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

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 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 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 $441,000 at July 31, 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 Jet Prep Acquisition, as further described in Note 3 to the 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 values of the contingent consideration liability and assumed contingent obligation were based on percentages of future sales projections of the Jet Prep 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 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 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 July 31, 2016 resulted in total potential contingent consideration payments to be zero. The decrease in the initial fair value from $2,490,000 at November 5, 2013 to zero at July 31, 2016 was primarily due to the delay in commercialization, 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 July 31, 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 July 31, 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:


	July 31, 2016
	Level 1		Level 2		Level 3		Total
Assets:
Cash and cash equivalents:
Money markets	$	740,000	$	—	$	—	$	740,000
Total assets	$	740,000	$	—	$	—	$	740,000

Liabilities:
Accrued expenses:
Assumed contingent obligation	$	—	$	—	$	12,000	$	12,000
Contingent guaranteed obligation		—		—		366,000		366,000
Total accrued expenses		—		—		378,000		378,000
Other long-term liabilities:
Assumed contingent obligation		—		—		1,126,000		1,126,000
Contingent guaranteed obligation		—		—		75,000		75,000
Total other long-term liabilities:		—		—		1,201,000		1,201,000
Total liabilities	$	—	$	—	$	1,579,000	$	1,579,000


	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 fiscals 2016, 2015 and 2014 is as follows:


					Jet Prep		Cantel Medical (UK)
	Byrne		Jet Prep		Assumed		Contingent
	Price		Contingent		Contingent		Guaranteed
	Floor		Consideration		Obligation		Obligation		Total
Balance, July 31, 2013	$	45,000	$	—	$	—	$	—	$	45,000
Total net unrealized (gains) losses included in general and administrative expense in earnings		(45,000)		232,000		32,000		—		219,000
Net purchases, issuances, sales and settlements		—		2,490,000		1,720,000		1,395,000		5,605,000
Balance, July 31, 2014		—		2,722,000		1,752,000		1,395,000		5,869,000
Total net unrealized gains included in general and administrative expense in earnings		—		(1,971,000)		(614,000)		—		(2,585,000)
Net purchases, issuances, sales and settlements		—		—		—		(507,000)		(507,000)
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		—		(751,000)		—		64,000		(687,000)
Net purchases, issuances, sales and settlements		—		—		—		(511,000)		(511,000)
Balance, July 31, 2016	$	—	$	—	$	1,138,000	$	441,000	$	1,579,000

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, as further described in Notes 2 and 7 to the Consolidated Financial Statements. 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.

In September 2013, we acquired a license from a third party granting us the exclusive right to manufacture, commercialize, distribute and sell an endoscopy product in exchange for a series of payments, which totaled $1,000,000 at January 31, 2015 and was recorded in other assets in our Consolidated Balance Sheets. We evaluated this long-lived asset for potential impairment and determined that the future use of this acquired license was unlikely based on a recent product analysis. Accordingly, we deemed the acquired license, together with related fixed assets of $287,000, to be fully impaired and recorded a loss of $1,287,000 during fiscal 2015 based on expected cash flows of the related endoscopy product, which was recorded in general and administrative expenses and as reductions in other assets and property and equipment in the Consolidated Financial Statements.

Management concluded on July 31, 2016 that none of our long-lived assets, including goodwill and intangibles with indefinite-lives, were impaired and no events or changes in circumstances have occurred during fiscal 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 July 31, 2016 and 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 July 31, 2016 and 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.