Inc. with prejudice at the request of the remaining parties pursuant to a settlement.  The Stipulation and Order of Dismissal with Prejudice entered by the Court provides that the settlement and dismissal does not affect any rights Weber may have to appeal dismissal of the action as against us.  We believe Weber's right to appeal expired earlier this year, and that there is no evidence to indicate that a reasonable possibility exists that a loss had been incurred as of June 30, 2011.

Securities Litigation

In August 2009, Plaintiff Charles Wozniak filed a lawsuit against us and our Chief Executive Officer and President, Thomas M. Prescott ("Mr. Prescott"), in District Court for the Northern District of California on behalf of a claimed class consisting of all persons or entities who purchased our common stock between January 30, 2007 and October 24, 2007.  The complaint alleges that Align and Mr. Prescott violated Section 10(b) of the Securities Exchange Act of 1934 and that Mr. Prescott violated Section 20(a) of the Securities Exchange Act of 1934.  Specifically, the complaint alleges that during the class period we failed to disclose that we had shifted the focus of our sales force to clearing backlog, causing a significant decrease in the number of new case starts.  On November 13, 2009, the Court appointed Plumbers and Pipefitters National

Pension Fund as lead plaintiff.   The lead plaintiff filed an amended complaint on January 29, 2010.   The amended complaint alleges that we and Mr. Prescott issued a number of purportedly false and misleading statements throughout the class period concerning the Patients First program, our production capacity, a purported backlog, and the focus of our sales force.   On March 26, 2010, we and Mr. Prescott filed a motion to dismiss the amended complaint.   The motion was heard by the Court on July 9, 2010 and on June 8, 2011, the Court granted our motion to dismiss with leave to amend.   On July 22, 2011, the lead plaintiff filed a second amended complaint adding allegations that Align and Mr. Prescott issued a number of purportedly false and misleading statements throughout the class period concerning our ClinAdvisor product.   A response to the seconded complaint is not yet due from Align or Mr. Prescott.  We believe the lawsuit to be without merit and intend to vigorously defend ourselves.   We believe there is no evidence to indicate that a reasonable possibility exists that a loss had been incurred as of June 30, 2011.

Note 8. Legal Settlements

Ormco

On August 16, 2009 we entered into a Settlement Agreement with Ormco Corporation, an affiliate of Danaher Corporation that ended all pending litigation between the parties and included a payment of $7.0 million for prepaid royalties.   We amortized $6.2 million of the prepaid royalties to cost of sales in fiscal year 2009 and the remaining $0.8 million in the first quarter of 2010.

Leiszler

On May 10, 2010, Christopher J. Leiszler filed a complaint against us in the United States District Court for the Northern District of California.   The complaint alleged that we implemented unfair and fraudulent requirements for the prescription of Invisalign through the Invisalign Proficiency Requirements for minimum case submission and continuing education credits requirements.   In January 2010 Dr. Leiszler's Invisalign provider status was suspended for failing to meet the Proficiency Requirements.   Dr. Leiszler sued on behalf of himself and all others similarly situated.   The complaint sought a refund of the price paid to us for Invisalign training.   On October 19, 2010, we entered into a memorandum of understanding to resolve this litigation, and on November 30, 2010, we executed a formal Stipulation of Settlement.   On December 23, 2010, the Court granted preliminary approval of the proposed settlement and on April 8, 2011, granted final approval of the settlement.   The settlement took effect on May 18, 2011.   Under the terms of the settlement, class members who did not elect to receive the cash remedy prior to the Court-ordered deadline will be reinstated to prescribe Invisalign treatment after the effective date under certain circumstances.   In January 2011, we deposited approximately $8.0 million into an escrow account to pay eligible class members who elected the cash remedy, as well as legal fees and other costs.   We recorded a total litigation settlement charge of $4.5 million during the third and fourth quarter of 2010 for this settlement.   In early June 2011, payments were made from the escrow account to class members who elected the cash remedy and the remaining balance of the escrow has been refunded to Align, except for a nominal amount which has been retained for administrative purposes. As of June 30, 2011, we have no further liability related to this matter.

Note 9. Credit Facilities

On December 14, 2010, we renegotiated and amended our existing credit facility with Comerica Bank.   Under this revolving line of credit, we have $30.0 million of available borrowings with a maturity date of December 31, 2012.   The interest rate on borrowings will range from Libor plus 1.5% to 2.0% depending upon the amount of cash we maintain at Comerica Bank.   This credit facility requires a quick ratio covenant and also requires us to maintain a minimum unrestricted cash balance of $10.0 million.   Additionally, in the event our unrestricted cash deposited is less than $55.0 million, the unused facility fee will increase from 0.050% per quarter to 0.125% per quarter.   As of June 30, 2011, we had no outstanding borrowings under this credit facility and are in compliance with the financial covenants.

Note 10. Commitments and Contingencies

Operating Leases

As of June 30, 2011, minimum future lease payments for non-cancelable leases are as follows (in thousands):

Warranty

We regularly review the accrued balances and update these balances based on historical warranty trends.  Actual warranty costs incurred have not materially differed from those accrued.  However, future actual warranty costs could differ from the estimated amounts.

Invisalign

We warrant our Invisalign products against material defects until the Invisalign case is complete.  We accrue for warranty costs in cost of revenues upon shipment of products.  The amount of accrued estimated warranty costs is primarily based on historical experience as to product failures as well as current information on replacement costs.

Scanners

We warrant our scanners for a period of one year, which include materials and labor.  Extended warranty may be purchased for additional fees.  We accrue for these warranty costs based on average historical repair costs.

The following table reflects the change in our warranty accrual during the six months ended June 30, 2011 and 2010, respectively (in thousands):

Note 11. Stock-based Compensation

Summary of stock-based compensation expense

On May 19, 2011 the Shareholders approved an increase of 3,000,000 shares to the 2005 Incentive Plan (as amended) for a total reserve of 16,283,379 shares for issuance, plus up to an aggregate of 5,000,000 shares that would have been returned to our 2001 Stock Incentive Plan as a result of termination of options on or after March 28, 2005.

Stock-based compensation expense is based on the estimated fair value of awards, net of estimated forfeitures and recognized over the requisite service period.  Estimated forfeitures are based on historical experience at the time of grant and may be revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates.  The stock-based compensation expense related to all of our stock-based awards and employee stock purchases for the three and six months ended June 30, 2011 and 2010 are as follows (in thousands):

Options

Activity for the six months period ended June 30, 2011 under the stock option plans are set forth below (in thousands, except years and per share amounts):

The fair value of stock options granted was estimated at the grant date using the Black-Scholes option pricing model with the following weighted average assumptions:

As of June 30, 2011, we expect to recognize $13.5 million of total unamortized compensation cost, net of estimated forfeitures, related to stock options over a weighted average period of 2.4 years.

Restricted Stock Units

A summary of the nonvested shares for the six months ended June 30, 2011 is as follows:

As of June 30, 2011 the total unamortized compensation cost related to restricted stock units, net of estimated forfeitures, was $16.7 million, which we expect to recognize over a weighted average period of 2.8 years.

On February 18, 2011, we granted market-performance based restricted stock units ("MSU") to our named executive officers.  Each MSU represents the right to one share of Align's common stock and will be issued through our amended 2005 Incentive Plan.  The actual number of MSUs which will be eligible to vest will be based on the performance of Align's stock price relative to the performance of the NASDAQ Composite Index over the vesting period, generally two to three years, up to 150% of the MSUs initially granted.

The following table summarizes the MSU performance as of June 30, 2011:

As of June 30, 2011, we expect to recognize $2.1 million of total unamortized compensation cost, net of estimated forfeitures, related to MSU over a weighted average period of 2.1 years.  There were no MSUs granted during the second quarter of 2011.

Employee Stock Purchase Plan

In May 2010, our shareholders approved the 2010 Employee Stock Purchase Plan (the "2010 Purchase Plan") to replace the 2001 Purchase Plan which expired on January 31, 2011.  The terms and features of the 2010 Purchase Plan are substantially the same as the 2001 Purchase Plan and will continue until terminated by either the Board or its administrator.  The maximum number of shares available for issuance under the 2010 Purchase Plan is 2,400,000 shares.

As of June 30, 2011, we expect to recognize $2.4 million of the total unamortized compensation cost related to employee purchases over a weighted average period of 0.5 years.

Note 12. Accounting for Income Taxes

The financial statement recognition of the benefit for an uncertain tax position is dependent upon the benefit being more-likely-than-not to be sustainable upon audit by the applicable taxing authority.  If this threshold is met, the tax benefit is then measured and recognized at the largest amount that is greater than fifty percent likely of being realized upon ultimate settlement.

During the second quarter of fiscal 2011, the amount of unrecognized tax benefits was increased by approximately $0.9 million.  The total amount of unrecognized tax benefits was $13.0 million as of June 30, 2011, which would impact our effective tax rate if recognized.  We are subject to taxation in the U.S. and various states and foreign jurisdictions.  All of our tax years will be open to examination by the U.S. federal and most state tax authorities due to our net operating loss and overall credit carryforward position.  With few exceptions, we are no longer subject to examination by foreign tax authorities for years before 2006.

Note 13. Net Profit Per Share

Basic net profit per share is computed using the weighted average number of shares of common stock outstanding during the period.  Diluted net profit per share is computed using the weighted average number of shares of common stock, adjusted for the dilutive effect of potential common stock.  Potential common stock, computed using the treasury stock method, include options, restricted stock units, and the dilutive component of Purchase Plan shares.

The following table sets forth the computation of basic and diluted net profit per share attributable to common stock (in thousands, except per share amounts):

For the three and six months ended June 30, 2011, stock options and restricted stock units totaling 0.8 million and 1.7 million, respectively, were excluded from diluted net profit per share because of their anti-dilutive effect.  For the three and six months ended June 30, 2010, stock options and restricted stock units totaling 3.3 million and 2.9 million, respectively, were excluded from diluted net profit per share because of their anti-dilutive effect.

Note 14. Comprehensive Income

Comprehensive income includes net profit, foreign currency translation adjustments and unrealized gains on available-for-sale securities.  The components of comprehensive income are as follows (in thousands):

Note 15. Segments and Geographical Information

Segment Information

Operating segments are defined as components of an enterprise about which separate financial information is available that is evaluated regularly by the Chief Operating Decision Maker ("CODM"), or decision-making group, in deciding how to allocate resources and in assessing performance.  Currently, the CODM is the Chief Executive Officer.  We report segment information based on the "management" approach.  The management approach designates the internal reporting used by management for making decisions and assessing performance as the source of our reportable segment.  During all periods presented, we operated as a single business segment based on the decisions and performance assessment of Align by our CODM.

Geographical Information

Net revenues and long-lived assets are presented below by geographic area (in thousands):

Note 16. Subsequent Event

On August 4, 2011, we entered into a definitive agreement with Lexmark International to purchase land and a manufacturing facility in Juarez, Mexico, for approximately $3.2 million. This purchase will expand our current manufacturing capacity in order to meet expected demand. The closing of the purchase and sale is subject to customary closing conditions and is expected to occur in approximately 75 days.

Short-term