Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations

Management’s Discussion and Analysis of Financial Condition and Results of Operations reviews the operating results of Paychex, Inc. and its wholly owned subsidiaries (“Paychex,” “we,” “our,” or “us”) for each of the three fiscal years ended May 31, 2013 (“fiscal 2013”), May 31, 2012 (“fiscal 2012”), and May 31, 2011 (“fiscal 2011”), and our financial condition as of May 31, 2013. This review should be read in conjunction with the accompanying consolidated financial statements and the related notes to consolidated financial statements contained in Item 8 of this Annual Report on Form 10-K (“Form 10-K”) and the “Risk Factors” discussed in Item 1A of this Form 10-K. Forward-looking statements in this review are qualified by the cautionary statement under the heading “Cautionary Note Regarding Forward-Looking Statements Pursuant to the United States Private Securities Litigation Reform Act of 1995” contained at the beginning of Part I of this Form 10-K.

Overview

We are a leading provider of payroll, human resource, insurance, and benefits outsourcing solutions for small- to medium-sized businesses. Our Payroll and Human Resource Services (“HRS”) offer a portfolio of services and products that allow our clients to meet their diverse payroll and human resource needs. Our payroll services are the foundation of our service portfolio and include:

•	payroll processing;

•	payroll tax administration services;

•	employee payment services; and

•	regulatory compliance services (new-hire reporting and garnishment processing).

We support small market companies through our core payroll and SurePayroll, Inc. (“SurePayroll”) product lines. Mid-market companies typically have more sophisticated payroll and benefits needs, and are primarily serviced through our Major Market Services (“MMS”). Our software-as-a-service (“SaaS”) solution through our MMS platform provides human resource management, employee benefits management, time and attendance systems, online expense reporting, and applicant tracking.

Our HRS products include:

•	Paychex HR Solutions, under which we offer our administrative services organization (“ASO”) and our professional employer organization (“PEO”). We also offer Paychex HR Essentials, an ASO product that provides support to our clients over the phone or online to help manage employee-related topics;

•	retirement services administration;

•	insurance services;

•	eServices; and

•	other human resource services and products.

Our primary goal is to transform the way businesses do business. We strive to achieve this goal by leveraging our industry-leading technology to provide outstanding customer service. Our business strategy is focused on strong long-term financial performance by providing high-quality, timely, accurate, and affordable services; growing our client base; increasing utilization of our ancillary services; leveraging our technology through our service organization; and expanding our product offerings. We continue to focus on driving growth in clients, revenue, and profits. We are managing our personnel costs and expenses while continuing to invest in our business, particularly in leading-edge technology. We believe these investments are critical to our success. Looking to the future, we continue to focus on investing in our products, people, and service capabilities, positioning ourselves to capitalize on opportunities for long-term growth.

Our financial results for fiscal 2013 reflected sustained growth in our business. Checks per payroll and revenue per check continued to show improvement. Checks per payroll grew 1.6% for fiscal 2013, slightly less than the 2.0% growth experienced for fiscal 2012. Our service execution was strong as we achieved our highest levels of customer satisfaction in our history and record levels of client retention.

Our financial results continue to be adversely impacted by the interest rate environment as interest rates available on high quality financial instruments remain low. The Federal Funds rate has been at a range of zero to 0.25% since December 2008. Our combined funds held for clients and corporate investment portfolios earned an average rate of return of 1.0% for fiscal 2013, compared to 1.1% for fiscal 2012 and 1.3% for fiscal 2011.

Highlights of our financial results for fiscal 2013, compared to fiscal 2012, are as follows:

•	Payroll service revenue increased 2% to $1.5 billion.

•	HRS revenue increased 10% to $746.0 million.

•	Interest on funds held for clients decreased 6% to $41.0 million.

•	Total revenue increased 4% to $2.3 billion.

•	Operating income increased 6% to $904.8 million, and operating income, net of certain items, increased 7% to $863.8 million. Refer to the “Non-GAAP Financial Measure” discussion below for further information on operating income, net of certain items.

•	Net income increased 4% to $569.0 million and diluted earnings per share increased 3% to $1.56 per share. Net income and diluted earnings per share were impacted by the settlement of a state income tax matter, which reduced diluted earnings per share by approximately $0.04 per share.

•	Dividends of $476.7 million were paid to stockholders, representing 84% of net income.

Non-GAAP Financial Measure

In addition to reporting operating income, a United States (“U.S.”) generally accepted accounting principle (“GAAP”) measure, we present operating income, net of certain items, which is a non-GAAP measure. We believe operating income, net of certain items, is an appropriate additional measure, as it is an indicator of our core business operations performance period over period. It is also the basis of the measure used internally for establishing the following year’s targets and measuring management’s performance in connection with certain performance-based compensation payments and awards. Operating income, net of certain items, excludes interest on funds held for clients. Interest on funds held for clients is an adjustment to operating income due to the volatility of interest rates, which are not within the control of management. Operating income, net of certain items, is not calculated through the application of GAAP and is not the required form of disclosure by the Securities and Exchange Commission. As such, it should not be considered as a substitute for the GAAP measure of operating income and, therefore, should not be used in isolation, but in conjunction with the GAAP measure. The use of any non-GAAP measure may produce results that vary from the GAAP measure and may not be comparable to a similarly defined non-GAAP measure used by other companies.

Business Outlook

Our client base totaled approximately 570,000 clients as of May 31, 2013, compared to approximately 567,000 clients as of May 31, 2012, and approximately 564,000 clients as of May 31, 2011. Our client base increased approximately 1% for fiscal 2013, compared to approximately 1% for fiscal 2012 and approximately 5% (1% decline on an organic basis) for fiscal 2011.

For fiscal 2013, payroll services client retention was at record levels, exceeding 81% of our beginning client base. We received the highest client satisfaction results in our history, which we believe is a result of our focus on providing high-quality service to our customers utilizing leading-edge technology to maximize client retention.

Our ancillary services provide services to employers and employees beyond payroll, but effectively leverage payroll processing data and, therefore, are beneficial to our operating margin. eServices ancillary services are often included as part of the SaaS solutions for mid-market clients. The following statistics demonstrate the growth in certain of our HRS ancillary service offerings:

		Balance at May 31, 2013			Growth rates for fiscal year
		2013			2012				2011
Paychex HR Solutions client employees served		672,000			9	%		8	%			12	%
Paychex HR Solutions clients		25,000			10	%		8	%			8	%
Insurance services clients(1)		108,000			1	%		6	%			8	%
Health and benefits services applicants		131,000			8	%		23	%			23	%
Retirement services plans (2)		62,000			4	%		4	%	568,000		12	%

(1)	Includes workers’ compensation insurance services clients and health and benefits services clients.

(2)	Retirement services plans include ePlan Services, Inc. ("ePlan") plans. ePlan was acquired in May 2011. The organic growth rate for retirement services plans for fiscal 2011 would have been approximately 5%.

Ongoing investment in our business is critical to our success. During fiscal 2013, we continued to expand our product portfolio through internal development and acquisitions to add value for our clients. We have positioned ourselves to capture the opportunity created by a greater interest in online SaaS solutions through both product development and recent acquisitions with SaaS-oriented business models, including our SurePayroll product, which continues to perform well. The combination of our market-leading SaaS solutions combined with our service model allow us to offer a unique value proposition in the market.

We enhanced our online and mobile offerings, adding greater value and convenience for our clients. These mobile applications allow our clients instant access and increased productivity. Our single-sign-on feature provides a new and improved interface and mobility enhancer. During fiscal 2013, we launched our mobile application for the smartphone. We also added access to flexible spending account ("FSA") and health and benefits employer and employee information to our mobile offerings. Early in fiscal 2013, we launched an industry-leading report center and robust report writer. This provides a one-stop shop for standard or on-demand reporting needs, ad-hoc and customized reporting, data-extract templates and more.

We continued to enhance our Paychex Next Generation platform and its suite of innovative products, as we believe this is a key building block to our future success. This platform allows us to leverage efficiencies in our processes and to continue to provide excellent customer service to our clients. This technology creates a truly integrated workforce management solution for our clients, bringing together the services those clients need, including our small and mid-market payroll products and various human resource and employee benefit management services.

In our retirement services area, we have also experienced success in driving more sales through an enhanced approach to our direct relationships with financial advisors. We recently announced a partnership with FSAStore.com, a national online store stocked exclusively with FSA-eligible products and services, to provide participants in the Paychex FSA a simple and convenient way to use their FSA funds.

We have strengthened our position as an expert in our industry by serving as a source of education and information to clients, small businesses, and other interested parties. During fiscal 2013, we launched a newly redesigned Paychex Accountant Knowledge Center, a free online resource available through www.paychex.com that brings valuable information and time-saving online tools to accounting professionals. We also launched a new and improved BuildMyBiz.com that includes a number of new features that provide enhanced resources for entrepreneurs and small business owners. In addition, we provide free webinars, white papers, and other information on our website to aid existing and prospective clients with the impact of regulatory changes. The Paychex Insurance Agency, Inc. website, www.paychexinsurance.com, helps small business owners navigate the area of insurance coverage and both this website and www.paychex.com have sections dedicated to the topic of health care reform.

Financial position and liquidity

The supply of high credit quality securities has been limited with the continued volatility in the global financial markets, thereby limiting our investment choices. Despite this macroeconomic environment, our financial position as of May 31, 2013 remained strong with cash and total corporate investments of $874.6 million and no debt.

Our investment strategy focuses on protecting principal and optimizing liquidity. Yields on high quality financial instruments remain low, negatively impacting our income earned on funds held for clients and corporate investments. We invest predominately in municipal bonds including general obligation bonds, pre-refunded bonds that are secured by a U.S. government escrow, and essential services revenue bonds. During fiscal 2013, our primary short-term investment vehicles were high quality variable rate demand notes (“VRDNs”) and bank demand deposit accounts.

A substantial portion of our portfolio is invested in high credit quality securities with AAA and AA ratings and A-1/P-1 ratings on short-term securities. We limit the amounts that can be invested in any single issuer and invest in short- to intermediate-term instruments whose fair value is less sensitive to interest rate changes. We believe that our investments as of May 31, 2013 were not other-than-temporarily impaired, nor has any event occurred subsequent to that date that would indicate any other-than-temporary impairment.

Our primary source of cash is our ongoing operations. Cash flow from operations was $675.3 million for fiscal 2013. Historically, we have funded our operations, capital purchases, business acquisitions, and dividend payments from our operating activities. Our positive cash flows in fiscal 2013 allowed us to support our business growth and to pay substantial dividends to our stockholders. During fiscal 2013, dividends paid to stockholders were 84% of net income. It is anticipated that cash and total

corporate investments as of May 31, 2013, along with projected operating cash flows, will support our normal business operations, capital purchases, and dividend payments for the foreseeable future.

For further analysis of our results of operations for fiscal years 2013, 2012, and 2011, and our financial position as of May 31, 2013, refer to the tables and analysis in the “Results of Operations” and “Liquidity and Capital Resources” sections of this Item 7 and the discussion in the “Critical Accounting Policies” section of this Item 7.

Outlook

Our outlook for the fiscal year ending May 31, 2014 (“fiscal 2014”) is based upon current economic and interest rate conditions continuing with no significant changes. Our expected fiscal 2014 payroll revenue growth rate is based upon anticipated client base growth and increases in revenue per check. HRS revenue growth is expected to remain in line with our recent organic experience.

Our fiscal 2014 guidance is as follows:

		Low					High
Payroll service revenue		3	%		—		4	%
HRS revenue		9	%		—		10	%
Total service revenue		5	%		—		6	%
Interest on funds held for clients		(9	)%		—		(7	)%
Investment income, net		—	%		—		5	%
Net income		8	%		—		9	%

We believe that net income growth for fiscal 2014 is expected to benefit from a strong comparison mainly due to results in the fourth quarter of fiscal 2013. In the fourth quarter of fiscal 2013, we settled a state income tax matter which reduced diluted earnings per share by approximately $0.04 per share. Operating income, net of certain items, as a percent of service revenue, is expected to be approximately 38% for fiscal 2014. The effective income tax rate for fiscal 2014 is expected to be in the range of 36% to 37%. The settlement of a state income tax matter in fiscal 2013 is not expected to have an impact on the effective income tax rate for fiscal 2014.

Interest on funds held for clients and investment income for fiscal 2014 are expected to continue to be impacted by the low interest rate environment. The average rate of return on our combined funds held for clients and corporate investment portfolios is expected to remain at 1.0% for fiscal 2014. As of May 31, 2013, the long-term investment portfolio had an average yield-to-maturity of 1.8% and an average duration of 3.1 years. In the next twelve months, slightly less than 15% of this portfolio will mature, and it is currently anticipated that these proceeds will be reinvested at a lower average interest rate of approximately 1.1%. Investment income is expected to benefit from ongoing investment of cash generated from operations.

Purchases of property and equipment for fiscal 2014 are expected to be in the range of $100 million to $110 million. This includes costs for internally developed software as we continue to invest in our service supporting technology. Fiscal 2014 depreciation expense is projected to be in the range of $85 million to $90 million, and we project amortization of intangible assets for fiscal 2014 to be approximately $15 million.

Results of Operations

Summary of Results of Operations for the Fiscal Years Ended May 31:

In millions, except per share amounts		2013				Change			2012				Change			2011
Revenue:
Payroll service revenue		$	1,539.2			2	%		$	1,510.0			5	%		$	1,438.8
HRS revenue		746.0				10	%		676.2				13	%		597.4
Total service revenue		2,285.2				5	%		2,186.2				7	%		2,036.2
Interest on funds held for clients		41.0				(6	)%		43.6				(9	)%		48.1
Total revenue		2,326.2				4	%		2,229.8				7	%		2,084.3
Combined operating and SG&A expenses		1,421.4				3	%		1,375.9				6	%		1,297.9
Operating income		904.8				6	%		853.9				9	%		786.4
Investment income, net		6.6				4	%		6.4				9	%		5.8
Income before income taxes		911.4				6	%		860.3				9	%		792.2
Income taxes		342.4				10	%		312.3				13	%		276.9
Effective income tax rate		37.6		%					36.3		%					35.0		%
Net income		569.0				4	%		$	548.0			6	%		$	515.3
Diluted earnings per share		$	1.56			3	%		$	1.51			6	%		$	1.42

We invest in highly liquid, investment-grade fixed income securities and do not utilize derivative instruments to manage interest rate risk. As of May 31, 2013, we had no exposure to high-risk or illiquid investments and had insignificant exposure to European investments. Details regarding our combined funds held for clients and corporate investment portfolios are as follows:

		Year ended May 31,
$ in millions		2013				2012				2011
Average investment balances:
Funds held for clients		$	3,715.6			$	3,584.3			$	3,350.3
Corporate investments		756.9				685.9				662.4
Total		$	4,472.5			$	4,270.2			$	4,012.7
Average interest rates earned (exclusive of net realized gains):
Funds held for clients		1.1		%		1.2		%		1.4		%
Corporate investments		0.8		%		0.9		%		0.9		%
Combined funds held for clients and corporate investments		1.0		%		1.1		%		1.3		%
Total net realized gains		$	0.9			$	1.0			$	1.3

$ in millions As of May 31,		2013				2012				2011
Net unrealized gains on available-for-sale securities(1)		$	34.7			$	59.5			$	59.3
Federal Funds rate(2)		0.25		%		0.25		%		0.25		%
Total fair value of available-for-sale securities		$	3,691.4			$	3,059.0			$	2,737.2
Weighted-average duration of available-for-sale securities in years(3)		3.1				3.0				2.4
Weighted-average yield-to-maturity of available-for-sale securities(3)		1.8		%		2.2		%		2.6		%

(1)	The net unrealized gain on our investment portfolios was approximately $2.7 million as of July 15, 2013.

(2)	The Federal Funds rate was a range of zero to 0.25% as of May 31, 2013, 2012, and 2011.

(3)	These items exclude the impact of VRDNs, as they are tied to short-term interest rates.

Payroll service revenue: Payroll service revenue increased 2% for fiscal 2013 and 5% for fiscal 2012 to $1.5 billion for both periods. Organic growth in payroll service revenue for fiscal 2012, which excludes the impact of acquisitions during fiscal 2011, was approximately 4%. Both fiscal 2013 and fiscal 2012 revenue benefited from increases in checks per payroll and revenue per check. Checks per payroll increased 1.6% and 2.0% for fiscal 2013 and fiscal 2012, respectively. Revenue per check in both periods was positively impacted by price increases, partially offset by discounting. Payroll service revenue for fiscal 2013 was modestly affected by the impact of Hurricane Sandy in the fall of 2012 and one less payroll processing day overall due to the leap year in fiscal 2012. Our client base growth was approximately 1% for both fiscal 2013 and fiscal 2012. Client retention reached record levels for fiscal 2013, following a year of further improvement.

Human Resource Services revenue: HRS revenue increased 10% for fiscal 2013 and 13% for fiscal 2012 to $746.0 million and $676.2 million, respectively. The growth rate for fiscal 2012 was impacted by the acquisition of ePlan in May 2011. Organic growth in HRS revenue was approximately 11% for fiscal 2012. The following factors contributed to the growth for fiscal 2013 and fiscal 2012:

•	Retirement services revenue benefited from growth in the number of plans, price increases, and an increase in the average asset value of retirement services participants' funds, partially offset by the impact from a shift in the mix of assets within these funds to investments that earn lower fees from external managers.

•

Paychex HR Solutions revenue was positively impacted by growth in both clients and client employees and price increases. The rate of growth for Paychex HR Solutions revenue for fiscal 2013 and fiscal 2012 was tempered by a lower average number of client employees within our PEO. During the second half of fiscal 2013, the PEO business stabilized and its results strengthened as the year progressed. For fiscal 2013, PEO revenue also benefited from positive rate impacts and fluctuations in workers' compensation costs.

•	Insurance services revenue continued to improve as a result of growth in health and benefits services applicants, though at moderating rates, and higher revenue from other insurance policies, such as dental, vision, disability, and life. Growth also resulted from increases in premiums for workers’ compensation insurance services.

•	eServices revenue growth reflects higher client base and price increases, particularly as we continue to focus on adding SaaS-based solutions through product development and acquisitions.

HRS product key statistics are as follows:

$ in billions As of May 31,		2013				Change			2012				Change			2011
Paychex HR Solutions client employees served		672,000				9	%		615,000				8	%		569,000
Paychex HR Solutions clients		25,000				10	%		23,000				8	%		21,000
Insurance services clients(1)		108,000				1	%		107,000				6	%		100,000
Health and benefits services applicants		131,000				8	%		121,000				23	%		99,000
Retirement services plans		62,000				4	%		59,000				4	%		57,000
Asset value of retirement services participants’ funds		$	19.3			23	%		$	15.7			3	%		$	15.3

(1)	Includes workers’ compensation insurance services clients and health and benefits services clients.

Total service revenue: Total service revenue increased 5% for fiscal 2013 and 7% for fiscal 2012, attributable to the factors previously discussed. Organic service revenue growth was approximately 6% for fiscal 2012.

Interest on funds held for clients: Interest on funds held for clients decreased 6% for fiscal 2013 and 9% for fiscal 2012 compared to the respective prior year periods. These declines were the result of lower average interest rates earned, partially offset by an increase in average investment balances. The lower average interest rates were the result of lower yields on high quality financial instruments. For fiscal 2013, the average interest rate earned was also impacted by the mix of investments in the short-term portfolio, with more invested in tax-exempt securities. Tax-exempt securities typically earn a lower pre-tax rate of return, but are expected to generate lower income tax expense on interest earned.

Average investment balances for funds held for clients increased 4% for fiscal 2013 and 7% for fiscal 2012. The increase for fiscal 2013 was largely due to the expiration of certain payroll tax cuts on December 31, 2012, which resulted in higher employee social security withholdings. In addition, the average investment balances for fiscal 2013 benefited from increases in checks per payroll and wage inflation. The increase in average investment balances for fiscal 2012 was the result of the inclusion of SurePayroll client funds, wage inflation, increase in state unemployment insurance rates, and the increase in checks per payroll.

Refer to the “Market Risk Factors” section, contained in Item 7A of this Form 10-K, for more information on changing interest rates.

Combined operating and SG&A expenses: The following table summarizes total combined operating and selling, general and administrative (“SG&A”) expenses for fiscal years:

In millions		2013				Change			2012				Change			2011
Compensation-related expenses		$	955.8			4	%		$	920.8			5	%		$	877.7
Facilities expenses		55.4				(5	)%		58.1				(3	)%		60.0
Depreciation and amortization		98.2				—	%		97.8				10	%		88.7
Other expenses		312.0				4	%		299.2				10	%		271.5
Total operating and SG&A expenses		$	1,421.4			3	%		$	1,375.9			6	%		$	1,297.9

A significant portion of the increases in expenses for fiscal 2012 was driven by our acquisitions during fiscal 2011. Organic growth in combined operating and SG&A expenses was approximately 3% for fiscal 2012. For both fiscal 2013 and fiscal 2012, continued investment in leading-edge technology contributed to the increases in total expenses, with those expenses growing at a faster rate than total expenses. Improvements in operations productivity with related lower headcount have moderated these increases.

Compensation-related costs for fiscal 2013 and fiscal 2012 were impacted by increased headcount in areas supporting our development of technology, and higher employee benefit-related costs. Fiscal 2013 was also impacted by variable compensation from strong sales execution in the small business market. As of both May 31, 2013 and 2012, we had approximately 12,400 employees.

Depreciation expense is primarily related to buildings, furniture and fixtures, data processing equipment, and software. Increases in depreciation expense were due to capital expenditures as we invested in technology and continued to grow our business. Amortization of intangible assets is primarily related to client list acquisitions, which are amortized using either straight-line or accelerated methods. Depreciation and amortization increased at a higher rate in fiscal 2012 due to business acquisitions.

Other expenses include items such as delivery, forms and supplies, communications, travel and entertainment, equipment costs, professional services, and other costs incurred to support our business. The increase in other expenses for fiscal 2012 was primarily attributable to the inclusion of our acquisitions. In addition, higher equipment costs within information technology and higher professional services supporting our technology development contributed to the increases in other expenses for both fiscal 2013 and fiscal 2012.

Operating income: Operating income increased 6% for fiscal 2013 and 9% for fiscal 2012. The fluctuations in operating income were attributable to the factors previously discussed.

Operating income, net of certain items, is as follows for fiscal years:

In millions		2013				Change			2012				Change			2011
Operating income		$	904.8			6	%		$	853.9			9	%		$	786.4
Excluding: Interest on funds held for clients		(41.0		)		(6	)%		(43.6		)		(9	)%		(48.1		)
Operating income, net of certain items		$	863.8			7	%		$	810.3			10	%		$	738.3
Operating income, net of certain items, as a percent of service revenue		37.8		%					37.1		%					36.3		%

Refer to the previous discussion of operating income, net of certain items, in the “Non-GAAP Financial Measure” section on page 14.

Investment income, net: Investment income, net, primarily represents earnings from our cash and cash equivalents and investments in available-for-sale securities. Investment income does not include interest on funds held for clients, which is included in total revenue. Investment income increased 4% for fiscal 2013 and 9% for fiscal 2012. The increases in investment income were primarily the result of higher average investment balances. Average investment balances increased 10% for fiscal 2013 and 4% for fiscal 2012. The increases were the result of investment of cash generated from operations. For fiscal 2013, investment income growth was tempered by lower average interest rates earned.

Income taxes: Our effective income tax rate was 37.6% for fiscal 2013 compared to 36.3% for fiscal 2012 and 35.0% for fiscal 2011. The increase in our effective tax rate for fiscal 2013 was the result of the settlement of a state income tax matter. The increase in our effective tax rate for fiscal 2012 was primarily the result of changes in state apportionment and lower levels of tax-exempt income derived from municipal debt securities in the funds held for clients and corporate investment portfolios. Refer to Note I of the Notes to Consolidated Financial Statements, contained in Item 8 of this Form 10-K, for additional disclosures on income taxes.

Net income and earnings per share: Net income increased 4% to $569.0 million for fiscal 2013 and 6% to $548.0 million for fiscal 2012. Diluted earnings per share increased 3% to $1.56 per share for fiscal 2013 and 6% to $1.51 per share for fiscal 2012. These fluctuations were attributable to the factors previously discussed. The settlement of a state income tax matter impacted diluted earnings per share by approximately $0.04 per share for fiscal 2013.

Liquidity and Capital Resources

The supply of high credit quality securities has been limited with the continued volatility in the global financial markets, thereby limiting our investment choices. Despite this macroeconomic environment, our financial position as of May 31, 2013 remained strong with cash and total corporate investments of $874.6 million and no debt. We also believe that our investments as of May 31, 2013 were not other-than-temporarily impaired, nor has any event occurred subsequent to that date that would indicate any other-than-temporary impairment. We anticipate that cash and total corporate investments as of May 31, 2013, along with projected operating cash flows, will support our normal business operations, capital purchases, and dividend payments for the foreseeable future.

Commitments and Contractual Obligations

Lines of credit: As of May 31, 2013, we had unused borrowing capacity available under four uncommitted, secured, short-term lines of credit at market rates of interest with financial institutions as follows:

Financial institution	Amount available	Expiration date
JP Morgan Chase Bank, N.A.	$350 million	February 28, 2014
Bank of America, N.A.	$250 million	February 28, 2014
PNC Bank, National Association	$150 million	February 28, 2014
Wells Fargo Bank, National Association	$150 million	February 28, 2014

Our credit facilities are evidenced by promissory notes and are secured by separate pledge security agreements by and between Paychex, Inc. and each of the financial institutions (the “Lenders”), pursuant to which we have granted each of the Lenders a security interest in certain of our investment securities accounts. The collateral is maintained in a pooled custody account pursuant to the terms of a control agreement and is to be administered under an intercreditor agreement among the Lenders. Under certain circumstances, individual Lenders may require that collateral be transferred from the pooled account into segregated accounts for the benefit of such individual Lenders.

The primary uses of the lines of credit would be to meet short-term funding requirements related to deposit account overdrafts and client fund obligations arising from electronic payment transactions on behalf of our clients in the ordinary course of business, if necessary. No amounts were outstanding against these lines of credit during fiscal 2013 or as of May 31, 2013.

The financial institutions are also parties to our credit facility and irrevocable standby letters of credit, which are discussed below.

Credit facility: In June 2013, we entered into a committed, unsecured, five-year syndicated credit facility, expiring on June 21, 2018. Under the credit facility, Paychex of New York LLP (the "Borrower") may, subject to certain restrictions, borrow up to $500 million to meet short-term funding requirements. The obligations under this facility have been guaranteed by us and certain of our subsidiaries. The outstanding obligations under this credit facility will bear interest at competitive rates to be elected by the Borrower. Upon expiration of the commitment in June 2018, any borrowings outstanding will mature and be payable on such date.

Certain lenders under this credit facility, and their respective affiliates, have performed, and may in the future perform for us and our subsidiaries, various commercial banking, investment banking, underwriting, and other financial advisory services, for which they have received, and will continue to receive in the future, customary fees and expenses.

Letters of credit: As of May 31, 2013, we had irrevocable standby letters of credit outstanding totaling $36.8 million, required to secure commitments for certain of our insurance policies. The letters of credit expire at various dates between July 2013 and December 2013, and are collateralized by securities held in our investment portfolios. No amounts were outstanding on these letters of credit during fiscal 2013 or as of May 31, 2013. Subsequent to May 31, 2013, the letter of credit expiring in July 2013 was renewed and will expire in July 2014.

Other commitments: We have entered into various operating leases and purchase obligations that, under GAAP, are not reflected on the Consolidated Balance Sheets as of May 31, 2013. The table below summarizes our estimated annual payment obligations under these commitments as of May 31, 2013:

		Payments due by period
In millions		Total				Less than 1 year				1-3 years				4-5 years				More than 5 years
Operating leases(1)		$	143.4			$	36.9			$	58.0			$	32.9			$	15.6
Purchase obligations(2)		89.1				59.1				28.2				1.4				0.4
Total		$	232.5			$	96.0			$	86.2			$	34.3			$	16.0

(1)	Operating leases are primarily for office space and equipment used in our branch operations.

(2)

Purchase obligations include our estimate of the minimum outstanding commitments under purchase orders to buy goods and services and legally binding contractual arrangements with future payment obligations. Included in the total purchase obligations is $9.9 million of commitments to purchase capital assets. Amounts actually paid under certain of these arrangements may be different due to variable components of these agreements.

The liability for uncertain tax positions was approximately $19.8 million as of May 31, 2013. Refer to Note I of the Notes to Consolidated Financial Statements, contained in Item 8 of this Form 10-K, for more information on income taxes. We are not able to reasonably estimate the timing of future cash flows related to this liability and have excluded it from the table above.

Certain deferred compensation plan obligations and other long-term liabilities reported in our Consolidated Balance Sheets amounting to $48.8 million are excluded from the table above because the timing of actual payments cannot be specifically or reasonably determined due to the variability in assumptions required to project the timing of future payments.

Advantage Payroll Services Inc. (“Advantage”) has license agreements with independently owned associate offices (“Associates”), which are responsible for selling and marketing Advantage payroll services and performing certain operational functions, while Paychex and Advantage provide all centralized back-office payroll processing and payroll tax administration services. Under these arrangements, Advantage pays the Associates commissions based on processing activity for the related clients. When we acquired Advantage, there were fifteen Associates. Over the past few years, arrangements with some Associates have been discontinued, and there are currently fewer than ten Associates. Since the actual amounts of future payments are uncertain, obligations under these arrangements are not included in the table above. Commission expense for the Associates for fiscal years 2013, 2012, and 2011 was $12.6 million, $11.7 million, and $10.4 million, respectively.

In the normal course of business, we make representations and warranties that guarantee the performance of services under service arrangements with clients. Historically, there have been no material losses related to such guarantees. In addition, we have entered into indemnification agreements with our officers and directors, which require us to defend and, if necessary, indemnify these individuals for certain pending or future legal claims as they relate to their services provided to us.

We currently self-insure the deductible portion of various insured exposures under certain employee benefit plans. Our estimated loss exposure under these insurance arrangements is recorded in other current liabilities on our Consolidated Balance Sheets. Historically, the amounts accrued have not been material. We also maintain insurance coverage in addition to our purchased primary insurance policies for gap coverage for employment practices liability, errors and omissions, warranty liability, theft and embezzlement, cyber threat, and acts of terrorism; and capacity for deductibles and self-insured retentions through our captive insurance company.

Off-Balance Sheet Arrangements

As part of our ongoing business, we do not participate in transactions with unconsolidated entities which would have been established for the purpose of facilitating off-balance sheet arrangements or other limited purposes. We do maintain investments as a limited partner in low-income housing projects that are not considered part of our ongoing operations. These investments are accounted for under the equity method of accounting and are less than 1% of our total assets as of May 31, 2013.

Operating Cash Flow Activities

		Year ended May 31,
In millions		2013				2012				2011
Net income		$	569.0			$	548.0			$	515.3
Non-cash adjustments to net income		183.3				175.1				166.5
Cash (used in)/provided by changes in operating assets and liabilities		(77.0		)		(16.5		)		33.5
Net cash provided by operating activities		$	675.3			$	706.6			$	715.3

The decreases in our operating cash flows for fiscal 2013 and fiscal 2012 resulted mainly from fluctuations in operating assets and liabilities, partially offset by higher net income adjusted for non-cash items. The fluctuations in our operating assets and liabilities between periods were primarily related to the timing of collections from clients and payments for compensation, PEO payroll, income tax, and other liabilities.

Investing Cash Flow Activities

		Year ended May 31,
In millions		2013				2012				2011
Net change in funds held for clients and corporate investment activities		$	306.8			$	(1,147.4	)		$	(179.8	)
Purchases of property and equipment		(98.7		)		(89.6		)		(100.5		)
Acquisition of businesses, net of cash acquired		(21.3		)		(6.0		)		(126.4		)
Purchases of other assets		(5.1		)		(1.3		)		(2.8		)
Net cash provided by/(used in) investing activities		$	181.7			$	(1,244.3	)		$	(409.5	)

Funds held for clients and corporate investments: Funds held for clients consist of short-term funds and available-for-sale securities. Corporate investments are primarily comprised of available-for-sale securities. The portfolio of funds held for clients and corporate investments is detailed in Note E of the Notes to Consolidated Financial Statements, contained in Item 8 of this Form 10-K.

The fluctuation in the net change in funds held for clients and corporate investment activities is largely due to timing within the client funds portfolio. There was a large cash outflow on Friday, May 31, 2013 that required the liquidation of funds held in funds held for clients short-term cash equivalents portion of the portfolio, resulting in positive cash flow from investing activities for fiscal 2013. There was a large inflow of collections on Thursday, May 31, 2012 that was invested primarily in short-term investments on that date reflecting a large cash outflow from investing activities for fiscal 2012. See further discussion of this timing in the financing cash flows discussion of net change in client fund obligations. Our net cash inflow from funds held for clients and corporate investment activities for fiscal 2013 was partially offset by higher purchases than sales of VRDN securities during the year. For fiscal 2012, the net cash outflow was increased from investment in longer-term available-for-sale securities within our corporate portfolio.

In general, fluctuations in net funds held for clients and corporate investment activities primarily relate to timing of purchases, sales, or maturities of investments. The amount of funds held for clients will vary based upon the timing of collection of client funds, and the related remittance of funds to applicable tax or regulatory agencies for payroll tax administration services and to employees of clients utilizing employee payment services. Additional discussion of interest rates and related risks is included in the “Market Risk Factors” section, contained in Item 7A of this Form 10-K.

Purchases of long-lived assets: To support our continued client and ancillary product growth, purchases of property and equipment were made for data processing equipment and software, and for the expansion and upgrade of various operating facilities. During fiscal years 2013, 2012, and 2011, we purchased approximately $6.5 million, $2.6 million, and $5.7 million, respectively, of data processing equipment and software from EMC Corporation. The Chairman, President, and Chief Executive Officer of EMC Corporation is a member of our Board of Directors (the “Board”).

During fiscal 2013 and fiscal 2012, we paid, net of cash acquired, $21.3 million and $6.0 million, respectively, for immaterial business acquisitions. During fiscal 2011, we paid $126.4 million for the combined acquisitions of SurePayroll and ePlan.

Financing Cash Flow Activities

		Year ended May 31,
In millions, except per share amounts		2013				2012				2011
Net change in client fund obligations		$	(454.6	)		$	980.5			$	(34.9	)
Dividends paid		(476.7		)		(460.5		)		(448.8		)
Equity activity related to stock-based awards		72.8				7.5				12.6
Net cash (used in)/provided by financing activities		$	(858.5	)		$	527.5			$	(471.1	)
Cash dividends per common share		$	1.31			$	1.27			$	1.24

Net change in client fund obligations: The client fund obligations liability will vary based on the timing of collecting client funds, and the related required remittance of funds to applicable tax or regulatory agencies for payroll tax administration services and to employees of clients utilizing employee payment services. Collections from clients are typically remitted from one to 30 days after receipt, with some items extending to 90 days.

The fluctuations in net change in client fund obligations for the years presented is primarily the result of timing of collections and remittances. May 31, 2013 fell on a Friday, which is a large cash outflow day for direct deposit funds, partially offset by tax payment funds collected on that day. May 31, 2012 fell on a Thursday, which is a large collection day for direct pay funds. These funds were then paid out on Friday, June 1, 2012. May 31, 2011 fell on a Tuesday, which is not typically a significant collection or payment day. In addition, the fluctuations were impacted by overall trends in client fund balances, which were 4% higher on average for fiscal 2013 than fiscal 2012 and 7% higher on average for fiscal 2012 than for fiscal 2011.

Dividends paid: In October 2012, the Board increased our quarterly dividend to stockholders by 3% to $0.33 per share from $0.32 per share. In October 2011, the Board increased our quarterly dividend by 3% to $0.32 per share from $0.31 per share. The dividends paid as a percentage of net income totaled 84%, 84%, and 87% for fiscal years 2013, 2012, and 2011, respectively. The payment of future dividends is dependent on our future earnings and cash flow, and is subject to the discretion of our Board.

Equity activity related to stock-based awards: The increase in activity related to stock-based awards for fiscal 2013 compared to fiscal 2012 was largely driven by an increase in proceeds from exercise of stock options. Common shares acquired through exercise of stock options were 2.4 million shares, 0.2 million shares, and 0.4 million shares for fiscal years 2013, 2012, and 2011, respectively. Refer to Note D of the Notes to Consolidated Financial Statements, contained in Item 8 of this Form 10-K, for additional disclosures on our stock-based compensation incentive plans.

Other

Recently adopted accounting pronouncements: Refer to Note A of the Notes to Consolidated Financial Statements, contained in Item 8 of this Form 10-K, for a discussion of recently adopted accounting pronouncements.

Recently issued accounting pronouncements: At this time, we do not anticipate that recently issued accounting guidance that has not yet been adopted will have a material impact on our consolidated financial statements. Refer to Note A of the Notes to Consolidated Financial Statements, contained in Item 8 of this Form 10-K, for a discussion of recently issued accounting pronouncements.

Critical Accounting Policies

Note A of the Notes to Consolidated Financial Statements, contained in Item 8 of this Form 10-K, discusses the significant accounting policies of Paychex. Our discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with U.S. GAAP. The preparation of these financial statements requires us to make estimates, judgments, and assumptions that affect reported amounts of assets, liabilities, revenue, and expenses. On an ongoing basis, we evaluate the accounting policies and estimates used to prepare the consolidated financial statements. We base our estimates on historical experience, future expectations, and assumptions believed to be reasonable under current facts and circumstances. Actual amounts and results could differ from these estimates. Certain accounting policies that are deemed critical to our results of operations or financial position are discussed below.

Revenue recognition: Service revenue is recognized in the period services are rendered and earned under service arrangements with clients where service fees are fixed or determinable and collectibility is reasonably assured. Certain processing services are provided under annual service arrangements with revenue recognized ratably over the service period. Our service revenue is largely attributable to payroll-related processing services where the fee is based on a fixed amount per processing period or a fixed amount per processing period plus a fee per employee or transaction processed. The revenue earned from delivery service

for the distribution of certain client payroll checks and reports is included in service revenue, and the costs for delivery are included in operating expenses on the Consolidated Statements of Income and Comprehensive Income. PEO revenue is included in service revenue and is reported net of direct costs billed and incurred, which include wages, taxes, benefit premiums, and claims of PEO worksite employees.

Interest on funds held for clients is earned primarily on funds that are collected from clients before due dates for payroll tax administration services and for employee payment services, and invested until remittance to the applicable tax or regulatory agencies or client employees. These collections from clients are typically remitted from one to 30 days after receipt, with some items extending to 90 days. The interest earned on these funds is included in total revenue on the Consolidated Statements of Income and Comprehensive Income because the collecting, holding, and remitting of these funds are critical components of providing these services. Interest on funds held for clients also includes net realized gains and losses from the sales of available-for-sale securities.

PEO workers’ compensation insurance: Workers’ compensation insurance reserves are established to provide for the estimated costs of paying claims underwritten by us. These reserves include estimates for reported losses, plus amounts for those claims incurred but not reported and estimates of certain expenses associated with processing and settling the claims. In establishing the workers’ compensation insurance reserves, we use an independent actuarial estimate of undiscounted future cash payments that would be made to settle the claims.

Estimating the ultimate cost of future claims is an uncertain and complex process based upon historical loss experience and actuarial loss projections, and is subject to change due to multiple factors, including economic trends, changes in legal liability law, and damage awards, all of which could materially impact the reserves as reported in the consolidated financial statements. Accordingly, final claim settlements may vary from our present estimates, particularly when those payments may not occur until well into the future.

We regularly review the adequacy of our estimated workers’ compensation insurance reserves. Adjustments to previously established reserves are reflected in our results of operations for the period in which the adjustment is identified. Such adjustments could possibly be significant, reflecting any variety of new and adverse or favorable trends.

Goodwill and other intangible assets: We have $533.9 million and $517.4 million of goodwill recorded on our Consolidated Balance Sheets as of May 31, 2013 and May 31, 2012, respectively, resulting from acquisitions of businesses. The increase in goodwill was due to two immaterial business acquisitions during fiscal 2013.

Goodwill is not amortized, but instead is tested for impairment on an annual basis and between annual tests if an event occurs or circumstances change in a way to indicate that there has been a potential decline in the fair value of a reporting unit. During fiscal 2012, we adopted guidance that allows us the option to perform a qualitative assessment to determine if it is more-likely-than-not that the fair value of a reporting unit has declined below its carrying value. This assessment considers various financial, macroeconomic, industry, and reporting unit specific qualitative factors. Our business is largely homogeneous and, as a result, goodwill is associated with one reporting unit. We perform our annual impairment testing in our fiscal fourth quarter. Based on the results of our reviews, no impairment loss was recognized in the results of operations for fiscal years 2013, 2012, or 2011. Subsequent to this review, there have been no events or circumstances that indicate any potential impairment of our goodwill balance.

We also test intangible assets for potential impairment when events or changes in circumstances indicate that the carrying value may not be recoverable.

Stock-based compensation costs: All stock-based awards to employees, including grants of stock options, are recognized as compensation costs in our consolidated financial statements based on their fair values measured as of the date of grant. We estimate the fair value of stock option grants using a Black-Scholes option pricing model. This model requires various assumptions as inputs including expected volatility of the Paychex stock price and expected option life. We estimate volatility based on a combination of historical volatility using weekly stock prices over a period equal to the expected option life and implied market volatility. Expected option life is estimated based on historical exercise behavior.

We are required to estimate forfeitures and only record compensation costs for those awards that are expected to vest. Our assumptions for forfeitures were determined based on type of award and historical experience. Forfeiture assumptions are adjusted at the point in time a significant change is identified, with any adjustment recorded in the period of change, and the final adjustment at the end of the requisite service period to equal actual forfeitures.

The assumptions of volatility, expected option life, and forfeitures all require significant judgment and are subject to change in the future due to factors such as employee exercise behavior, stock price trends, and changes to type or provisions of stock-based awards. Any change in one or more of these assumptions could have a material impact on the estimated fair value of a future award.

We have determined that the Black-Scholes option pricing model, as well as the underlying assumptions used in its application, is appropriate in estimating the fair value of stock option grants. We periodically reassess our assumptions as well as our choice of valuation model, and will reconsider use of this model if additional information becomes available in the future indicating that another model would provide a more accurate estimate of fair value, or if characteristics of future grants would warrant such a change.

Income taxes: We account for deferred taxes by recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been included in the consolidated financial statements or tax returns. Under this method, deferred tax assets and liabilities are determined based on the difference between the financial statement and tax basis of assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to reverse. We record a deferred tax asset related to the stock-based compensation costs recognized for certain stock-based awards. At the time of exercise of non-qualified stock options or vesting of stock awards, we account for the resulting tax deduction by reducing our accrued income tax liability with an offset to the deferred tax asset and any excess tax benefit increasing additional paid-in capital. We currently have a sufficient pool of excess tax benefits in additional paid-in capital to absorb any deficient tax benefits related to stock-based awards.

We maintain a reserve for uncertain tax positions. We evaluate tax positions taken or expected to be taken in a tax return for recognition in our consolidated financial statements. Prior to recording the related tax benefit in our consolidated financial statements, we must conclude that tax positions must be more-likely-than-not to be sustained, assuming those positions will be examined by taxing authorities with full knowledge of all relevant information. The benefit recognized in our consolidated financial statements is the amount we expect to realize after examination by taxing authorities. If a tax position drops below the more-likely-than-not standard, the benefit can no longer be recognized. Assumptions, judgment, and the use of estimates are required in determining if the more-likely-than-not standard has been met when developing the provision for income taxes and in determining the expected benefit. A change in the assessment of the more-likely-than-not standard could materially impact our results of operations or financial position. Our total reserve for uncertain tax positions was $19.8 million as of May 31, 2013 and $36.8 million as of May 31, 2012. Refer to Note I of the Notes to Consolidated Financial Statements, contained in Item 8 of this Form 10-K, for further discussion of our reserve for uncertain tax positions.