realized greater benefits associated with our ongoing cost-improvement programs. As a result, new product introductions may initially negatively impact our gross margin.
Our research and development expenses include costs for supplies and materials related to product development, as well as the engineering costs incurred to design capacitive interface solutions for OEM customers prior to and after their commitment to incorporate those solutions into their products. These expenses have generally increased, reflecting our continuing commitment to the technological and design innovation required to maintain our position in our existing markets and to adapt our existing technologies or develop new technologies for new markets.
Selling, general, and administrative expenses include expenses related to sales, marketing, and administrative personnel; internal sales and outside sales representatives' commissions; market and usability research; outside legal, accounting, and consulting costs; and other marketing and sales activities. These expenses have generally increased, primarily reflecting incremental staffing and related support costs associated with our increased business levels, growth in our existing markets, and penetration into new markets. Critical Accounting Policies and Estimates The preparation of consolidated financial statements in conformity with U.S. generally accepted accounting principles requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenue, expenses, and related disclosure of contingent assets and liabilities. On an ongoing basis, we evaluate our estimates, including those related to revenue recognition, allowance for doubtful accounts, cost of revenue, inventories, product warranty, provision for income taxes, income taxes payable, intangible assets, and contingencies. We base our estimates on historical experience, applicable laws, and various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.
The methods, estimates, interpretations, and judgments we use in applying our most critical accounting policies can have a significant impact on the results that we report in our consolidated financial statements. The SEC considers an entity's most critical accounting policies to be those policies that are both most important to the portrayal of the entity's financial condition and results of operations and those that require the entity's most difficult, subjective, or complex judgments, often as a result of the need to make estimates about matters that are inherently uncertain when estimated. We believe the following critical accounting policies affect our more significant judgments and estimates used in the preparation of our consolidated financial statements. Revenue Recognition
We recognize revenue from product sales when there is persuasive evidence that an arrangement exists, delivery has occurred or title has transferred, the price is fixed or determinable, and collection is reasonably assured. We accrue for estimated sales returns and other allowances, based on historical experience, at the time we recognize revenue. We record contract revenue for research and development as we provide the services under the terms of the contract. We recognize non-refundable contract fees for which no further performance obligations exist and for which there is no continuing involvement by us on the earlier of when the payments are received or when collection is assured.
Investments
We account for investment securities in accordance with U.S. GAAP. The current accounting standards require us to record available-for-sale securities at fair value, with unrealized gains and losses being reported as a component of other comprehensive income, to assess whether our investments with unrealized loss positions are other-than-temporarily impaired and to determine whether an impairment of debt securities is other-than-temporary. We follow the hierarchal approach to determine fair value of our investments, which we adopted at the beginning of fiscal 2009.
Fair value is defined as the price to be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Our fair value estimates consider, among other factors, the collateral underlying the security investments, creditworthiness of the counterparty, timing of expected future cash flows, and, in the case of ARS, the probability of a successful auction in a future period. We follow the guidance provided by current accounting standards to estimate fair value when the volume and level of activity for an asset or liability have significantly decreased in relation to normal market activity for the asset or liability, and to determine circumstances that may indicate that a transaction is not orderly.

Further, we use judgment in evaluating whether a decline in fair value is temporary or other-than-temporary and consider the following indicators: changes in credit ratings or asset quality; changes in the economic environment; length of time and extent to which fair value has been below cost basis; changes in market conditions; changes in expected cash flows; and our ability and intent to hold the investment for a period of time that may be sufficient for anticipated recovery in market value. Temporary declines in fair value are recorded as charges to accumulated other comprehensive income/(loss) in the equity section of our balance sheet, while other-than-temporary declines in fair value are bifurcated between credit losses, which are charged to earnings, and noncredit losses, which depending on facts and circumstances may be charged to other comprehensive income/(loss) or earnings. Inventory
We state our inventories at the lower of cost or market. We base our assessment of the ultimate realization of inventories on our projections of future demand and market conditions. Sudden declines in demand, rapid product improvements, or technological changes, or any combination of these factors can cause us to have excess or obsolete inventories. On an ongoing basis, we review for estimated obsolete or unmarketable inventories and write down our inventories to their net realizable value based upon our forecasts of future demand and market conditions. If actual market conditions are less favorable than our forecasts, additional inventory write-downs may be required. The following factors influence our estimates: changes to or cancellations of customer orders, unexpected decline in demand, rapid product improvements and technological advances, and termination or changes by our OEM customers of any product offerings incorporating our product solutions.
Periodically, we purchase inventory from our contract manufacturers when a customer delays its delivery schedule or cancels its order. In those circumstances in which our customer has cancelled its order and we purchase inventory from our contract manufacturers, we consider a write-down to reduce the carrying value of the inventory purchased to its net realizable value. We charge write-downs to reduce the carrying value of obsolete, slow moving, and non-usable inventory to net realizable value to cost of revenue. The effect of these write-downs is to establish a new cost basis in the related inventory, which we do not subsequently write up.
Share-Based Compensation Costs
We utilize the Black-Scholes option pricing model to estimate the grant date fair value of employee share-based compensatory awards, which requires the input of highly subjective assumptions, including expected volatility and expected life. Historical and implied volatilities were used in estimating the fair value of our share-based awards, while the expected life for our options and estimated forfeitures for share-based awards that are not expected to vest were estimated based on historical trends since our initial public offering. Changes in these inputs and assumptions can materially affect the measure of estimated fair value of our share-based compensation. We charge the estimated fair value less estimated forfeitures to earnings on a straight-line basis over the vesting period of the underlying awards, which is generally four years for our stock options and deferred stock units and up to two years for our employee stock purchase plan.
The Black-Scholes option pricing model was developed for use in estimating the fair value of traded options that have no vesting restrictions and are fully transferable. As our stock option and employee stock purchase plan awards have characteristics that differ significantly from traded options, and as changes in the subjective assumptions can materially affect the estimated value, our estimate of fair value may not accurately represent the value assigned by a third party in an arms-length transaction. There currently is no market-based mechanism to verify the reliability and accuracy of the estimates derived from the Black-Scholes option pricing model or other allowable valuation models, and there is no means to compare and adjust the estimates to actual values. While our estimate of fair value and the associated charge to earnings materially affects our results of operations, it has no impact on our cash position.
There are significant variations among allowable valuation models, and there is a possibility that we may adopt a different valuation model or refine the inputs and assumptions under our current valuation model in the future, resulting in a lack of consistency in future periods. Our current or future valuation model and the inputs and assumptions we make may also lack comparability to other companies that use different models, inputs, or assumptions, and the resulting differences in comparability could be material. Income Taxes
We recognize federal, foreign, and state current tax liabilities or assets based on our estimate of taxes payable or refundable in the then current fiscal year for each tax jurisdiction. We also recognize federal, foreign, and state deferred tax liabilities or assets for our estimate of future tax effects attributable to temporary differences and carryforwards and

record a valuation allowance to reduce any deferred tax assets by the amount of any tax benefits that, based on available evidence and our judgment, are not expected to be realized. If our assumptions, and consequently our estimates, change in the future, the valuation allowance we have established for our deferred tax assets may be changed, which could impact income tax expense.
We follow a two-step approach to recognizing and measuring uncertain tax positions. The first step is to determine whether it is more-likely-than-not that a tax position will be sustained upon examination, including resolution of any related appeals or litigation processes. The second step is to measure the tax benefit as the largest amount that is more than 50% likely of being realized upon ultimate settlement with a taxing authority. The calculation of tax liabilities involves significant judgment in estimating the impact of uncertainties in the application of highly complex tax laws. Resolution of these uncertainties in a manner inconsistent with our expectations could have a material impact on our consolidated financial position, result of operations, or cash flows. We believe we have adequately provided for reasonably foreseeable outcomes in connection with the resolution of income tax uncertainties. However, our results have in the past, and could in the future, include favorable and unfavorable adjustments to our estimated tax liabilities in the period a determination of such estimated tax liability is made or resolved, upon the filing of an amended return, upon a change in facts, circumstances, or interpretation, or upon the expiration of a statute of limitation. Accordingly, our effective tax rate could fluctuate materially from period to period.
We recognize tax benefit upon expensing nonqualified stock options and deferred stock units issued under our share-based compensation plans. However, we cannot recognize tax benefit concurrent with expensing incentive stock options and employee stock purchase plan shares (qualified stock options) issued under our share-based compensation plans. For qualified stock options that vested after we began expensing share-based compensation, we recognize tax benefit only in the period when disqualifying dispositions of the underlying stock occur, which historically has been up to several years after vesting and in periods when our stock price substantially increases. For qualified stock options that vested prior to when we began expensing share-based compensation, we record the tax benefit directly to additional paid-in capital. Accordingly, because we cannot recognize the tax benefit for share-based compensation expense associated with qualified stock options until the occurrence of future disqualifying dispositions of the underlying stock and such disqualified dispositions may happen in periods when our stock price substantially increases, and because a portion of that tax benefit may be directly recorded to additional paid-in capital, our future quarterly and annual effective tax rates will be subject to greater volatility and, consequently, our ability to estimate reasonably our future quarterly and annual effective tax rates is greatly diminished.

Results of Operations
Three months ended September 30, 2009 compared with the three months ended
September 30, 2008
Net Revenue.

                                                   Three Months Ended September 30,
(in thousands)                             2009          2008        $ Change       % Change
PC applications                          $  74,565     $  83,440     $  (8,875 )        -10.6 %
% of net revenue                              62.3 %        72.0 %
Digital lifestyle product applications      45,027        32,417        12,610           38.9 %
% of net revenue                              37.7 %        28.0 %

Net revenue                              $ 119,592     $ 115,857     $   3,735            3.2 %

Net revenue was $119.6 million for the quarter ended September 30, 2009 compared with $115.9 million for the quarter ended September 30, 2008, an increase of $3.7 million, or 3.2%. Of our first quarter fiscal 2010 net revenue, $74.6 million, or 62.3%, was from personal computing products and $45.0 million, or 37.7%, was from digital lifestyle products, including $34.9 million from mobile smartphones. The increase in net revenue for the quarter ended September 30, 2009 was attributable to a to a $12.6 million, or 38.9%, increase in net revenue from digital lifestyle product applications, partially offset by a $8.9 million, or 10.6%, reduction in net revenue from PC applications. Digital lifestyle products net revenue growth resulted primarily from higher market penetration of our products in the mobile smartphone market. The decline in PC applications net revenue reflected a reduced attach rate of our multimedia control solutions in notebook computers, partially offset by market share gains in notebooks. The overall increase in net revenue was primarily attributable to a 9.6% increase in unit shipments, reflecting higher market penetration of our products in the mobile smartphone market, partially offset by a lower priced product mix and general competitive pricing pressure. Based on calendar year 2010 industry estimates, the notebook market is anticipated to increase approximately 17% and the mobile smartphone market is anticipated to increase approximately 20%.

Gross Margin.

                                         Three Months Ended September 30,
             (in thousands)        2009          2008       $ Change     % Change
             Gross Margin        $ 48,322     $ 46,593      $ 1,729          3.7 %
             % of net revenue        40.4 %       40.2 %

Gross margin as a percentage of net revenue was 40.4%, or $48.3 million, for the quarter ended September 30, 2009 compared with 40.2%, or $46.6 million, for the quarter ended September 30, 2008. As each custom-designed module we sell utilizes our capacitive sensing technology in a design that is generally unique or specific to a customer's application, gross margin varies on a product-by-product basis, making our cumulative gross margin a blend of our product specific designs and independent of the vertical markets that our products serve. The slight increase in gross margin as a percentage of net revenue primarily reflected a higher margin product mix.

Operating Expenses.

                                                                 Three Months Ended September 30,
(in thousands)                                       2009             2008           $ Change          % Change
Research and development expenses                  $  19,975        $ 15,805        $    4,170              26.4 %
% of net revenue                                        16.7 %          13.6 %
Selling, general, and administrative expenses         13,764          14,570              (806 )            -5.5 %
% of net revenue                                        11.5 %          12.6 %

Operating expenses                                 $  33,739        $ 30,375        $    3,364              11.1 %

% of net revenue                                        28.2 %          26.2 %

Research and Development Expenses. Research and development expenses increased as a percentage of net revenue to 16.7% from 13.6%, while the cost of research and development activities increased $4.2 million, or 26.4%, to $20.0 million for the three-month period ended September 30, 2009 compared with $15.8 million for the three-month period ended September 30, 2008. The increase in research and development expenses primarily reflected a $2.3 million increase in employee compensation costs from our annual merit adjustments, additional staffing, and employee benefits costs; a $1.1 million increase in infrastructure and support costs; and a $782,000 increase in share-based compensation costs. Non-cash share-based compensation costs included in research and development expenses were $2.8 million and $2.0 million for the three-month periods ended September 30, 2009 and 2008, respectively.
Selling, General, and Administrative Expenses. Selling, general, and administrative expenses decreased to $13.8 million for the three-month period ended September 30, 2009 compared with $14.6 million for the three-month period ended September 30, 2008. The decrease in selling, general, and administrative expenses primarily reflected a $1.2 million decrease in professional service costs, primarily legal costs, a $487,000 decrease in consulting and contractor costs, and a $205,000 decrease in travel and related costs, partially offset by a $1.0 million increase in employee compensation costs from our annual merit adjustments, additional staffing, employee benefits costs and recruiting costs, and a $348,000 increase in share-based compensation costs,. Non-cash share-based compensation costs included in selling, general, and administrative expenses were $3.8 million and $3.5 million for the three-month periods ended September 30, 2009 and 2008, respectively.

Income from Operations.

                                           Three Months Ended September 30,
         (in thousands)             2009         2008       $ Change       % Change
         Income from operations   $ 14,583     $ 16,218     $  (1,635 )        -10.1 %

         % of net revenue             12.2 %       14.0 %

We generated operating income of $14.6 million, or 12.2% of net revenue, for the three months ended September 30, 2009 compared with approximately $16.2 million, or 14.0% of net revenue, for the three months ended September 30, 2008. The decrease in operating income primarily reflected the $3.4 million increase in operating expenses, partially offset by a 20 basis point increase in the gross margin percentage.

Non-Operating Income/(Loss).

                                            Three Months Ended September 30,
                                     2009         2008        $ Change       % Change
       Interest income             $    331     $  1,258     $     (927 )        -73.7 %
       % of net revenue                 0.3 %        1.1 %
       Interest expense              (1,423 )     (2,541 )        1,118          -44.0 %
       % of net revenue                -1.2 %       -2.2 %
       Impairment of investments       (443 )          -           (443 )            -
       % of net revenue                -0.4 %        0.0 %

       Net non-operating income    $ (1,535 )   $ (1,283 )   $     (252 )         19.6 %

       % of net revenue                -1.3 %       -1.1 %

Interest Income. Interest income was $331,000 for the three-month period ended September 30, 2009 compared with $1.3 million for the three-month period ended September 30, 2008. The $927,000 decrease in interest income resulted primarily from lower average interest rates and lower average invested cash balances. The decrease in average invested cash balances during the past 12 months was primarily attributable to the use of $55.7 million for the early retirement of debt, $25.5 million used for common stock repurchases, and $8.4 million used for capital expenditures.
Interest Expense. All of our interest expense relates to our convertible senior subordinated notes issued in December 2004. Interest expense was $1.4 million for the three months ended September 30, 2009, which includes a $1.2 million non-cash charge for amortization of debt discount, compared with interest expense of $2.5 million for the three months ended September 30, 2008, which includes a $2.1 million non-cash charge for amortization of debt discount. The non-cash charges for amortization of debt discount result from the retrospective application of a new accounting standard applicable to convertible debt that can be settled in cash. The remaining interest expense consists of coupon interest and amortization of debt issuance costs.

Provision for Income Taxes.

. . .