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,” the “Company,” “we,” “our,” or “us”) for each of the three fiscal years ended May 31, 2017 (“fiscal 2017” or the “fiscal year”), May 31, 2016 (“fiscal 2016”), and May 31, 2015 (“fiscal 2015”), and our financial condition as of May 31, 2017. 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 HR 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 proprietary, robust, software-as-a-service (“SaaS”) Paychex Flex® platform, and our SurePayroll® SaaS-based products. Mid-market companies typically have more sophisticated payroll and benefits needs, and are serviced through our Paychex Flex Enterprise solution set, which offers an integrated suite of HCM solutions through the Paychex Flex platform, or through our legacy platform. Our SaaS solution through Paychex Flex Enterprise integrates payroll processing with HR management, employee benefits administration, time and labor management, applicant tracking, and onboarding solutions.

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

	·		comprehensive HR 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 HR services and products.

Our wholly owned subsidiary, Paychex Advance LLC (“Paychex Advance”), provides a portfolio of services to the temporary staffing industry. This includes the purchasing of accounts receivable as a means of providing payroll funding to these clients.

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 maintain industry-leading margins by 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 2017 reflected another year of solid growth. Payroll service revenue continued to experience steady growth of 3% for fiscal 2017 as compared with fiscal 2016, primarily driven by growth in revenue per check, which improved as a result of our price increases, net of discounts. As of May 31, 2017, we served approximately 605,000 payroll clients, consistent with a year ago. Fiscal 2017 new sales were challenged by comparison to a strong fiscal 2016, which benefited from higher demand as a result of the Affordable Care Act (“ACA”). Client retention was approximately 81% of our beginning client base for the fiscal year, down slightly from prior years’ near-record-high levels.

Interest rates available on high-quality financial instruments remain low, but are gradually beginning to increase. Our combined funds held for clients and corporate investment portfolios earned an average rate of return of 1.2% for fiscal 2017, compared to 1.1% for fiscal 2016 and 1.0% for fiscal 2015. The United States (“U.S.”) Federal Reserve raised the Federal Funds rate by a total of 50 basis points during fiscal 2017 to a range of 0.75% to 1.0% as of May 31, 2017. Subsequent to the end of fiscal 2017, the Federal Funds rate was raised an additional 25 basis points to a range of 1.0% to 1.25%. The Federal Funds rate was in the range of 0.25% to 0.50% as of May 31, 2016.

Highlights of our financial results for fiscal 2017, compared to fiscal 2016, are as follows:

	·		Total revenue increased 7% to $3.2 billion.

	·		Total service revenue increased 7% to $3.1 billion.

	o		Payroll service revenue increased 3% to $1.8 billion.

	o		HRS revenue increased 12% to $1.3 billion.

	·		Interest on funds held for clients increased 10% to $50.6 million.

	·		Operating income increased 8% to $1.2 billion.

	·		Net income and diluted earnings per share each increased 8% to $817.3 million and $2.25 per share, respectively.

	·		Adjusted net income(1) increased 9% to $799.0 million and adjusted diluted earnings per share(1) increased 8% to $2.20 per share.

	·		Dividends of $662.3 million were paid to stockholders, representing 81% of net income.

	(1)		Adjusted net income and adjusted diluted earnings per share are not U.S. Generally Accepted Accounting Principle (“GAAP”) measures. Please refer to the “Non-GAAP Financial Measures” section on page 21 for a discussion of these non-GAAP measures.

Business Outlook

Our payroll client base totaled approximately 605,000 clients as of both May 31, 2017 and May 31, 2016, and approximately 590,000 clients as of May 31, 2015. Our payroll client base growth was relatively flat for fiscal 2017 and increased approximately 2% for each of the fiscal years 2016 and 2015.

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 included as part of the integrated HCM solution within Paychex Flex. The following table illustrates the growth in selected HRS service offerings:

		Balance as of		Growth rates for fiscal year
		May 31, 2017		2017			2016			2015
Paychex HR Services client worksite employees		1,021,000		8	%		10	%		12	%
Paychex HR Services clients		37,000		7	%		10	%		11	%
Health and benefits services applicants		162,000		8	%		6	%		6	%
Retirement services plans		78,000		5	%		7	%		6	%

In fiscal 2017, we continued to focus on enhancing the value to clients of our Paychex Flex platform. Enhancements to our Paychex Flex platform made in fiscal 2017 included:

	·		Mobile-first design, which allows employers and employees full functionality of all application components, regardless of device or screen size;

	·		The addition of Paychex FlexTM Time Essentials, the TrueShiftTM time clock, and a new advanced scheduling feature within our Paychex FlexTM Time module; and

	·		Function-focused analytics in context throughout the platform. The enhanced data analytics tool and reports assist HR leaders with making more informed business decisions.

We believe our leading-edge technology, along with our personalized, flexible service, will help our clients stay more connected to their employees and their businesses. Our continued investment in our Paychex Flex platform during fiscal 2017 demonstrates that we are committed to providing industry-leading solutions to our clients and their employees.

Our full-service Paychex Employer Shared Responsibility (“ESR”) services continued to show growth in fiscal 2017. The 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. During fiscal 2017 we enhanced our full-service ESR product, offering an all-new online dashboard for ease of predictive employer workforce analysis and risk monitoring, as well as year-end reporting.

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, 2017 remained strong with cash and total corporate investments of $777.4 million and no debt. Our investment strategy continues to focus on protecting principal and optimizing liquidity. Yields on high quality financial instruments remain low, although gradually beginning to increase, 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 2017, our primary short-term investment vehicles were Variable Rate Demand Notes (“VRDNs”) and bank demand deposit accounts.

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, 2017 that were in an unrealized loss position 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 flows from operations were $960.4 million for fiscal 2017. 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 2017 allowed us to support our business growth and to pay substantial dividends to our stockholders. In July 2016, we announced an increase in our quarterly dividend of 10%, or $0.04 per share. In July 2017, we subsequently announced an additional $0.04 per share, or 9%, increase in our quarterly dividend. Dividends paid to stockholders were 81% of net income for fiscal 2017. It is anticipated that cash and total corporate investments as of May 31, 2017, along with projected operating cash flows and available short-term financing, 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 2017, 2016, and 2015, and our financial position as of May 31, 2017, 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, 2018 (“fiscal 2018”) is based upon current market, economic, and interest rate conditions continuing with no significant changes. Our guidance for fiscal 2018 is as follows:

	·		Payroll service revenue is anticipated to increase in the range of 1% to 2%;

	·		HRS Revenue is anticipated to increase in the range of 8% to 10%;

	·		Interest on funds held for clients is expected to reflect growth in the mid- to upper-teens;

	·		Total revenue is expected to grow approximately 5%;

	·		Operating income, as a percent of total revenue, is expected to approximate 40%;

	·		Investment income, net is expected to be in the range of $9.0 million to $11.0 million;

	·		The effective income tax rate for fiscal 2018 is expected to be in the range of 35.5% to 36.0%;

	·		Net income is expected to increase approximately 5% and adjusted net income(1) is anticipated to increase approximately 7%; and

	·		Diluted earnings per share is expected to increase in the range of 5% to 6% and adjusted diluted earnings per share(1) is expected to increase in the range of 7% to 8%.

	(1)		Adjusted net income and adjusted diluted earnings per share are not U.S. GAAP measures. Please refer to the “Non-GAAP Financial Measures” section on page 21 for a discussion of these non-GAAP measures. The difference between our guidance for the GAAP measures of net income and diluted earnings per share and the related non-GAAP measures of adjusted net income and adjusted diluted earnings per share is limited to the net tax benefit recognized in fiscal 2017 related to employee stock-based compensation payments. We have not incorporated any assumptions regarding such a discrete tax benefit in our fiscal 2018 projections, as factors impacting the amount are subject to uncertainty. Uncertainty primarily relates to employee decisions regarding exercise of stock-based awards and the market price of our common stock at that time.

The average rate of return on our combined funds held for clients and corporate investment portfolios is expected to be approximately 1.4% for fiscal 2018, reflecting increases to the Federal Funds rate through the most recent change in June 2017. As of May 31, 2017, the long-term investment portfolio had an average yield-to-maturity of 1.7% and an average duration of 3.2 years.

Purchases of property and equipment for fiscal 2018 are expected to be in the range of $180.0 million to $190.0 million. This includes anticipated non-recurring expenditures for the purchase of currently leased space. In addition, this includes costs for internally developed software as we continue to invest in our service supporting technology. Fiscal 2018 depreciation expense is projected to be in the range of $110.0 million to $120.0 million, and we project amortization of intangible assets for fiscal 2018 to be in the range of $15.0 million to $20.0 million.

Our guidance for fiscal 2018 is subject to factors and uncertainties, including the risk factors described in Item 1A, “Risk Factors,” which could cause our actual results to differ materially from our guidance. Our guidance reflects our current expectations and are not guarantees of future performance. Please see our “Cautionary Note Regarding Forward-Looking Statements” on page 1 for further information regarding our forward-looking statements.

Results of Operations

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

In millions, except per share amounts		2017				Change			2016				Change			2015
Revenue:
Payroll service revenue		$	1,779.3			3	%		$	1,729.9			4	%		$	1,656.8
HRS revenue			1,321.4			12	%			1,175.9			13	%			1,040.7
Total service revenue			3,100.7			7	%			2,905.8			8	%			2,697.5
Interest on funds held for clients			50.6			10	%			46.1			9	%			42.1
Total revenue			3,151.3			7	%			2,951.9			8	%			2,739.6
Combined operating and SG&A expenses			1,911.7			6	%			1,805.3			7	%			1,686.0
Operating income			1,239.6			8	%			1,146.6			9	%			1,053.6
Investment income, net			5.2			13	%			4.5			(28)	%			6.4
Income before income taxes			1,244.8			8	%			1,151.1			9	%			1,060.0
Income taxes			427.5			8	%			394.3			2	%			385.1
Effective income tax rate			34.3	%						34.3	%						36.3	%
Net income		$	817.3			8	%		$	756.8			12	%		$	674.9
Diluted earnings per share		$	2.25			8	%		$	2.09			13	%		$	1.85

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, 2017, 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		2017				2016				2015
Average investment balances:
Funds held for clients		$	4,066.3			$	4,105.5			$	4,080.0
Corporate investments			906.7				922.6				1,011.5
Total		$	4,973.0			$	5,028.1			$	5,091.5
Average interest rates earned (exclusive of net realized gains):
Funds held for clients			1.2	%			1.1	%			1.0	%
Corporate investments			1.1	%			0.9	%			0.7	%
Combined funds held for clients and corporate investments			1.2	%			1.1	%			1.0	%
Total net realized gains		$	0.1			$	0.1			$	0.3

$ in millions
As of May 31,		2017				2016				2015
Net unrealized gains on available-for-sale securities(1)		$	32.0			$	47.6			$	13.6
Federal Funds rate(2)			1.00	%			0.50	%			0.25	%
Total fair value of available-for-sale securities		$	4,613.2			$	4,141.9			$	3,595.6
Weighted-average duration of available-for-sale securities in years(3)			3.2				3.1				3.2
Weighted-average yield-to-maturity of available-for-sale securities(3)			1.7	%			1.7	%			1.6	%

	(1)		The net unrealized gain on our investment portfolios was approximately $27.2 million as of July 19, 2017.

	(2)		The Federal Funds rate was in the range of 0.75% to 1.0% as of May 31, 2017, 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. On June 15, 2017, the Federal Funds rate was raised an additional 25 basis points to a range of 1.0% to 1.25%.

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

Payroll service revenue: Payroll service revenue was $1.8 billion for fiscal 2017 and $1.7 billion for fiscal 2016, reflecting growth of 3% and 4%, respectively, compared to each of the prior fiscal year periods. Both fiscal 2017 and fiscal 2016 benefited from increases in revenue per check. Revenue per check improved as a result of price increases, net of discounts. In addition, fiscal 2016 benefited from growth in our client base and two additional processing days during the year. The acquisition of Advance Partners in December 2015 contributed approximately 1% and 0.5% to the growth in payroll service revenue for fiscal 2017 and fiscal 2016, respectively.

As of May 31, 2017, we served approximately 605,000 payroll clients, consistent with levels one year ago. For fiscal 2016 and fiscal 2015, our total payroll client base growth was approximately 2%. The flat growth for fiscal 2017 was impacted by a challenging comparison for new sales to a strong fiscal 2016, which benefited from the implementation of the ACA. In addition, we experienced a slight increase in client attrition for fiscal 2017 as compared to the prior year. Client retention was approximately 81% of the beginning of the year client base for fiscal 2017, compared to approximately 82% for both fiscal 2016 and fiscal 2015.

Human Resource Services revenue: HRS revenue was $1.3 billion for fiscal 2017 and $1.2 billion for fiscal 2016, reflecting growth of 12% and 13%, respectively, compared to each of the prior fiscal year periods.

For both fiscal 2017 and fiscal 2016, 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 administration. HRS product key statistics are as follows:

$ in billions
As of May 31,		2017			Change			2016			Change			2015
Paychex HR Services client worksite employees			1,021,000		8	%			944,000		10	%			858,000
Paychex HR Services clients			37,000		7	%			35,000		10	%			31,000
Health and benefits services applicants			162,000		8	%			150,000		6	%			142,000
Retirement services plans			78,000		5	%			74,000		7	%			70,000
Asset value of retirement services participants’ funds		$	27.4		16	%		$	23.6		—	%		$	23.5

We continue to experience strong demand for our Paychex HR Services, our largest HRS revenue stream, as evidenced by the continued strong growth in client worksite employees for both our ASO and PEO.

Retirement services revenue growth for fiscal 2017 benefited from an increase in asset fee revenue earned on the asset value of participant funds. Growth for fiscal 2016 was tempered by a lower average asset value of participants’ funds, offset somewhat by higher basis points earned from external fund managers.

Insurance services revenue growth for both fiscal 2017 and 2016 benefited from growth of our full-service ACA product and growth in the number of applicants. In addition, higher average premiums in our workers’ compensation product positively impacted revenue for both fiscal years.

Advance Partners contributed approximately 1% to the growth in HRS revenue for both fiscal 2017 and fiscal 2016.

Total service revenue: Total service revenue increased 7% for fiscal 2017 and 8% for fiscal 2016, attributable to the factors previously discussed.

Interest on funds held for clients: Interest on funds held for clients increased 10% for fiscal 2017 and 9% for fiscal 2016 to $50.6 million and $46.1 million, respectively. For fiscal 2017, the increase was primarily due to higher average interest rates earned. For fiscal 2016, the increase was attributed to higher average interest rates earned as well as slightly higher average investment balances.

Average investment balances for funds held for clients decreased approximately 1% for fiscal 2017 primarily due to the impacts of timing of certain remittances due to taxing authorities and client mix. Average investment balances increased approximately 1% for fiscal 2016 driven mainly by client base growth and wage inflation, partially offset by lower state unemployment insurance rates.

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		2017			Change			2016			Change			2015
Compensation-related expenses		$	1,188.5		4	%		$	1,148.2		6	%		$	1,087.1
Depreciation and amortization			126.9		10	%			115.1		8	%			106.6
PEO insurance costs			142.2		17	%			122.0		27	%			96.2
Other expenses			454.1		8	%			420.0		6	%			396.1
Total expenses		$	1,911.7		6	%		$	1,805.3		7	%		$	1,686.0

Total expenses increased 6% for fiscal 2017 and 7% for fiscal 2016. The increases in total expenses were driven largely by growth in compensation-related expenses. For fiscal 2017, compensation-related expenses increased due to higher headcount in operations, partially offset by lower variable selling costs. For fiscal 2016, compensation-related expenses increased due to higher wages and performance-based compensation costs. As of May 31, 2017, we had approximately 13,700 employees, compared with 13,500 employees as of May 31, 2016.

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 for fiscal 2017 was primarily driven by higher depreciation related to an increase in internally developed software that was placed in service over the past two years.

Expense growth for fiscal 2017 and fiscal 2016 was impacted by continued growth in our PEO. 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. Continued investment in product development and supporting technology impacted other expense growth for both fiscal 2017 and fiscal 2016. Advance Partners contributed approximately 1% to the growth in total expenses for fiscal 2017 and less than 1% to the growth for fiscal 2016.

Operating income: Operating income increased 8% for fiscal 2017 to $1.2 billion and 9% for fiscal 2016 to $1.1 billion. The fluctuations in operating income were attributable to the factors previously discussed. Operating income, as a percent of total revenue, was 39.3%, 38.8%, and 38.5% for the fiscal years 2017, 2016, and 2015, respectively.

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, increased 13% for fiscal 2017 primarily due to higher average interest rates earned, partially offset by a 2% decrease in average investment balances. Investment income, net, decreased 28% for fiscal 2016 as the result of immaterial losses on equity method investments and a 9% decrease in average investment balances, partially offset by higher average interest rates earned. The decrease in average investment balances for fiscal 2016 was primarily the result of cash consideration paid for the acquisition of Advance Partners in December 2015 and stock repurchase activity. This lower starting balance for fiscal 2017, along with additional stock repurchases and higher dividend payments made during the fiscal year, contributed to the decline for fiscal 2017.

Income taxes: Our effective income tax rate was 34.3% for both fiscal 2017 and fiscal 2016 and was 36.3% for fiscal 2015. The effective income tax rates were impacted by discrete tax items recognized during fiscal 2017 and fiscal 2016. Effective June 1, 2016, we early-adopted new accounting guidance related to employee stock-based compensation payments which resulted in discrete tax benefits recognized in income tax expense. This discrete tax benefit impacted diluted earnings per share by approximately $0.05 per share for fiscal 2017. During fiscal 2016, we recognized a net tax benefit on income derived in prior tax years related to customer-facing software that we produced. During the first quarter of fiscal 2016, 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 tax item in fiscal 2016, which increased diluted earnings per share by approximately $0.06. Additional discrete tax items recognized during each respective period are insignificant. 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 diluted earnings per share: Net income and diluted earnings per share both increased 8% to $817.3 million and $2.25 per share, respectively, for fiscal 2017. For fiscal 2016, net income increased 12% to $756.8 million and diluted earnings per share increased 13% to $2.09 per share. These fluctuations were attributable to the factors previously discussed. Adjusted net income increased 9% to $799.0 million for fiscal 2017 and increased 9% to $735.7 million for fiscal 2016. Adjusted diluted earnings per share was $2.20 per share for fiscal 2017 and $2.03 per share for fiscal 2016, reflecting increases of 8% and 10%, respectively. Refer to the “Non-GAAP Financial Measures” section that follows for a discussion of these non-GAAP measures.

Non-GAAP Financial Measures: Adjusted net income and adjusted diluted earnings per share are summarized as follows:

$ in millions		2017			Change			2016			Change			2015
Net income (GAAP)		$	817.3		8	%		$	756.8		12	%		$	674.9
Non-GAAP adjustments:
Excess tax benefit related to employee stock compensation			(18.3)						—						—
Net tax benefit on income derived from prior tax years for customer-facing software			—						(21.1)						—
Total non-GAAP adjustments			(18.3)						(21.1)						—
Adjusted net income (non-GAAP)		$	799.0		9	%		$	735.7		9	%		$	674.9
Diluted earnings per share (GAAP)		$	2.25		8	%		$	2.09		13	%		$	1.85
Non-GAAP adjustments:
Excess tax benefit related to employee stock compensation			(0.05)						—						—
Net tax benefit on income derived from prior tax years for customer-facing software			—						(0.06)						—
Total non-GAAP adjustments			(0.05)						(0.06)						—
Adjusted diluted earnings per share (non-GAAP)		$	2.20		8	%		$	2.03		10	%		$	1.85

In addition to reporting net income and diluted earnings per share, U.S. GAAP measures, we present adjusted net income and adjusted diluted earnings per share, which are non-GAAP measures. We believe adjusted net income and adjusted diluted earnings per share are appropriate additional measures, as they are indicators of our core business operations performance period over period. Adjusted net income and adjusted diluted earnings per share both exclude the additional tax benefit or shortfall related to employee stock-based compensation payments recognized in income taxes. This arose from early-adoption in June 2016 of new accounting guidance, but will be a recurring item going forward. This item is subject to volatility and will vary based on employee decisions on exercising employee stock options and fluctuations in our stock price, neither of which is in the control of management. Also excluded is a net tax benefit that was recorded in fiscal 2016 for income derived in prior tax years related to customer-facing software that we produced. This was an unusual event that is not expected to recur. We believe presenting net income and diluted earnings per share excluding these particular discrete tax items allows a better understanding of core business performance. Adjusted net income and adjusted diluted earnings per share are not calculated through the application of GAAP and are not a required form of disclosure by the SEC. As such, they should not be considered as a substitute for the GAAP measures of net income and diluted earnings per share, and therefore should not be used in isolation, but in conjunction with, the GAAP measures. 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.

Liquidity and Capital Resources

Our financial position as of May 31, 2017 remained strong with cash and total corporate investments of $777.4 million and no debt. We believe that our investments as of May 31, 2017 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, 2017, along with projected operating cash flows and available short-term financing, will support our normal business operations, capital purchases, business acquisitions, share repurchases, and dividend payments for the foreseeable future.

Short-Term Financing

Lines of credit: As of May 31, 2017, we had unused borrowing capacity available under four uncommitted, secured, short-term lines of credit at market rates of interest with financial institutions as follows:

Financial institution		Amount available		Expiration date
JP Morgan Chase Bank, N.A.		$350 million		February 28, 2018
Bank of America, N.A.		$250 million		February 28, 2018
PNC Bank, National Association		$150 million		February 28, 2018
Wells Fargo Bank, National Association		$150 million		February 28, 2018

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 these 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 under these lines of credit during fiscal 2017 or as of May 31, 2017.

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

Letters of credit: As of May 31, 2017, we had irrevocable standby letters of credit available totaling $47.3 million, required to secure commitments for certain insurance policies. The letters of credit expire at various dates between July 2017 and May 2018, and are collateralized by securities held in our investment portfolios. No amounts were outstanding on these letters of credit during fiscal 2017 or as of May 31, 2017. The letter of credit expiring in July 2017 was subsequently renewed through July 2018.

Credit facilities: On August 5, 2015, we entered into a committed, unsecured, five-year syndicated credit facility, expiring on August 5, 2020 with JP Morgan Chase Bank, N.A. as the administrative agent. 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 us and certain of our subsidiaries. The outstanding obligations under this credit facility will bear interest at competitive rates based on options provided to the Borrower. Upon expiration of the commitment in August 2020, any borrowings outstanding will mature and be payable on such date.

During fiscal 2017 and fiscal 2016, we borrowed against this credit facility as follows:

		Year ended May 31,
$ in millions		2017				2016
Number of days borrowed			30				5
Maximum amount borrowed		$	450.0			$	450.0
Weighted-average amount borrowed		$	196.7			$	305.0
Weighted-average interest rate			2.89	%			3.39	%

We typically borrow on an overnight basis. In addition to overnight borrowings, during fiscal 2017, we borrowed $150.0 million for seven days and $50.0 million for a period of eighteen days at a weighted-average LIBOR-based interest rate of 1.40%. There were no amounts outstanding under this credit facility as of May 31, 2017. Subsequent to May 31, 2017, we borrowed four times, on an overnight basis, $335.0 million on a weighted-average basis under this line.

In March 2016, we entered into a committed, unsecured, three-year credit facility with PNC Bank, National Association, expiring on March 17, 2019. Under this credit facility, Paychex Advance may, subject to certain restrictions, borrow up to $150.0 million to finance working capital needs and for general corporate purposes. 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 based on options provided to Paychex Advance. Upon expiration of the commitment in March 2019, any borrowings outstanding will mature and be payable on such date.

There were no borrowings under this credit facility during fiscal 2016 or as of May 31, 2016. There were no amounts outstanding under this credit facility as of May 31, 2017. Details of borrowings under this credit facility during fiscal 2017 are as follows:

					Year ended May 31,
$ in millions					2017
Number of days borrowed							353
Maximum amount borrowed					$		55.6
Weighted-average amount borrowed					$		52.8
Weighted-average interest rate							1.21	%

Subsequent to May 31, 2017, Paychex Advance borrowed approximately $55.0 million under this line, which remains outstanding as of the date of this report.

The credit facilities contain various financial and operational covenants that are usual and customary for such arrangements. We were in compliance with these covenants as of May 31, 2017.

Certain lenders under these credit facilities, 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.

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, 2017. The table below summarizes our estimated annual payment obligations under these commitments as of May 31, 2017:

		Payments due by period
					Less than									More than
In millions		Total			1 year			1-3 years			4-5 years			5 years
Operating leases(1)		$	106.3		$	36.1		$	46.6		$	19.3		$	4.3
Purchase obligations(2)			127.4			78.8			44.4			4.2			—
Total		$	233.7		$	114.9		$	91.0		$	23.5		$	4.3

	(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 $7.4 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 $39.2 million as of May 31, 2017. 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 $73.8 million as of May 31, 2017 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. In addition, during fiscal 2017 we entered into a limited partnership agreement to contribute a maximum amount of $10.0 million to a venture capital fund in the financial technology sector, of which approximately $1.8M has been contributed as of May 31, 2017. The timing of future contributions to be made to the venture capital fund cannot be specifically or reasonably determined and thus have been excluded from the table above.

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 five 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 2017, 2016, and 2015 was $16.4 million, $16.1 million, and $15.1 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 both low-income housing projects and a venture capital fund focused on the financial technology sector. These 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, 2017.

Operating Cash Flow Activities

		Year ended May 31,
In millions		2017			2016			2015
Net income		$	817.3		$	756.8		$	674.9
Non-cash adjustments to net income			257.0			234.9			211.4
Cash (used in)/provided by changes in operating assets and liabilities			(113.9)			26.5			8.9
Net cash provided by operating activities		$	960.4		$	1,018.2		$	895.2

The decrease in our operating cash flows for fiscal 2017 compared to fiscal 2016 is primarily the result of cash outflows from fluctuations in our operating assets and liabilities, partially offset by higher net income and adjustments for non-cash items. The increase in operating cash flows for fiscal 2016 compared to fiscal 2015 is primarily the result of higher net income, adjusted for non-cash items, and the increase in cash provided by fluctuations in our operating assets and liabilities. The increase in non-cash adjustments for fiscal 2017 and for fiscal 2016 was largely due to higher depreciation expense related to an increase in internally developed software placed in service over the last two years. In addition, for fiscal 2016 the increase was impacted by an increase in the deferred tax provision. 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. In addition, the larger outflows in fiscal 2017 were impacted by higher accounts receivable balances related to growth in our payroll funding business for temporary staffing agency clients.

Investing Cash Flow Activities

		Year ended May 31,
In millions		2017			2016			2015
Net change in funds held for clients and corporate investments		$	(321.7)		$	339.7		$	(151.8)
Purchases of property and equipment			(94.3)			(97.7)			(102.8)
Acquisition of businesses, net of cash acquired			—			(296.1)			(27.1)
Purchases of other assets			(8.6)			(9.0)			(3.3)
Net cash used in investing activities		$	(424.6)		$	(63.1)		$	(285.0)

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 investments are largely due to timing within the client funds portfolio. Specific timing impacting cash flows for fiscal years 2017, 2016, and 2015 are discussed further in the financing cash flows discussion of net changes in client fund obligations. Fiscal 2017 had greater purchases of short-term or available-for-sale investments of client collections than sales of investments to fund client fund remittances, whereas fiscal 2016 reflected more sales of investments than purchases. For fiscal 2016, the client fund timing impacts reflected in the net change in funds held for clients and corporate investments were somewhat offset by a change in mix of investments when compared to fiscal 2015. Fiscal 2016 had more funds invested in VRDN securities and less in cash equivalents.

In general, fluctuations in the net change in funds held for clients and corporate investments 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 2017, 2016, and 2015, we purchased approximately $0.6 million, $4.9 million, and $6.9 million, respectively, of data processing equipment and software from EMC Corporation. The former Chairman, President, and Chief Executive Officer of EMC Corporation is a member of our Board of Directors (the “Board”).

There were no acquisitions completed during fiscal 2017. During fiscal 2016, we paid, net of cash acquired, $296.1 million for the acquisition of Advance Partners, and during fiscal year 2015, we paid, net of cash acquired, $27.1 million for an immaterial business acquisition.

Financing Cash Flow Activities

		Year ended May 31,
In millions, except per share amounts		2017			2016			2015
Net change in client fund obligations		$	317.3		$	(304.8)		$	93.0
Dividends paid			(662.3)			(606.5)			(551.8)
Repurchases of common shares			(166.2)			(107.9)			(182.4)
Activity related to equity-based plans			28.5			25.6			48.5
Net cash used in financing activities		$	(482.7)		$	(993.6)		$	(592.7)
Cash dividends per common share		$	1.84		$	1.68		$	1.52

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.

Client fund obligation balances are significantly impacted by the timing of the period end. Fluctuations in the 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. May 31, 2017 fell on a Wednesday compared to May 31, 2016 which was a Tuesday. Payroll tax funds continued to be collected on Wednesday, May 31, 2017, yet the federal semi-weekly tax payment was delayed until Thursday, June 1, 2017 due to the Memorial Day holiday weekend. As such, a higher client fund obligation existed on May 31, 2017 than May 31, 2016. The timing of the Memorial Day holiday in May 2016 prompted many clients to remit their payrolls before the holiday weekend, resulting in lower direct deposit funds as of May 31, 2016.

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. May 31, 2015 was a Sunday and Fridays are typically higher cash collection days. This timing left higher cash on hand at May 31, 2015 compared to May 31, 2016. As a result, there was a net cash outflow over the period in fiscal 2016 as compared to fiscal 2015.

Dividends paid: In July 2016, our Board increased our quarterly dividend to stockholders by 10% to $0.46 per share from $0.42 per share. In July 2015, our Board increased our quarterly dividend to stockholders by 11% to $0.42 per share from $0.38 per share. The dividends paid as a percentage of net income totaled 81%, 80%, and 82% for fiscal years 2017, 2016, and 2015, 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 July 2016, our Board approved a program to repurchase up to $350.0 million of our common stock, authorized through May 31, 2019 (the “July 2016 Program”). In addition, under a previous plan initiated in May 2014 that expired May 31, 2017 (the “May 2014 Program”), we were also authorized to repurchase up to $350.0 million of our common stock. The purpose of both programs is to manage common stock dilution. During fiscal 2017, we repurchased 2.9 million shares for a total of $166.2 million. $59.7 million of the total purchased was under our May 2014 Program and $106.5 million was under our July 2016 Program. During fiscal 2016, we repurchased 2.2 million shares for a total of $107.9 million and 3.9 million shares for a total of $182.4 million, respectively, all under the May 2014 Plan. Shares repurchased were retired. As of May 31, 2017, all amounts authorized under the May 2014 Program have been purchased.

Activity related to equity-based plans: The increase in activity related to stock-based awards for fiscal 2017 compared to fiscal 2016 and the decrease for fiscal 2016 compared to fiscal 2015 was largely driven by changes in proceeds received from the exercise of stock options. Shares of common stock issued through the exercise of stock options were 1.4 million shares, 0.9 million shares, and 1.6 million shares for fiscal years 2017, 2016, and 2015, respectively. During fiscal 2017, the increase in proceeds was partially offset by the prospective change in classification of excess tax benefits related to employee stock-based compensation, which is now reflected in operating activities. 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 we retain 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 insurance 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.

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 insurance 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.

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. 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 perform our annual impairment testing in our fiscal fourth quarter. For fiscal 2017, it was determined that we had three reporting units. A qualitative analysis was performed for our Paychex Advance reporting unit. The assessment considered various financial, macroeconomic, industry, and reporting unit specific qualitative factors. For all other defined reporting units, a quantitative analysis was performed to determine if it more-likely-than-not that the fair value of the reporting unit had declined below its carrying value. Based on the results of our testing, no impairment loss was recognized in the results of operations for fiscal years 2017, 2016, or 2015. Subsequent to the latest review, there have been no events or circumstances that indicate any potential impairment of the Company’s 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.

The fair value of stock awards is determined based on the stock price at the date of grant. For grants that do not accrue dividends or dividend equivalents, the fair value is the stock price reduced by the present value of estimated dividends over the vesting period or performance period.

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

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

We early-adopted new guidance related to employee stock-based compensation costs effective June 1, 2016. Refer to Note A to the Consolidated Financial Statements contained in Item 8 of this Form 10-K for more information.

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. With the early-adoption of Accounting Standards Update No. 2016-09, at the time of the exercise of non-qualified stock options or vesting of stock awards, we recognize any excess tax benefit within income taxes in the Consolidated Statements of Income and Comprehensive Income. Previously, we accounted 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 in the Consolidated Balance Sheets.

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.