(1)          Basis of Presentation and Description of Business

MGC Diagnostics Corporation (the “Company”), through its Medical Graphics Corporation and Medisoft SA subsidiaries, designs and markets non-invasive cardiorespiratory diagnostic systems that are sold under the MGC Diagnostics, MedGraphics and Medisoft brand and trade names. These cardiorespiratory diagnostic systems have a wide range of applications within cardiorespiratory healthcare.

The consolidated balance sheet as of July 31, 2016, the consolidated statements of comprehensive income for the three and nine months ended July 31, 2016 and 2015, the consolidated statements of cash flows for the nine months ended July 31, 2016 and 2015 and the related information presented in these notes have been prepared by management in accordance with U.S. generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Rule 10-01 of Regulation S-X, without audit. Accordingly, they do not include all of the information and notes required by U.S. generally accepted accounting principles for complete financial statements. In the opinion of management, all adjustments considered necessary for a fair presentation of results have been included. The consolidated balance sheet at October 31, 2015 was derived from the audited consolidated financial statements as of that date. Operating results for the three and nine months ended July 31, 2016 are not necessarily indicative of the results that may be expected for the year ending October 31, 2016. For further information, refer to the consolidated financial statements and notes thereto included in MGC Diagnostics Corporation’s Annual Report on Form 10-K for the year ended October 31, 2015.

Preparation of the consolidated financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities made in the consolidated financial statements and accompanying notes. Actual results could differ from those estimates. Estimates include accounts receivable reserves, product warranty and inventory reserves, realizability of deferred tax assets and depreciable lives of property, equipment and intangible assets (including internal software development costs).

(2)          Summary of Significant Accounting Policies

(3)           Stock-Based Compensation and Stock Options

The MGC Diagnostics Corporation 2007 Stock Incentive Plan (the “2007 Plan”) provides that incentive stock options and nonqualified stock options to purchase shares of common stock may be granted at prices determined by the Human Capital Committee of Company's Board of Directors, except that the purchase price of incentive stock options may not be less than the fair market value of the stock at the date of grant. Options under the 2007 Plan are subject to vesting schedules established on the date of grant. In addition, the 2007 Plan allows the granting of restricted stock awards, stock appreciation rights and performance stock. 

Total stock-based compensation expense included in the Company’s statements of comprehensive income was $175,000 and $131,000 for the three months ended July 31, 2016 and 2015, respectively, and was $523,000 and $353,000 for the nine months ended July 31, 2016 and 2015, respectively.

Stock Options

A summary of the Company’s stock option activity for the nine months ended July 31, 2016 and 2015 is presented in the following table:

The following table summarizes information concerning stock options outstanding as of July 31, 2016:

The total intrinsic values for outstanding options and exercisable options as of July 31, 2016 were $120,000 and $46,000, calculated using the closing stock price at the end of the third quarter less the option price of in-the-money options. The Company issues new shares when stock options are exercised. Unrecognized compensation expense related to outstanding stock options as of July 31, 2016 was $388,000 and is expected to be recognized over a weighted average period of 1.88 years.

Valuation Assumptions

The Company uses the Black-Scholes option-pricing model (“Black-Scholes model”) to determine the fair value of stock options as of the grant date. In determining the fair value of stock options under the Black-Scholes model, management must make assumptions regarding projected employee stock option exercise behaviors, risk-free interest rates, volatility of the Company’s stock price and expected dividends. The expense recognized for options granted under the 2007 Plan is equal to the fair value of stock options as of the grant date. The following table provides the weighted average fair value of options granted to employees and the related assumptions used in the Black-Scholes model for stock option grants made during the nine months ended July 31, 2016:

Restricted Stock Awards

Restricted stock awards are awards of common stock that are subject to restrictions on transfer and to a risk of forfeiture if the holder leaves the Company before the restrictions lapse. The holder of a restricted stock award is generally entitled at all times on and after the date of issuance of the restricted shares to exercise the rights of a shareholder of the Company, including the right to vote the shares. The value of stock awards that vest over time was established by the market price on the date of its grant. A summary of the Company’s restricted stock activity for the nine months ended July 31, 2016 and 2015 is presented in the following table:

Unrecognized compensation expense related to outstanding restricted stock awards to employees and directors as of July 31, 2016 was $191,000 and is expected to be recognized over a weighted average period of 0.79 years.

Director Stock Awards in Lieu of Cash Retainer Fees

The Company has a program that allows non-employee Board members to elect and receive shares from the 2007 Plan in lieu of some or all of their quarterly cash retainer fees. During the three months ended July 31, 2016 and 2015, the Company issued 2,079 and 1,617 shares, respectively, and during the nine months ended July 31, 2016 and 2015, the Company issued 5,421 and 4,915 shares, respectively, under this program. The expense was recognized at the time of share issuance and totaled $11,000 in each of the three-month periods ended July 31, 2016 and 2015 and $34,000 in each of the nine-month periods ended July 31, 2016 and 2015.

Stock Issued in Lieu of Cash

In fiscal 2016, the Company entered into a consulting arrangement with a third party entity under which it agreed to issue shares to this consultant as a portion of the overall compensation under the consulting arrangement. The number of shares to be issued to this entity is determined and paid quarterly for fixed monthly dollar values per the agreement. Amounts expensed under this agreement to be paid in shares for the three- and nine-month periods ended July 31, 2016 were $7,500 and $17,500, respectively.

Employee Stock Purchase Plan

The MGC Diagnostics Corporation 2003 Employee Stock Purchase Plan, as amended (“Purchase Plan”), allows participating employees to purchase up to 200,000 shares of the Company’s common stock at a discount through payroll deductions. The Purchase Plan is available to all employees subject to eligibility requirements. Under the Purchase Plan, participating employees may purchase the Company’s common stock on a voluntary after-tax basis at a price that is the lower of 85% of the fair market value of one share of common stock at the beginning or end of each stock purchase phase. The Purchase Plan is carried out in six-month phases, with phases beginning on January 1 and July 1 of each calendar year. For the phase that ended on December 31, 2015 and June 30, 2016, employees purchased 11,248 and 8,481 shares at a price of $4.47 and $5.54 per share, respectively. As of July 31, 2016, the Company has withheld approximately $6,000 from employees participating in the phase that began on July 1, 2016. As of July 31, 2016, 49,353 shares of common stock were available for future purchase under the Purchase Plan.

The following table presents the classification of pre-tax stock-based compensation expense recognized in the consolidated statements of comprehensive income for the three and nine months ended July 31, 2016 and 2015:

Tax Impact of Stock-Based Compensation

The Company reports the benefit of tax deductions in excess of recognized stock-based compensation expense on the consolidated statements of cash flows as financing cash flows. For the nine months ended July 31, 2016 and 2015, there were no excess tax benefits.

(4)          Inventories

Inventories consisted of the following as of July 31, 2016 and October 31, 2015:

(5)          Intangible Assets

Intangible assets consisted of the following as of July 31, 2016 and October 31, 2015:

The Company amortizes the intangible assets related to developed technology, patents and trademarks using the straight-line method over the estimated useful lives of the assets, which range from five to ten years. Total amortization expense was $322,000 and $360,000 for the three months ended July 31, 2016 and 2015, respectively, and $484,000 and $534,000 for the nine months ended July 31, 2016 and 2015, respectively. The fiscal 2016 and 2015 amounts expensed included impairment charges of $245,000 and $266,000, respectively, for software products the Company deemed to have no future value at July 31 of each year. Of the total, amortization expense of $270,000 and $305,000 related to software costs is included in the cost of equipment, supplies and accessories revenues for the three months ended July 31, 2016 and 2015, respectively, and $307,000 and $366,000 for the nine months ended July 31, 2016 and 2015, respectively. The Company estimates it will incur the following amortization expense in future fiscal years based on the intangible assets the Company expects to have placed in service at the end of fiscal 2016:

This table does not include estimated amortization expense for either (i) patents included in “Developed technology,” not yet placed into service of $111,000, or (ii) capitalized software costs of $2,632,000 for software the Company expects to place into service after the current fiscal year. The Company capitalized software development costs of $203,000 and $179,000 during the three months ended July 31, 2016 and 2015, respectively, and $569,000 and $531,000 during the nine months ended July 31, 2016 and 2015, respectively. Upon completion of these development projects, the Company expects to amortize the capitalized software costs over a five year period.

(6)          Warranty Reserve

Sales of the Company’s equipment are subject to a warranty obligation. Equipment warranties typically extend for a period of twelve months from the date of installation. Standard warranty terms are included in customer contracts. Under the terms of these warranties, the Company is obligated to repair or replace any components or assemblies that it deems defective in workmanship or materials. The Company reserves the right to reject warranty claims if it determines that failure is due to normal wear, customer modifications, improper maintenance or misuse. The Company maintains a warranty reserve that reflects the estimated expenses it will incur to honor the warranties on its products. The Company adjusts the warranty reserve based on the number and type of equipment subject to warranty and the remaining months of warranty coverage. The warranty reserve adjustment reflects the Company’s historical warranty experience based on the type of equipment.

Warranty provisions and claims for the nine months ended July 31, 2016 and 2015 were as follows:

(7)          Financing Arrangements

On July 24, 2014, MGC Diagnostics Corporation and its wholly-owned subsidiary Medical Graphics Corporation (collectively the “Company”) entered into a credit agreement (“Agreement”) with BMO Harris Bank NA (“Bank”).

The Agreement, as amended through January 8, 2015, included a $4.0 million term loan and $250,000 revolving credit facility. The term loan, which bore interest at a floating rate, was payable in equal monthly principal installments of $66,667 over a five-year period commencing August 31, 2014 and was evidenced by a term note. The Company funded the $4.0 million under the term loan on July 24, 2014 and used these proceeds in connection with its acquisition of Medisoft SA. The revolving credit facility had a one-year term, which had been renewed through July 31, 2016 and was evidenced by a revolving note. On June 14, 2016, the Company paid off the remaining balance of the term loan and terminated the revolving credit facility.

(8)          Net Income per Share

 Basic income (loss) per share is computed by dividing net income (loss) by the weighted average shares outstanding during the reporting period. Diluted income per share is computed similarly to basic income (loss) per share except that the weighted average shares outstanding are increased to include additional shares issuable from the assumed exercise of warrants and stock options, if dilutive, as well as the dilutive effects of any unvested restricted share awards. Diluted loss per share does not include any of these dilutive effects in its calculation. The number of additional shares is calculated by assuming that outstanding warrants and stock options are exercised, outstanding restricted share grants vest and that the cash proceeds from the exercise together with the assumed employment value represented by the unamortized stock-based compensation were used to reacquire shares of common stock at the average market price during the reporting period.

 The Company had unexpired options and warrants for the purchase of its common stock and unvested restricted awards as of July 31, 2016 and 2015 of 463,572 and 418,385 shares, respectively.

Shares used in the net income per share computations are as follows: 

Antidilutive shares excluded from the calculation for the three and nine months ended July 31, 2016 totaled 428,000 and 452,000, respectively, and the three and nine months ended July 31, 2015 totaled 361,000 and 388,000, respectively.

(9)         Income Taxes

The Company has recorded a provision for (benefit from) income taxes of $273,000 and $(3,115,000) for the three months ended July 31, 2016 and 2015, respectively, and $460,000 and $(3,399,000) for the nine months ended July 31, 2016 and 2015, respectively.

The Company records its interim provision for income taxes based on its estimated worldwide annual effective rate for the year.  In computing this provision, the Company excluded MGC Diagnostics Belgium S.P.R.L.and Medisoft RAM Italia SRL net losses of $40,000 and $219,000 for the three- and nine-month periods ended July 31, 2016, respectively, for which no tax benefit can be recognized due to future expected losses and a resulting valuation allowance related to these losses. As a result, the $460,000 fiscal 2016 year-to-date tax expense compared to the world wide consolidated pre-tax income of $761,000 (which includes the Medisoft Belgium S.P.R.L. and Medisoft RAM Italia SRL net losses) results in an effective rate of approximately 60%.

The provision for 2016 income taxes includes federal alternative minimum tax expense, state and foreign income tax expense and expense related to reserves for uncertain tax positions. The benefit from income taxes for the three- and nine-month periods ended July 31, 2015 included these same cost categories as well as a partial reversal of the Company's valuation allowance, which had been maintained historically as a result of uncertainty over the realization of its domestic net operating loss carry forwards. This partial reversal of the valuation allowance was based on an assessment of all available evidence, including (i) previous three-year cumulative income before infrequent and unusual items, (ii) a history of generating income before taxes for the past two years and (iii) estimates of future Medical Graphics profitability, resulting in a Company determination that it was more likely than not that the Company would be able to realize a portion of its deferred tax assets in the future and a decision to record the non-cash partial reversal of our deferred tax asset valuation allowance of approximately $3,111,000.  As of  October 31, 2015, the Company had a remaining valuation allowance of approximately $963,000.

The Company also recorded a deferred tax benefit of $37,000 and $340,000 in the three- and nine-month periods ended July 31, 2016, resulting from the benefit of the Medisoft current net operating loss and the reversals of deferred tax liabilities from the Medisoft acquisition. 

As of July 31, 2016, the Company had a reserve for uncertain tax positions of $75,000 compared to the October 31, 2015 balance of $61,000. If recognized, approximately $48,000 of these benefits would lower the effective tax rate. The remaining $27,000, if recognized, would result in a deferred tax asset subject to a valuation allowance and therefore would not affect the effective rate.

Estimated interest and penalties related to potential underpayment of income taxes are classified as a component of tax expense in the consolidated statements of comprehensive income. The Company does not expect the amount of reserves for uncertain tax positions to change significantly in the next twelve months. Similarly, the Company does not anticipate that the total reserve for uncertain tax positions will significantly change due to the settlement of audits and the expiration of statutes of limitations within the next twelve months.

The Company files a consolidated federal income tax return in the United States federal jurisdiction and files various combined and separate tax returns in several state and local jurisdictions. For United States federal tax, the Company is no longer subject to examinations by the authorities for fiscal years ending prior to November 1, 1998. The expiration dates of the statute of limitations related to the various state income tax returns that the Company files vary by state. There is no statute of limitations for assessments related to jurisdictions where the Company may have a nexus but has chosen not to file an income tax return.

The Company has federal net operating loss (“NOL”) and general business tax credit carry forwards; however, the utilization of some of these tax loss and tax credit carry forwards is limited under Internal Revenue Code (“IRC”) §382 and §383, respectively, as a result of an IRS-deemed change in ownership that occurred in the fourth quarter of fiscal 2006. The Company estimates that the amount of federal NOL carry forward from October 31, 2015 that is not limited is approximately $10.0 million. These loss carry forwards will expire in years 2018 through 2032. Additionally, the Company has general business credit carry forwards of $299,000 that will expire in 2033. Use of this general business credit carry forward is not limited because it was generated after the change in ownership. The Company also has $193,000 of alternative minimum tax credit carry forwards that do not have expiration dates. The alternative minimum tax credit carry forwards are limited by IRC §383, but their ultimate use is not affected since these do not expire. 

The Company’s domestic NOL carry forwards of $10.0 million as of October 31, 2015 include $2.8 million of income tax deductions in excess of previously recorded tax benefits. Although these additional tax deductions are reflected in NOL carry forwards referenced above, based on current accounting guidance, the related tax benefit is not recognized until the deductions reduce taxes payable. Accordingly, since the tax benefit did not reduce the Company’s current taxes payable in 2016 or 2015, these tax benefits are not reflected in the Company’s deferred tax assets. Under current accounting guidance, the tax benefit of these excess deductions will be reflected as a credit to additional paid-in capital when recognized. See Note 2 regarding New Accounting Pronouncements that will change this treatment for annual reporting periods beginning after December 15, 2016.

In addition, as of October 31, 2015, the Company has state NOL carry forwards of approximately $1.7 million and foreign NOL carry forwards of approximately $4.3 million. Expiration of state NOLs vary by state and approximately $166,000 will expire in fiscal 2016 if not utilized. Foreign NOL expiration varies by country; however, a substantial portion of the foreign NOLs are in Belgium, and do not expire.

(10)       Segment Reporting

The Company operates in a single industry segment, the manufacture and sale of cardiorespiratory diagnostic products. The Company sells its products into many countries throughout the world. Net sales and long-lived assets by geographic area are shown in the following tables.