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, 2016 (“fiscal 2016”), May 31, 2015 (“fiscal 2015”), and May 31, 2014 (“fiscal 2014”), and our financial condition as of May 31, 2016. 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 human capital management (“HCM”) solutions for payroll, human resource (‘HR”), retirement, and insurance services for small- to medium-sized businesses. We offer a comprehensive portfolio of HCM services and products that allow our clients to meet their diverse payroll and human resource needs. Our payroll processing services, the foundation of our service model, include:

	·		payroll processing;

	·		payroll tax administration services;

	·		employee payment services; and

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

We support small-business companies through our core payroll, utilizing our robust Paychex FlexSM platform, and our software-as-a-service (“SaaS”) SurePayroll® products. Mid-market companies typically have more sophisticated payroll and benefits needs, and are primarily serviced through our Paychex Flex Enterprise solution set, which offers an integrated suite of HCM solutions through the Paychex Flex platform, or through our traditional mid-market platform. Our SaaS solution through Paychex Flex Enterprise integrates payroll processing with human resource management, employee benefits administration, time and labor management, and applicant tracking and onboarding solutions.

We offer a suite of complementary Human Resource Services (“HRS”) products including:

	·		comprehensive human resource outsourcing through Paychex HR Services, under which we offer Paychex HR Solutions, our administrative services organization (“ASO”), and Paychex PEO, our professional employer organization (“PEO”);

	·		retirement services administration;

	·		insurance services;

	·		HR administration services, including time and attendance, benefit enrollment, recruiting, and onboarding; and

	·		other human resource services and products.

We also offer certain accounting and financial services, which include: the purchase of accounts receivable as a means of providing payroll funding to clients in the temporary staffing industry; a cloud-based accounting service; payment processing services; payment distribution services; and a small-business loan resource center.

Our mission is to be the leading provider of payroll, HR, and employee benefits services for small- and mid-sized companies by being an essential partner with America's businesses. We believe success in this mission will lead to strong long-term financial performance. Our strategy focuses on flexible, convenient service; industry-leading, integrated technology; solid sales execution; providing a comprehensive suite of value-added HCM services; continued service penetration; and engaging in strategic acquisitions.

We continue to focus on driving growth in the number of clients, revenue, and profits, while providing industry-leading service and technology solutions to our clients and their employees. 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 believe that investing in our products, people, and service capabilities will position us to capitalize on opportunities for long-term growth.

Our financial results for fiscal 2016 reflected sustained growth in our business. Payroll service revenue continued to experience steady growth of 4% for fiscal 2016 as compared with fiscal 2015, driven by growth in client base and revenue per check. Our payroll client base grew 2% in fiscal 2016 to approximately 605,000 clients as of May 31, 2016, resulting from solid sales execution and client retention results in excess of 82% of the beginning of the fiscal year client base, consistent with the prior year’s record high.

Our financial results continue to be impacted by the interest rate environment as interest rates available on high-quality financial instruments remain low. Our combined funds held for clients and corporate investment portfolios earned an average rate of return of 1.1% for fiscal 2016, compared to 1.0% for fiscal years 2015 and 2014. In December 2015, the United States (“U.S.”) Federal Reserve raised the Federal Funds rate by 25 basis points. This was the first interest hike in nearly a decade. The Federal Funds rate was in the range of 0.25% to 0.50% as of May 31, 2016, and was in the range of zero to 0.25% as of May 31, 2015.

Highlights of our financial results for fiscal 2016, compared to fiscal 2015, are as follows:

	·		Total revenue increased 8% to $3.0 billion.

	·		Total service revenue increased 8% to $2.9 billion.

	o		Payroll service revenue increased 4% to $1.7 billion.

	o		HRS revenue increased 13% to $1.2 billion.

	·		Interest on funds held for clients increased 9% to $46.1 million.

	·		Operating income increased 9% to $1.1 billion.

	·		Net income increased 12% to $756.8 million and diluted earnings per share increased 13% to $2.09 per share. During the first quarter of fiscal 2016 (the “first quarter”), a net tax benefit was recorded for income derived in prior tax years that increased full-year diluted earnings per share by approximately $0.05. Excluding this net tax benefit, net income and diluted earnings per share would have increased 9% and 10%, respectively, for fiscal 2016.

	·		Dividends of $606.5 million were paid to stockholders, representing 80% of net income.

Business Outlook

Our payroll client base totaled approximately 605,000 clients as of May 31, 2016, compared to approximately 590,000 clients as of May 31, 2015, and approximately 580,000 clients as of May 31, 2014. Our payroll client base increased approximately 2% for each of the fiscal years 2016, 2015 and 2014.

While HRS provides services to employers and employees beyond payroll, they effectively leverage payroll processing data and, therefore, are beneficial to our operating margin. Our HR administration services are often included as part of the SaaS solutions for mid-market clients. The following table illustrates the growth in selected HRS service offerings:

		Balance at		Growth rates for fiscal year
		May 31, 2016		2016			2015			2014
Paychex HR Services client worksite employees		944,000		10	%		12	%		14	%
Paychex HR Services clients		35,000		10	%		11	%		13	%
Health and benefits services applicants		150,000		6	%		6	%		3	%
Retirement services plans		74,000		7	%		6	%		5	%

In fiscal 2016, we made significant enhancements to our Paychex Flex platform, which is our cloud-based HCM solution. In fiscal 2016, we completed the integration of key HCM modules with the release of Paychex Flex Time, Paychex Flex Benefits Administration, and Paychex Flex Hiring. We believe this leading-edge technology, along with our flexible service options, positively impacted our performance in the mid-market space, as we experienced especially strong sales results for this division in fiscal 2016.

In December 2015, a wholly owned subsidiary of Paychex acquired substantially all of the net assets of Advance Partners. Advance Partners is a leading provider of integrated financial, operational, and strategic services to support independent staffing firms. Advance Partners offers customizable solutions to the temporary staffing industry, including payroll funding and outsourcing services.

Our full-service Paychex Employer Shared Responsibility (“ESR”) services continued to show strong market acceptance and growth in fiscal 2016. The Affordable Care Act (“ACA”) sets forth specific coverage and reporting requirements that employers must meet. Paychex ESR services help clients navigate the complexities of those requirements, avoid steep fines and penalties, and reduce ACA-related administrative work.

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. 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, 2016 remained strong with cash and total corporate investments of $793.2 million and no debt. Our investment strategy continues to focus 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, which are secured by a U.S. government escrow; and essential services revenue bonds – along with U.S. government agency securities and corporate bonds. During fiscal 2016, our primary short-term investment vehicles were bank demand deposit accounts, variable rate demand notes (“VRDNs”), high-quality commercial paper, and government agency discount notes.

A substantial portion of our portfolio is invested in high credit quality securities with ratings of AA or higher, 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, 2016 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 exceeded $1.0 billion for the first time for fiscal 2016. Historically, we have funded our operations, capital purchases, business acquisitions, share repurchases, and dividend payments from our operating activities. Our positive operating cash flows for fiscal 2016 allowed us to support our business growth and to pay substantial dividends to our stockholders. In July 2015, we announced an increase in our quarterly dividend of 11%, or $0.04 per share. In July 2016, we subsequently announced an additional $0.04 per share, or 10%, increase in our quarterly dividend. Dividends paid to stockholders were 80% of net income in fiscal 2016. It is anticipated that cash and total corporate investments as of May 31, 2016, along with projected operating cash flows, will support our normal business operations, capital purchases, share repurchases, dividend payments, and business acquisitions, if any, for the foreseeable future.

For further analysis of our results of operations for fiscal years 2016, 2015, and 2014, and our financial position as of May 31, 2016, 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, 2017 (“fiscal 2017”) is based upon current market, economic, and interest rate conditions continuing with no significant changes. Our expected full-year fiscal 2017 payroll revenue growth rate is based upon anticipated client base growth and increases in revenue per check. Our guidance for fiscal 2017 is as follows:

	·		Payroll service revenue is anticipated to increase approximately 4%;

	·		HRS Revenue is anticipated to increase in the range of 12% to 14%;

	·		total service revenue is expected to increase in the range of 7% to 8%;

	·		interest on funds held for clients is expected to reflect mid-single-digit growth;

	·		net income is expected to increase approximately 8%, excluding the net tax benefit recognized in fiscal 2016 related to income derived in prior tax years;

	·		operating income, net of certain items, as a percent of service revenue is expected to approximate 38%; and

	·		the effective income tax rate for fiscal 2017 is expected to be in the range of 35.5% to 36%.

The average rate of return on our combined funds held for clients and corporate investment portfolios is expected to be approximately 1.1% for fiscal 2017. As of May 31, 2016, the long-term investment portfolio had an average yield-to-maturity of 1.7% and an average duration of 3.1 years.

Purchases of property and equipment for fiscal 2017 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 2017 depreciation expense is projected to be in the range of $100 million to $110 million, and we project amortization of intangible assets for fiscal 2017 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		2016				Change			2015				Change			2014
Revenue:
Payroll service revenue		$	1,729.9			4	%		$	1,656.8			4	%		$	1,599.3
HRS revenue			1,175.9			13	%			1,040.7			18	%			878.9
Total service revenue			2,905.8			8	%			2,697.5			9	%			2,478.2
Interest on funds held for clients			46.1			9	%			42.1			3	%			40.7
Total revenue			2,951.9			8	%			2,739.6			9	%			2,518.9
Combined operating and SG&A expenses			1,805.3			7	%			1,686.0			10	%			1,536.2
Operating income			1,146.6			9	%			1,053.6			7	%			982.7
Investment income, net			4.5			(28)	%			6.4			17	%			5.4
Income before income taxes			1,151.1			9	%			1,060.0			7	%			988.1
Income taxes			394.3			2	%			385.1			7	%			360.6
Effective income tax rate			34.3	%						36.3	%						36.5	%
Net income		$	756.8			12	%		$	674.9			8	%		$	627.5
Diluted earnings per share		$	2.09			13	%		$	1.85			8	%		$	1.71

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, 2016, we had no exposure to high-risk or illiquid investments. Details regarding our combined funds held for clients and corporate investment portfolios are as follows:

		Year ended May 31,
$ in millions		2016				2015				2014
Average investment balances:
Funds held for clients		$	4,105.5			$	4,080.0			$	3,968.7
Corporate investments			922.6				1,011.5				973.8
Total		$	5,028.1			$	5,091.5			$	4,942.5
Average interest rates earned (exclusive of net realized gains):
Funds held for clients			1.1	%			1.0	%			1.0	%
Corporate investments			0.9	%			0.7	%			0.7	%
Combined funds held for clients and corporate investments			1.1	%			1.0	%			1.0	%
Total net realized gains		$	0.1			$	0.3			$	0.6

$ in millions
As of May 31,		2016				2015				2014
Net unrealized gains on available-for-sale securities(1)		$	47.6			$	13.6			$	34.5
Federal Funds rate(2)			0.50	%			0.25	%			0.25	%
Total fair value of available-for-sale securities		$	4,141.9			$	3,595.6			$	3,391.4
Weighted-average duration of available-for-sale securities in years(3)			3.1				3.2				3.0
Weighted-average yield-to-maturity of available-for-sale securities(3)			1.7	%			1.6	%			1.6	%

	(1)		The net unrealized gain on our investment portfolios was approximately $63.5 million as of July 15, 2016.

	(2)		The Federal Funds rate was in the range of 0.25% to 0.50% as of May 31, 2016, and in the range of zero to 0.25% as of May 31, 2015.

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

Payroll service revenue: Payroll service revenue was $1.7 billion for both fiscal 2016 and fiscal 2015, reflecting growth of 4% for both fiscal 2016 and fiscal 2015 compared to fiscal 2014. Both fiscal 2016 and fiscal 2015 benefited from increases in client base and revenue per check. Revenue per check improved as a result of price increases, net of discounts. Fiscal 2016 also benefited from two additional processing days during the year.

For fiscal 2016 and fiscal 2015, our total payroll client base growth was approximately 2%. Client retention was in excess of 82% of the beginning of the year client base for fiscal 2016, consistent with fiscal 2015, which reflected a record high.

Human Resource Services revenue: HRS revenue was $1.2 billion for fiscal 2016 and $1.0 billion for fiscal 2015, reflecting growth of 13% and 18%, respectively, compared to each of the prior fiscal year periods.

For both fiscal 2016 and fiscal 2015, HRS revenue growth was primarily driven by increases in client base across all major HCM services, including: comprehensive outsourcing services; retirement services; time and attendance; and HR. HRS product key statistics are as follows:

$ in billions
As of May 31,		2016			Change			2015			Change			2014
Paychex HR Services client worksite employees			944,000		10	%			858,000		12	%			766,000
Paychex HR Services clients			35,000		10	%			31,000		11	%			28,000
Health and benefits services applicants			150,000		6	%			142,000		6	%			134,000
Retirement services plans			74,000		7	%			70,000		6	%			66,000
Asset value of retirement services participants’ funds		$	23.6		—	%		$	23.5		7	%		$	21.9

We continue to experience strong demand for our Paychex HR Services, our largest HRS revenue stream, as evidenced by the continued double-digit growth in client worksite employees. During both fiscal 2016 and fiscal 2015, the PEO, in particular, experienced strong demand.

Retirement services revenue growth was tempered in fiscal 2016 by a lower average asset value of participants’ funds, offset somewhat by higher basis points earned from external fund managers. Retirement services revenue for fiscal 2015 compared to fiscal 2014 benefited from pricing and higher average asset value of participants’ funds.

Insurance services revenue growth for both fiscal 2016 and 2015 benefited from growth in our full-service ACA product. In addition, higher average premiums and clients in our workers’ compensation product positively impacted revenue in both years.

Our HR administration products, including time and attendance and HR management, contributed to growth through strong sales of our SaaS solutions. Time and attendance solutions benefited from a small business acquisition in fiscal 2015.

Total service revenue: Total service revenue increased 8% for fiscal 2016 and 9% for fiscal 2015, attributable to the factors previously discussed.

Interest on funds held for clients: Interest on funds held for clients increased 9% for fiscal 2016 and increased 3% for fiscal 2015. For fiscal 2016, the increase was primarily due to higher average interest rates and slightly higher average investment balances. For fiscal 2015, the increase was primarily due to an increase in average investment balances, while average interest rates earned were flat.

Average investment balances for funds held for clients increased 1% for fiscal 2016 and 3% for fiscal 2015. The net increase in average investment balances for fiscal 2016 was mainly due to client base growth and wage inflation, partially offset by lower state unemployment insurance rates. The increase in average investment balances for fiscal 2015 was mainly driven by increases in 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		2016			Change			2015			Change			2014
Compensation-related expenses		$	1,148.2		6	%		$	1,087.1		8	%		$	1,003.9
Depreciation and amortization			115.1		8	%			106.6		2	%			105.0
Other expenses			542.0		10	%			492.3		15	%			427.3
Total expenses		$	1,805.3		7	%		$	1,686.0		10	%		$	1,536.2

Total expenses increased 7% for fiscal 2016 and 10% for fiscal 2015. Fiscal 2015 was impacted by costs relating to the new minimum premium plan health insurance offering within our PEO, introduced in January 2014, which contributed three percentage points of the increase in total expenses for fiscal 2015.

The increases in total expenses were driven largely by growth in compensation-related expenses. For fiscal 2016, compensation-related expenses increased due to higher wages and performance-based compensation costs. For fiscal 2015, compensation-related expenses increased due to higher sales headcount and variable costs resulting from strong sales execution, along with higher employee-benefit-related costs, primarily medical expenses. As of May 31, 2016, we had approximately 13,500 employees, compared with 13,000 employees as of May 31, 2015.

Depreciation expense is primarily related to buildings, furniture and fixtures, data processing equipment, and software. Amortization of intangible assets is primarily related to client list acquisitions, which are amortized using either straight-line or accelerated methods. The higher growth rate for depreciation and amortization in fiscal 2016 was primarily driven by higher depreciation related to an increase in internally developed software that was placed in service.

Other expenses include items such as non-capital equipment, delivery, forms and supplies, communications, travel and entertainment, professional services, and other costs incurred to support our business. Other expenses increased due to growth within the PEO. In addition, continued investment in product development and supporting technology impacted other expense growth for both fiscal 2016 and fiscal 2015.

Operating income: Operating income increased 9% for fiscal 2016 and 7% for fiscal 2015. 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		2016			Change			2015			Change			2014
Operating income		$	1,146.6		9	%		$	1,053.6		7	%		$	982.7
Excluding: Interest on funds held for clients			(46.1)		9	%			(42.1)		3	%			(40.7)
Operating income, net of certain items (1)		$	1,100.5		9	%		$	1,011.5		7	%		$	942.0

	(1)		Operating income, net of certain items is a non-GAAP measure. Refer to the “Non-GAAP Financial Measure” discussion that follows.

Operating income, net of certain items, as a percentage of service revenue was approximately 38% for each of the fiscal years 2016, 2015 and 2014.

Non-GAAP Financial Measure: In addition to reporting operating income, a 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.

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 28% for fiscal 2016 as the result of immaterial losses on equity method investments and a decrease in average investment balances, partially offset by higher average interest rates earned. The decrease in average investment balances for fiscal 2016 is the result of cash consideration paid for the acquisition of Advance Partners in December 2015 and stock repurchase activity. Investment income increased 17% for fiscal 2015 due to an increase in average investment balances resulting from investment of cash generated from operations, while interest rates earned remained relatively flat.

Income taxes: Our effective income tax rate was 34.3% for fiscal 2016 compared to 36.3% for fiscal 2015 and 36.5% for fiscal 2014. The decrease in the effective income tax rate for fiscal 2016 is related primarily to a net tax benefit that was recorded for income derived in prior tax years from customer-facing software we produced. During the first quarter, we engaged tax specialists to assess the qualification of such software for the Federal “Qualified Production Activities Deduction.” Based on this assessment, we concluded that certain of our software offerings qualified for this tax deduction in prior tax years and, therefore, we recorded the tax benefits and related tax reserves as a discrete item in the first quarter. Excluding this net tax benefit, the effective income tax rate would have been approximately 35.8% for fiscal 2016. Refer to Note J 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 12% to $756.8 million for fiscal 2016 and 8% to $674.9 million for fiscal 2015. Diluted earnings per share increased 13% to $2.09 per share for fiscal 2016 and 8% to $1.85 per share for fiscal 2015. These fluctuations were attributable to the factors previously discussed. Excluding the net tax benefit recognized in the first quarter, net income and diluted earnings per share for fiscal 2016 would have increased 9% and 10%, respectively.

Liquidity and Capital Resources

Our financial position as of May 31, 2016 remained strong with cash and total corporate investments of $793.2 million and no debt. We believe that our investments as of May 31, 2016 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, 2016, 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, 2016, 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 27, 2017
Bank of America, N.A.		$250 million		February 28, 2017
PNC Bank, National Association		$150 million		February 27, 2017
Wells Fargo Bank, National Association		$150 million		February 27, 2017

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 2016 or as of May 31, 2016.

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

Credit facilities: On August 5, 2015, the Company entered into a committed, unsecured, five-year syndicated credit facility, expiring on August 5, 2020. Under the credit facility, Paychex of New York LLC (the “Borrower”) may, subject to certain restrictions, borrow up to $1 billion to meet short-term funding requirements. The obligations under this facility have been guaranteed by the Company and certain of its 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 August 2020, any borrowings outstanding will mature and be payable on such date. This agreement supersedes the $750 million credit facility agreement set to expire on June 21, 2018, which was terminated as part of the new agreement.

There were no amounts outstanding under this credit facility as of May 31, 2016. During fiscal 2016, the Company borrowed against this facility, and its predecessor facility, for one-day periods each, from one to two times a quarter as follows:

$ in millions		2016				2015
Number of days borrowed			5			2
Maximum amount borrowed		$	450.0		$	150.0
Average amount borrowed		$	305.0		$	125.0
Weighted-average interest rate			3.39	%		3.25	%

The Company subsequently borrowed $100 million for one day under this line in June 2016.

The credit facility contains various financial and operational covenants that are usual and customary for such arrangements. The Borrower was in compliance with these covenants during fiscal 2016.

Certain lenders under this credit facility, and their respective affiliates, have performed, and may in the future perform for us, 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.

On March 17, 2016, the Company entered into a committed, unsecured, three-year credit facility with PNC Bank, National Association, expiring on March 17, 2019. Under the credit facility, Paychex Advance LLC (“Paychex Advance”) may, subject to certain restrictions, borrow up to $150 million to finance working capital needs and for general corporate purposes. The obligations under this facility have been guaranteed by the Company and certain of its subsidiaries. The outstanding obligations under this credit facility will bear interest at competitive rates to be elected by Paychex Advance. Upon expiration of the commitment in March 2019, any borrowings outstanding will mature and be payable on such date.

There were no amounts outstanding under this credit facility as of May 31, 2016. Subsequent to May 31, 2016, Paychex Advance borrowed approximately $56 million under this line, which remains outstanding as of the date of this report.

Letters of credit: As of May 31, 2016, 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 2016 and April 2017, and are collateralized by securities held in our investment portfolios. No amounts were outstanding on these letters of credit during fiscal 2016 or as of May 31, 2016. Subsequent to May 31, 2016, the letter of credit expiring in July 2016 was renewed through July 2017.

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, 2016. The table below summarizes our estimated annual payment obligations under these commitments as of May 31, 2016:

		Payments due by period
					Less than									More than
In millions		Total			1 year			1-3 years			4-5 years			5 years
Operating leases(1)		$	106.7		$	35.7		$	48.5		$	20.3		$	2.2
Purchase obligations(2)			109.7			73.6			28.1			7.4			0.6
Total		$	216.4		$	109.3		$	76.6		$	27.7		$	2.8

	(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 $6.8 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 $54.2 million as of May 31, 2016. Refer to Note J 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 $68.3 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 2016, 2015, and 2014 was $16.1 million, $15.1million, and $14.4 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 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, 2016.

Operating Cash Flow Activities

		Year ended May 31,
In millions		2016			2015			2014
Net income		$	756.8		$	674.9		$	627.5
Non-cash adjustments to net income			234.9			211.4			198.6
Cash provided by changes in operating assets and liabilities			26.5			8.9			54.8
Net cash provided by operating activities		$	1,018.2		$	895.2		$	880.9

The increase in our operating cash flows for fiscal 2016 compared to fiscal 2015 is primarily the result of higher net income, adjusted for non-cash items, along with the positive impact from fluctuations in our operating assets and liabilities. The increase for fiscal 2015 compared to fiscal 2014 is primarily the result of higher net income, adjusted for non-cash items, offset by the decrease in cash provided by changes in our operating assets and liabilities. Non-cash adjustments to net income increased for both fiscal 2016 and fiscal 2015, compared to the respective prior year periods. The increase in non-cash adjustments for fiscal 2016 was largely due to higher depreciation expense related to an increase in internally developed software placed in service, and an increase in the deferred tax provision. The increase in non-cash adjustments for fiscal 2015 was largely due to higher amortization of premiums on available-for-sale securities as the Company has increased its holdings of longer-duration investments, and higher stock-based compensation costs. The fluctuations in our operating assets and liabilities between all 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		2016			2015			2014
Net change in funds held for clients and corporate investment activities		$	339.7		$	(151.8)		$	(211.4)
Purchases of property and equipment			(97.7)			(102.8)			(84.1)
Acquisition of businesses, net of cash acquired			(296.1)			(27.1)			(9.3)
Purchases of other assets			(9.0)			(3.3)			(11.3)
Net cash used in investing activities		$	(63.1)		$	(285.0)		$	(316.1)

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 F of the Notes to Consolidated Financial Statements contained in Item 8 of this Form 10-K.

Fluctuations in the net change in funds held for clients and corporate investment activities are largely due to timing within the client funds portfolio. For fiscal 2016 compared to fiscal 2015, there was a significant fluctuation due to timing of the day of the week for fiscal year-end. There were larger cash outflows on Tuesday, May 31, 2016 that required the liquidation of funds held in the funds held for clients portfolio. This resulted in positive cash flow from investing activities for fiscal 2016. Our net cash inflow from funds held for clients and corporate investment activities for fiscal 2016 was partially offset by the change in mix of investments with more invested in VRDN securities and less in cash equivalents as of May 31, 2016. For fiscal 2015 compared to fiscal 2014, there was not a significant fluctuation due to timing of the day of the week for fiscal year-end. The net cash outflow position for both fiscal 2015 and fiscal 2014 is related to more purchases of short-term and available-for-sale securities resulting from higher average collections from clients. See further discussion of this timing in the financing cash flows discussion of net change in client fund obligations.

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.

Other investing activities: 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 2016, 2015, and 2014, we purchased approximately $4.9 million, $6.9 million, and $4.7 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 2016, we paid, net of cash acquired, $296.1 million for the acquisition of Advance Partners. During fiscal years 2015 and 2014, we paid, net of cash acquired, $27.1 million and $9.3 million, respectively, for immaterial business acquisitions.

Financing Cash Flow Activities

		Year ended May 31,
In millions, except per share amounts		2016			2015			2014
Net change in client fund obligations		$	(304.8)		$	93.0		$	127.4
Dividends paid			(606.5)			(551.8)			(510.6)
Repurchases of common shares			(107.9)			(182.4)			(249.7)
Equity activity related to stock-based awards			25.6			48.5			113.3
Net cash used in financing activities		$	(993.6)		$	(592.7)		$	(519.6)
Cash dividends per common share		$	1.68		$	1.52		$	1.40

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.

Fluctuations in net change in client fund obligations for the years presented are primarily the result of timing of collections and remittances and overall trends in client fund balances. Timing for fiscal 2016 resulted in a net cash outflow position. May 31, 2016 was a Tuesday, a larger cash outflow day due to clearing of Readychex and tax payments. As May 31, 2015 was a Sunday, cash on hand would have been higher. As a result, there was a net cash outflow over the period in fiscal 2016.

May 31, 2015 fell on a Sunday, while May 31, 2014 fell on a Saturday. Friday is a large cash outflow day for direct deposit funds, partially offset by tax payment funds collected on that day. This impact was consistent and did not impact the net cash flow position for client funds obligations reflected in fiscal 2015 or fiscal 2014. The net cash inflow position in those years is the result of growth in average client funds held. The slight decrease in net cash inflows for fiscal 2015 was the result of lower cash collections for state unemployment insurance with many states lowering their rates early in calendar 2015.

Dividends paid: In July 2015, the Board increased our quarterly dividend to stockholders by 11% to $0.42 per share from $0.38 per share. In July 2014, the Board increased our quarterly dividend to stockholders by 9% to $0.38 per share from $0.35 per share. The dividends paid as a percentage of net income totaled 80%, 82%, and 81% for fiscal years 2016, 2015, and 2014, 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 May 2014, the Board approved a program to repurchase up to $350 million of Paychex common stock, with authorization expiring in May 2017. Under this share repurchase program, we repurchased 2.2 million shares for a total of $107.9 million during fiscal 2016 and 3.9 million shares for a total of $182.4 million during fiscal 2015. In fiscal 2014, we repurchased 6.2 million shares for a total of $249.7 million under a previously authorized program to repurchase up to $350 million of Paychex common stock, with authorization for that program expiring in May 2014.

Equity activity related to stock-based awards: The decrease in activity related to stock-based awards for fiscal 2016 compared to fiscal 2015 and for fiscal 2015 compared to fiscal 2014 was largely driven by a decrease in proceeds from the exercise of stock options. Shares of common stock acquired through the exercise of stock options were 0.9 million shares, 1.6 million shares, and 3.4 million shares for fiscal years 2016, 2015, and 2014, respectively. Refer to Note E 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 collectability 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. Fees earned for funding of temporary staffing clients’ payrolls via purchase of accounts receivable are based on a percentage of funding amounts as specified in the client contract. 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, recognizing the revenue and related expenses over the expected life of clients.

PEO revenue is included in service revenue and is reported net of certain direct pass-through costs billed and incurred, which include wages, taxes, and certain benefit premiums. Direct costs related to certain benefit plans where the Company retains risk are 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 reserves: 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 PEO 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 combination 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 the reporting unit. We performed our annual impairment testing in our fiscal fourth quarter. A quantitative analysis was performed for our German reporting unit. For all other reporting units, we utilized a qualitative assessment to determine if it is more-likely-than-not that the fair value of the reporting unit had declined below its carrying value. The assessment considered various financial, macroeconomic, industry, and reporting unit specific qualitative factors. Based on the results of our testing, no impairment loss was recognized in the results of operations for fiscal years 2016, 2015, or 2014. 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 E 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 non-qualified stock options are exercised or stock awards vest, 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 J 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.