Note 4. Stock-Based Compensation

The following table shows the income statement components of stock-based compensation expense recognized in the Condensed Consolidated Statements of Income:


	Three Months Ended
	October 31,
	2016		2015

Cost of sales	$	110,000	$	79,000
Operating expenses:
Selling		629,000		190,000
General and administrative		2,153,000		1,425,000
Research and development		30,000		26,000
Total operating expenses		2,812,000		1,641,000
Stock-based compensation before income taxes		2,922,000		1,720,000
Income tax benefits		(1,039,000)		(613,000)
Excess tax benefits		(2,241,000)		—
Total stock-based compensation expense, net of tax	$	(358,000)	$	1,107,000

The above stock-based compensation expense before income taxes was recorded in the Condensed Consolidated Financial Statements as stock-based compensation expense and an increase to additional paid-in capital and was determined based upon the award’s fair value at the time the award was granted.

Income tax benefits on stock-based compensation expense were recorded as an increase to deferred income tax assets (which are netted with deferred income tax liabilities) and a reduction to income tax expense. If certain criteria are met when options are exercised or restricted stock awards become vested, the Company is allowed a deduction on its United States income tax return. Accordingly, we account for the income tax effect on such income tax deductions as a reduction of previously recorded deferred income tax assets and as a reduction of income taxes payable.

Excess tax benefits arise when the ultimate tax effect of the deduction for tax purposes is greater than the income tax benefit on stock-based compensation described above. Prior to the adoption of ASU 2016-09 on August 1, 2016, the differences noted above between actual tax deductions and the previously recorded deferred income tax assets were recorded as additional paid-in capital. For the three months ended October 31, 2015, income tax deductions of $3,041,000 were generated, of which $1,552,000 were recorded as a reduction in income tax expense over the equity awards’ vesting period and the remaining excess tax benefits of $1,489,000 were recorded as an increase to additional paid-in capital during the three months ended October 31, 2015. As a result of the adoption of ASU 2016-09, we no longer record excess tax benefits as an increase to additional paid-in capital, but record such excess tax benefits prospectively as a reduction of income tax expense. For the three months ended October 31, 2016, income tax deductions of $5,376,000 were generated, of which $3,135,000 were previously recorded as a reduction in income tax expense over the equity awards’ vesting period and the remaining excess tax benefit of $2,241,000 was recorded as a reduction in income tax expense during the three months ended October 31, 2016. In addition, we elected to record excess tax benefits as an operating cash flow prospectively and not adjust the prior year period. As such, the current period excess tax benefits were reflected as an operating cash flow rather than a financing cash flow in our Condensed Consolidated Statement of Cash Flows for the three months ended October 31, 2016.

All of our stock options and restricted stock awards are expected to be deductible for tax purposes, except for certain stock awards granted to employees residing outside of the United States, and were tax-effected using the Company’s estimated U.S. effective tax rate at the time of grant.

Our stock options and time-based stock awards are subject to graded vesting in which portions of the awards vest at different times during the vesting period, as opposed to awards that vest at the end of the vesting period. We recognize compensation expense for awards subject to graded vesting using the straight-line basis over the vesting period.

In October 2016, we granted for the first time to certain employees 12,810 equity awards with performance conditions and 9,800 equity awards with market conditions. The actual number of equity awards earned and eligible to vest will be determined based on the level of achievement against budgeted revenue and a defined gross profit percentage, with respect to the awards with performance conditions, and the Company’s 3-year relative total stockholder return performance as measured against the S&P Healthcare Equipment Index, with respect to the awards with market conditions. The maximum share attainment of these awards are 200% of the initial granted shares. We recognize compensation expense for the awards with performance conditions using the accelerated attribution method over the requisite service period for each separately vesting portion of the award when it is probable that the performance condition will be achieved. We record expense for the awards that are subject to market conditions ratably over the vesting period regardless of whether the market condition is satisfied.

At October 31, 2016, total unrecognized stock-based compensation expense, before income taxes, related to total nonvested stock options and restricted stock awards was $14,242,000 with a remaining weighted average period of 25 months over which such expense is expected to be recognized. Most of our nonvested awards relate to restricted stock awards. As a result of the adoption of ASU 2016-09 on August 1, 2016, we have elected to account for forfeitures as they occur, rather than estimate expected forfeitures over the course of a vesting period.

We determine the fair value of each time-based stock award and performance-based stock award by using the closing market price of our common stock on the date of grant. We determine the fair value of each stock award with market conditions using the Monte Carlo simulation on the date of grant using the following assumptions:


Performance Share Unit	Three Months Ended
Valuation Assumption	October 31, 2016

Volatility of common stock	27.75	%
Average volatility of peer companies	32.98	%
Average correlation coefficient of peer companies	35.35	%
Risk-free interest rate	0.96	%

A summary of nonvested stock award activity follows:


		Weighted
	Number of	Average
	Shares	Fair Value

Nonvested stock awards at July 31, 2016	331,367	$	46.09
Granted	91,841		78.05
Canceled	(2,238)		55.09
Vested	(188,163)		41.61
Nonvested stock awards at October 31, 2016	232,807	$	62.23

There were no option grants during the three months ended October 31, 2016. The fair value of each option grant in the prior year was estimated on the date of grant using the Black-Scholes option valuation model with the following weighted average assumptions:


Weighted-Average
Black-Scholes Option	Three Months Ended
Valuation Assumptions	October 31, 2015

Dividend yield	0.22	%
Expected volatility (1)	55.90	%
Risk-free interest rate (2)	1.41	%
Expected lives (in years) (3)	5.00

(1)

Volatility was based on historical closing prices of our common stock.

(2)

The U.S. Treasury rate based on the expected life at the date of grant.

(3)

Based on historical exercise behavior.

Additionally, all options were considered to be deductible for tax purposes in the valuation model. Such non-qualified options were tax-effected using the Company’s estimated U.S. effective tax rate at the time of grant. For the three months ended October 31, 2015, these non-qualified options had a weighted average fair value of $26.49.

There were no option exercises during the three months ended October 31, 2016 and 2015, respectively.