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, 2018 (“fiscal 2018” or the “fiscal year”), May 31, 2017 (“fiscal 2017”), and May 31, 2016 (“fiscal 2016”), and our financial condition as of May 31, 2018. 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, when possible.

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 2018 reflect another year of steady growth. HRS revenue continued to experience strong growth of 14% for fiscal 2018 as compared with fiscal 2017. HRS revenue growth was primarily driven by increases in client bases across the following HCM services: comprehensive HR outsourcing services, including HR Outsourcing Holdings, Inc. (“HROI”) acquired in fiscal 2018; retirement services; time and attendance; and insurance services. Payroll service revenue increased 2% for fiscal 2018 as compared with fiscal 2017, primarily driven by growth in revenue per check, which improved as a result of our price increases, net of discounts. As of May 31, 2018, including the Lessor Group (“Lessor”) acquisition, we served over 650,000 payroll clients. As of May 31, 2017, we served approximately 605,000 payroll clients. Client retention was approximately 81% of our beginning client base for the fiscal year, consistent with a year ago.

Interest rates available on high-quality financial instruments are gradually increasing. Our combined funds held for clients and corporate investment portfolios earned an average rate of return of 1.5% for fiscal 2018, compared to 1.2% for fiscal 2017 and 1.1% for fiscal 2016. The United States (“U.S.”) Federal Reserve raised the Federal Funds rate by a total of 75 basis points during fiscal 2018 to a range of 1.50% to 1.75% as of May 31, 2018. In June 2018, the Federal Funds rate was raised an additional 25 basis points to a range of 1.75% to 2.0%. The Federal Funds rate was in the range of 0.75% to 1.0% as of May 31, 2017.

Highlights of our financial results for fiscal 2018, compared to fiscal 2017, are as follows:

	·		Total revenue increased 7% to $3.4 billion.

	o		HRS revenue increased 14% to $1.5 billion.

	o		Payroll service revenue increased 2% to $1.8 billion.

	o		Interest on funds held for clients increased 26% to $63.5 million.

	·		Operating income increased 4% to $1.3 billion. Adjusted operating income(1) increased 6% to $1.3 billion.

	·		Net income increased 14% to $933.7 million. Adjusted net income(1) increased 15% to $920.0 million.

	·		Diluted earnings per share increased 15% to $2.58 per share. Adjusted diluted earnings per share(1) increased 16% to $2.55 per share.

	·		Dividends of $739.7 million were paid to stockholders, representing 79% of net income.

	(1)		Adjusted operating income, adjusted net income and adjusted diluted earnings per share are not U.S. generally accepted accounting principles (“GAAP”) measures. Please refer to the “Non-GAAP Financial Measures” section of this Item 7 for a discussion of these non-GAAP measures and a reconciliation to the most comparable GAAP measures of operating income, net income, and diluted earnings per share.

Business Outlook

Our payroll client base, including Lessor, exceeded 650,000 clients as of May 31, 2018, and was approximately 605,000 clients as of May 31, 2017 and May 31, 2016. Excluding Lessor, our payroll client base was relatively flat for fiscal 2018 as compared to fiscal 2017.

While HRS products provide services to employers and employees beyond payroll, they effectively leverage payroll processing data. 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, 2018		2018			2017			2016
Paychex HR Services client worksite employees(1)		1,157,000		13	%		8	%		10	%
Paychex HR Services clients(1)		41,000		12	%		7	%		10	%
Health and benefits services applicants		177,000		9	%		8	%		6	%
Retirement services plans		82,000		6	%		5	%		7	%

(1) The total number of worksite employees and clients for fiscal 2018 include HROI.

In fiscal 2018, we expanded our commitment to delivering superior technology and service solutions to our Paychex clients. New offerings introduced in fiscal 2018 included:

	·		Accountant HQ, a Paychex Flex platform-based offering, which provides access to authorized client payroll and HR data and key account contacts to assist a client’s accountant in driving greater efficiency;

	·		InVisionTM Iris Time Clock, a biometric clock that scans the iris, providing fast and accurate time capture;

	·		Netspend’s Tip NetworkTM, which streamlines the process for paying tipped employees;

	·		Do-It-Yourself online employee handbook; and

	·		Onboarding Essentials, which enables clients to onboard new hires quickly and in a completely paperless fashion.

Concentrated effort remains on the continued enhancements of Paychex Flex, our robust cloud-based HCM platform, which allows direct client access to payroll, HR, and benefits information in a streamlined and integrated approach to workplace management.

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.paychex.com/group-health-insurance, helps small-business owners navigate the area of insurance coverage. Both this website and www.paychex.com/worx have sections dedicated to the topic of health care reform.

Financial position and liquidity

Our financial position as of May 31, 2018 remained strong with cash and total corporate investments of $719.7 million and no debt. Our investment strategy continues to focus on protecting principal and optimizing liquidity. 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 2018, our primary short-term investment vehicles were Variable Rate Demand Notes (“VRDNs”) and bank demand deposit accounts.

A majority 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 values are less sensitive to interest rate changes. We believe that our investments as of May 31, 2018 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 generated by our ongoing operations. Cash flows from operations were $1.3 billion for fiscal 2018. 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 2018 allowed us to support our business and to pay substantial dividends to our stockholders. In April 2018 and July 2017, our Board of Directors (the “Board”) increased our quarterly dividend by 12% to $0.56 per share from $0.50 per share, and 9% to $0.50 per share from $0.46 per share, respectively. Dividends paid to stockholders were 79% of net income for fiscal 2018. It is anticipated that cash and total corporate investments as of May 31, 2018, 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 2018, 2017, and 2016, and our financial position as of May 31, 2018, 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.

Results of Operations

Summary of Results of Operations for Fiscal Years:

In millions, except per share amounts		2018				Change			2017				Change			2016
Revenue:
Payroll service revenue		$	1,810.0			2	%		$	1,779.3			3	%		$	1,729.9
HRS revenue			1,507.4			14	%			1,321.4			12	%			1,175.9
Total service revenue			3,317.4			7	%			3,100.7			7	%			2,905.8
Interest on funds held for clients			63.5			26	%			50.6			10	%			46.1
Total revenue			3,380.9			7	%			3,151.3			7	%			2,951.9
Combined operating and SG&A expenses			2,093.4			10	%			1,911.7			6	%			1,805.3
Operating income			1,287.5			4	%			1,239.6			8	%			1,146.6
Investment income, net			8.6			66	%			5.2			13	%			4.5
Income before income taxes			1,296.1			4	%			1,244.8			8	%			1,151.1
Income taxes			362.4			(15)	%			427.5			8	%			394.3
Effective income tax rate			28.0	%						34.3	%						34.3	%
Net income		$	933.7			14	%		$	817.3			8	%		$	756.8
Diluted earnings per share		$	2.58			15	%		$	2.25			8	%		$	2.09

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, 2018, 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		2018				2017				2016
Average investment balances:
Funds held for clients		$	4,040.8			$	4,066.3			$	4,105.5
Corporate investments			915.1				906.7				922.6
Total		$	4,955.9			$	4,973.0			$	5,028.1
Average interest rates earned (exclusive of net realized gains):
Funds held for clients			1.6	%			1.2	%			1.1	%
Corporate investments			1.3	%			1.1	%			0.9	%
Combined funds held for clients and corporate investments			1.5	%			1.2	%			1.1	%
Total net realized gains		$	0.1			$	0.1			$	0.1

$ in millions
As of May 31,		2018				2017				2016
Net unrealized (losses)/gains on available-for-sale securities(1)		$	(38.3)			$	32.0			$	47.6
Federal Funds rate(2)			1.75	%			1.00	%			0.50	%
Total fair value of available-for-sale securities		$	3,104.8			$	4,613.2			$	4,141.9
Weighted-average duration of available-for-sale securities in years(3)			3.1				3.2				3.1
Weighted-average yield-to-maturity of available-for-sale securities(3)			1.9	%			1.7	%			1.7	%

	(1)		The net unrealized loss on our investment portfolios was approximately $33.0 million as of July 18, 2018.

	(2)		The Federal Funds rate was in the range of 1.50% to 1.75% as of May 31, 2018, in the range of 0.75% to 1.00% as of May 31, 2017, and in the range of 0.25% to 0.50% as of May 31, 2016. In June 2018, the Federal Funds rate was raised an additional 25 basis points to a range of 1.75% to 2.0%.

	(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 2018 and $1.8 billion for fiscal 2017, reflecting growth of 2% and 3%, respectively, compared to each of the prior fiscal year periods. Both fiscal 2018 and fiscal 2017 benefited from increases in revenue per check, which improved as a result of price increases, net of discounts. The impact of the acquisition of Lessor on payroll service revenue growth for fiscal 2018 was insignificant. The acquisition of Paychex Advance contributed approximately 1% to payroll service revenue growth for fiscal 2017.

As of May 31, 2018, including the Lessor acquisition, we served over 650,000 payroll clients. For fiscal 2017, our total payroll client base of 605,000 was comparable to fiscal 2016. Client retention was approximately 81% of the beginning client base for fiscal 2018, consistent with fiscal 2017. Client retention was approximately 82% of the beginning of the year client base for fiscal 2016.

Human Resource Services revenue: HRS revenue was $1.5 billion for fiscal 2018 and $1.3 billion for fiscal 2017, reflecting growth of 14% and 12%, respectively, compared to each of the prior fiscal year periods. HROI contributed approximately 6% to the growth in HRS revenue for fiscal 2018 and Paychex Advance contributed approximately 1% to the growth in HRS revenue for fiscal 2017.

For both fiscal 2018 and fiscal 2017, HRS revenue growth was primarily driven by increases in client bases across all major HCM services, including: comprehensive HR outsourcing services (including HROI), retirement services, time and attendance, and insurance services. HRS product key statistics are as follows:

$ in billions
As of May 31,		2018			Change			2017			Change			2016
Paychex HR Services client worksite employees(1)			1,157,000		13	%			1,021,000		8	%			944,000
Paychex HR Services clients(1)			41,000		12	%			37,000		7	%			35,000
Health and benefits services applicants			177,000		9	%			162,000		8	%			150,000
Retirement services plans			82,000		6	%			78,000		5	%			74,000
Asset value of retirement services participants’ funds		$	30.6		12	%		$	27.4		16	%		$	23.6

(1) The total number of worksite employees and clients for fiscal 2018 include HROI.

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 2018 and fiscal 2017 benefited from an increase in asset fee revenue earned on the asset value of participant funds, along with an increase in the number of plans served. Insurance services revenue growth for both fiscal 2018 and fiscal 2017 benefited from growth in the number of health and benefits applicants. In addition, for fiscal 2017, revenue was positively impacted by higher average premiums in our workers’ compensation insurance product.

Total service revenue: Total service revenue increased 7% for both fiscal 2018 and fiscal 2017, attributable to the factors previously discussed.

Interest on funds held for clients: Interest on funds held for clients increased 26% for fiscal 2018 and 10% for fiscal 2017 to $63.5 million and $50.6 million, respectively. For both fiscal 2018 and fiscal 2017, the increases were primarily due to higher average interest rates earned.

Average investment balances for funds held for clients decreased approximately 1% for fiscal 2018, primarily due to the impact of the Tax Cut and Jobs Act of 2017 (the “Tax Act”) on employee withholdings and changes in client mix, which offset the impact of wage inflation. 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.

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		2018			Change			2017			Change			2016
Compensation-related expenses		$	1,242.4		5	%		$	1,188.5		4	%		$	1,148.2
Depreciation and amortization			138.0		9	%			126.9		10	%			115.1
PEO insurance costs			205.2		44	%			142.2		17	%			122.0
Other expenses			507.8		12	%			454.1		8	%			420.0
Total expenses		$	2,093.4		10	%		$	1,911.7		6	%		$	1,805.3

Total expenses increased 10% for fiscal 2018 and 6% for fiscal 2017. For fiscal 2018, compensation-related expenses increased due to higher headcount reflecting accelerated investment in technology, sales teams, and the impact of the acquisitions of Lessor and HROI. In addition, compensation-related expenses in fiscal 2018 included a one-time bonus paid to non-management employees. For fiscal 2017, compensation-related expenses increased due to higher headcount in operations, partially offset by lower variable selling costs. As of May 31, 2018, we had approximately 14,300 employees, including Lessor, compared with 13,700 employees as of May 31, 2017.

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 increase in depreciation and amortization for fiscal 2018 and fiscal 2017 was primarily driven by an increase in internally developed software that was placed in service over the past two years as well as changes to the useful life of certain assets which accelerated depreciation expense recognition.

Expense growth for fiscal 2018 and fiscal 2017 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 2018 and fiscal 2017. For fiscal 2018, other expenses also reflect a one-time expense of $32.6 million related to the termination of certain license agreements. In addition, the combined acquisitions of HROI and Lessor contributed approximately 5% to the total expense growth for fiscal 2018 compared to fiscal 2017. The acquisition of Paychex Advance contributed approximately 1% to the growth in total expenses for fiscal 2017.

Operating income: Operating income increased 4% to $1.3 billion for fiscal 2018 and 8% to $1.2 billion for fiscal 2017. The fluctuations in operating income were attributable to the factors previously discussed. Operating income, as a percent of total revenue, was 38.1%, 39.3%, and 38.8% for the fiscal years 2018, 2017, and 2016, respectively. Adjusted operating income increased 6% to $1.3 billion for fiscal 2018 and 8% to $1.2 billion for fiscal 2017. See the “Non-GAAP Financial Measures” section of this Item 7 for further discussion of this non-GAAP measure.

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 66% for fiscal 2018 primarily due to higher average interest rates earned. The increase in average investment balances for fiscal 2018 was the result of higher net income partially offset by share repurchases, business acquisitions, and an increase in the rate for quarterly dividend payments. 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.

Income taxes: Our effective income tax rate was 28.0% for fiscal 2018 and was 34.3% for both fiscal 2017 and fiscal 2016. The effective income tax rate for fiscal 2018 was significantly impacted by the Tax Act. As a result of the Tax Act, we recorded a non-recurring net tax benefit of $25.5 million for fiscal 2018 for the revaluation of our net deferred tax liabilities. This amount impacted diluted earnings per share by approximately $0.07 per share for fiscal 2018. In addition, as it relates to the Tax Act, our effective income tax rate for fiscal 2018 benefited from a reduced statutory tax rate applied to our current year taxable income. The effective income tax rates were impacted by additional discrete tax items recognized during fiscal 2018, 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 $0.04 per diluted share for fiscal 2018 and $0.05 per diluted share for fiscal 2017. During fiscal 2018, we recognized a tax benefit as a result of the termination of certain license agreements, which increased diluted earnings per share by approximately $0.02 per diluted share. During fiscal 2016, we recognized a net tax benefit on income derived in prior tax years related to customer-facing software that we produced which increased diluted earnings per share by approximately $0.06 per diluted share. Additional discrete tax items recognized during each respective period are insignificant. Refer to Note K 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 increased 14% to $933.7 million for fiscal 2018 and 8% to $817.3 million for fiscal 2017. Diluted earnings per share increased 15% to $2.58 per diluted share for fiscal 2018 and 8% to $2.25 per diluted share for fiscal 2017. These fluctuations were attributable to the factors previously discussed. Adjusted net income increased 15% to $920.0 million for fiscal 2018 and increased 9% to $799.0 million for fiscal 2017. Adjusted diluted earnings per share was $2.55 per diluted share for fiscal 2018 and $2.20 per diluted share for fiscal 2017, reflecting increases of 16% and 8%, respectively. Refer to the “Non-GAAP Financial Measures” section that follows for a discussion of these non-GAAP measures.

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

$ in millions		2018(5)			Change			2017			Change			2016
Operating income		$	1,287.5		4	%		$	1,239.6		8	%		$	1,146.6
Non-GAAP adjustments:
Termination of license agreements(1)			32.6						—						—
Total non-GAAP adjustments			32.6						—						—
Adjusted operating income		$	1,320.1		6	%		$	1,239.6		8	%		$	1,146.6
Net income		$	933.7		14	%		$	817.3		8	%		$	756.8
Non-GAAP adjustments:
Excess tax benefit related to employee stock-based compensation payments(2)			(12.9)						(18.3)						—
Net tax benefit on income derived from prior tax years for customer-facing software(3)			—						—						(21.1)
Revaluation of net deferred tax liabilities(4)			(25.5)						—						—
Termination of license agreements(1)			24.7						—						—
Total non-GAAP adjustments			(13.7)						(18.3)						(21.1)
Adjusted net income		$	920.0		15	%		$	799.0		9	%		$	735.7
Diluted earnings per share		$	2.58		15	%		$	2.25		8	%		$	2.09
Non-GAAP adjustments:
Excess tax benefit related to employee stock-based compensation payments(2)			(0.04)						(0.05)						—
Net tax benefit on income derived from prior tax years for customer-facing software(3)			—						—						(0.06)
Revaluation of net deferred tax liabilities(4)			(0.07)						—						—
Termination of license agreements(1)			0.07						—						—
Total non-GAAP adjustments			(0.04)						(0.05)						(0.06)
Adjusted diluted earnings per share		$	2.55		16	%		$	2.20		8	%		$	2.03

	(1)		Additional expense and corresponding tax benefit recognized as a result of the termination of certain license agreements. This event is not expected to recur.

	(2)		Net tax windfall or shortfall benefits related to employee stock-based compensation payments recognized in income taxes. 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 within the control of management.

	(3)		Non-recurring net tax benefit recognized on income derived in prior tax years related to customer-facing software that we produced.

	(4)		Non-recurring tax benefits recognized as a result of the Tax Act related to the revaluation of net deferred tax liabilities.

	(5)		The calculation of the impact of non-GAAP adjustments on diluted earnings per share is performed on each line independently. The table above may not add down by +/- $0.01 due to rounding.

In addition to reporting operating income, net income, and diluted earnings per share, which are U.S. GAAP measures, we present adjusted operating income, adjusted net income, and adjusted diluted earnings per share, which are non-GAAP measures. We believe adjusted operating income, 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 operating income, 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 Securities and Exchange Commission (“SEC”). As such, they should not be considered as a substitute for the GAAP measures of operating income, 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, 2018 remained strong with cash and total corporate investments of $719.7 million and no debt. We believe that our investments in an unrealized loss position as of May 31, 2018 were not other-than-temporarily impaired, nor has any event occurred subsequent to that date to indicate any other-than-temporary impairment. We anticipate that cash and total corporate investments as of May 31, 2018, along with projected operating cash flows and available short-term financing, will support our normal business operations, capital purchases, business acquisitions, if any, share repurchases, and dividend payments for the foreseeable future.

Short-Term Financing

We maintain credit facilities, letters of credit, and lines of credit as part of our normal and recurring business operations.

Credit Facilities: We maintain three committed, unsecured credit facilities as follows:

Bank		Borrower (1)		Date Entered		Expiration Date		Maximum Amount Available		Purpose
JP Morgan Chase Bank, N.A.(2)		Paychex of New York, LLC		August 5, 2015		August 5, 2020		$1 Billion		To meet short-term funding requirements.
JP Morgan Chase Bank, N.A.(2)		Paychex of New York, LLC		August 17, 2017		August 17, 2022		$500 Million		To meet short-term funding requirements.
PNC Bank, National Association (“PNC”)		Paychex Advance, LLC		March 17, 2016		March 17, 2020		$150 Million		To finance working capital needs and general corporate purposes.

	(1)		Borrower is a wholly owned subsidiary of the Company.

	(2)		JP Morgan Chase Bank, N.A. (“JPM”) acts as the administrative agent for this syndicated credit facility.

For all credit facilities, obligations under any facility are guaranteed by the Company and certain of its subsidiaries and will

bear interest at competitive rates based on options provided to the borrower. Upon the expiration date, any borrowings outstanding will mature and be payable on such date.

JPM $1 Billion Credit Facility: There were no borrowings outstanding under this credit facility as of May 31, 2018. Details of borrowings under this credit facility are as follows:

		Year ended May 31,
$ in millions		2018				2017
Number of days borrowed			22				30
Maximum amount borrowed		$	700.0			$	450.0
Weighted-average amount borrowed		$	319.1			$	196.7
Weighted-average interest rate			4.27	%			2.89	%

We typically borrow on an overnight basis. In addition to overnight borrowings, we also borrowed:

	·		Fiscal 2018 - $100.0 million for a three-day period at a weighted-average interest rate of 4.25%;

	·		Fiscal 2017 - $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%.

Subsequent to May 31, 2018, we borrowed two times, on an overnight basis, $171.8 million on a weighted-average basis

under this line.

JPM $500 Million Credit Facility: There were no borrowings outstanding under this credit facility as of May 31, 2018. Details of borrowings under this credit facility are as follows:

		Year ended May 31,
$ in millions		2018
Number of days borrowed			42
Maximum amount borrowed		$	400.0
Weighted-average amount borrowed		$	144.8
Weighted-average interest rate			2.80	%

In addition to overnight borrowings, during fiscal 2018, we borrowed $300.0 million for seven days and $75.0 million for 30 days at weighted average LIBOR-based interest rates of 2.13% and 2.19%, respectively. Subsequent to May 31, 2018, we borrowed three times, on an overnight basis, $103.5 million on a weighted-average basis under this line.

PNC $150 Million Credit Facility: There were no borrowings outstanding under this credit facility as of May 31, 2018. Details of borrowings under this credit facility are as follows:

		Year ended May 31,
$ in millions		2018				2017
Number of days borrowed			358				353
Maximum amount borrowed		$	59.9			$	55.6
Weighted-average amount borrowed		$	57.2			$	52.8
Weighted-average interest rate			1.94	%			1.21	%

Subsequent to May 31, 2018, we borrowed approximately $56.8 million under this line, which remains outstanding as of the date of this report.

All of our credit facilities contain various financial and operational covenants that are usual and customary for such arrangements. We were in compliance with all of these covenants as of May 31, 2018.

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.

Letters of credit: As of May 31, 2018, we had irrevocable standby letters of credit available totaling $56.8 million, required to secure commitments for certain insurance policies. The letters of credit expire at various dates between July 2018 and May 2019. No amounts were outstanding on these letters of credit during fiscal 2018 or as of May 31, 2018. Subsequent to May 31, 2018, the letter of credit expiring in July 2018 was renewed through July 2019, and the total amount available under the letters of credit was increased $4.1 million to $60.9 million.

Lines of credit: Effective August 17, 2017, we terminated four uncommitted, secured, short-term lines of credit totaling $900.0 million. The lines of credit were available to us at market rates of interest and were primarily used to meet short-term funding requirements related to deposit account overdrafts and client fund obligations arising from electronic payment transactions made on behalf of our clients in the ordinary course of business. There were no amounts outstanding under these lines of credit during fiscal 2018 or as of May 31, 2018. We do not have any other open lines of credit as of the date of this report.

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, 2018. The table below summarizes our estimated annual payment obligations under these commitments as of May 31, 2018:

		Payments due by period
					Less than									More than
In millions		Total			1 year			1-3 years			4-5 years			5 years
Operating leases(1)		$	110.1		$	35.1		$	46.6		$	19.6		$	8.8
Purchase obligations(2)			130.2			83.9			45.2			1.1			—
Total		$	240.3		$	119.0		$	91.8		$	20.7		$	8.8

	(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 $6.7 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 $14.7 million as of May 31, 2018. Refer to Note K 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 $84.8 million as of May 31, 2018 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 $4.2 million has been contributed as of May 31, 2018. 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.

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.

In August 2017, we announced our plan for a new multi-building Paychex campus based in Rochester, NY. This involves the purchase of five buildings and the renovation of over 300,000 square feet of existing space for an estimated cost of $60.0 million. We completed the purchase of these buildings during the three months ended November 30, 2017, for a combined cost of approximately $34.7 million and placed approximately $16.0 million in escrow for the building renovations, which are in-process. Renovations on the buildings purchased are in-process, and are expected to be substantially completed during the fiscal year ending May 31, 2019. In addition, in September 2017, we entered into a transaction with the County of Monroe Industrial Development Agency for purposes of obtaining public benefits and inducements, expiring on December 31, 2039. The public inducements include exemption from sales and use taxes for goods and services directly related to the renovations of the new multi-building campus.

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 represented less than one percent of our total assets as of May 31, 2018.

Operating Cash Flow Activities

		Year ended May 31,
In millions		2018			2017			2016
Net income		$	933.7		$	817.3		$	756.8
Non-cash adjustments to net income			270.7			257.0			234.9
Cash provided by/(used in) changes in operating assets and liabilities			72.0			(113.9)			26.5
Net cash provided by operating activities		$	1,276.4		$	960.4		$	1,018.2

The increase in our operating cash flows for fiscal 2018 compared to fiscal 2017 is the result of higher net income and adjustments for non-cash items, and an increase in cash provided by fluctuations in our operating assets and liabilities. The increase in net income in fiscal 2018 was impacted by the enactment of the Tax Act. The decrease in operating cash flows for fiscal 2017 compared to fiscal 2016 is primarily the result of net 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 non-cash adjustments for fiscal 2018 and for fiscal 2017 was largely due to higher depreciation expense related to an increase in internally developed software placed in service over the last three years. The fluctuations in our operating assets and liabilities between all periods were impacted by 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		2018			2017			2016
Net change in funds held for clients and corporate investments		$	(304.8)		$	(321.7)		$	339.7
Purchases of property and equipment			(154.0)			(94.3)			(97.7)
Acquisition of businesses, net of cash acquired			(180.4)			—			(296.1)
Purchases of other assets			(39.8)			(8.6)			(9.0)
Net cash used in investing activities		$	(679.0)		$	(424.6)		$	(63.1)

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 investments are largely due to timing within the client funds portfolio. Specific timing impacting cash flows for fiscal years 2018, 2017, and 2016 are discussed further in the financing cash flows discussion of net changes in client fund obligations. Fiscal 2018 and 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. 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 2018, 2017, and 2016, we purchased approximately $0.5 million, $0.6 million, and $4.9 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.

The net cash outflow for purchases of property and equipment during fiscal 2018 includes the purchase of five buildings and ongoing renovations of over 300,000 square feet of existing space in Rochester, NY. This new multi-building Paychex campus, announced in August 2017, will result in the consolidation of current leased space in the Rochester area.

Acquisition of businesses, net of cash acquired, reflects our acquisitions of Lessor in February 2018, our acquisition of HROI in August 2017, and our acquisition of Advance Partners in December 2015. The Lessor and Advance Partners acquisition consideration was cash while the HROI acquisition was a combination of cash and common stock.

Purchases of other assets relates primarily to client list acquisitions. During fiscal 2018, we resolved a contractual dispute with certain licensees. As it relates to this agreement, we acquired rights to certain client lists for approximately $30.0 million.

Financing Cash Flow Activities

		Year ended May 31,
In millions, except per share amounts		2018			2017			2016
Net change in client fund obligations		$	462.4		$	317.3		$	(304.8)
Dividends paid			(739.7)			(662.3)			(606.5)
Repurchases of common shares			(143.1)			(166.2)			(107.9)
Activity related to equity-based plans			(3.4)			28.5			25.6
Net cash used in financing activities		$	(423.8)		$	(482.7)		$	(993.6)
Cash dividends per common share		$	2.06		$	1.84		$	1.68

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, 2018 fell on a Thursday, which is a significant collection day for direct pay funds. These funds were then paid out on Friday June 1, 2018. 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. In addition, May 31, 2016 was a Tuesday, a larger cash outflow day due to clearing of Readychex and tax payments.

Dividends paid: In April 2018 and July 2017, our Board increased our quarterly dividend to shareholders by 12% to $0.56 per share from $0.50 per share, and by 9% to $0.50 per share from $0.46 per share, respectively. The dividends paid as a percentage of net income totaled 79%, 81%, and 80% for fiscal years 2018, 2017, and 2016, 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”). The purpose of the July 2016 Program is to manage common stock dilution. During fiscal 2018, we repurchased 2.5 million shares for a total of $143.1 million. During fiscal 2017, we repurchased 2.9 million shares for a total of $166.2 million. Of the shares repurchased during fiscal 2017, $59.7 million was repurchased under a previously authorized common stock repurchase program. During fiscal 2016, we purchased 2.2 million shares for a total of $107.9 million, all under the previously authorized common stock repurchase program. Shares repurchased were retired.

Activity related to equity-based plans: The decrease in cash flows related to stock-based awards for fiscal 2018 compared to fiscal 2017 and the increase for fiscal 2017 compared to fiscal 2016 were 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 0.6 million shares, 1.4 million shares, and 0.9 million shares for fiscal years 2018, 2017, and 2016, 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, 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 primarily include payroll wages, payroll taxes, and certain benefit premiums. Direct costs related to certain benefit plans where we retain risk are recognized 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 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 2018, it was determined that the Company has three reporting units. A qualitative analysis was performed for all reporting units in fiscal 2018, to determine if it is more-likely-than-not that the fair value of the reporting units had declined below its carrying value. The qualitative 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 2018, 2017, or 2016. 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.

Impairment of Long-Lived Assets: Long-lived assets, including intangible assets with finite lives, are reviewed for impairment when events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to estimated undiscounted future cash flows expected to be generated by the asset. If the carrying amount of an asset exceeds its estimated future cash flows, an impairment charge is recognized for the amount by which the carrying amount of the asset exceeds the estimated fair value of the asset. We have determined that there is no impairment of long-lived assets for the fiscal 2018, 2017, or 2016.

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 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 fiscal 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.

The Tax Act enacted in December 2017 was the most comprehensive tax reform legislation approved in more than two decades and makes broad and complex changes to the U.S. federal corporate income taxation, including, but not limited to: (i) reducing the statutory corporate tax rate from 35% to 21% (a blended statutory tax rate of 29.2% for fiscal 2018); (ii) creating new or furthering limitations to the deductibility of officer compensation, interest, meals, entertainment, and other expenses; and (iii) changing from a worldwide to a territorial taxation system. As a result of the Tax Act, we made a one-time revaluation of our net deferred tax liabilities and made a change in the Company’s annual effective income tax rate applied to income before income taxes for the first six months of fiscal 2018.

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 its 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 K 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.