Note 6. Fair Value Measurements

Fair Value Hierarchy

We apply the provisions of Accounting Standards Codification (“ASC”) 820, “Fair Value Measurements and Disclosures,” (“ASC 820”), for our financial assets and liabilities that are re-measured and reported at fair value each reporting period and our nonfinancial assets and liabilities that are re-measured and reported at fair value on a non-recurring basis. We define fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. ASC 820 establishes a three level fair value hierarchy to prioritize the inputs used in valuations, as defined below:

Level 1: Observable inputs that reflect unadjusted quoted prices for identical assets or liabilities in active markets.

Level 2: Inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly.

Level 3: Unobservable inputs for the asset or liability.

Assets and Liabilities Measured and Recorded at Fair Value on a Recurring Basis

As of April 30, 2013 and 2012, our financial assets that are re-measured at fair value on a recurring basis include money market funds that are classified as cash and cash equivalents in the Condensed Consolidated Balance Sheets. As there are no withdrawal restrictions, they are classified within Level 1 of the fair value hierarchy and are valued using quoted market prices for identical assets.

Additionally, in order to protect our interest rate exposure in future years, we entered into forward starting interest rate swap agreements in February 2012 in which we agree to exchange our variable interest cash flows with fixed interest cash flows provided by one of our existing senior lenders, as further described in Notes 5 and 9 to the Condensed Consolidated Financial Statements. Our interest rate swap agreements are classified within Level 2 and are valued using discounted cash flow analyses based on the terms of the contracts and the interest rate curves. Changes in fair value in these interest rate swap agreements during the three and nine months ended April 30, 2013 were recorded in accumulated other comprehensive income in the Condensed Consolidated Statements of Comprehensive Income. Amounts are reclassified from accumulated other comprehensive income in the period the hedged transaction affects earnings. Accordingly, during the three and nine months ended April 30, 2013, we reclassified $53,000 and $168,000, respectively, from accumulated other comprehensive income to interest expense in the Condensed Consolidated Statements of Income.

We also had contingent consideration relating to the acquisition of the sterilization monitoring business of ConFirm Monitoring Systems, Inc. on February 11, 2011. The fair value of this liability was based on future sales projections of the ConFirm Monitoring Business under various potential scenarios for the one year period ended January 31, 2012 and weighting the probability of these outcomes. At the date of the acquisition, these cash flow projections were discounted using a rate of 7%. The discount rate was based on the weighted average cost of capital of the acquired business plus a credit risk premium for non-performance risk. This analysis resulted in an initial contingent consideration liability of $656,000, which was subsequently adjusted by recording the change in the fair value through our results of operations as shown below in the reconciliation of our liabilities that are measured and recorded at fair value on a recurring basis. These fair value measurements were based on significant inputs not observed in the market and thus represented a Level 3 measurement. Based on actual sales results for the one year period ended January 31, 2012, the final contingent consideration liability was determined to be $855,000 at January 31, 2012 and was paid in March 2012.

On August 1, 2011 (the first day of our fiscal 2012), we recorded a $2,700,000 liability for the estimated fair value of contingent consideration and a $3,000,000 liability for the estimated fair value of the three year price floor relating to the Byrne Acquisition, as further described in Note 3 to the Condensed Consolidated Financial Statements. These fair value measurements were based on significant inputs not observed in the market and thus represent Level 3 measurements.

The fair value of the contingent consideration liability was based on future gross profit projections of the Byrne Medical Business under various potential scenarios for the two year period ending July 31, 2013 and weighting the probability of these outcomes. As such, the determination of fair value of the contingent consideration is subjective in nature and highly dependent on future gross profit projections. At the date of the acquisition, these cash flow projections were discounted using a rate of 14%. The discount rate was based on the weighted average cost of capital of the acquired business plus a credit risk premium for non-performance risk. This contingent consideration liability was adjusted periodically by recording changes in the fair value through our Condensed Consolidated Statements of Income, as shown below in the reconciliation of our liabilities that are measured and recorded at fair value on a recurring basis, driven by the time value of money and changes in the assumptions that were initially used in the valuation. The decrease to the contingent consideration liability was due to the actual gross profit results for the first year and three-quarters of the two-year contingent consideration period, and the reassessment of the weighted probability of the future gross profit projections of the remaining portion of the two year period ending July 31, 2013 and was recorded as a decrease to both acquisition payable and general and administrative expenses in the Condensed Consolidated Financial Statements. The final contingent consideration liability has the potential of being between zero and $10,000,000. However, the different likely scenarios of future gross profit and the weighted average of such scenarios resulted in a fair value of zero at each of January 31, 2013 and April 30, 2013. Such fair value would have been higher if we had used different probability factors, future gross profit projections or discount factors. However, given the short period of time until the end of the two year period, it is highly unlikely that any portion of the contingent consideration liability will be earned.

The fair value of the three year price floor liability was determined using the Black-Scholes option valuation model, which is affected by our stock price and risk free interest rate as well as assumptions regarding a number of subjective variables, including, but not limited to, the expected stock price volatility of our common stock over the expected life of the instrument and the expected dividend yield. This liability is adjusted periodically by recording changes in the fair value through our Condensed Consolidated Statements of Income, as shown below in the reconciliation of our liabilities that are measured and recorded at fair value on a recurring basis, driven by the time value of money and changes in the assumptions that were initially used in the valuation. The decrease to the fair value of the price floor (as determined by the Black-Scholes option valuation model) was recorded as a decrease to both acquisition payable and general and administrative expenses in the Condensed Consolidated Financial Statements and was primarily due to the impact of our stock price being higher than at the time of the acquisition, the life of the price floor being less than three years and changes in the expected stock price volatility. Future changes in these factors, especially changes in our stock price, may result in significant future earnings volatility. For instance, if our stock price at April 30, 2013 was $1.00 lower, the fair value of the price floor would have been approximately $36,000 higher, which would have decreased our operating income by $36,000. Conversely, if our stock price at April 30, 2013 was $1.00 higher, the fair value of the price floor would have been approximately $31,000 lower, which would have increased our operating income by $31,000.

The fair values of the Company’s financial instruments measured on a recurring basis were categorized as follows:

	April 30, 2013
	Level 1		Level 2		Level 3		Total
Assets:
Cash and cash equivalents:
Money markets	$	4,258,000	$	—	$	—	$	4,258,000
Total assets	$	4,258,000	$	—	$	—	$	4,258,000

Liabilities:
Acquisition payable:
Contingent consideration	$	—	$	—	$	—	$	—
Price floor	—		—		255,000		255,000
Total acquisition payable	—		—		255,000		255,000
Other liabilities:
Interest rate swap agreements	—		240,000		—		240,000
Total other liabilities (1)	—		240,000		—		240,000
Total liabilities	$	—	$	240,000	$	255,000	$	495,000

	July 31, 2012
	Level 1		Level 2		Level 3		Total
Assets:
Cash and cash equivalents:
Money markets	$	3,916,000	$	—	$	—	$	3,916,000
Total assets	$	3,916,000	$	—	$	—	$	3,916,000

Liabilities:
Acquisition payable:
Contingent consideration	$	—	$	—	$	1,500,000	$	1,500,000
Price floor	—		—		1,037,000		1,037,000
Total acquisition payable	—		—		2,537,000		2,537,000
Other liabilities:
Interest rate swap agreements	—		335,000		—		335,000
Total other liabilities (1)	—		335,000		—		335,000
Total liabilities	$	—	$	335,000	$	2,537,000	$	2,872,000

(1) At April 30, 2013 and July 31, 2012, the current portions of the interest swap agreements of $174,000 and $212,000, respectively, are recorded in accrued expenses and the long-term portions of the interest swap agreements of $66,000 and $123,000, respectively, are recorded in other long-term liabilities.

A reconciliation of our liabilities that are measured and recorded at fair value on a recurring basis using significant unobservable inputs (Level 3) for the last seven quarters is as follows:

	ConFirm Contingent Consideration			Byrne Contingent Consideration			Byrne Price Floor			Total
Balance, July 31, 2011	$	775,000		$	—		$	—		775,000
Total net unrealized (gains)/losses included in general and administrative expense in earnings	(86,000		)	100,000			(582,000		)	(568,000		)
Transfers into or out of level 3	—			—			—			—
Net purchases, issuances, sales and settlements	—			2,700,000			3,000,000			5,700,000
Balance, October 31, 2011	689,000			2,800,000			2,418,000			5,907,000
Total net unrealized (gains)/losses included in general and administrative expense in earnings	166,000			100,000			(623,000		)	(357,000		)
Transfers into or out of level 3	—			—			—			—
Net purchases, issuances, sales and settlements	—			—			—			—
Balance, January 31, 2012	855,000			2,900,000			1,795,000			5,550,000
Total net unrealized gains included in general and administrative expense in earnings	—			—			(395,000		)	(395,000		)
Transfers into or out of level 3	—			—			—			—
Net purchases, issuances, sales and settlements	(855,000		)	—			—			(855,000		)
Balance, April 30, 2012	—			2,900,000			1,400,000			4,300,000
Total net unrealized gains included in general and administrative expense in earnings	—			(1,400,000		)	(363,000		)	(1,763,000		)
Transfers into or out of level 3	—			—			—			—
Net purchases, issuances, sales and settlements	—			—			—			—
Balance, July 31, 2012	—			1,500,000			1,037,000			2,537,000
Total net unrealized gains included in general and administrative expense in earnings	—			—			(313,000		)	(313,000		)
Transfers into or out of level 3	—			—			—			—
Net purchases, issuances, sales and settlements	—			—			—			—
Balance, October 31, 2012	—			1,500,000			724,000			2,224,000
Total net unrealized gains included in general and administrative expense in earnings	—			(1,500,000		)	(410,000		)	(1,910,000		)
Transfers into or out of level 3	—			—			—			—
Net purchases, issuances, sales and settlements	—			—			—			—
Balance, January 31, 2013	—			—			314,000			314,000
Total net unrealized gains included in general and administrative expense in earnings	—			—			(59,000		)	(59,000		)
Transfers into or out of level 3	—			—			—			—
Net purchases, issuances, sales and settlements	—			—			—			—
Balance, April 30, 2013	$	—		$	—		$	255,000		$	255,000

Assets Measured and Recorded at Fair Value on a Nonrecurring Basis

We re-measure the fair value of certain assets, such as intangible assets, goodwill and long-lived assets, including property and equipment and convertible notes receivable, whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable, and goodwill and intangible assets with indefinite lives are reviewed for impairment at least annually. In performing a review for goodwill impairment, management first assesses qualitative factors to determine whether it is more likely than not that the fair value of the reporting unit is less than the carrying amount before proceeding to step one of the two-step quantitative goodwill impairment test, if necessary. For our quantitative test, we use a two-step process that begins with an estimation of the fair value of the related operating segments by using fair value results of the discounted cash flow methodology, as well as the market multiple and comparable transaction methodologies when applicable. The first step is a review for potential impairment, and the second step measures the amount of impairment, if any. In performing our annual review for indefinite lived intangibles, management performs a qualitative assessment, and if a quantitative assessment is necessary, we compare the current fair value of such assets to their carrying values. With respect to amortizable intangible assets when impairment indicators are present, management determines whether expected future non-discounted cash flows is sufficient to recover the carrying value of the assets; if not, the carrying value of the assets is adjusted to their fair value. With respect to long-lived assets, an assessment is made to determine if the sum of the expected future non-discounted cash flows from the use of the assets and eventual disposition is less than the carrying value. If the sum of the expected non-discounted cash flows is less than the carrying value, an impairment loss is recognized based on fair value. As the inputs utilized for our periodic impairment assessments are not based on observable market data, but are based on management’s assumptions and estimates, our goodwill, intangibles and long-lived assets are classified within Level 3 of the fair value hierarchy on a non-recurring basis. On July 31, 2012, management concluded that none of our long-lived assets, including goodwill and intangibles with indefinite-lives, were impaired and no other events or changes in circumstances have occurred during the nine months ended April 30, 2013 that would indicate that the carrying amount of our long-lived assets may not be recoverable.

Disclosure of Fair Value of Financial Instruments

As of April 30, 2013 and July 31, 2012, the carrying amounts for cash and cash equivalents (excluding money markets), accounts receivable and accounts payable approximated fair value due to the short maturity of these instruments. We believe that as of April 30, 2013 and July 31, 2012, the fair value of our outstanding borrowings under our credit facilities approximated the carrying value of those obligations since the borrowing rates were at prevailing market interest rates, principally under LIBOR contracts ranging from one to twelve months.