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Table of Contents

 
 
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended November 30, 2009
Commission file number 0-11330
 
PAYCHEX, INC.
911 Panorama Trail South
Rochester, New York 14625-2396
(585) 385-6666
A Delaware Corporation
IRS Employer Identification Number: 16-1124166
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes þ No o
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes þ No o
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):
             
Large accelerated filer þ   Accelerated filer o   Non-accelerated filer o   Smaller reporting company o
        (Do not check if a smaller reporting company)    
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No þ
The number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date:
     
Common Stock, $0.01 Par Value   361,406,822 Shares
     
CLASS   OUTSTANDING AS OF NOVEMBER 30, 2009
 
 

 


TABLE OF CONTENTS

PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
Item 3. Quantitative and Qualitative Disclosure About Market Risk
Item 4. Controls and Procedures
PART II. OTHER INFORMATION
Item 4. Submission of Matters to a Vote of Security Holders
Item 6. Exhibits
SIGNATURES
EX-31.1
EX-31.2
EX-32.1
EX-32.2
EX-101 INSTANCE DOCUMENT
EX-101 SCHEMA DOCUMENT
EX-101 CALCULATION LINKBASE DOCUMENT
EX-101 LABELS LINKBASE DOCUMENT
EX-101 PRESENTATION LINKBASE DOCUMENT
EX-101 DEFINITION LINKBASE DOCUMENT


Table of Contents

PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
PAYCHEX, INC.
CONSOLIDATED STATEMENTS OF INCOME (UNAUDITED)

In thousands, except per share amounts
                                 
 
    For the three months ended     For the six months ended  
    November 30,     November 30,  
    2009     2008     2009     2008  
 
Revenue:
                               
Service revenue
  $ 483,024     $ 504,383     $ 969,515     $ 1,014,250  
Interest on funds held for clients
    13,552       19,777       27,275       43,995  
     
Total revenue
    496,576       524,160       996,790       1,058,245  
 
                               
Expenses:
                               
Operating expenses
    162,648       170,675       325,994       339,143  
Selling, general and administrative expenses
    140,863       141,585       287,864       285,617  
     
Total expenses
    303,511       312,260       613,858       624,760  
     
 
                               
Operating income
    193,065       211,900       382,932       433,485  
 
                               
Investment income, net
    1,147       1,932       2,052       4,983  
     
Income before income taxes
    194,212       213,832       384,984       438,468  
 
                               
Income taxes
    68,362       73,590       135,514       149,517  
     
Net income
  $ 125,850     $ 140,242     $ 249,470     $ 288,951  
     
 
                               
Basic earnings per share
  $ 0.35     $ 0.39     $ 0.69     $ 0.80  
 
                               
Diluted earnings per share
  $ 0.35     $ 0.39     $ 0.69     $ 0.80  
 
                               
Weighted-average common shares outstanding
    361,392       360,812       361,288       360,710  
 
                               
Weighted-average common shares outstanding, assuming dilution
    361,692       360,977       361,515       360,998  
 
                               
Cash dividends per common share
  $ 0.31     $ 0.31     $ 0.62     $ 0.62  
 
See Notes to Consolidated Financial Statements.

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PAYCHEX, INC.
CONSOLIDATED BALANCE SHEETS (UNAUDITED)

In thousands, except per share amount
                       
 
    November 30,     May 31,  
    2009     2009  
 
ASSETS
               
Cash and cash equivalents
  $   225,304     $ 472,769  
Corporate investments
    62,011       19,710  
Interest receivable
    29,107       27,722  
Accounts receivable, net of allowance for doubtful accounts
    221,711       177,958  
Deferred income taxes
          10,180  
Prepaid income taxes
          2,198  
Prepaid expenses and other current assets
    27,958       27,913  
       
Current assets before funds held for clients
    566,091       738,450  
Funds held for clients
    2,996,115       3,501,376  
       
Total current assets
    3,562,206       4,239,826  
Long-term corporate investments
    317,430       82,234  
Property and equipment, net of accumulated depreciation
    262,024       274,530  
Intangible assets, net of accumulated amortization
    71,478       76,641  
Goodwill
    421,559       433,316  
Deferred income taxes
    18,488       16,487  
Other long-term assets
    3,947       4,381  
       
Total assets
  $4,657,132     $ 5,127,415  
       
 
               
LIABILITIES
               
Accounts payable
  $     36,494     $ 37,334  
Accrued compensation and related items
    136,777       135,064  
Deferred revenue
    2,516       9,542  
Accrued income taxes
    1,739        
Deferred income taxes
    23,683       17,159  
Litigation reserve
    20,396       20,411  
Other current liabilities
    42,138       44,704  
       
Current liabilities before client fund obligations
    263,743       264,214  
Client fund obligations
    2,922,986       3,437,679  
       
Total current liabilities
    3,186,729       3,701,893  
Accrued income taxes
    26,580       25,730  
Deferred income taxes
    7,743       12,773  
Other long-term liabilities
    43,890       45,541  
       
Total liabilities
    3,264,942       3,785,937  
 
               
COMMITMENTS AND CONTINGENCIES — NOTE H
               
 
               
STOCKHOLDERS’ EQUITY
               
Common stock, $0.01 par value; Authorized: 600,000 shares;
Issued and outstanding: 361,407 shares as of November 30, 2009
and 360,976 shares as of May 31, 2009, respectively
    3,614       3,610  
Additional paid-in capital
    485,853       466,427  
Retained earnings
    853,084       829,501  
Accumulated other comprehensive income
    49,639       41,940  
       
Total stockholders’ equity
    1,392,190       1,341,478  
       
Total liabilities and stockholders’ equity
  $4,657,132     $ 5,127,415  
       
 
 
See Notes to Consolidated Financial Statements.

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Table of Contents

PAYCHEX, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)

In thousands
                 
 
    For the six months ended
    November 30,
    2009     2008  
 
OPERATING ACTIVITIES
               
Net income
  $ 249,470     $ 288,951  
Adjustments to reconcile net income to net cash provided by operating activities:
               
Depreciation and amortization on property and equipment and intangible assets
    43,313       41,678  
Amortization of premiums and discounts on available-for-sale securities
    16,801       11,940  
Stock-based compensation costs
    13,310       13,942  
Provision for deferred income taxes
    4,263       13,089  
Provision for allowance for doubtful accounts
    1,958       1,084  
Net realized gains on sales of available-for-sale securities
    (1,014 )     (705 )
Changes in operating assets and liabilities:
               
Interest receivable
    (1,385 )     4,644  
Accounts receivable
    (44,641 )     (35,836 )
Prepaid expenses and other current assets
    1,665       5,501  
Accounts payable and other current liabilities
    (1,422 )     (18,712 )
Net change in other assets and liabilities
    (3,147 )     2,809  
     
Net cash provided by operating activities
    279,171       328,385  
 
               
INVESTING ACTIVITIES
               
Purchases of available-for-sale securities
    (756,826 )     (16,284,599 )
Proceeds from sales and maturities of available-for-sale securities
    284,071       17,493,183  
Net change in funds held for clients’ money market securities and other cash equivalents
    697,664       (820,736 )
Purchases of property and equipment
    (23,091 )     (39,207 )
Proceeds from sale of business
    13,050        
Purchases of other assets
    (9,168 )     (13,445 )
     
Net cash provided by investing activities
    205,700       335,196  
 
               
FINANCING ACTIVITIES
               
Net change in client fund obligations
    (514,693 )     (279,002 )
Dividends paid
    (224,234 )     (223,840 )
Proceeds from and excess tax benefit related to exercise of stock options
    6,591       5,657  
     
Net cash used in financing activities
    (732,336 )     (497,185 )
     
 
               
(Decrease)/increase in cash and cash equivalents
    (247,465 )     166,396  
Cash and cash equivalents, beginning of period
    472,769       164,237  
     
Cash and cash equivalents, end of period
  $ 225,304     $ 330,633  
     
 
 
See Notes to Consolidated Financial Statements.

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PAYCHEX, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
November 30, 2009
Note A: Description of Business and Significant Accounting Policies
Description of business: Paychex, Inc. and its wholly owned subsidiaries (collectively, the “Company” or “Paychex”) is a leading provider of payroll, human resource, and benefits outsourcing solutions for small- to medium-sized businesses in the United States (“U.S.”). The Company also has a subsidiary in Germany.
Paychex, a Delaware corporation formed in 1979, reports as one segment. Substantially all of the Company’s revenue is generated within the U.S. The Company also generates revenue within Germany, which was less than one percent of its total revenue for the six months ended November 30, 2009 and 2008. Long-lived assets in Germany are insignificant in relation to total long-lived assets of the Company as of November 30, 2009 and May 31, 2009.
Basis of presentation: The accompanying Consolidated Financial Statements have been prepared in accordance with U.S. generally accepted accounting principles (“GAAP”) for interim financial information and with the instructions to the Quarterly Report on Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by GAAP for complete financial statement presentation. The Consolidated Financial Statements include the consolidated accounts of the Company with all significant intercompany transactions eliminated. In the opinion of management, the information furnished herein reflects all adjustments (consisting of items of a normal recurring nature), which are necessary for a fair presentation of the results for the interim period. These financial statements should be read in conjunction with the Company’s Consolidated Financial Statements and related Notes to Consolidated Financial Statements presented in the Company’s Annual Report on Form 10-K as of and for the year ended May 31, 2009 (“fiscal 2009”). Operating results and cash flows for the six months ended November 30, 2009 are not necessarily indicative of the results that may be expected for other interim periods or the full fiscal year ending May 31, 2010 (“fiscal 2010”). The Company has evaluated subsequent events for potential recognition and/or disclosure through December 16, 2009, the date of issuance of these financial statements.
PEO revenue recognition: Professional Employer Organization (“PEO”) revenue is included in service revenue and is reported net of direct costs billed and incurred which include wages, taxes, benefit premiums, and claims of PEO worksite employees. Direct costs billed and incurred were $730.7 million and $637.4 million for the three months ended November 30, 2009 and 2008, respectively, and $1.4 billion and $1.3 billion for the six months ended November 30, 2009 and 2008, respectively.
PEO workers’ compensation insurance: Workers’ compensation insurance for PEO worksite employees is provided under a deductible workers’ compensation policy with a national insurance company. Claims are paid as incurred and the Company’s maximum individual claims liability is $1.0 million under both its fiscal 2010 and fiscal 2009 policies.

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Note A: Description of Business and Significant Accounting Policies — continued
The Company has recorded the following amounts on its Consolidated Balance Sheets for workers’ compensation claims as of:
                 
   
    November 30,     May 31,  
In thousands   2009     2009  
 
Prepaid expense
  $ 2,746     $ 2,500  
Current liability
  $ 7,072     $ 7,911  
Long-term liability
  $ 17,978     $ 17,881  
 
The amounts included in prepaid expense on the Consolidated Balance Sheets relate to the policy for the fiscal year ended May 31, 2004, which was a pre-funded policy.
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. Adjustments to previously established reserves are reflected in the results of operations for the period in which the adjustment is identified. Such adjustments could possibly be significant, reflecting any variety of new and adverse or favorable trends.
Stock-based compensation costs: The Company has issued stock-based awards to employees consisting of stock options, restricted stock awards, and restricted stock units (“RSUs”). Grants approved by the Company’s Board of Directors (the “Board”) were as follows:
                                 
 
    For the six months ended  
    November 30,
    2009     2008  
            Weighted-             Weighted-  
            average             average  
    Shares     fair value     Shares     fair value  
In thousands, except per share amounts   granted     per share     granted     per share  
 
Stock options
    1,248     $ 4.32       783     $ 6.90  
Restricted stock
    153     $ 24.60       137     $ 31.86  
RSUs
    567     $ 20.62       607     $ 28.30  
 
The Company accounts for all stock-based awards to employees and directors as compensation costs in the Consolidated Financial Statements based on the fair value measured as of the date of grant. These costs are recognized as an expense in the Consolidated Statements of Income over the requisite service period and increase additional paid-in capital. Stock-based compensation costs recognized were $6.6 million and $13.3 million for the three and six months ended November 30, 2009, as compared with $7.0 million and $13.9 million for the respective prior year periods. As of November 30, 2009, the total unrecognized compensation cost related to all unvested stock-based awards was $63.7 million and is expected to be recognized over a weighted-average period of 2.1 years.

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Note A: Description of Business and Significant Accounting Policies — continued
The fair value of restricted stock awards is equal to the closing market price of the underlying common stock as of the date of grant. The fair value of RSUs is equal to the closing market price of the underlying common stock as of the date of grant, adjusted for the present value of expected dividends over the vesting period, as these awards do not earn dividend equivalents.
The fair value of stock option grants is estimated as of the date of grant using a Black-Scholes option pricing model. The weighted-average assumptions used for valuation under the Black-Scholes model were as follows:
                                 
 
        For the six months ended
        November 30,
            2009     2008  
 
Risk-free interest rate
            3.0 %     3.3 %
Dividend yield
            4.5 %     3.4 %
Volatility factor
                .28       .28  
Expected option life in years
                6.3       6.4  
 
Risk-free interest rates are yields for zero-coupon U.S. Treasury notes maturing approximately at the end of the expected option life. The estimated volatility factor is based on a combination of historical volatility using weekly stock prices and implied market volatility, both over a period equal to the expected option life. The expected option life is based on historical exercise behavior.
The Company has determined that the Black-Scholes option pricing model, as well as the underlying assumptions used in its application, is appropriate in estimating the fair value of its stock option grants. The Company periodically assesses its assumptions as well as its 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.
Newly adopted accounting pronouncements: On June 1, 2009, the Company adopted Statement of Financial Accounting Standard (“SFAS”) No. 141 (revised 2007) (“SFAS No. 141R”), “Business Combinations.” SFAS No. 141R provides guidance on how an entity recognizes and measures the identifiable assets acquired (including goodwill), liabilities assumed, and noncontrolling interests, if any, acquired in a business combination. SFAS No. 141R also requires that acquisition-related costs and costs associated with restructuring or exiting activities of an acquired entity be expensed as incurred. The Company cannot anticipate if the adoption of SFAS No. 141R will have a material effect on its results of operations or financial position as the impact is solely dependent on whether the Company enters into any business combination, and the terms of any such transaction.
On June 1, 2009, the Company adopted SFAS No. 165, “Subsequent Events.” This statement establishes guidance related to accounting for and disclosure of events that happen after the date of the balance sheet but before the release of the financial statements. The adoption of this statement had no material effect on the Company’s results of operations or financial position.

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Note A: Description of Business and Significant Accounting Policies — continued
On June 1, 2009, the Company adopted Financial Accounting Standards Board (“FASB”) Staff Position (“FSP”) No. FAS 142-3, “Determination of the Useful Life of Intangible Assets.” This FSP amends the factors that should be considered in developing renewal or extension assumptions used to determine the useful life of a recognized intangible asset. The adoption of this FSP had no material effect on the Company’s results of operations or financial position.
On June 1, 2009, the Company adopted the following three FSPs which provide additional accounting guidance and enhanced disclosures regarding fair value measurements and impairments of debt securities:
    FSP No. FAS 107-1 and APB 28-1, “Interim Disclosures about Fair Value of Financial Instruments,” requiring publicly traded companies to disclose the fair value of financial instruments in interim financial statements;
 
    FSP No. FAS 157-4, “Determining Fair Value When the Volume and Level of Activity for the Asset or Liability Have Significantly Decreased and Identifying Transactions That Are Not Orderly,” providing guidance for determining fair value when there is no active market or where price inputs being used represent distressed sales; and
 
    FSP No. FAS 115-2 and FAS 124-2, “Recognition and Presentation of Other-Than-Temporary Impairments,” providing guidance for measurement and recognition of impaired debt securities along with expanded disclosures with respect to impaired debt securities.
The adoption of these FSPs did not have a material effect on the Company’s results of operations or financial position. Refer to Notes C and D of the Notes to Consolidated Financial Statements for additional disclosures related to these FSPs.
On September 1, 2009, the Company adopted SFAS No. 168, “The FASB Accounting Standards CodificationTM and the Hierarchy of Generally Accepted Accounting Principles — a replacement of FASB Statement No. 162” (the “Codification”). The Codification, released on July 1, 2009, became the single source of authoritative non-governmental U.S. GAAP. The Codification eliminates the GAAP hierarchy contained in SFAS No. 162 and establishes one level of authoritative GAAP.
On September 1, 2009, the Company adopted Accounting Standards Update (“ASU”) No. 2009-05, “Fair Value Measurements and Disclosures (Topic 820) — Measuring Liabilities at Fair Value.” ASU No. 2009-05 provides guidance for measuring the fair value of a liability in circumstances in which a quoted price in an active market for an identical liability may not be available. The adoption of this ASU had no material effect on the Company’s results of operations or financial position.
In August and September 2009, the Company adopted the following ASUs, neither of which had a material effect on its results of operations or financial position:
    ASU No. 2009-03, “SEC Update — Amendments to Various Topics Containing SEC Staff Accounting Bulletins”; and
 
    ASU No. 2009-07, “Accounting for Various Topics — Technical Corrections to SEC Paragraphs.”

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Note A: Description of Business and Significant Accounting Policies — continued
Recently issued accounting pronouncements: In June 2009, the FASB issued the following statements:
    SFAS No. 166, “Accounting for Transfers of Financial Assets — an amendment of FASB Statement No. 140.” SFAS No. 166 makes several amendments to Codification Topic 860, Transfers and Servicing, including the removal of the concept of a qualifying special purpose entity; and
 
    SFAS No. 167, “Amendments to FASB Interpretation No. 46(R).” SFAS No. 167 will require a qualitative rather than a quantitative analysis to determine the primary beneficiary of a variable interest entity for consolidation purposes.
Both standards are effective for annual periods beginning after November 15, 2009, and are applicable to the Company’s fiscal year beginning June 1, 2010. The Company does not expect the adoption of these standards to have a material effect on its results of operations or financial position.
In October 2009, the FASB issued ASU No. 2009-13, “Revenue Recognition (Topic 605) — Multiple-Deliverable Revenue Arrangements — a consensus of the FASB Emerging Issues Task Force.” ASU No. 2009-13 amends accounting guidance related to revenue recognition for arrangements with multiple deliverables and related disclosure requirements. This ASU is effective prospectively for revenue arrangements entered into or materially modified in fiscal years beginning on or after June 15, 2010, with early adoption permitted, and is applicable to the Company’s fiscal year beginning June 1, 2011. The Company is currently evaluating the impact, if any, that the adoption of this ASU will have on its results of operations and financial position.
In October 2009, the FASB issued ASU No. 2009-14, “Software (Topic 985) — Certain Revenue Arrangements That Include Software Elements — a consensus of the FASB Emerging Issues Task Force.” ASU No. 2009-14 eliminates tangible products containing both software and non-software components that operate together to deliver a product’s functionality from the scope of current GAAP for software. This ASU is effective for arrangements entered into or materially modified in fiscal years that start on or after June 15, 2010 and is applicable to the Company’s fiscal year beginning June 1, 2011. The Company is currently evaluating the impact, if any, that the adoption of this ASU will have on its results of operations and financial position.
Other recent accounting pronouncements issued by the FASB (including ASUs), the American Institute of Certified Public Accountants, and the Securities and Exchange Commission did not, or are not, expected to have a material effect on the Company’s results of operations or financial position.

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Note B: Basic and Diluted Earnings Per Share
Basic and diluted earnings per share were calculated as follows:
                                 
 
      For the three months ended     For the six months ended  
    November 30,     November 30,  
In thousands, except per share amounts     2009       2008       2009       2008  
 
Basic earnings per share:
                               
Net income
  $ 125,850     $ 140,242     $ 249,470     $ 288,951  
     
Weighted-average common shares outstanding
    361,392       360,812       361,288       360,710  
     
Basic earnings per share
  $ 0.35     $ 0.39     $ 0.69     $ 0.80  
     
 
                               
Diluted earnings per share:
                               
Net income
  $ 125,850     $ 140,242     $ 249,470     $ 288,951  
     
Weighted-average common shares outstanding
    361,392       360,812       361,288       360,710  
Dilutive effect of common share equivalents at
average market price
    300       165       227       288  
     
Weighted-average common shares outstanding,
assuming dilution
    361,692       360,977       361,515       360,998  
     
Diluted earnings per share
  $ 0.35     $ 0.39     $ 0.69     $ 0.80  
     
Weighted-average anti-dilutive common share equivalents
    13,459       14,035       14,016       12,711  
 
Weighted-average common share equivalents that have an anti-dilutive impact are excluded from the computation of diluted earnings per share.
Shares of the Company’s common stock issued for the three months ended November 30, 2009 and 2008 were minimal. For the six months ended November 30, 2009 and 2008, shares of the Company’s common stock issued for stock option exercises and vesting of restricted stock and RSUs were 0.5 million and 0.3 million, respectively.

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Note C: Funds Held for Clients and Corporate Investments
Funds held for clients and corporate investments consisted of the following:
                                 
    November 30, 2009  
            Gross     Gross        
    Amortized     unrealized     unrealized     Fair  
In thousands   cost     gains     losses     value  
 
Type of issue:
                               
Money market securities and other cash equivalents
  $ 1,118,614     $     $     $ 1,118,614  
Available-for-sale securities:
                               
General obligation municipal bonds
    943,218       40,277       (16 )     983,479  
Pre-refunded municipal bonds(1)
    551,829       23,442             575,271  
Revenue municipal bonds
    347,439       15,129       (66 )     362,502  
Variable rate demand notes(2)
    328,615                   328,615  
Other equity securities
    20       54             74  
     
Total available-for-sale securities
    2,171,121       78,902       (82 )     2,249,941  
Other
    7,441       69       (509 )     7,001  
     
Total funds held for clients and corporate investments
  $ 3,297,176     $ 78,971     $ (591 )   $ 3,375,556  
 
 
    May 31, 2009  
            Gross     Gross        
    Amortized     unrealized     unrealized     Fair  
In thousands   cost     gains     losses     value  
 
Type of issue:
                               
Money market securities and other cash equivalents
  $ 1,816,278     $     $     $ 1,816,278  
Available-for-sale securities:
                               
General obligation municipal bonds
    849,594       32,698       (136 )     882,156  
Pre-refunded municipal bonds(1)
    527,864       21,334       (24 )     549,174  
Revenue municipal bonds
    336,675       12,818       (32 )     349,461  
Variable rate demand notes(2)
                       
Other equity securities
    20       42             62  
     
Total available-for-sale securities
    1,714,153       66,892       (192 )     1,780,853  
Other
    7,477             (1,288 )     6,189  
     
Total funds held for clients and corporate investments
  $ 3,537,908     $ 66,892     $ (1,480 )   $ 3,603,320  
 
 
(1)   Pre-refunded municipal bonds are secured by an escrow fund of U.S. government obligations.
 
(2)   For the first time since September 2008, the Company began to invest in variable rate demand notes (“VRDNs”) beginning in November 2009.

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Note C: Funds Held for Clients and Corporate Investments — continued
Included in money market securities and other cash equivalents as of November 30, 2009 and May 31, 2009 are U.S. agency discount notes, government money market funds, and bank demand deposit accounts.
Classification of investments on the Consolidated Balance Sheets is as follows:
                 
    November 30,     May 31,  
In thousands   2009     2009  
 
Funds held for clients
  $2,996,115     $ 3,501,376  
Corporate investments
    62,011       19,710  
Long-term corporate investments
    317,430       82,234  
       
Total funds held for clients and corporate investments
  $3,375,556     $ 3,603,320  
 
The Company is exposed to credit risk in connection with these investments through the possible inability of borrowers to meet the terms of their bonds. In addition, the Company is exposed to interest rate risk, as rate volatility will cause fluctuations in the fair value of held investments and in the earnings potential of future investments. The Company maintains a conservative investment strategy of maximizing liquidity and protecting principal. The Company invests primarily in high credit quality securities with AAA and AA ratings and short-term securities with A-1/P-1 ratings. It limits the amounts that can be invested in any single issuer, and invests in short- to intermediate-term instruments whose fair value is less sensitive to interest rate changes. All the investments held as of November 30, 2009 are traded in active markets. The Company has not and does not utilize derivative financial instruments to manage interest rate risk.
The Company’s available-for-sale securities reflected a net unrealized gain of $78.8 million as of November 30, 2009 compared with a net unrealized gain of $66.7 million as of May 31, 2009. The gross unrealized losses of $0.1 million, included in the net unrealized gain as of November 30, 2009, were comprised of 5 available-for-sale securities, which had a total fair value of $17.1 million. The gross unrealized losses of $0.2 million, included in the net unrealized gain as of May 31, 2009, were comprised of 14 available-for-sale securities, which had a total fair value of $39.4 million.

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Note C: Funds Held for Clients and Corporate Investments - continued
The securities in an unrealized loss position were as follows:
                                                 
    November 30, 2009  
    Less than 12 months     More than 12 months     Total  
    Gross             Gross             Gross        
    unrealized     Fair     unrealized     Fair     unrealized     Fair  
In thousands   loss     value     loss     value     loss     value  
 
Type of issue:
                                               
General obligation municipal bonds
  $ (16 )   $ 8,495     $     $     $ (16 )   $ 8,495  
Revenue municipal bonds
    (66 )     8,598                   (66 )     8,598  
     
Total
  $ (82 )   $ 17,093     $     $     $ (82 )   $ 17,093  
 
 
    May 31, 2009  
    Less than 12 months     More than 12 months     Total  
    Gross             Gross             Gross        
    unrealized     Fair     unrealized     Fair     unrealized     Fair  
In thousands   loss     value     loss     value     loss     value  
 
Type of issue:
                                               
General obligation municipal bonds
  $ (136 )   $ 28,915     $     $     $ (136 )   $ 28,915  
Pre-refunded municipal bonds
    (24 )     4,490                   (24 )     4,490  
Revenue municipal bonds
    (21 )     2,943       (11 )     3,010       (32 )     5,953  
     
Total
  $ (181 )   $ 36,348     $ (11 )   $ 3,010     $ (192 )   $ 39,358  
 
The Company regularly reviews its investment portfolios to determine if any investment is other-than-temporarily impaired due to changes in credit risk or other potential valuation concerns. The Company believes that the investments it held as of November 30, 2009 were not other-than-temporarily impaired. While $17.1 million of available-for-sale securities had fair values that were below amortized cost, the Company believes that it is probable that the principal and interest will be collected in accordance with contractual terms, and that the decline in the fair value to $0.1 million below amortized cost was due to changes in interest rates and was not due to increased credit risk or other valuation concerns. All of the securities in an unrealized loss position as of November 30, 2009 and the majority of the securities in an unrealized loss position as of May 31, 2009 held an AA rating or better. The Company intends to hold these investments until the recovery of their amortized cost basis or maturity, and further believes that it is more-likely-than-not that it will not be required to sell these investments prior to that time. The Company’s assessment that an investment is not other-than-temporarily impaired could change in the future due to new developments or changes in the Company’s strategies or assumptions related to any particular investment.

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Note C: Funds Held for Clients and Corporate Investments — continued
Realized gains and losses on the sales of securities are determined by specific identification of the cost basis of each security. On the Consolidated Statements of Income, realized gains and losses from funds held for clients are included in interest on funds held for clients and realized gains and losses from corporate investments are included in investment income, net. Realized gains and losses were as follows:
                                 
    For the three months ended     For the six months ended  
    November 30,     November 30,  
In thousands   2009     2008     2009     2008  
 
Gross realized gains
  $ 729     $ 540     $ 1,014     $ 840  
Gross realized losses
          (135 )           (135 )
     
Net realized gains
  $ 729     $ 405     $ 1,014     $ 705  
 
The amortized cost and fair value of available-for-sale securities that had stated maturities as of November 30, 2009 are shown below by contractual maturity. Expected maturities can differ from contractual maturities because borrowers may have the right to prepay obligations without prepayment penalties.
                 
    November 30, 2009  
            Fair  
In thousands   Cost     value  
 
Maturity date:
               
Due in one year or less
  $ 270,427     $ 274,999  
Due after one year through three years
    810,854       839,797  
Due after three years through five years
    491,437       524,465  
Due after five years
    598,383       610,606  
     
Total
  $ 2,171,101     $ 2,249,867  
 
VRDNs are primarily categorized as due after five years in the table above as the contractual maturities on these securities are typically 20 to 30 years. Although these securities are issued as long-term securities, they are priced and traded as short-term instruments because of the liquidity provided through the tender feature.
Note D: Fair Value Measurements
The carrying values of cash and cash equivalents, accounts receivable, net of allowance for doubtful accounts, and trade accounts payable approximate fair value due to the short maturities of these instruments. Marketable securities included in funds held for clients and corporate investments consist primarily of securities classified as available-for-sale and are recorded at fair value on a recurring basis.
The accounting standards related to fair value measurements include a hierarchy for information and valuations used in measuring fair value that is broken down into three levels based on reliability, as follows:
    Level 1 valuations are based on quoted prices in active markets for identical instruments that the Company has the ability to access.

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Note D: Fair Value Measurements — continued
    Level 2 valuations are based on quoted prices for similar, but not identical, instruments in active markets; quoted prices for identical or similar instruments in markets that are not active; or other than quoted prices observable inputs.
 
    Level 3 valuations are based on information that is unobservable and significant to the overall fair value measurement.
The following table presents information on the Company’s financial assets and liabilities measured at fair value on a recurring basis as of November 30, 2009:
                                 
            Quoted     Significant        
            prices in     other     Significant  
    Carrying     active     observable     unobservable  
    value     markets     inputs     inputs  
In thousands   (Fair value)     (Level 1)     (Level 2)     (Level 3)  
 
Assets:
                               
Available-for-sale securities:
                               
General obligation municipal bonds
  $ 983,479     $     $ 983,479     $     —  
Pre-refunded municipal bonds
    575,271             575,271        
Revenue municipal bonds
    362,502             362,502        
Variable rate demand notes
    328,615             328,615        
Other equity securities
    74       74              
     
Total available-for-sale securities
  $ 2,249,941     $ 74     $ 2,249,867     $  
Other securities
  $ 7,001     $ 7,001     $     $  
Liabilities:
                               
Other long-term liabilities
  $ 7,014     $ 7,014     $     $  
 
In determining the fair value of its assets and liabilities, the Company predominately uses the market approach. In determining the fair value of its available-for-sale securities, the Company utilizes the Interactive Data Pricing service. Other securities are comprised of mutual fund investments, which are valued based on quoted market prices. Other long-term liabilities include the liability for the Company’s non-qualified and unfunded deferred compensation plans, and are valued based on the quoted market prices for various mutual fund investment choices.
The preceding methods described may produce a fair value calculation that may not be indicative of net realizable value or reflective of future fair values. Furthermore, although the Company believes its valuation methods are appropriate and consistent with other market participants, the use of different methodologies or assumptions to determine the fair value of certain financial instruments could result in a different fair value measurement at the reporting date.

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Note E: Property and Equipment, Net of Accumulated Depreciation
The components of property and equipment, at cost, consisted of the following:
                 
    November 30,     May 31,  
In thousands   2009     2009  
 
Land and improvements
  $ 4,033     $ 4,033  
Buildings and improvements
    83,456       83,386  
Data processing equipment
    184,853       180,448  
Software
    170,117       165,959  
Furniture, fixtures, and equipment
    145,520       143,638  
Leasehold improvements
    88,924       88,509  
Construction in progress
    5,060       4,034  
     
Total property and equipment, gross
    681,963       670,007  
Less: Accumulated depreciation and amortization
    419,939       395,477  
     
Property and equipment, net of accumulated depreciation
  $ 262,024     $ 274,530  
 
Depreciation expense was $16.0 million and $32.4 million for the three and six months ended November 30, 2009, respectively, as compared with $15.6 million and $31.5 million for the three and six months ended November 30, 2008, respectively.
Within construction in progress, there were costs for software being developed for internal use of $3.0 million and $3.4 million as of November 30, 2009 and May 31, 2009, respectively. Capitalization of costs ceases when the software is ready for its intended use, at which time the Company begins amortization of the costs.
Note F: Goodwill and Intangible Assets, Net of Accumulated Amortization
The Company had goodwill balances on its Consolidated Balance Sheets of $421.6 million and $433.3 million as of November 30, 2009 and May 31, 2009, respectively. The decrease in goodwill was due to divesting of Stromberg time and attendance, an immaterial component of the Company.
The Company has certain intangible assets with finite lives. The components of intangible assets, at cost, consisted of the following:
                 
    November 30,     May 31,  
In thousands   2009     2009  
 
Client lists and associate office license agreements
  $ 191,595     $ 194,887  
Other intangible assets
    4,935       5,675  
     
Total intangible assets, gross
    196,530       200,562  
Less: Accumulated amortization
    125,052       123,921  
     
Intangible assets, net of accumulated amortization
  $ 71,478     $ 76,641  
 
Amortization expense relating to intangible assets was $5.7 million and $10.9 million for the three and six months ended November 30, 2009, respectively, as compared with $5.4 million and $10.2 million for the three and six months ended November 30, 2008, respectively.

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Note F: Goodwill and Intangible Assets, Net of Accumulated Amortization — continued
The estimated amortization expense relating to intangible asset balances for the full fiscal year 2010 and the following four fiscal years, as of November 30, 2009, is as follows:
         
    Estimated  
In thousands   amortization  
Fiscal year ending May 31,   expense  
 
2010
  $ 21,718  
2011
  $ 18,703  
2012
  $ 15,700  
2013
  $ 10,885  
2014
  $ 6,798  
 
Note G: Comprehensive Income
Comprehensive income is comprised of two components: net income and other comprehensive income. Comprehensive income includes all changes in equity during a period except those resulting from transactions with owners of the Company. The change in unrealized gains and losses, net of applicable taxes, related to available-for-sale securities is the primary component reported in accumulated other comprehensive income in the Consolidated Balance Sheets.
Comprehensive income, net of related tax effects, is as follows:
                                 
    For the three months ended     For the six months ended  
    November 30,     November 30,  
In thousands   2009     2008     2009     2008  
 
Net income
  $ 125,850     $ 140,242     $ 249,470     $ 288,951  
Other comprehensive income/(loss):
                               
Unrealized gains/(losses) on available-for-sale securities, net of taxes
    6,898       (1,046 )     8,339       5,404  
Reclassification adjustment for the net gain on sale of available-for-sale securities realized in net income, net of tax
    (460 )     (262 )     (640 )     (456 )
     
Total other comprehensive income/(loss)
    6,438       (1,308 )     7,699       4,948  
     
 
Total comprehensive income
  $ 132,288     $ 138,934     $ 257,169     $ 293,899  
 
As of November 30, 2009, accumulated other comprehensive income was $49.6 million, which was net of taxes of $29.2 million. As of May 31, 2009, accumulated other comprehensive income was $41.9 million, which was net of taxes of $24.7 million.

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Note H: Commitments and Contingencies
Lines of credit: As of November 30, 2009, the Company 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 2010
Bank of America, N.A.
  $250 million     February 2010
PNC Bank, National Association
  $150 million     February 2010
Wells Fargo Bank, National Association
  $150 million     February 2010
 
The primary uses of the lines of credit would be to meet short-term funding requirements related to deposit account overdrafts and client fund obligations arising from electronic payment transactions on behalf of clients in the ordinary course of business, if necessary. No amounts were outstanding against these lines of credit as of, or during the six months ended, November 30, 2009.
JP Morgan Chase Bank, N.A. and Bank of America, N.A. are also parties to the Company’s irrevocable standby letters of credit, which are discussed below.
Letters of credit: As of November 30, 2009, and May 31, 2009, the Company had irrevocable standby letters of credit available totaling $65.8 million required to secure commitments for certain insurance policies and bonding requirements. The letters of credit expire at various dates between May 2010 and December 2012 and are collateralized by securities held in the Company’s investment portfolios. No amounts were outstanding on these letters of credit as of, or during the six months ended, November 30, 2009.
Other commitments: The Company enters into various purchase commitments with vendors in the ordinary course of business. The Company had outstanding commitments to purchase approximately $12.1 million and $4.5 million of capital assets as of November 30, 2009 and May 31, 2009, respectively. During the three months ended November 30, 2009, the Company entered into a multi-year commitment with a vendor to purchase computer systems.
The Company guarantees performance of service on annual maintenance contracts for clients who financed their service contracts through a third party. In the normal course of business, the Company makes representations and warranties that guarantee the performance of its services under service arrangements with clients. In addition, the Company has entered into indemnification agreements with its officers and directors, which require it to defend and, if necessary, indemnify these individuals for certain pending or future claims as they relate to their services provided to the Company. Historically, there have been no material losses related to such guarantees and indemnifications.
Paychex currently self-insures the deductible portion of various insured exposures under certain employee benefit plans. The Company’s estimated loss exposure under these insurance arrangements is recorded in other current liabilities on the Consolidated Balance Sheets. Historically, the amounts accrued have not been material. The Company also maintains insurance coverage in addition to its purchased primary insurance policies for gap coverage for employment practices liability, errors and omissions, warranty liability, and acts of terrorism; and capacity for deductibles and self-insured retentions through its captive insurance company.

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Note H: Commitments and Contingencies — continued
Contingencies: The Company is subject to various claims and legal matters that arise in the normal course of its business. These include disputes or potential disputes related to breach of contract, breach of fiduciary duty, employment-related claims, tax claims, and other matters.
The Company has a reserve for pending litigation matters of $20.4 million as of November 30, 2009. This reserve is included in current liabilities on the Consolidated Balance Sheets.
In light of the reserve for all pending litigation matters, the Company’s management currently believes that resolution of outstanding legal matters will not have a material adverse effect on the Company’s financial position or results of operations. However, legal matters are subject to inherent uncertainties and there exists the possibility that the ultimate resolution of these matters could have a material adverse impact on the Company’s financial position and the results of operations in the period in which any such effect is recorded.
Note I: Related Party Transactions
During the three and six months ended November 30, 2009, the Company purchased approximately $0.1 million and $1.6 million of data processing equipment and software from EMC Corporation, as compared with $2.3 million and $2.6 million in the respective prior year periods. The Chairman, President, and Chief Executive Officer (“CEO”) of EMC Corporation is a member of the Company’s Board.
During the six months ended November 30, 2009 and 2008, the Company purchased $0.4 million and $0.5 million of services from Dun & Bradstreet Corporation, respectively. Purchases for the three months ended November 30, 2009 and 2008 were minimal. Jonathan J. Judge, the Company’s President and CEO, is a member of the Board of Directors of Dun & Bradstreet Corporation.

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Item 2.   Management’s Discussion and Analysis of Financial Condition and Results of Operations
Management’s Discussion and Analysis of Financial Condition and Results of Operations reviews the operating results of Paychex, Inc. and its wholly owned subsidiaries (“Paychex,” “we,” “our,” or “us”) for the three and six months ended November 30, 2009 and 2008, and our financial condition as of November 30, 2009. The focus of this review is on the underlying business reasons for significant changes and trends affecting our revenue, expenses, net income, and financial condition. This review should be read in conjunction with the November 30, 2009 Consolidated Financial Statements and the related Notes to Consolidated Financial Statements contained in this Quarterly Report on Form 10-Q (“Form 10-Q”). This review should also be read in conjunction with our Annual Report on Form 10-K (“Form 10-K”) for the year ended May 31, 2009 (“fiscal 2009”). Forward-looking statements in this review are qualified by the cautionary statement included in this review under the next sub-heading, “Safe-Harbor Statement under the Private Securities Litigation Reform Act of 1995.”
“Safe Harbor” Statement Under the Private Securities Litigation Reform Act of 1995: Certain written and oral statements made by us may constitute “forward-looking statements” as defined in the Private Securities Litigation Reform Act of 1995 (the “Reform Act”). Forward-looking statements are identified by such words and phrases as “we expect,” “expected to,” “estimates,” “estimated,” “current outlook,” “we look forward to,” “would equate to,” “projects,” “projections,” “projected to be,” “anticipates,” “anticipated,” “we believe,” “could be,” and other similar phrases. All statements addressing operating performance, events, or developments that we expect or anticipate will occur in the future, including statements relating to revenue growth, earnings, earnings-per-share growth, or similar projections, are forward-looking statements within the meaning of the Reform Act. Because they are forward-looking, they should be evaluated in light of important risk factors. These risk factors include, but are not limited to, the following risks, as well as those that are described in our periodic filings with the Securities and Exchange Commission (“SEC”):
    general market and economic conditions including, among others, changes in United States (“U.S.”) employment and wage levels, changes in new hiring trends, legislative changes to stimulate the economy, changes in short- and long-term interest rates, changes in the fair value and the credit rating of securities held by us, and accessibility of financing;
 
    changes in demand for our services and products, ability to develop and market new services and products effectively, pricing changes and the impact of competition, and the availability of skilled workers;
 
    changes in the laws regulating collection and payment of payroll taxes, professional employer organizations, and employee benefits, including retirement plans, workers’ compensation, health insurance, state unemployment, and section 125 plans;
    changes in workers’ compensation rates and underlying claims trends;
 
    the possibility of failure to keep pace with technological changes and provide timely enhancements to services and products;
 
    the possibility of failure of our operating facilities, computer systems, and communication systems during a catastrophic event;
 
    the possibility of third-party service providers failing to perform their functions;
 
    the possible failure of internal controls or our inability to implement business processing improvements; and
 
    potentially unfavorable outcomes related to pending legal matters.

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Any of these factors could cause our actual results to differ materially from our anticipated results. The information provided in this Form 10-Q is based upon the facts and circumstances known at this time. We undertake no obligation to update these forward-looking statements after the date of filing of this Form 10-Q with the SEC to reflect events or circumstances after such date, or to reflect the occurrence of unanticipated events.
Business
We are a leading provider of payroll, human resource, and benefits outsourcing solutions for small- to medium-sized businesses. Our business strategy is focused on achieving strong long-term financial performance by providing high quality, timely, accurate, and affordable services; growing our client base; increasing utilization of our ancillary services; leveraging our technological and operating infrastructure; and expanding our service offerings.
Our Payroll and Human Resource Services offer a portfolio of services and products that allow our clients to meet their diverse payroll and human resource needs. Our Payroll services are the foundation of our service portfolio. They are provided through either our core payroll or Major Market Services (“MMS”), which is utilized by clients that have more sophisticated payroll and benefit needs, and include the services that follow.
    Payroll processing includes the calculation, preparation, and delivery of employee payroll checks; production of internal accounting records and management reports; preparation of federal, state, and local payroll tax returns; and collection and remittance of clients’ payroll obligations.
 
    Payroll tax administration services provide accurate preparation and timely filing of quarterly and year-end tax returns, as well as the electronic transfer of funds to the applicable federal, state, and local tax or regulatory agencies.
 
    Employee payment services provide the employer the option of paying their employees by direct deposit, Chase Pay Card Plus, a check drawn on a Paychex, Inc. account (Readychex®), or a check drawn on the employer’s account and electronically signed by us.
 
    Regulatory compliance services include new-hire reporting and garnishment processing, which allow employers to comply with legal requirements and reduce the risk of penalties.
In addition to the above, our software-as-a-service solution through the MMS platform provides human resource management, employee benefits management, time and attendance systems, online expense reporting, and applicant tracking.
Our Human Resource Services include the services that follow.
    Comprehensive human resource outsourcing services are provided through Paychex Premier® Human Resources and our Professional Employer Organization (“PEO”). Both offer a package that includes payroll and compliance, human resource and employee benefits administration, and the on-site availability of a professionally trained human resource representative, among other services. With our PEO we serve as co-employer of the clients’ employees, assume the risks and rewards of workers’ compensation insurance, and provide more sophisticated health care offerings to PEO clients.

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    Retirement services administration offers a variety of retirement plan options to employers, as well as recordkeeping services which include plan implementation, ongoing compliance with government regulations, employee and employer reporting, participant and employer access online, electronic funds transfer, and other administrative services.
 
    Health and benefits services provide insurance through a variety of carriers, simplifying the insurance process for clients and allowing them to offer valuable benefits to their employees at an affordable cost.
 
    Workers’ compensation insurance services provide insurance through a variety of carriers and enable clients to pay premiums in regular monthly amounts rather than with large up-front payments, which helps stabilize their cash flow.
 
    Time and attendance solutions help employers minimize the time spent compiling time sheet information, allowing flexibility for the employer and improved productivity, accuracy, and reliability in the payroll process.
 
    Other human resource services and products include section 125 plans, state unemployment insurance services, employee handbooks, management manuals, and personnel and required regulatory forms.
Overview
The weak economic conditions, credit crisis in the financial markets, and extremely low investment rates of return on our funds held for clients of the last twelve months continue to impact our financial results for the first half of the fiscal year ending May 31, 2010 (“fiscal 2010”). The weak economy affects our ability to sell and retain clients, reduces our transaction volumes due to fewer employees in our client base, and results in lower average investment balances in our funds held for clients.
Although the economy remains weak, our key indicators have stabilized with consecutive quarter comparisons continuing to improve in fiscal 2010. The year-over-year change in some of our key indicators for the three months ended November 30, 2009. (the “second quarter”), the three months ended August 31, 2009 (the “first quarter”), and the three months ended May 31, 2009 (the “fourth quarter”) are as follows:
                         
    Second     First     Fourth  
    quarter     quarter     quarter  
% Change   fiscal 2010     fiscal 2010     fiscal 2009  
 
Checks per client
    (3.7 %)     (5.0 %)     (5.2 %)
New client sales from new business starts
    (8 %)     (13 %)     (27 %)
Clients lost due to companies going out of business or no longer having any employees
    (9 %)     1 %     19 %
 
Highlights of the financial results for the second quarter as compared to the same period last year are as follows:
    Payroll service revenue decreased 7% to $350.8 million.
 
    Human Resource Services revenue increased 3% to $132.2 million.
 
    Total revenue decreased 5% to $496.6 million.

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    Operating income decreased 9% to $193.1 million, as interest on funds held for clients decreased 31%.
 
    Operating income excluding interest on funds held for clients decreased 7% to $179.5 million. Refer to the “Non-GAAP Financial Measure” section below for further information on this non-GAAP measure.
 
    Net income and diluted earnings per share decreased 10% to $125.8 million and $0.35 per share, respectively.
Our service revenue for the second quarter decreased 4% compared to the same period last year. Weak economic conditions negatively impacted our client base and check volume. Despite the economic pressures, we continue to focus on providing excellent customer service, and invest in our sales force for key areas and technological infrastructure, while controlling expenses.
The credit crisis in the financial markets caused a flight to quality investments, resulting in lower available yields on high quality investments. The average rate of return earned on our combined funds held for clients and corporate investment portfolio was 1.7% for the second quarter compared to 2.4% for the same period last year. We have seen stabilization here as well, as the 1.7% average interest rate earned is comparable with the first quarter of fiscal 2010. Our short-term portfolio has been heavily invested in taxable securities and our short-term taxable interest rates earned averaged 0.1% for the second quarter compared to 1.4% for the same period last year.
Non-GAAP Financial Measure
In addition to reporting operating income, a U.S. generally accepted accounting principle (“GAAP”) measure, we present operating income excluding interest on funds held for clients, which is a non-GAAP measure. We believe operating income excluding interest on funds held for clients is an appropriate additional measure, as it is an indicator of our core business operations performance period over period. It is also the measure used internally for establishing the following year’s targets and measuring management’s performance in connection with certain performance-based compensation payments and awards. Interest on funds held for clients is an adjustment to operating income due to the volatility of interest rates, which are not within the control of management. Operating income excluding interest on funds held for clients is not calculated through the application of GAAP and is not the required form of disclosure by the SEC. As such, it should not be considered as a substitute for the GAAP measure of operating income and, therefore, should not be used in isolation, but in conjunction with the GAAP measure. The use of any non-GAAP measure may produce results that vary from the GAAP measure and may not be comparable to a similarly defined non-GAAP measure used by other companies. Operating income excluding interest on funds held for clients decreased 7% to $179.5 million and 9% to $355.6 million for the three and six months ended November 30, 2009 as compared to the same periods last year. Refer to the reconciliation of operating income to operating income excluding interest on funds held for clients on page 30 of this Form 10-Q.

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Financial Position and Liquidity
We continue to follow our conservative investment strategy of maximizing liquidity and protecting principal. With the turmoil in the financial markets, this has translated to significantly lower yields on high quality instruments, negatively impacting our income earned on funds held for clients and corporate investments. During the past year, our primary short-term investment vehicle has been U.S. agency discount notes. However, we have seen gradual improvements in liquidity in certain money market sectors, and during the second quarter we began to invest in select A-1/P-1-rated variable rate demand notes (“VRDNs”). We are currently earning an after-tax rate of approximately 0.18% on VRDNs compared to approximately 0.04% for U.S. agency discount notes.
We invest primarily in high credit quality securities with AAA and AA ratings and short-term securities with A-1/P-1 ratings. We limit the amounts that can be invested in any single issuer. All investments held as of November 30, 2009 are traded in active markets. Despite the macroeconomic environment, as of November 30, 2009, our financial position remained strong with cash and total corporate investments of $604.7 million and no debt.
Our primary source of cash is from our ongoing operations. Cash flow from operations was $279.2 million for the six months ended November 30, 2009, as compared with $328.4 million for the six months ended November 30, 2008. The decrease in cash flow from operations primarily related to lower net income. Historically, we have funded operations, capital purchases, and dividend payments from our operating activities. It is anticipated that cash and total corporate investments as of November 30, 2009, along with projected operating cash flows, will support our normal business operations, capital purchases, and dividend payments for the foreseeable future.
For further analysis of our results of operations for the three and six months ended November 30, 2009, and our financial position as of November 30, 2009, refer to the analysis and discussion in the “Results of Operations,” “Liquidity and Capital Resources,” and “Critical Accounting Policies” sections of this Form 10-Q.
Outlook
Our outlook for the full year fiscal 2010 is unchanged from guidance provided at the end of the first quarter. This guidance reflects the impact of current economic and financial conditions, and assumes these conditions will continue through the remainder of the fiscal year. Refer to page 22 for information on some of our key indicators, which provides statistical evidence of the economic weakness experienced in the first half of fiscal 2010.
Consistent with our policy regarding guidance, our projections do not anticipate or speculate on future changes in interest rates. Projected changes in revenue and net income for fiscal 2010 are as follows:
                     
    Low       High
Payroll service revenue
    (7 %)       (5 %)
Human Resource Services revenue
    3 %       6 %
Total service revenue
    (5 %)       (2 %)
Interest on funds held for clients
    (30 %)       (25 %)
Total revenue
    (5 %)       (2 %)
Investment income, net
    (35 %)       (30 %)
Net income
    (12 %)       (10 %)
 

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Operating income excluding interest on funds held for clients as a percentage of service revenue is expected to range from 34% to 35% for fiscal 2010. The effective income tax rate is expected to approximate 35% throughout fiscal 2010. The higher tax rate for fiscal 2010 is driven by higher state income tax rates resulting from state legislative changes.
Interest on funds held for clients and investment income for fiscal 2010 are expected to be impacted by interest rate volatility, and comparisons to the prior year are expected to improve in the second half of fiscal 2010. Interest on funds held for clients will be further impacted by a projected 8% decline in average invested balances for fiscal 2010 compared to the prior year. This decline is the result of overall economic factors, which have negatively impacted our client base, and the American Recovery and Reinvestment Act of 2009 (the “2009 economic stimulus package”) generating lower tax withholdings for client employees. As of November 30, 2009, the long-term investment portfolio had an average yield-to-maturity of 3.0% and an average duration of 2.6 years. In the next twelve months, slightly less than 15% of this portfolio will mature, and it is currently anticipated that these proceeds will be reinvested at a lower average interest rate of approximately 1.1%.
Based upon current interest rate and economic conditions, we expect interest on funds held for clients and investment income to (decrease)/increase by the following amounts in the remaining quarters of fiscal 2010:
                 
    Interest on        
    funds held for     Investment
Fiscal 2010   clients     income, net
Third quarter
    (20%)     15 %
Fourth quarter
    (15%)     55 %
 
Under normal financial market conditions, the impact to our earnings from a 25-basis-point increase or decrease in the short-term interest rates would be approximately $3.5 million, after taxes, for a twelve-month period. Such a basis point change may or may not be tied to changes in the Federal Funds rate.
Purchases of property and equipment for fiscal 2010 are expected to be in the range of $60 million to $65 million, in line with our growth rates. Fiscal 2010 depreciation expense is projected to be approximately $65 million, and we project amortization of intangible assets to be approximately $20 million to $25 million.

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RESULTS OF OPERATIONS
Summary of Results of Operations:
                                                   
    For the three months               For the six months          
    ended               ended          
    November 30,               November 30,          
$ in millions   2009     2008     % Change       2009     2008     % Change  
       
Revenue:
                                                 
Payroll service revenue
  $ 350.8     $ 376.1       (7 %)     $ 705.2     $ 754.5       (7 %)
Human Resource Services revenue
    132.2       128.3       3 %       264.3       259.7       2 %
                           
Total service revenue
    483.0       504.4       (4 %)       969.5       1,014.2       (4 %)
Interest on funds held for clients
    13.6       19.8       (31 %)       27.3       44.0       (38 %)
                           
Total revenue
    496.6       524.2       (5 %)       996.8       1,058.2       (6 %)
 
                                                 
Combined operating and SG&A expenses
    303.5       312.3       (3 %)       613.9       624.7       (2 %)
                           
Operating income
    193.1       211.9       (9 %)       382.9       433.5       (12 %)
 
                                                 
As a % of total revenue
    39 %     40 %               38 %     41 %        
 
                                                 
Investment income, net
    1.1       1.9       (41 %)       2.1       5.0       (59 %)
                           
 
                                                 
Income before income taxes
    194.2       213.8       (9 %)       385.0       438.5       (12 %)
 
                                                 
As a % of total revenue
    39 %     41 %               39 %     41 %        
 
                                                 
Income taxes
    68.4       73.6       (7 %)       135.5       149.5       (9 %)
                           
 
                                                 
Effective income tax rate
    35.2 %     34.4 %               35.2 %     34.1 %        
 
                                                 
Net income
  $ 125.8     $ 140.2       (10 %)     $ 249.5     $ 289.0       (14 %)
                           
 
                                                 
As a % of total revenue
    25 %     27 %               25 %     27 %        
 
                                                 
Diluted earnings per share
  $ 0.35     $ 0.39       (10 %)     $ 0.69     $ 0.80       (14 %)
       

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We invest in highly liquid, investment-grade fixed income securities and do not utilize derivative instruments to manage interest rate risk. As of November 30, 2009, 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:
                                                   
    For the three months               For the six months        
    ended               ended        
    November 30,               November 30,        
$ in millions   2009     2008     % Change       2009     2008     % Change  
       
Average investment balances:
                                                 
Funds held for clients
  $ 2,790.8     $ 3,088.3       (10 %)     $ 2,849.0     $ 3,154.2       (10 %)
Corporate investments
    627.1       510.2       23 %       622.8       497.3       25 %
           
Total
  $ 3,417.9     $ 3,598.5       (5 %)     $ 3,471.8     $ 3,651.5       (5 %)
           
 
                                                 
Average interest rates earned (exclusive of net realized gains):
                                                 
Funds held for clients
    1.8 %     2.5 %               1.8 %     2.7 %        
Corporate investments
    0.9 %     1.6 %               0.8 %     2.1 %        
Combined funds held for clients and corporate investments
    1.7 %     2.4 %               1.7 %     2.7 %        
 
                                                 
Net realized gains:
                                                 
Funds held for clients
  $ 0.7     $ 0.4               $ 1.0     $ 0.7          
Corporate investments
                                         
           
Total
  $ 0.7     $ 0.4               $ 1.0     $ 0.7          
       
                 
As of:   November 30,     May 31,  
$ in millions   2009     2009  
 
Net unrealized gain on available-for-sale securities (1)
  $ 78.8     $ 66.7  
 
               
Federal Funds rate (2)
    0.25 %     0.25 %
 
               
Three-year “AAA” municipal securities yield
    0.93 %     1.35 %
 
               
Total fair value of available-for-sale securities
  $ 2,249.9     $ 1,780.9  
 
               
Weighted-average duration of available-for-sale securities in years (3)
    2.6       2.5  
 
               
Weighted-average yield-to-maturity of available-for-sale securities (3)
    3.0 %     3.3 %
 
(1)   The net unrealized gain of our investment portfolio was approximately $79.2 million as of December 11, 2009.
 
(2)   The Federal Funds rate was a range of 0% to 0.25% as of November 30, 2009 and May 31, 2009.
 
(3)   These items exclude the impact of VRDNs as they are tied to short-term interest rates.

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Payroll service revenue: Payroll service revenue decreased 7% for both the second quarter and six months ended November 30, 2009 (“six months”) from the same periods last year. Weak economic conditions negatively impacted our client base and check volume. During the second quarter and six months of fiscal 2010, checks per client declined 3.7% and 4.3%, respectively. New client sales from new business starts declined 8% and 10% for the second quarter and six months, respectively, compared to the same periods last year. Our client base declined less than 1% from May 31, 2009.
Our payroll tax administration services were utilized by 94% of all clients as of November 30, 2009 compared with 93% as of November 30, 2008. Our employee payment services were utilized by 74% of all clients as of November 30, 2009 and 2008. Nearly all new clients purchase our payroll tax administration services and more than 80% of new clients select a form of employee payment services.
Human Resource Services revenue: Human Resource Services revenue increased 3% to $132.2 million and 2% to $264.3 million for the second quarter and six months, respectively, compared to the same periods last year. The following factors contributed to Human Resource Services revenue growth:
                                 
As of:   November 30,           November 30,        
$ in billions   2009     % Change     2008     % Change(1)  
 
Comprehensive human resource outsourcing services client employees served
    468,000       5 %     445,000       11 %
Comprehensive human resource outsourcing services clients
    19,000       8 %     17,000       15 %
Workers’ compensation insurance clients
    78,000       5 %     75,000       11 %
Retirement services clients
    50,000       (1 %)     50,000       10 %
Asset value of retirement services client employees’ funds
    $      10.3       43 %     $      7.2       (22 %)
 
(1)   Percent change compared to balances as of November 30, 2007.
Positively contributing to Human Resource Services revenue growth is our health and benefits services revenue which increased 54% to $7.4 million for the second quarter and 46% to $14.0 million for the first six months of fiscal 2010. Human Resource Services products that primarily support our MMS clients have experienced growth for the second quarter and six months of fiscal 2010 compared to the same periods last year. In addition, fluctuations in workers’ compensation claims have resulted in favorability in PEO net service revenue.
Offsetting some of this revenue growth has been the impact from weak economic conditions on our client base and fee revenue. The most significant impacts have been to retirement services and comprehensive human resource outsourcing services. Our retirement services client base is flat compared to a year ago. While our comprehensive human resource services client base has grown, the rate of growth is lower than we have seen historically, and we are experiencing fewer employees per client.
Our retirement services revenue is down for both the second quarter and six months of fiscal 2010 compared to the same periods last year, partly as a result of the economic impacts previously noted. The asset value of retirement services client employees’ funds has increased 43% from the lowest point in fiscal 2009 of $7.2 billion at February 28, 2009, as a result of recovery in the financial markets. This positive impact has been offset by retirement services client employees shifting the mix of assets invested to funds earning lower fees.

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Also, retirement services revenue growth was impacted by $3.4 million and $5.1 million for billings in the three and six months ended November 30, 2008, respectively, related to statutory required restatements of clients’ retirement plans which are not expected to recur for approximately six years.
During the second quarter, we sold Stromberg time and attendance, an immaterial component of Paychex. Our Human Resource Services revenue growth excluding Stromberg revenue and the retirement plan restatement billings would have been as follows for the second quarter and six months, respectively, and comparative prior year periods.
                                   
    For the three months       For the six months  
    ended       ended  
    November 30,       November 30,  
% Change   2009     2008       2009     2008  
       
Human Resource Services revenue, as reported
    3 %     11 %       2 %     14 %
       
Human Resource Services revenue excluding Stromberg revenue and retirement plan restatement billings
    9 %     9 %       5 %     12 %
       
Total service revenue: Total service revenue declined 4% for both the second quarter and six months of fiscal 2010 compared to the same periods last year. The weak economy continues to have a negative impact on service revenue growth as described above.
Interest on funds held for clients: For the second quarter and six months of fiscal 2010, interest on funds held for clients decreased 31% and 38%, respectively, compared to the same periods last year. The decreases were the result of lower average interest rates earned and lower average investment balances. Average investment balances for funds held for clients decreased 10% for both the second quarter and six months as compared to the same periods last year. These declines were the result of overall economic factors, which have negatively impacted our client base, and the impact of the 2009 economic stimulus package generating lower tax withholdings for client employees.
Combined operating and SG&A expenses: The following table summarizes total combined operating and selling, general and administrative (“SG&A”) expenses:
                                                   
    For the three months               For the six months        
    ended               ended        
    November 30,               November 30,        
$ in millions   2009     2008     % Change       2009     2008     % Change  
       
Compensation-related expenses
  $ 199.9     $ 203.2       (2 %)     $ 403.0     $ 404.8        
Stock-based compensation costs
    6.6       7.0       (6 %)       13.3       13.9       (5 %)
Facilities expense
    15.0       14.5       4 %       30.1       29.5       2 %
Depreciation of property and equipment
    16.0       15.6       3 %       32.4       31.5       3 %
Amortization of intangible assets
    5.7       5.4       5 %       10.9       10.2       7 %
Other expenses
    60.3       66.6       (9 %)       124.2       134.8       (8 %)
                           
Total operating and SG&A expenses
  $ 303.5     $ 312.3       (3 %)     $ 613.9     $ 624.7       (2 %)
       

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Combined operating and SG&A expenses decreased 3% and 2% for the second quarter and six months as compared with the same periods last year, primarily as a result of cost control measures and lower headcount, offset slightly by costs related to continued investment in our sales force for key areas, customer service, and technological infrastructure. The decrease in employees to approximately 12,300 as of November 30, 2009 from approximately 12,700 employees as of November 30, 2008 was the result of employee attrition.
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 amortization was mainly due to intangibles from acquisitions and client list acquisitions. Other expenses include such items as delivery, forms and supplies, communications, travel and entertainment, professional services, and other costs incurred to support our business.
Operating income: Operating income declined 9% and 12% for the second quarter and six months of fiscal 2010 as compared with the same periods last year. The fluctuations in operating income were attributable to the factors previously discussed.
Operating income excluding interest on funds held for clients is summarized as follows:
                                                   
    For the three months               For the six months        
    ended               ended        
    November 30,               November 30,        
$ in millions   2009     2008     % Change       2009     2008     % Change  
       
Operating income
  $ 193.1     $ 211.9       (9 %)     $ 382.9     $ 433.5       (12 %)
Excluding interest on funds held for clients
    (13.6 )     (19.8 )     (31 %)       (27.3 )     (44.0 )     (38 %)
                           
Operating income excluding interest on funds held for clients
  $ 179.5     $ 192.1       (7 %)     $ 355.6     $ 389.5       (9 %)
                           
Operating income excluding interest on funds held for clients as a % of service revenue
    37.2 %     38.1 %               36.7 %     38.4 %        
       
Refer to the previous discussion of operating income excluding interest on funds held for clients in the “Non-GAAP Financial Measure” section on page 23 of this Form 10-Q.
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 decreased 41% and 59% for the second quarter and six months of fiscal 2010, respectively. The decreases in investment income were primarily due to lower average interest rates earned, offset somewhat by higher average investment balances resulting from investment of cash generated from operations.
Income taxes: Our effective income tax rate was 35.2% for both the second quarter and six months of fiscal 2010 compared with 34.4% and 34.1% for the respective prior year periods. The increases in the effective income tax rate are a result of higher state income tax rates from state legislative changes.

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Net income and earnings per share: The decreases in net income and diluted earnings per share were 10% and 14% for the second quarter and six months of fiscal 2010, respectively, as compared with the same periods last year. The decreases in net income were attributable to the factors previously discussed.
LIQUIDITY AND CAPITAL RESOURCES
The volatility in the global financial markets in the past year has caused diminished liquidity and limited investment choices. Despite this macroeconomic environment, our financial position as of November 30, 2009 remained strong with cash and total corporate investments of $604.7 million and no debt. We also believe that our investments as of November 30, 2009 were not other-than-temporarily impaired, nor has any event occurred subsequent to that date to indicate any other-than-temporary impairment. It is anticipated that cash and total corporate investments as of November 30, 2009, along with projected operating cash flows, will support our normal business operations, capital purchases, and dividend payments for the foreseeable future.
Lines of credit: As of November 30, 2009 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 2010
Bank of America, N.A.
  $250 million   February 2010
PNC Bank, National Association
  $150 million   February 2010
Wells Fargo Bank, National Association
  $150 million   February 2010
 
The primary uses of the lines of credit would be to meet short-term funding requirements related to deposit account overdrafts and client fund obligations arising from electronic payment transactions on behalf of clients in the ordinary course of business, if necessary. No amounts were outstanding against these lines of credit as of, or during the six months ended, November 30, 2009.
JP Morgan Chase Bank, N.A. and Bank of America, N.A. are also parties to our irrevocable standby letters of credit, which are discussed below.
Letters of credit: As of November 30, 2009, we had irrevocable standby letters of credit available totaling $65.8 million, required to secure commitments for certain insurance policies and bonding requirements. The letters of credit expire at various dates between May 2010 and December 2012 and are collateralized by securities held in our investment portfolios. No amounts were outstanding on these letters of credit as of, or during the six months ended, November 30, 2009.
Other commitments: We enter into various purchase commitments with vendors in the ordinary course of business. We had outstanding commitments to purchase approximately $12.1 million and $4.5 million of capital assets as of November 30, 2009 and May 31, 2009, respectively. During the second quarter, we entered into a multi-year commitment with a vendor to purchase computer systems.

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We guarantee performance of service on annual maintenance contracts for clients who financed their service contracts through a third party. In the normal course of business, we make representations and warranties that guarantee the performance of our services under service arrangements with clients. 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 claims as they relate to their services provided to us. Historically, there have been no material losses related to such guarantees and indemnifications.
We currently self-insure the deductible portion of various insured exposures under certain employee benefit plans. Our estimated loss exposure under these insurance arrangements is recorded in other current liabilities on our Consolidated Balance Sheets. Historically, the amounts accrued have not been material. We also maintain insurance coverage in addition to our purchased primary insurance policies for gap coverage for employment practices liability, errors and omissions, warranty liability, 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 such as special purpose entities or structured finance entities, which would have been established for the purpose of facilitating off-balance sheet arrangements or other limited purposes. We do maintain investments as a limited partner in low-income housing projects that are not considered part of our ongoing operations. These investments are accounted for under the equity method of accounting and are less than 1% of our total assets as of November 30, 2009.
Operating Cash Flow Activities
                 
    For the six months ended  
    November 30,  
In millions   2009     2008  
 
Net income
  $ 249.5       $289.0  
Non-cash adjustments to net income
    78.6       81.0  
Cash used in changes in operating assets and liabilities
    (48.9 )     (41.6 )
     
Net cash provided by operating activities
  $ 279.2       $328.4  
 
The decrease in our operating cash flows for the six months of fiscal 2010 related primarily to lower net income and changes in operating assets and liabilities. The fluctuation in operating assets and liabilities between periods was primarily the result of timing of billing cycles within accounts receivable and timing of payments for compensation, PEO payroll, income tax, and other liabilities.

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Investing Cash Flow Activities
                 
    For the six months ended  
    November 30,  
In millions   2009     2008  
 
Net change in funds held for clients and corporate investment activities
  $ 224.9       $387.8  
Purchases of property and equipment, net of proceeds from the sale of property and equipment
    (23.1 )     (39.2 )
Proceeds from sale of business
    13.1        
Purchases of other assets
    (9.2 )     (13.4 )
     
Net cash provided by investing activities
  $ 205.7       $335.2  
 
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 C of the Notes to Consolidated Financial Statements.
The decrease in cash provided by investing activities reflects more corporate funds invested in U.S. agency discount notes, which are cash equivalents, and less in available-for-sale securities during the six months of fiscal 2010 compared to the prior year period as a result of the financial markets’ environment over the past twelve months. In September 2008, we divested of any VRDN securities held and began to utilize U.S. agency discount notes as our primary short-term investment vehicle. VRDNs, although priced and traded as short-term securities, are classified as available-for-sale securities and the cash paid and proceeds received for these securities are included in net cash provided by investing activities. In the six months of fiscal 2010, most of the securities traded for short-term needs were U.S. agency discount notes, which are classified as cash equivalents and not reflected in net cash provided by investing activities. In November 2009, we began to again invest in select A-1/P-1-rated VRDNs, but there is considerably less activity reflected in investing activities for these securities than in the prior year.
In general, fluctuations in net funds held for clients and corporate investment activities primarily relate to timing of purchases, sales, or maturities of investments. The amount of funds held for clients will also vary based upon the timing of collecting 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 of this Form 10-Q.
Purchases of long-lived assets: To support our continued client and ancillary product growth, purchases of property and equipment were made for data processing equipment and software, and for the expansion and upgrade of various operating facilities. We purchased approximately $0.1 million and $1.6 million of data processing equipment and software from EMC Corporation during the second quarter and six months of fiscal 2010 as compared with $2.3 million and $2.6 million in the respective prior year periods. The Chairman, President, and Chief Executive Officer of EMC Corporation is a member of our Board of Directors (the “Board”).
During the six months ended November 30, 2009, we received $13.1 million from the sale of Stromberg time and attendance, an immaterial component of Paychex. The purchase of other assets relates to purchases of customer lists.

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Financing Cash Flow Activities
                 
    For the six months ended  
    November 30,  
In millions, except per share amounts   2009     2008  
 
Net change in client fund obligations
  $ (514.7 )   $ (279.0 )
Dividends paid
    (224.2 )     (223.8 )
Proceeds from and excess tax benefit related to exercise of stock options
    6.6       5.6  
     
Net cash used in financing activities
  $ (732.3 )   $ (497.2 )
     
Cash dividends per common share
  $ 0.62     $ 0.62  
 
Net change in client fund obligations: The client fund obligations liability will vary based on the timing of collecting client funds and the related required remittance of funds to applicable tax or regulatory agencies for payroll tax administration services and to employees of clients utilizing employee payment services. Collections from clients are typically remitted from one to 30 days after receipt, with some items extending to 90 days. The increase in cash used for client obligations is due to this timing as November 30, 2009 was a Monday, on which there are large cash outflows for remittances to client employees. This compares to November 30, 2008, a Sunday, where these outflows had not yet occurred.
Dividends paid: A quarterly dividend of $0.31 per share, unchanged since July 2008, was paid November 16, 2009 to stockholders of record as of November 2, 2009. The payment of future dividends is dependent on our future earnings and cash flow and is subject to the discretion of our Board.
Exercise of stock options: The increase in proceeds from and excess tax benefit related to exercise of stock options is due to an increase in the number of shares issued for stock option exercises to 0.3 million shares during the six months of fiscal 2010 from 0.2 million shares during the same period last year.
MARKET RISK FACTORS
Changes in interest rates and interest rate risk: Funds held for clients are primarily comprised of short-term funds and available-for-sale securities. Corporate investments are primarily comprised of available-for-sale securities. As a result of our operating and investing activities, we are exposed to changes in interest rates that may materially affect our results of operations or financial position. Changes in interest rates will impact the earnings potential of future investments and will cause fluctuations in the fair value of our longer-term available-for-sale securities. We follow a conservative investment strategy of maximizing liquidity and protecting principal. We invest primarily in high credit quality securities with AAA and AA ratings and short-term securities with A-1/P-1 ratings. 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 manage the available-for-sale securities to a benchmark duration of two and one-half to three years. All investments held as of November 30, 2009 are traded in active markets.

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During the past year, our primary short-term investment vehicle has been U.S. agency discount notes. We have seen gradual improvement in liquidity in certain money market sectors, and during the second quarter we began to invest in select A-1/P-1-rated VRDNs. We are currently earning an after-tax rate of approximately 0.18% for VRDNs as compared to approximately 0.04% for U.S. agency discount notes. We have no exposure to high risk or illiquid investments such as auction rate securities, sub-prime mortgage securities, asset-backed securities or asset-backed commercial paper, collateralized debt obligations, enhanced cash or cash plus mutual funds, or structured investment vehicles (SIVs). We have not and do not utilize derivative financial instruments to manage our interest rate risk.
During the six months of fiscal 2010, the average interest rate earned on our combined funds held for clients and corporate investment portfolios was 1.7% compared with 2.7% for the same period last year. With the turmoil in the financial markets, our conservative investment strategy has translated to significantly lower yields on high quality instruments. When interest rates are falling, the full impact of lower interest rates will not immediately be reflected in net income due to the interaction of short- and long-term interest rate changes. During a falling interest rate environment, the decreases in interest rates decrease earnings from our short-term investments, and over time decrease earnings from our longer-term available-for-sale securities. Earnings from the available-for-sale-securities, which as of November 30, 2009 had an average duration of 2.6 years, would not reflect decreases in interest rates until the investments are sold or mature and the proceeds are reinvested at lower rates. In the next twelve months, slightly less than 15% of our available-for-sale portfolio will mature, and it is currently anticipated that these proceeds will be reinvested at a lower average interest rate of approximately 1.1%.
The cost and fair value of available-for-sale securities that had stated maturities as of November 30, 2009 are shown below by contractual maturity. Expected maturities can differ from contractual maturities because borrowers may have the right to prepay obligations without prepayment penalties.
                 
    November 30, 2009  
            Fair  
In millions   Cost     value  
 
Maturity date:
               
Due in one year or less
  $ 270.4     $ 275.0  
Due after one year through three years
    810.9       839.8  
Due after three years through five years
    491.4       524.5  
Due after five years
    598.4       610.6  
     
Total
  $ 2,171.1     $ 2,249.9  
 
VRDNs are primarily categorized as due after five years in the table above as the contractual maturities on these securities are typically 20 to 30 years. Although these securities are issued as long-term securities, they are priced and traded as short-term instruments because of the liquidity provided through the tender feature.

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The following table summarizes recent changes in the Federal Funds rate:
                         
    Fiscal year     Fiscal year     Fiscal year  
    through     ended     ended  
    November 30,     May 31,     May 31,  
    2009     2009     2008  
 
Federal Funds rate — beginning of period (1)
    0.25 %     2.00 %     5.25 %
Rate decrease:
                       
First quarter
          ¾       ¾  
Second quarter
          (1.00 )     (0.75 )
Third quarter
  NA       (0.75 )     (1.50 )
Fourth quarter
  NA       ¾       (1.00 )
     
Federal Funds rate — end of period (1)
    0.25 %     0.25 %     2.00 %
     
Three-year “AAA” municipal securities yield — end of period
    0.93 %     1.35 %     2.65 %
 
(1)   The Federal Funds rate was a range of 0% to 0.25% as of November 30, 2009 and May 31, 2009.
Calculating the future effects of changing interest rates involves many factors. These factors include, but are not limited to:
    daily interest rate changes;
 
    seasonal variations in investment balances;
 
    actual duration of short-term and available-for-sale securities;
 
    the proportional mix of taxable and tax-exempt investments;
 
    changes in tax-exempt municipal rates as compared to taxable investment rates, which are not synchronized or simultaneous; and
 
    financial market volatility and the resulting effect on benchmark and other indexing interest rates.
Subject to these factors, a 25-basis-point change generally affects our tax-exempt interest rates by approximately 17 basis points.
Our total investment portfolio (funds held for clients and corporate investments) is expected to average approximately $3.7 billion for fiscal 2010. Our normal and anticipated allocation is approximately 50% invested in short-term and available-for-sale securities with an average duration of less than 30 days and 50% invested in available-for-sale securities with an average duration of two and one-half to three years.
The combined funds held for clients and corporate available-for-sale securities reflected a net unrealized gain of $78.8 million as of November 30, 2009, compared with a net unrealized gain of $66.7 million as of May 31, 2009. During the first six months of fiscal 2010, the net unrealized gain on our investment portfolios ranged from $55.1 million to $78.8 million. Our investment portfolios reflected a net unrealized gain of approximately $79.2 million as of December 11, 2009.

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As of November 30, 2009 and May 31, 2009, we had $2.2 billion and $1.8 billion, respectively, invested in available-for-sale securities at fair value. The weighted-average yield-to-maturity was 3.0% and 3.3% as of November 30, 2009 and May 31, 2009, respectively. The weighted-average yield-to-maturity excludes available-for-sale securities tied to short-term interest rates, such as VRDNs. Assuming a hypothetical decrease in both short-term and longer-term interest rates of 25 basis points, the resulting potential increase in fair value for our portfolio of available-for-sale securities held as of November 30, 2009 would be in the range of $12.0 to $12.5 million. Conversely, a corresponding increase in interest rates would result in a comparable decrease in fair value. This hypothetical increase or decrease in the fair value of the portfolio would be recorded as an adjustment to the portfolio’s recorded value, with an offsetting amount recorded in stockholders’ equity. These fluctuations in fair value would have no related or immediate impact on the results of operations, unless any declines in fair value were considered to be other-than-temporary.
Credit Risk: We are exposed to credit risk in connection with these investments through the possible inability of the borrowers to meet the terms of their bonds. We regularly review our investment portfolios to determine if any investment is other-than-temporarily impaired due to changes in credit risk or other potential valuation concerns. We believe that the investments we held as of November 30, 2009 were not other-than-temporarily impaired. While $17.1 million of our available-for-sale securities had fair values that were below amortized cost, we believe that it is probable that the principal and interest will be collected in accordance with contractual terms, and that the decline in the fair value to $0.1 million below amortized cost was due to changes in interest rates and was not due to increased credit risk or other valuation concerns. All of the securities with an unrealized loss as of November 30, 2009 and the majority of the securities with an unrealized loss as of May 31, 2009 held an AA rating or better. We intend to hold these investments until the recovery of their amortized cost basis or maturity and further believe that it is more-likely-than-not that we will not be required to sell these investments prior to that time. Our assessment that an investment is not other-than-temporarily impaired could change in the future due to new developments or changes in our strategies or assumptions related to any particular investment.
CRITICAL ACCOUNTING POLICIES
Our critical accounting policies are described in Item 7 of our Form 10-K for fiscal 2009, filed with the SEC on July 20, 2009. On an ongoing basis, we evaluate the critical accounting policies used to prepare our Consolidated Financial Statements, including, but not limited to, those related to:
    revenue recognition;
 
    PEO workers’ compensation insurance;
 
    valuation of investments;
 
    goodwill and other intangible assets;
 
    contingent liabilities;
 
    stock-based compensation costs; and
 
    income taxes.
There have been no material changes in these aforementioned critical accounting policies.

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NEW ACCOUNTING PRONOUNCEMENTS
Newly adopted accounting pronouncements: On June 1, 2009, we adopted Statement of Financial Accounting Standard (“SFAS”) No. 141 (revised 2007) (“SFAS No. 141R”), “Business Combinations.” SFAS No. 141R provides guidance on how an entity recognizes and measures the identifiable assets acquired (including goodwill), liabilities assumed, and noncontrolling interests, if any, acquired in a business combination. SFAS No. 141R also requires that acquisition-related costs and costs associated with restructuring or exiting activities of an acquired entity be expensed as incurred. We cannot anticipate if the adoption of SFAS No. 141R will have a material effect on our results of operations or financial position as the impact is solely dependent on whether we enter into any business combination, and the terms of any such transaction.
On June 1, 2009, we adopted SFAS No. 165, “Subsequent Events.” This statement establishes guidance related to accounting for and disclosure of events that happen after the date of the balance sheet but before the release of the financial statements. The adoption of this statement had no material effect on our results of operations or financial position.
On June 1, 2009, we adopted Financial Accounting Standards Board (“FASB”) Staff Position (“FSP”) No. FAS 142-3, “Determination of the Useful Life of Intangible Assets.” This FSP amends the factors that should be considered in developing renewal or extension assumptions used to determine the useful life of a recognized intangible asset. The adoption of this FSP had no material effect on our results of operations or financial position.
On June 1, 2009, we adopted the following three FSPs which provide additional accounting guidance and enhanced disclosures regarding fair value measurements and impairments of debt securities:
    FSP No. FAS 107-1 and APB 28-1, “Interim Disclosures about Fair Value of Financial Instruments,” requiring publicly traded companies to disclose the fair value of financial instruments in interim financial statements;
 
    FSP No. FAS 157-4, “Determining Fair Value When the Volume and Level of Activity for the Asset or Liability Have Significantly Decreased and Identifying Transactions That Are Not Orderly,” providing guidance for determining fair value when there is no active market or where price inputs being used represent distressed sales; and
 
    FSP No. FAS 115-2 and FAS 124-2, “Recognition and Presentation of Other-Than-Temporary Impairments,” providing guidance for measurement and recognition of impaired debt securities along with expanded disclosures with respect to impaired debt securities.
The adoption of these FSPs did not have a material effect on our results of operations or financial position. Refer to Notes C and D of the Notes to Consolidated Financial Statements for additional disclosures related to these FSPs.
On September 1, 2009, we adopted SFAS No. 168, “The FASB Accounting Standards Codification™ and the Hierarchy of Generally Accepted Accounting Principles — a replacement of FASB Statement No. 162” (the “Codification”). The Codification, released on July 1, 2009, became the single source of authoritative non-governmental U.S. GAAP. The Codification eliminates the GAAP hierarchy contained in SFAS No. 162 and establishes one level of authoritative GAAP.

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On September 1, 2009, we adopted Accounting Standards Update (“ASU”) No. 2009-05, “Fair Value Measurements and Disclosures (Topic 820) — Measuring Liabilities at Fair Value.” ASU No. 2009-05 provides guidance for measuring the fair value of a liability in circumstances in which a quoted price in an active market for an identical liability may not be available. The adoption of this ASU had no material effect on our results of operations or financial position.
In August and September 2009, we adopted the following ASUs, neither of which had a material effect on our results of operations or financial position:
    ASU No. 2009-03, “SEC Update — Amendments to Various Topics Containing SEC Staff Accounting Bulletins”; and
 
    ASU No. 2009-07, “Accounting for Various Topics — Technical Corrections to SEC Paragraphs.”
Recently issued accounting pronouncements: In June 2009, the FASB issued the following statements:
    SFAS No. 166, “Accounting for Transfers of Financial Assets — an amendment of FASB Statement No. 140.” SFAS No. 166 makes several amendments to Codification Topic 860, Transfers and Servicing, including the removal of the concept of a qualifying special purpose entity; and
 
    SFAS No. 167, “Amendments to FASB Interpretation No. 46(R).” SFAS No. 167 will require a qualitative rather than a quantitative analysis to determine the primary beneficiary of a variable interest entity for consolidation purposes.
Both standards are effective for annual periods beginning after November 15, 2009, and are applicable to our fiscal year beginning June 1, 2010. We do not expect the adoption of these standards to have a material effect on our results of operations or financial position.
In October 2009, the FASB issued ASU No. 2009-13, “Revenue Recognition (Topic 605) — Multiple-Deliverable Revenue Arrangements — a consensus of the FASB Emerging Issues Task Force.” ASU No. 2009-13 amends accounting guidance related to revenue recognition for arrangements with multiple deliverables and related disclosure requirements. This ASU is effective prospectively for revenue arrangements entered into or materially modified in fiscal years beginning on or after June 15, 2010, with early adoption permitted, and is applicable to our fiscal year beginning June 1, 2011. We are currently evaluating the impact, if any, that the adoption of this ASU will have on our results of operations and financial position.
In October 2009, the FASB issued ASU No. 2009-14, “Software (Topic 985) — Certain Revenue Arrangements That Include Software Elements — a consensus of the FASB Emerging Issues Task Force.” ASU No. 2009-14 eliminates tangible products containing both software and non-software components that operate together to deliver a product’s functionality from the scope of current GAAP for software. This ASU is effective for arrangements entered into or materially modified in fiscal years that start on or after June 15, 2010 and is applicable to our fiscal year beginning June 1, 2011. We are currently evaluating the impact, if any, that the adoption of this ASU will have on our results of operations and financial position.
Other recent accounting pronouncements issued by the FASB (including ASUs), the American Institute of Certified Public Accountants, and the SEC did not, or are not, expected to have a material effect on our results of operations or financial position.

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Item 3. Quantitative and Qualitative Disclosure About Market Risk
The information called for by this item is provided under the caption “Market Risk Factors” under Item 2 — Management’s Discussion and Analysis of Financial Condition and Results of Operations and is incorporated herein by reference.
Item 4. Controls and Procedures
Disclosure Controls and Procedures and Internal Control Over Financial Reporting: Disclosure controls and procedures are designed with the objective of ensuring that information required to be disclosed in our reports filed under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), such as this report, is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms. Disclosure controls and procedures are also designed with the objective of ensuring that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure.
Evaluation of Disclosure Controls and Procedures: As of the end of the period covered by this report, we carried out an evaluation, under the supervision and with the participation of our Chief Executive Officer and Chief Financial Officer of the effectiveness of disclosure controls and procedures, as defined in Rules 13a-15(e) and 15d-15(e) of the Exchange Act. Based on such evaluation, the Chief Executive Officer and Chief Financial Officer have concluded that as of the end of the period covered by this report, our disclosure controls and procedures were effective.
Changes in Internal Control over Financial Reporting: We also carried out an evaluation of the internal control over financial reporting to determine whether any changes occurred during the period covered by this report. Based on such evaluation, there has been no change in our internal control over financial reporting that occurred during the most recently completed fiscal quarter ended November 30, 2009, that materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
PART II. OTHER INFORMATION
Item 4. Submission of Matters to a Vote of Security Holders
The Annual Meeting of Stockholders was held on October 13, 2009. There were present at the meeting, either in person or by proxy, holders of 315,059,382 common shares. Stockholders elected the seven directors nominated in the September 3, 2009 Proxy Statement, constituting our entire Board, to hold office until the next Annual Meeting of Stockholders, and ratified the selection of our independent registered public accounting firm.
Results of stockholder voting are as follows:
                         
Election of Directors     For       Against       Abstain  
 
B. Thomas Golisano
    308,770,640       5,923,601       365,141  
David J. S. Flaschen
    311,037,043       3,548,159       474,178  
Grant M. Inman
    309,513,523       4,903,494       635,806  
Pamela A. Joseph
    311,658,039       2,928,677       466,109  
Jonathan J. Judge
    307,304,552       7,357,094       391,179  
Joseph M. Tucci
    300,005,810       14,597,812       449,203  
Joseph M. Velli
    311,451,985       3,151,267       449,572  
 

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Ratification of Selection of Ernst & Young LLP as the
Company’s Independent Registered Public Accounting Firm
    For       Against       Abstain  
 
 
    312,026,327       2,400,201       626,296  
 
Item 6. Exhibits
     
Exhibit    
number   Description
 
   
31.1
  Certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
 
   
31.2
  Certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
 
   
32.1
  Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to the Sarbanes-Oxley Act of 2002.
 
   
32.2
  Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to the Sarbanes-Oxley Act of 2002.
 
   
101.INS*
  XBRL instance document.
 
   
101.SCH*
  XBRL taxonomy extension schema document.
 
   
101.CAL*
  XBRL taxonomy extension calculation linkbase document.
 
   
101.LAB*
  XBRL taxonomy label linkbase document.
 
   
101.PRE*
  XBRL taxonomy extension presentation linkbase document.
 
   
101.DEF*
  XBRL taxonomy extension definition linkbase document.
*   As provided in Rule 406T of Regulation S-T, this information is furnished and not filed for purposes of Sections 11 and 12 of the Securities Act of 1933 and Section 18 of the Exchange Act.

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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
         
PAYCHEX, INC.
 
Date: December 16, 2009  /s/ Jonathan J. Judge    
  Jonathan J. Judge   
  President and Chief Executive Officer   
 
     
Date: December 16, 2009  /s/ John M. Morphy    
  John M. Morphy   
  Senior Vice President, Chief
Financial Officer, and Secretary 
 
 

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