Note 7.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

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. These money market funds are classified within Level 1 of the fair value hierarchy and are valued using quoted market prices for identical assets.

In connection with our June 2014 acquisition of a UK endoscopy company (“Cantel Medical (UK)”), we acquired a contingent guaranteed obligation to reimburse an endoscope service company for endoscope repair costs it incurs when servicing its customers’ endoscopes that are damaged by one of Cantel Medical (UK)’s discontinued endoscope reprocessing machine models. Although the terms of the guarantee provide for no limit to the maximum potential future payments, we estimated the fair value of the liability on the date of the acquisition to be approximately $1,414,000. This fair value measurement was based on significant inputs not observed in the market and thus represents a Level 3 measurement. The fair value of the contingent guaranteed obligation was based on the estimated cost to repair endoscopes that may be damaged by one of Cantel Medical (UK)’s discontinued endoscope reprocessing machine models that remain in the marketplace, the historical frequency of claims and the likely timeframe that each machine will continue to be used. As such, the determination of the fair value of this contingent guaranteed obligation is subjective in nature and can be impacted by significant changes in third party service repair rates, the frequency of claims and a change in the expected life of these discontinued machines. At the date of the acquisition, the cash flow projection relating to this contingent guaranteed obligation was discounted using a rate of 10.1%, which was based on the weighted average cost of capital of the acquired business plus a credit risk premium for non-performance risk. This liability is adjusted periodically by the reimbursement of repair costs, as well as recording changes in the fair value through our Condensed Consolidated Statements of Income driven by the time value of money and changes in the assumptions that were initially used in the valuation. Given the subjective nature of the assumptions used in the determination of fair value, we may potentially have earnings volatility in our future results of operations. However, the largest factor for the decrease in the initial fair value from $1,414,000 at June 30, 2014 to $569,000 at April 30, 2016 was the reimbursement of repair costs.

On November 5, 2013, we recorded a $2,490,000 liability for the estimated fair value of contingent consideration and a $1,720,000 liability for the estimated fair value of an assumed contingent obligation payable to the Israeli Government relating to the acquisition of a private Israeli company that developed the Jet Prep® Endoscopic Flushing Device, a novel single-use irrigation and aspiration catheter to improve visualization during colonoscopy procedures (“Jet Prep”). These fair value measurements were based on significant inputs not observed in the market and thus represent Level 3 measurements.

The fair values of the contingent consideration liability and assumed contingent obligation were based on percentages of future sales projections of Jet Prep’s business, above a minimum threshold with respect to the contingent consideration, under various potential scenarios over a seven year period ending November 4, 2020 and weighting the probability of these outcomes. As such, the determinations of fair values of these contingent liabilities are subjective in nature and highly dependent on future sales projections. At the date of the acquisition, the cash flow projections relating to the contingent consideration and assumed contingent obligation were discounted using rates of 12.6% and 2.5%, respectively. The discount rate relating to the contingent consideration was based on the weighted average cost of capital of the acquired business plus a credit risk premium for non-performance risk. Since payment of the assumed contingent obligation to the Israeli Government is highly probable, the discount rate relating to this government obligation was based on a risk free rate plus a premium for non-performance risk. These two liabilities will be adjusted periodically by recording changes in the fair value through our Condensed Consolidated Statements of Income driven by the time value of money and changes in the assumptions that were initially used in the valuations. Due to the structure of the acquisition, any such adjustments through our Condensed Consolidated Statements of Income will not be tax effected, except for amounts in excess of $810,000 with respect to the assumed contingent obligation, therefore impacting our effective tax rate.

The actual contingent consideration and assumed contingent obligation have the potential of being between zero and a percentage of unlimited sales that could occur until the completion of the seven year period with respect to the contingent consideration liability and until the assumed contingent obligation is satisfied in full, or until the sales of the Jet Prep products no longer exist. However, with respect to the contingent consideration, the different likely scenarios of future sales projections used in our fair value determination at April 30, 2016 resulted in total potential contingent consideration payments ranging between zero and approximately $452,000 and the weighted average present value of such scenarios plus the accretion of interest for the passing of time resulted in a fair value of $148,000 at April 30, 2016. The decrease in the initial fair value from $2,490,000 at November 5, 2013 to $148,000 at April 30, 2016 was primarily due to changes in probability factors and future sales projections based on the results of several market research analyses, product modification plans, updated pricing models and the remaining years in the seven year measurement period. With respect to the assumed contingent obligation, the different likely scenarios of future sales projections used in our fair value determination at April 30, 2016 along with the requirement to repay at least the original seed funding with interest to the Israeli Government resulted in a fair value of $1,138,000 at April 30, 2016. Given the subjective nature of the assumptions used in the determinations of fair value, we may potentially have further earnings volatility in our future results of operations related to these Jet Prep obligations.

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


	April 30, 2016
	Level 1		Level 2		Level 3		Total
Assets:
Cash and cash equivalents:
Money markets	$	880,000	$	—	$	—	$	880,000
Total assets	$	880,000	$	—	$	—	$	880,000

Liabilities:
Accrued expenses:
Assumed contingent obligation	$	—	$	—	$	12,000	$	12,000
Contingent guaranteed obligation		—		—		414,000		414,000
Total accrued expenses		—		—		426,000		426,000
Other long-term liabilities:
Contingent consideration		—		—		148,000		148,000
Assumed contingent obligation		—		—		1,126,000		1,126,000
Contingent guaranteed obligation		—		—		155,000		155,000
Total other long-term liabilities:		—		—		1,429,000		1,429,000
Total liabilities	$	—	$	—	$	1,855,000	$	1,855,000


	July 31, 2015
	Level 1		Level 2		Level 3		Total
Assets:
Cash and cash equivalents:
Money markets	$	1,680,000	$	—	$	—	$	1,680,000
Total assets	$	1,680,000	$	—	$	—	$	1,680,000

Liabilities:
Accrued expenses:
Assumed contingent obligation	$	—	$	—	$	12,000	$	12,000
Contingent guaranteed obligation		—		—		566,000		566,000
Total accrued expenses		—		—		578,000		578,000
Other long-term liabilities:
Contingent consideration		—		—		751,000		751,000
Assumed contingent obligation		—		—		1,126,000		1,126,000
Contingent guaranteed obligation		—		—		322,000		322,000
Total other long-term liabilities:		—		—		2,199,000		2,199,000
Total liabilities	$	—	$	—	$	2,777,000	$	2,777,000

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:


			Jet Prep		Cantel Medical (UK)
	Jet Prep		Assumed		Contingent
	Contingent		Contingent		Guaranteed
	Consideration		Obligation		Obligation		Total
Balance, July 31, 2014	$	2,722,000	$	1,752,000	$	1,395,000	$	5,869,000
Total net unrealized losses included in general and administrative expense in earnings		82,000		11,000		54,000		147,000
Settlements		—		—		(132,000)		(132,000)
Foreign currency translation		—		—		(77,000)		(77,000)
Balance, October 31, 2014		2,804,000		1,763,000		1,240,000		5,807,000
Total net unrealized losses included in general and administrative expense in earnings		84,000		10,000		33,000		127,000
Settlements		—		—		(164,000)		(164,000)
Foreign currency translation		—		—		(69,000)		(69,000)
Balance, January 31, 2015		2,888,000		1,773,000		1,040,000		5,701,000
Total net unrealized (gains) losses included in general and administrative expense in earnings		(2,159,000)		(642,000)		11,000		(2,790,000)
Settlements		—		—		(161,000)		(161,000)
Foreign currency translation		—		—		24,000		24,000
Balance, April 30, 2015		729,000		1,131,000		914,000		2,774,000
Total net unrealized losses included in general and administrative expense in earnings		22,000		7,000		23,000		52,000
Settlements		—		—		(109,000)		(109,000)
Foreign currency translation		—		—		60,000		60,000
Balance, July 31, 2015		751,000		1,138,000		888,000		2,777,000
Total net unrealized (gains) losses included in general and administrative expense in earnings		(612,000)		—		20,000		(592,000)
Settlements		—		—		(120,000)		(120,000)
Foreign currency translation		—		—		(15,000)		(15,000)
Balance, October 31, 2015		139,000		1,138,000		773,000		2,050,000
Total net unrealized losses included in general and administrative expense in earnings		4,000		—		17,000		21,000
Settlements		—		—		(100,000)		(100,000)
Foreign currency translation		—		—		(53,000)		(53,000)
Balance, January 31, 2016		143,000		1,138,000		637,000		1,918,000
Total net unrealized losses included in general and administrative expense in earnings		5,000		—		15,000		20,000
Settlements		—		—		(95,000)		(95,000)
Foreign currency translation		—		—		12,000		12,000
Balance, April 30, 2016	$	148,000	$	1,138,000	$	569,000	$	1,855,000

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, equipment and other assets, 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, where appropriate. 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 are 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. Management concluded on July 31, 2015 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, 2016 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, 2016 and July 31, 2015, 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, 2016 and July 31, 2015, the fair value of our outstanding borrowings under our credit facility approximated the carrying value of those obligations since the borrowing rates were at prevailing market interest rates.