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, 2014 (“fiscal 2014”), May 31, 2013 (“fiscal 2013”), and May 31, 2012 (“fiscal 2012”), and our financial condition as of May 31, 2014. 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 integrated payroll, human resource, insurance, and benefits outsourcing solutions for small- to medium-sized businesses. Our payroll services 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 our software-as-a-service (“SaaS”) 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 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 Services, under which we offer Paychex HR Solutions, our administrative services organization (“ASO”), and Paychex PEO, 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;

•	online HR administration services, including time and attendance and benefit enrollment; and

•	other human resource services and products.

Our primary goal is to support the success of our clients and their businesses through innovative technology solutions and outstanding personal 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 2014 reflected sustained growth in our business. Payroll service revenue continued to advance with growth of 4% for fiscal 2014 as compared with fiscal 2013. Revenue per check, client base, and checks per payroll continued to show improvement. Checks per payroll increased 1.4% for fiscal 2014 and 1.6% for fiscal 2013. HRS revenue achieved double-digit growth, primarily due to demand for our human resource outsourcing solutions. Our service execution was strong as we achieved record levels of client retention, at approximately 82% of the beginning of the year client base.

Our financial results continue to be 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 both fiscal 2014 and fiscal 2013, and 1.1% for fiscal 2012.

With the introduction of a new health insurance offering within our PEO during fiscal 2014, we began classifying PEO direct costs related to certain benefit plans where the Company retains risk as operating expenses rather than a reduction in service revenue. This change, referred to as the "PEO direct cost adjustment" throughout this discussion, had no impact on operating income. Refer to the Results of Operations section of this Item 7 and Note O to the Notes to Consolidated Financial Statements, contained in Item 8 of this Form 10-K, for further details on the impact to service revenue, total revenue, and operating expenses. In evaluating HRS revenue, we historically have considered the PEO revenue net of these direct costs.

Highlights of our financial results for fiscal 2014, compared to fiscal 2013, are as follows:

•	Total service revenue increased 8% to $2.5 billion (6% growth excluding the PEO direct cost adjustment).

◦	Payroll service revenue increased 4% to $1.6 billion.

◦	HRS revenue increased 18% to $878.9 million (12% excluding the PEO direct cost adjustment).

•	Interest on funds held for clients decreased 1% to $40.7 million.

•	Total revenue increased 8% to $2.5 billion (6% excluding the PEO direct costs adjustment).

•	Operating income increased 9% to $982.7 million, and operating income, net of certain items, increased 9% to $942.0 million. Refer to the “Non-GAAP Financial Measure” discussion below for further information on operating income, net of certain items.

•

•	Net income and diluted earnings per share increased 10% to $627.5 million and $1.71 per share, respectively. The growth rate for net income and diluted earnings per share was positively impacted by comparison to the prior year, which reflected settlement of a state income tax matter. This settlement reduced diluted earnings per share by approximately $0.04 per share for fiscal 2013.

•	Dividends of $510.6 million were paid to stockholders, representing 81% 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 (“SEC”). 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 580,000 clients as of May 31, 2014, compared to approximately 570,000 clients as of May 31, 2013, and approximately 567,000 clients as of May 31, 2012. Our client base increased approximately 2% for fiscal 2014, compared to approximately 1% for both fiscal 2013 and fiscal 2012.

For fiscal 2014, payroll services client retention was at a record level of approximately 82% of our beginning of the year client base. Our client satisfaction results remained high, which we believe is a result of our focus on providing innovative technology solutions and outstanding personal service to our clients 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. Our online HR administration services are often included as part of the SaaS solutions for mid-market clients. The following statistics demonstrate the growth in selected HRS ancillary service offerings:

		Balance at May 31, 2014			Growth rates for fiscal year
		2014			2013			2012
Paychex HR Services client employees served		766,000			14	%		9	%		8	%
Paychex HR Services clients		28,000			13	%		10	%		8	%
Health and benefits services applicants		134,000			3	%		8	%		23	%
Retirement services plans		65,000			5	%		4	%		4	%

We continue to position ourselves to capitalize on the opportunities arising from the shift to SaaS solutions as we invest heavily in product development relating to our SaaS capabilities and mobile applications. Our Paychex Next Generation suite of innovative products and services includes a SaaS platform that combines the latest technology with superior customer service to provide human resource administrators a streamlined and integrated approach to workforce management. With this, all Paychex services, including payroll, time and attendance, HR, benefits, training, and performance management, are accessible on a single cloud-based platform with Paychex Single Sign-On. We believe continued investment in our technology is a key building block for future success.

In fiscal 2014, we broadened our portfolio of value-added services, offering the following new accounting and finance services:

•

Paychex Accounting Online is a cloud-based accounting service that is being created and delivered via a strategic partnership and investment in Kashoo, a leading provider of cloud accounting services. This SaaS solution complements our industry-leading payroll and HR Solutions by expanding our suite of services for new businesses and entrepreneurs. This is a revenue sharing arrangement with Kashoo.

•

Biz2Credit is a leading online credit resource for small businesses we partnered with to offer the Paychex Small Business Loan Resource Center. This is an online resource that gives business owners access to more than 1,200 lenders offering a variety of loan options that fit their specific financing needs. This partnership underscores our commitment to help small businesses succeed by giving them access to funds they need to start, grow, and manage their business. We earn a referral fee from this partnership.

•

Paychex Payment Processing Services is a full suite of payment processing solutions, including credit and debit card processing, mobile and online payment services, and point-of-sale solutions, designed to meet the evolving needs of today’s small businesses. This service is being offered in partnership with Elavon, a leading global payments provider. This is a revenue sharing arrangement with Elavon.

We introduced our new comprehensive solutions to help employers and employees with certain mandates under U.S. health care reform legislation. These offerings include Paychex Employer Shared Responsibility Service designed to make it easier for business owners to determine if the Employer Shared Responsibility (“ESR”) provision applies to them, and what actions they may need to take. We also offer our new ESR Complete Analysis and Monitoring Services for those clients that want a more robust solution. The Paychex Benefit Account product allows employers to offer Flexible Savings Accounts, Health Savings Accounts, and Health Reimbursement Accounts on a single platform with one debit card for their flexibility. The new health care reform section on our website is designed to provide answers, information, and solutions that employers need to prepare for and take action on health care reform.

We focused on product expansion in new markets and geographies by increasing our presence in Germany and expanding into South America. We completed a business acquisition of a small payroll provider in Germany. While not material to our consolidated financial results, this acquisition will increase our revenue and client base in Germany and help us gain a greater share of the payroll market in that country. In South America, we are utilizing a joint venture arrangement in Brazil. Brazil is a significant market with a growing economy, approximately five million small businesses, and, with recent regulatory changes, a significant opportunity for outsourcing payroll and human resource services. The decision to expand into Brazil and further expand in Germany represents our focus on growth, specifically targeting product expansion through new markets and geographies.

We continue to strengthen 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. 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

Our financial position as of May 31, 2014 remained strong with cash and total corporate investments of $936.8 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 2014, 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, 2014 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 $880.9 million for fiscal 2014. Historically, we have funded our operations, capital purchases, business acquisitions, share repurchases, and dividend payments from our operating activities. Our positive cash flows in fiscal 2014 allowed us to support our business growth and to pay substantial dividends to our stockholders. During fiscal 2014, dividends paid to stockholders were 81% of net income. It is anticipated that cash and total corporate investments as of May 31, 2014, along with projected operating cash flows, will support our normal business operations, capital purchases, business acquisitions, share repurchases, and dividend payments for the foreseeable future.

For further analysis of our results of operations for fiscal years 2014, 2013, and 2012, and our financial position as of May 31, 2014, 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, 2015 (“fiscal 2015”) is based upon current market, economic and interest rate conditions continuing with no significant changes. Our expected fiscal 2015 payroll revenue growth rate is based upon anticipated client base growth and increases in revenue per check. HRS revenue and total service revenue growth reflect the change to classify certain PEO direct costs as operating expenses and not as a reduction in service revenue.

Our fiscal 2015 guidance is as follows:

		Low					High
Payroll service revenue		3	%		—		5	%
HRS revenue		16	%		—		19	%
Total service revenue		8	%		—		10	%
Net income		6	%		—		8	%

Operating income, net of certain items, as a percent of total service revenue, is expected to be in the range of 37% to 38% for fiscal 2015. The effective income tax rate for fiscal 2015 is expected to be consistent with that experienced in fiscal 2014.

Interest on funds held for clients for fiscal 2015 is expected to be relatively flat, as it continues to be impacted by the low interest rate environment, with funds reinvested at lower yields. The average rate of return on our combined funds held for clients and corporate investment portfolios is expected to be 0.9% for fiscal 2015. As of May 31, 2014, the long-term investment portfolio had an average yield-to-maturity of 1.6% and an average duration of 3.0 years. In the next twelve months, approximately 15% of this portfolio will mature, and it is currently anticipated that these proceeds will be reinvested at an interest rate of approximately 1.6%. Investment income is expected to benefit from ongoing investment of cash generated from operations.

Purchases of property and equipment for fiscal 2015 are expected to be in the range of $110 million to $120 million. This includes costs for internally developed software as we continue to invest in our service supporting technology. Fiscal 2015 depreciation expense is projected to be in the range of $95 million to $100 million, and we project amortization of intangible assets for fiscal 2015 to be in the range of $15 million to $20 million.

Results of Operations

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

In millions, except per share amounts		2014				Change			2013				Change			2012
Revenue:
Payroll service revenue		$	1,599.3			4	%		$	1,539.2			2	%		$	1,510.0
HRS revenue		878.9				18	%		746.0				10	%		676.2
Total service revenue		2,478.2				8	%		2,285.2				5	%		2,186.2
Interest on funds held for clients		40.7				(1	)%		41.0				(6	)%		43.6
Total revenue		2,518.9				8	%		2,326.2				4	%		2,229.8
Combined operating and SG&A expenses		1,536.2				8	%		1,421.4				3	%		1,375.9
Operating income		982.7				9	%		904.8				6	%		853.9
Investment income, net		5.4				(18	)%		6.6				4	%		6.4
Income before income taxes		988.1				8	%		911.4				6	%		860.3
Income taxes		360.6				5	%		342.4				10	%		312.3
Effective income tax rate		36.5		%					37.6		%					36.3		%
Net income		627.5				10	%		$	569.0			4	%		$	548.0
Diluted earnings per share		$	1.71			10	%		$	1.56			3	%		$	1.51

With the introduction of a new health insurance offering within the PEO during fiscal 2014, we began classifying PEO direct costs related to certain benefit plans where we retain risk as operating expenses rather than as a reduction in service revenue. This had no impact on operating income. The amounts reported for service revenue, total revenue, and combined operating and selling, general and administrative (“SG&A”) expenses reflect this gross presentation.

In addition to reporting the PEO revenue on a gross basis within HRS revenue as described above, a GAAP measure, we use an HRS net revenue presentation, which is a non-GAAP measure, to provide an additional view of our performance. We believe HRS net revenue provides useful information as a measure of our revenue, eliminating the cost of services provided and on a consistent basis. We use HRS net revenue in evaluating our operating results on a comparative basis, to identify trends in our business, and in evaluating the effectiveness of our business strategies. HRS net revenue is not calculated through the application of GAAP and is not the required form of disclosure by the SEC. As such, it should not be considered as a substitute for the GAAP measure 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.

Had the direct costs of certain benefit plans been reported as a reduction in service revenue, the following would have been reflected for fiscal 2014:

		For the twelve months ended May 31, 2014												% Change
In millions		As reported				PEO direct cost adjustment				HRS net revenue				As Reported			HRS net revenue
Revenue:
HRS revenue		$	878.9			$	46.8			$	832.1			18	%		12	%
Total service revenue		$	2,478.2			$	46.8			$	2,431.4			8	%		6	%
Total revenue		$	2,518.9			$	46.8			$	2,472.1			8	%		6	%

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, 2014, 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		2014				2013				2012
Average investment balances:
Funds held for clients		$	3,877.0			$	3,715.6			$	3,584.3
Corporate investments		888.2				756.9				685.9
Total		$	4,765.2			$	4,472.5			$	4,270.2
Average interest rates earned (exclusive of net realized gains):
Funds held for clients		1.0		%		1.1		%		1.2		%
Corporate investments		0.7		%		0.8		%		0.9		%
Combined funds held for clients and corporate investments		1.0		%		1.0		%		1.1		%
Total net realized gains		$	0.6			$	0.9			$	1.0

$ in millions As of May 31,		2014				2013				2012
Net unrealized gains on available-for-sale securities(1)		$	34.5			$	34.7			$	59.5
Federal Funds rate(2)		0.25		%		0.25		%		0.25		%
Total fair value of available-for-sale securities		$	3,391.4			$	3,691.4			$	3,059.0
Weighted-average duration of available-for-sale securities in years(3)		3.0				3.1				3.0
Weighted-average yield-to-maturity of available-for-sale securities(3)		1.6		%		1.8		%		2.2		%

(1)	The net unrealized gain on our investment portfolios was approximately $26.9 million as of July 16, 2014.

(2)	The Federal Funds rate was a range of zero to 0.25% as of May 31, 2014, 2013, and 2012.

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

Payroll service revenue: Payroll service revenue was $1.6 billion for fiscal 2014 and $1.5 billion for fiscal 2013, reflecting growth of 4% and 2%, respectively, compared to the prior fiscal year periods. Both fiscal 2014 and fiscal 2013 revenue benefited from increases in revenue per check, client base, and checks per payroll. Revenue per check was positively impacted by price increases, partially offset by discounting, together with increased product penetration. For fiscal 2014, our total payroll client base growth was approximately 2%, compared to 1% for both fiscal 2013 and fiscal 2012. Checks per payroll have increased for seventeen consecutive quarters. 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. Client retention reached record levels for fiscal 2014, at approximately 82% of the beginning of the year client base, compared to exceeding 81% of the beginning of the year client base in the prior year.

Human Resource Services revenue: HRS revenue was $878.9 million for fiscal 2014 and $746.0 million for fiscal 2013, reflecting growth of 18% and 10%, respectively compared to the prior fiscal year. Excluding the impact of the PEO direct cost adjustment, HRS revenue would have increased 12% for fiscal 2014.

The growth for fiscal 2014 and fiscal 2013 in HRS revenue was driven primarily by client base growth, particularly in Paychex HR Services, retirement services, and online HR administration products. Our online HR administration products contributed to growth through sales success for SaaS solutions. The most significant contributors, all of which increased by high single or low double-digit percentages, are as follows:

•

Paychex HR Services revenue was positively impacted for both years by growth in both clients and client employees. Fiscal 2013 growth was also impacted by price increases. During the second half of fiscal 2014, we introduced a new health care option, a minimum premium plan, within our PEO product. For fiscal 2014, the PEO experienced growing demand contributing to the increase in the growth rate for Paychex HR Services revenue. The rate of growth for Paychex HR Services revenue for fiscal 2013 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.

•	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 for both fiscal 2014 and fiscal 2013. This growth was 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.

•

Insurance services revenue growth for both fiscal 2014 and fiscal 2013 was the result of increases in premiums and clients for workers' compensation insurance services. We experienced growth in health and benefits services applicants, though at moderating rates. Health and benefits revenue has also experienced higher revenue from other insurance policies, such as dental, vision, disability, and life.

•	Our online HR administration products, including time and attendance and benefit enrollment, contributed to growth through strong sales of SaaS solutions.

HRS product key statistics are as follows:

$ in billions As of May 31,		2014				Change			2013				Change			2012
Paychex HR Services client employees served		766,000				14	%		672,000				9	%		615,000
Paychex HR Services clients		28,000				13	%		25,000				10	%		23,000
Health and benefits services applicants		134,000				3	%		131,000				8	%		121,000
Retirement services plans		65,000				5	%		62,000				4	%		59,000
Asset value of retirement services participants’ funds		$	21.9			13	%		$	19.3			23	%		$	15.7

Total service revenue: Total service revenue increased 8% for fiscal 2014 and 5% for fiscal 2013, attributable to the factors previously discussed. Excluding the impact of the PEO direct costs adjustment, service revenue would have increased 6% for fiscal 2014.

Interest on funds held for clients: Interest on funds held for clients decreased 1% for fiscal 2014 and 6% for fiscal 2013 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 both fiscal 2014 and fiscal 2013. The increase for fiscal 2014 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 both fiscal 2014 and fiscal 2013 benefited from increases in checks per payroll and client base, and wage inflation.

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 SG&A expenses for fiscal years:

In millions		2014				Change			2013				Change			2012
Compensation-related expenses		$	1,003.9			5	%		$	955.8			4	%		$	920.8
Depreciation and amortization		105.0				7	%		98.2				—	%		97.8
Other expenses		380.5				4	%		367.4				3	%		357.3
PEO direct cost adjustment		46.8				100	%		—				na			—
Total expenses		$	1,536.2			8	%		$	1,421.4			3	%		$	1,375.9

Total expenses increased 8% for fiscal 2014 and 3% for fiscal 2013. Excluding the PEO direct cost adjustment, growth in total expenses for fiscal 2014 would have been 5%. The increases in total expenses were primarily in compensation-related expenses. For fiscal 2014, compensation-related expenses increased due to higher wages and performance-based compensation costs. The increase in wages was largely related to investments in product development and supporting technology, as well as sales force investment initiatives that began in fiscal 2013. For fiscal 2013, compensation-related expenses were impacted by increased headcount in areas supporting our development of technology, and higher employee benefit-related costs, partially offset by the impact of improvements in operations productivity with related lower headcount. As of May 31, 2014, we had approximately 12,700 employees, compared with 12,400 employees as of both May 31, 2013 and May 31, 2012.

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. The higher growth rate for fiscal 2014 was related to additional internally developed software related to our Paychex Next Generation platform that was placed in service during the year. Amortization of intangible assets is primarily related to client list acquisitions, which are amortized using either straight-line or accelerated methods.

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. Higher equipment costs within information technology and higher professional services supporting our technology development contributed to the increases in other expenses for both fiscal 2014 and fiscal 2013.

Operating income: Operating income increased 9% for fiscal 2014 and 6% for fiscal 2013. 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		2014				Change			2013				Change			2012
Operating income		$	982.7			9	%		$	904.8			6	%		$	853.9
Excluding: Interest on funds held for clients		(40.7		)		(1	)%		(41.0		)		(6	)%		(43.6		)
Operating income, net of certain items		$	942.0			9	%		$	863.8			7	%		$	810.3
Operating income, net of certain items, as a percent of service revenue (1)		38.0		%					37.8		%					37.1		%

(1)	Operating income, net of certain items, as a percent of service revenue (“operating margin”) for fiscal 2014 is based on service revenue numbers as reported. Excluding the impact of the PEO direct cost adjustment, operating margin for fiscal 2014 would have been 38.7%.

Refer to the previous discussion of operating income, net of certain items, in the “Non-GAAP Financial Measure” section on page 16.

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, net, decreased 18% for fiscal 2014 and increased 4% for fiscal 2013. The decrease in investment income, net, for fiscal 2014 was the result of lower average interest rates earned on investments, partially offset by an increase in average investment balances. The increase in investment income for fiscal 2013 was primarily the result of higher average investment balances. Average investment balances increased 17% for fiscal 2014 and 10% for fiscal 2013. The increases were the result of investment of cash generated from operations.

Income taxes: Our effective income tax rate was 36.5% for fiscal 2014 compared to 37.6% for fiscal 2013 and 36.3% for fiscal 2012. The higher effective tax rate for fiscal 2013 was the result of the settlement of a state income tax matter. 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 10% to $627.5 million for fiscal 2014 and 4% to $569.0 million for fiscal 2013. Diluted earnings per share increased 10% to $1.71 per share for fiscal 2014 and 3% to $1.56 per share for fiscal 2013. These fluctuations were attributable to the factors previously discussed. The settlement of a state income tax matter reduced diluted earnings per share by approximately $0.04 per share for fiscal 2013.

Liquidity and Capital Resources

Our financial position as of May 31, 2014 remained strong with cash and total corporate investments of $936.8 million and no debt. We believe that our investments as of May 31, 2014 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, 2014, along with projected operating cash flows, will support our normal business operations, capital purchases, business acquisitions, share repurchases, and dividend payments for the foreseeable future.

Commitments and Contractual Obligations

Lines of credit: As of May 31, 2014, we had unused borrowing capacity available under 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, 2015
Bank of America, N.A.	$250 million	February 28, 2015
PNC Bank, National Association	$150 million	February 28, 2015
Wells Fargo Bank, National Association	$150 million	February 28, 2015

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 2014 or as of May 31, 2014.

Certain of 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.

There were no amounts outstanding under this credit facility as of May 31, 2014. During fiscal 2014, we borrowed against this facility, for one day each, as follows:

$ in millions Fiscal quarter		Amount borrowed				Interest rate
First quarter		$	25.0			3.25	%
Second quarter		$	175.0			3.25	%

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, 2014, we had irrevocable standby letters of credit outstanding totaling $43.0 million, required to secure commitments for certain insurance policies. The letters of credit expire at various dates between July 2014 and April 2015, and are collateralized by securities held in our investment portfolios. No amounts were outstanding on these letters of credit during fiscal 2014 or as of May 31, 2014. Subsequent to May 31, 2014, the letter of credit expiring in July 2014 was renewed, at the same terms and amount, and will expire in July 2015.

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, 2014. The table below summarizes our estimated annual payment obligations under these commitments as of May 31, 2014:

		Payments due by period
In millions		Total				Less than 1 year				1-3 years				4-5 years				More than 5 years
Operating leases(1)		$	129.2			$	37.5			$	52.9			$	27.6			$	11.2
Purchase obligations(2)		88.9				61.3				26.8				0.5				0.3
Total		$	218.1			$	98.8			$	79.7			$	28.1			$	11.5

(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 $16.0 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, including interest and net of federal benefits, was approximately $29.8 million as of May 31, 2014. 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 $56.6 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 2014, 2013, and 2012 was $14.4 million, $12.6 million, and $11.7 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 and are not material as of the reporting date. 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 threats, 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, 2014.

Operating Cash Flow Activities

		Year ended May 31,
In millions		2014				2013				2012
Net income		$	627.5			$	569.0			$	548.0
Non-cash adjustments to net income		198.6				183.3				175.1
Cash provided by/(used in) changes in operating assets and liabilities		54.8				(77.0		)		(16.5		)
Net cash provided by operating activities		$	880.9			$	675.3			$	706.6

The increase in our operating cash flows for fiscal 2014 compared to fiscal 2013 is primarily the result of higher net income, adjusted for non-cash items, and fluctuations in our operating assets and liabilities. The decrease in our operating cash flows for fiscal 2013 compared to fiscal 2012 resulted mainly from fluctuations in operating assets and liabilities, partially offset by higher net income adjusted for non-cash items. Non-cash adjustments to net income increased for both years, driven largely by higher amortization of premiums on available-for-sale securities as the Company has increased its holdings of longer-duration investments. 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. Income taxes contributed significantly to these fluctuations as a result of a higher prepaid income tax position as of May 31, 2013 that arose from the federal benefit on the settlement of a state tax matter during fiscal 2013.

Investing Cash Flow Activities

		Year ended May 31,
In millions		2014				2013				2012
Net change in funds held for clients and corporate investment activities		$	(211.4	)		$	306.8			$	(1,147.4	)
Purchases of property and equipment		(84.1		)		(98.7		)		(89.6		)
Acquisition of businesses, net of cash acquired		(9.3		)		(21.3		)		(6.0		)
Purchases of other assets		(11.3		)		(5.1		)		(1.3		)
Net cash (used in)/provided by investing activities		$	(316.1	)		$	181.7			$	(1,244.3	)

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. For fiscal 2014, there was not a significant fluctuation due to timing of fiscal year-ends. The net cash outflow for fiscal 2014 is related to more purchases of short-term and available-for-sale securities resulting from higher average collections from clients. For fiscal 2013 and fiscal 2012, there was a significant timing impact. There was a large cash outflow on Friday, May 31, 2013 that required the liquidation of funds held in the 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.

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 2014, 2013, and 2012, we purchased approximately $4.7 million, $6.5 million, and $2.6 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 years 2014, 2013, and 2012, we paid, net of cash acquired, $9.3 million, $21.3 million, and $6.0 million, respectively, for immaterial business acquisitions.

Financing Cash Flow Activities

		Year ended May 31,
In millions, except per share amounts		2014				2013				2012
Net change in client fund obligations		$	127.4			$	(454.6	)		$	980.5
Dividends paid		(510.6		)		(476.7		)		(460.5		)
Repurchases of common shares		(249.7		)		—				—
Equity activity related to stock-based awards		113.3				72.8				7.5
Net cash (used in)/provided by financing activities		$	(519.6	)		$	(858.5	)		$	527.5
Cash dividends per common share		$	1.40			$	1.31			$	1.27

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, 2014 fell on a Saturday and May 31, 2013 fell on a Friday. Friday is a large cash outflow day for direct deposit funds, partially offset by tax payment funds collected on that day. Therefore, timing did not impact the net change in client obligations for fiscal 2014. 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. Therefore, timing is the primary reason for the fluctuation in these amounts for fiscal 2013 and fiscal 2012. In addition, the fluctuations were impacted by overall trends in client fund balances, which were 4% higher on average for fiscal 2014 than fiscal 2013 and 4% higher on average for fiscal 2013 than for fiscal 2012.

Dividends paid: In July 2013, the Board increased our quarterly dividend to stockholders by 6% to $0.35 per share from $0.33 per share. 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 81%, 84%, and 84% for fiscal years 2014, 2013, and 2012, respectively. The payment of future dividends is dependent on our future earnings and cash flow, and is subject to the discretion of our Board.

Repurchases of common shares: In October 2012, the Board approved a stock repurchase program to purchase up to $350 million of Paychex common stock, with authorization for this program expiring in May 2014. During fiscal 2014, we repurchased 6.2 million shares for a total of $249.7 million. In May 2014, the Board approved a new program to repurchase up to $350 million of Paychex common stock, with authorization expiring in May 2017.

Equity activity related to stock-based awards: The increase in activity related to stock-based awards for fiscal 2014 compared to fiscal 2013 was largely driven by an increase in proceeds from exercise of stock options. Common shares acquired through exercise of stock options were 3.4 million shares, 2.4 million shares, and 0.2 million shares for fiscal years 2014, 2013, and 2012, 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 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: 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 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.

For certain of our service offerings, we receive advance payments for set-up fees from our clients. We defer revenue associated with these advance payments and the related costs over the expected life of clients.

PEO revenue is included in service revenue and is reported net of certain direct costs billed and incurred, which include wages, taxes, and certain benefit premiums. In fiscal 2014, with the addition of a new health care offering within the PEO, direct costs related to certain benefit plans where the Company retains risk were classified as operating expenses rather than as a reduction in service revenue.

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 insurance services: As part of the PEO service, we offer workers’ compensation insurance and health insurance to client companies for the benefit of client employees. Workers' compensation insurance is provided under a fully insured high deductible workers’ compensation policy with a national insurance carrier. Workers’ compensation insurance reserves are established to provide for the estimated costs of paying claims up to per occurrence liability limits. 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, workers' compensation final claim settlements may vary from the present estimates, particularly when those payments may not occur until well into the future.

With respect to our PEO health insurance, we offer various health insurance plans that take the form of either fully insured fixed cost plans with various national insurance carriers or a fully insured minimum premium insurance arrangement with coverage provided through a single national carrier. Under the minimum premium arrangement, our health benefits insurance reserves are established to provide for the payment of claims liability charges in accordance with our service contract with the carrier. The claims liability charges 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.

We regularly review the adequacy of our estimated insurance reserves. Adjustments to previously established reserves are reflected in the 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: 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. We have 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 2014, 2013, or 2012. 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 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 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.

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.

Refer to Note D of the Notes to Consolidated Financial Statements, contained in Item 8 of this Form 10-K, for further discussion of our stock-based compensation plans.

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 of the tax benefit over the deferred tax asset as an increase to additional paid-in capital. We currently have a sufficient pool of excess tax benefits in additional paid-in capital to absorb any deficiency in tax benefits that fall short of the related deferred tax asset 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 will 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. 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.