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UNITED STATES

FORM 10-K

ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended May 31, 2004

Commission file number 0-11330

Paychex, Inc.

(585) 385-6666

Securities registered pursuant to section 12(b) of the act: None

Securities registered pursuant to section 12(g) of the act:

COMMON STOCK, $.01 PAR VALUE

     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 if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.     o.

      Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act).     Yes þ          No o.

      As of November 30, 2003, shares held by nonaffiliates of the registrant had an aggregate market value of $12,742,795,000.

      As of June 30, 2004, 378,093,104 shares of the registrant’s common stock, $.01 par value, were outstanding.

Documents Incorporated By Reference

      Portions of the registrant’s Definitive Proxy Statement for its Annual Meeting to be held on October 6, 2004, are incorporated herein by reference thereto in response to Part III, Items 10 through 14, inclusive.

PART I

“SAFE HARBOR” STATEMENT UNDER THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995

      Certain written and oral statements made by Paychex, Inc. (the “Company”) management may constitute “forward-looking statements” as defined in the Private Securities Litigation Reform Act of 1995. Forward-looking statements are identified by such words and phrases as “we expect,” “expected to,” “estimates,” “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 the Company expects or anticipates 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 and those that are described in the “Risk Factors Section” of Item 1 of this Form 10-K: general market and economic conditions, including demand for the Company’s products and services, competition, price levels, availability of internal and external resources, execution of expansion plans, and effective integration of acquisitions; changes in the laws regulating collection and payment of payroll taxes, professional employer organizations, and employee benefits, including 401(k) plans, workers’ compensation, state unemployment, and section 125 plans; delays in the development, timing of the introduction, and marketing of new products and services; changes in technology, including use of the Internet; the possibility of catastrophic events that could impact the Company’s operating facilities, computer systems, and communication systems; the possibility of third-party service providers failing to perform their functions; the possibility of penalties and losses resulting from errors and omissions in performing services; the possibility that internal control weaknesses may be identified during control reviews; potential unfavorable outcomes related to pending legal matters; potential damage to the Company’s business reputation due to these and other operational risks; the possible inability of clients to meet payroll obligations; stock volatility; and changes in short- and long-term interest rates, changes in the market value of available-for-sale securities, and the credit rating of cash, cash equivalents, and securities held in the Company’s investment portfolios, all of which could cause actual results to differ materially from anticipated results. The information provided in this document is based upon the facts and circumstances known at this time.

      Paychex, Inc. (the “Company” or “Paychex”) is a leading, national provider of comprehensive payroll and integrated human resource and employee benefits outsourcing solutions for small- to medium-sized businesses. Paychex, a Delaware corporation, was formed in 1979 through the consolidation of seventeen corporations engaged in providing computerized payroll accounting services. As of the end of fiscal 2004, the Company serviced approximately 505,000 clients and had approximately 9,400 employees. The Company has its corporate headquarters in Rochester, New York, and more than 100 offices nationwide. The Company’s fiscal year ends May 31.

      Information about the Company’s products and services, shareholder information, press releases, and filings with the Securities and Exchange Commission (SEC) can be found on the Company’s Web site at www.paychex.com. The Company’s annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and other SEC filings, and any amendments to such reports, are made available, free of charge, on the Investor Relations section of this Web site as soon as reasonably practical after such material is filed with, or furnished to the SEC. Also, copies of the Company’s annual report to shareholders and proxy statement will be made available, free of charge, upon written request submitted to Paychex, Inc., c/o Secretary, 911 Panorama Trail South, Rochester, New York 14625-2396.

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Company Strategy

      As part of its continuing growth strategy, Paychex is focused on the following:

	•	Achieving strong financial performance while providing high-quality, timely, accurate, and affordable payroll processing services and value-added, comprehensive ancillary services to meet the human resource and employee benefits needs of the Company’s client base.
	•	Delivering these services utilizing a well-trained and responsive work force through a network of local and corporate offices servicing over 100 of the largest markets in the United States.
	•	Growing the client base, primarily through the Company’s direct sales force, while minimizing client losses.
	•	Capitalizing on the growth opportunities, from within the current client base and from new clients, by increasing utilization of the Company’s payroll-related and human resource ancillary products.
	•	Capitalizing on and leveraging the Company’s highly developed technological and operating infrastructure.
	•	Supplementing the Company’s growth through strategic acquisition or expansion of product offerings when opportunities arise.

      During fiscal 2003, Paychex acquired two comprehensive payroll service providers servicing small- to medium-sized businesses. Advantage Payroll Services, Inc. (“Advantage”) was acquired September 20, 2002, for $314 million in cash, including the redemption of preferred stock and repayment of outstanding debt of Advantage. InterPay, Inc. (“InterPay”), a wholly owned subsidiary of FleetBoston Financial Corporation (“Fleet®”), was acquired April 1, 2003, for $182 million in cash. These acquisitions provided Paychex with over 80,000 new clients and geographic coverage into some areas that were not previously served by the Company. In addition, the integration of these companies provides Paychex the opportunity to achieve economies of scale in providing services to its clients.

      During fiscal 2003 and fiscal 2004, the Company has been actively integrating Advantage and InterPay into the operations of Paychex. By the end of fiscal 2003, the sales forces of these companies were combined with the Paychex sales force, and the responsibility for their operations and corporate support had been integrated into the management structure of Paychex. In addition, by the end of fiscal 2004, most branch operations were combined into existing Paychex locations. The Company’s focus has been on client service and retention. The Advantage payroll system will be retained to service clients affiliated with the independently owned associate offices and Advantage co-branded products. Approximately one-half of the Interpay clients were converted to Paychex software platforms by the end of fiscal 2004, with the remainder expected to be converted by December 2004.

      In October 2003, Paychex purchased the Time In A Box® product, a time and attendance solution for small- to medium-sized businesses, from Stromberg LLC (“Stromberg”). Effective April 12, 2004, Paychex acquired substantially all the assets and certain liabilities of Stromberg, a provider of time and attendance software solutions, for $13.6 million. These product line acquisitions allow Paychex to offer value-added products and services to payroll and non-payroll clients.

      In the fourth quarter of fiscal 2004, Paychex began a start-up payroll sales and operations facility in Germany, representing the first expansion of Paychex outside of the United States. By the end of the fiscal 2004, this location had acquired a small number of clients.

Market Opportunities

      The outsourcing of business processes is a growing trend within the United States. Outsourcing of the payroll and human resource functions allows small-to medium-sized businesses to minimize the compliance risks associated with increasingly complex and changing administrative requirements and federal, state, and local tax regulations. By utilizing the expertise of outsourcing service providers, businesses are able to reduce processing costs and administrative burdens while, at the same time, adding competitive benefits for their

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      There are approximately 7.5 million employers in the payroll markets that Paychex currently serves within the United States. Of those employers, 99% have fewer than 100 employees and are the Company’s primary customers and target market. Based on industry data, the Company estimates that all payroll processors combined serve somewhere between 15% to 20% of the potential businesses, with much of the unpenetrated market in businesses with ten or fewer employees. Paychex remains focused on servicing small- to medium-sized businesses based upon this growth potential that management believes exists in this market segment.

Clients

      Paychex serves a diverse base of small- to medium-sized clients operating in a broad range of industries located throughout the continental United States. At May 31, 2004, the Company serviced approximately 505,000 clients. The Company utilizes service agreements and arrangements with clients that are generally terminable by the client at any time or upon relatively short notice. Paychex’s client losses have historically been slightly higher than 20% of the beginning client base. The most significant factor contributing to client losses is companies going out of business. No single client has a material impact on total service revenues or results of operations.

      The composition of the market and the client base serviced by the Company (in the United States) by employee size is as follows:

Products and Services

      Paychex offers a comprehensive portfolio of payroll, payroll-related, and human resource products to meet the diverse needs of its client base. These include payroll processing, tax filing and payment, employee payment, time and attendance solutions, regulatory compliance (new-hire reporting and garnishment processing), retirement services administration, employee benefits administration, workers’ compensation insurance, and comprehensive bundled human resource administrative services. By offering ancillary services that leverage the information gathered in the base payroll processing service, Paychex is able to provide comprehensive outsourcing services that allow employers to expand their employee benefits offerings at an affordable cost. The Company earns its revenues primarily through recurring fees for repetitive services performed related to these products. Service revenues are largely driven by the number of clients, utilization of ancillary services, and checks or transactions per client per pay period.

      Payroll Processing: Payroll processing is the backbone of the Paychex product portfolio. The Paychex Payroll service includes the calculation, preparation, and delivery of employee payroll checks; production of internal accounting records and management reports; and the preparation of federal, state, and local payroll tax returns. Payroll processing clients are charged a base fee each period that payroll is processed, plus a fee per employee check processed.

      The Core Payroll product is generally targeted for clients with one to forty-nine employees, although many clients with fifty or more employees utilize this service. The Company’s average Core Payroll client (including Advantage and InterPay clients) employs approximately thirteen people and processes approximately thirty-one payrolls each year. Core Payroll clients communicate their payroll information, including

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      Paychex also offers Core Payroll services to its clients and their accountants via Paychex Online. This secure Internet site offers clients a suite of interactive, self-service products and services twenty-four hours a day, seven days a week. These include Paychex Online Payroll^SM, Internet Time Sheet, Internet Report Service, and General Ledger Reporting Service. Clients can communicate payroll information via Internet Time Sheet or use the Online Payroll service, as well as access current and historical payroll information using the Paychex Internet Report Service. The General Ledger Reporting Service transfers payroll information calculated by Paychex to the client’s general ledger accounting software, eliminating manual entries and improving the accuracy of bookkeeping. Over 100,000 clients are currently utilizing some type of online service.

      The Company’s Major Market Services (MMS) Payroll product primarily targets companies that have outgrown the Company’s Core Payroll service or new clients that have fifty or more employees or more complex payroll and benefits needs. Due to expansion efforts in recent years, the Company currently offers this product in all of its significant markets. Approximately one-third of new MMS clients are conversions from the Company’s Core Payroll product.

      Most MMS clients communicate their payroll information to Paychex using the Company’s Preview® software. Preview provides clients in-house control of payroll and human resource information because the software and the payroll and human resource database reside on the client’s personal computer or personal computer network. Clients can produce reports and checks at their convenience. Paychex handles the software maintenance and provides the client ancillary services as requested.

      Ancillary Products and Services: Paychex provides its clients with a portfolio of ancillary products and services that have been developed and refined over many years. Ancillary products provide the Company with additional recurring revenue streams and increased service efficiencies as these products are integrated with payroll processing services. Paychex offers the following ancillary products and services:

      Tax Filing and Payment Services: As of May 31, 2004, 89% of the Company’s clients utilized its tax filing and payment services (including Taxpay®), which provide accurate preparation and timely filing of quarterly and year-end tax returns, as well as the electronic transfer of funds to the appropriate agencies (federal, state, and local). More than 90% of new clients purchase the Company’s tax filing and payment services. The Company believes that the client utilization percentage of these services is near maturity. In connection with these services, the Company electronically collects payroll taxes from clients’ bank accounts, typically on payday, files the applicable tax returns, and pays taxes to the appropriate taxing authorities on the respective due dates. These taxes are typically paid between one and thirty days after receipt of collections from clients, with some items extending to ninety days. The Company handles all regulatory correspondence, amendments, and penalty and interest disputes, and is subject to cash penalties imposed by tax authorities for late filings and late or underpayments of taxes. Clients utilizing the tax filing and payment services are charged a base fee each period that payroll is processed. In addition to fees paid by clients, the Company earns interest on client funds that are collected before due dates and invested until remittance to the appropriate taxing authority.

      Employee Payment Services: As of May 31, 2004, 63% of the Company’s clients utilized its employee payment services, which provide the employer the option of paying their employees by Direct Deposit, Paychex Access Visa® Card, a check drawn on a Paychex account (Readychex®), or a check drawn on the employer’s account. More than 70% of new clients purchase some form of employee payment services. For the first three methods, Paychex electronically collects net payroll from the client’s bank account, typically one day before payroll, and provides payment to the employee on payday. The Company offers flexible payment

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      The tax filing and payment services and employee payment services are integrated with the Company’s Payroll processing service. Interest earned on funds held for clients is included in total revenues on the Consolidated Statements of Income because the collection, holding, and remittance of these funds are critical components of providing these services.

      Time and Attendance Solutions: Paychex offers Time In A Box and other time and attendance solutions, which help minimize the time spent compiling time sheet information. These computer-based systems allow the employer flexibility to handle multiple payroll scenarios and result in improved productivity, accuracy, and reliability in the payroll process. Certain clients are charged a monthly fee for use of hardware, software, and support. Clients also have the option to purchase the hardware and software with annual maintenance contracts.

      Regulatory Compliance Services: Paychex offers New-Hire Reporting services, which enable clients to comply with federal and state requirements to report information on newly hired employees, to aid the government in enforcing child support orders, and to minimize fraudulent unemployment and workers’ compensation insurance claims. The Company’s Garnishment Processing service provides deductions from employees’ pay, forwards payments to third-party agencies, including those that require electronic payments, and tracks the obligation to fulfillment. These services enable employers to comply with legal requirements and reduce the risk of penalties.

      Comprehensive Administrative Services: The Paychex Administrative Services (PAS) product provides businesses a full-service approach to the outsourcing of employer and employee administrative needs. PAS offers businesses a package of services that includes payroll, employer compliance, human resource and employee benefits administration, and employee risk management. This comprehensive bundle of services is designed to make it easier for businesses to manage their payroll and benefit costs while providing a benefits package equal to that of larger companies. The Company also operates a Professional Employer Organization (PEO), which provides businesses with the same combined package of services as the PAS product, but with Paychex acting as a co-employer of the client’s employees. The Company’s PEO is operated primarily in Florida and Georgia, where PEOs are more prevalent. Paychex offers its PEO product through its subsidiary, Paychex Business Solutions, Inc. For these two products, the client pays a fee per employee per processing period. As of May 31, 2004, the PAS and PEO products combined serviced over 157,000 client employees.

      Retirement Services: The Company’s Retirement Services product line offers a variety of options to clients, including 401(k) plans, 401(k) SIMPLE, SIMPLE IRA, 401(k) plans with Safe Harbor provisions, profit sharing, and money purchase plans. These services provide plan implementation, ongoing compliance with government regulations, employee and employer reporting, participant access online, electronic funds transfer, and other administrative services. Selling efforts for these products are focused primarily on the Company’s existing payroll client base, as the processed payroll information allows for data integration necessary to provide these services efficiently. Retirement Services products were utilized by over 29,000 clients at May 31, 2004. This demonstrates the continuing interest of small- to medium-sized businesses in providing retirement savings benefits to their employees. Paychex is now one of the largest 401(k) recordkeepers for small businesses in the United States. Clients utilizing this service are charged a monthly fee and a fee per employee. Client employee 401(k) funds externally managed totaled approximately $3.9 billion at May 31, 2004. The Company earns a fee approximating thirty basis points from the external managers based on the total of client employee 401(k) funds.

      Workers’ Compensation Services: Most employers are required to carry workers’ compensation insurance, which provides payments to employees who are unable to work because of job-related injuries. Paychex provides Workers’ Compensation Insurance Administration services by serving, via its licensed insurance agency, as a general agent providing qualified workers’ compensation insurance through a variety of insurance

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      Section 125 Plans: The Company offers the outsourcing of plan administration under section 125 of the Internal Revenue Code. The Premium Only Plan allows employees to pay for certain health insurance benefits with pretax dollars, which can result in a reduction in payroll taxes for employers and employees. The Flexible Spending Account Plan allows a client’s employees to pay, with pretax dollars, health and dependent care expenses not covered by insurance. All required implementation, administration, compliance, claims processing and reimbursement, and coverage tests are provided with these services.

      Other Human Resource Products: Group health benefits are offered in select geographic areas, as are state unemployment insurance services, which provide clients with prompt processing for all claims, appeals, determinations, change statements, and requests for separation documents. Other Human Resource and Benefits products include employee handbooks, management manuals, and personnel forms. These products are designed to simplify clients’ office processes and enhance their employee benefits programs.

Sales and Marketing

      The Company markets its services primarily through its direct sales force based in major metropolitan markets serviced by the Company. The Company’s sales representatives specialize in Core Payroll, Major Market Services Payroll, or Human Resource and Benefits product lines. For fiscal 2005, the Company’s sales force is expected to total approximately 1,625, with 1,045 focused on Core Payroll, 175 focused on Major Market Services Payroll, and 405 focused on various Human Resource and Benefits products. The Human Resource and Benefits sales force is comprised of 220 401(k) recordkeeping sales representatives, 135 PAS/ PEO sales representatives, and 50 licensed agents selling Workers’ Compensation Insurance services. In addition to its direct selling and marketing efforts, the Company utilizes relationships with existing clients, certified public accountants (CPAs), and banks for new client referrals. Approximately two-thirds of the Company’s new clients (excluding acquisitions) come from these referral sources. To further enhance its strong relationship with CPAs, during fiscal 2004, Paychex partnered with the American Institute of Certified Public Accountants (AICPA) as the preferred payroll provider for its AICPA Business Solutions Partner Program. The sales force for Human Resource and Benefits products is primarily focused on selling products and services to existing payroll clients as their processed payroll information provides the data integration necessary to provide these services.

      The Company’s Web site at www.paychex.com, which includes online payroll sales presentations and product information, is a cost-efficient tool that serves as a source of leads and new sales while complementing the efforts of the field sales force. This online tool allows Paychex to market to clients in more geographically remote areas. The Company’s sales representatives are also supported by marketing, advertising, public relations, trade shows, and telemarketing programs. The Company has grown and expects to continue to grow its direct sales force. In recent years, the Company has increased its emphasis on the selling of ancillary services to both new clients and its existing client base.

      The acquisitions of Advantage and InterPay provided Paychex with additional sales channels. Paychex, through its acquisition of Advantage, has license agreements with fifteen independently owned associate offices, which are responsible for selling and marketing payroll services and performing certain operational functions, while Paychex provides all centralized back-office payroll processing and tax filing services. In addition, as a result of the Advantage acquisition, Paychex has a relationship with NEBS® (“New England Business Service, Inc.”) whereby Paychex performs all client functions other than sales and marketing. As part of the InterPay acquisition, Fleet entered into a referral relationship with Paychex.

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Competition

      The market for payroll processing and human resource services is highly competitive and fragmented. The Company believes its primary national competitor, ADP® (“Automatic Data Processing”), is the largest U.S. third-party provider of payroll processing and human resource services in terms of revenue. Paychex competes with other national, regional, local, and online service providers, all of which have significantly smaller client bases.

      In addition to traditional payroll processing and human resource service providers, the Company competes with in-house payroll and human resource systems and departments. Payroll and human resource systems and software are sold by many vendors. The Company’s Human Resource and Benefits products also compete with a variety of providers of unbundled human resource services, such as retirement services companies, insurance companies, and human resources and benefits consulting firms.

      Competition in the payroll processing and human resource services industry is primarily based on service responsiveness, product quality and reputation, breadth of product offering, and price. Paychex believes it is competitive in each of these areas.

Software Maintenance and Product Development

      The ever-changing mandates of federal, state, and local taxing authorities require Paychex to update the proprietary software utilized by the Company to provide Payroll and Human Resource and Benefits services to its clients. The Company is continually engaged in developing enhancements and maintenance to its various software platforms to meet the changing requirements of its clients and the marketplace. Research and development expenses are not significant to the Company’s overall results of operations.

Employees

      As of May 31, 2004, the Company employed approximately 9,400 people. None of the employees are covered by collective bargaining agreements.

Intellectual Property

      The Company owns or licenses and uses a number of trademarks, trade names, copyrights, service marks, trade secrets, computer programs and software, and other intellectual property rights. Taken as a whole, the Company’s intellectual property rights are material to the conduct of the Company’s business. Where it is determined to be appropriate, the Company takes measures to protect its intellectual property rights, including by way of example, through confidentiality/non-disclosure agreements or policies with employees, vendors and others, use of license agreements with licensees and licensors of intellectual property, and registration of certain trademarks. Paychex believes that the “Paychex” name, trademark, and logo are of material importance to the Company.

Seasonality

      There is no significant seasonality to the Company’s business. However, during the Company’s third fiscal quarter, which ends in February, the number of new Payroll clients, Retirement Services clients, and new PAS and PEO worksite employees tends to be higher than in the rest of the fiscal year, primarily because a majority of new clients start using services in the beginning of a calendar year. In addition, calendar year-end transaction processing and client funds activity are traditionally higher during the third fiscal quarter due to clients paying year-end bonuses and requesting additional year-end services. Historically, as a result of these factors, the Company’s total revenue has been slightly higher in the third and fourth fiscal quarters, with greater sales commission expenses also reported in these quarters.

Risk Factors

      The Company’s future results of operations are subject to a number of risks and uncertainties. These risks and uncertainties could cause actual results to differ materially from historical and current results and from

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      The Company may make errors and omissions in providing services: Processing, tracking, collecting, and remitting client funds to the various taxing authorities, client employees, and other third parties are complex operations. Errors have occurred in the past and are likely to occur in the future. These errors could include, but are not limited to, late filing with tax agencies, underpayment of taxes, and failure to comply with applicable banking regulations and laws relating to employee benefits administration, which could result in significant penalties and liabilities that would adversely affect the Company’s results of operations. The Company could also transfer funds in error to an incorrect party or for the wrong amount, and may be unable to correct the error or recover the funds, resulting in a loss to the Company.

      Changes in government regulations and policies could adversely impact the business: Many of the Company’s services, particularly tax filing and payment services and benefit plan administration services, are designed according to government regulations that continue to change. Changes in regulations could affect the extent and type of benefits employers are required, or may choose, to provide employees or the amount and type of taxes employers and employees are required to pay. Such changes could reduce or eliminate the need for some of the Company’s services and substantially decrease its revenue. Added requirements could also increase the cost of doing business. Failure by the Company to modify its services in a timely fashion in response to regulatory changes could have adverse effects on the Company’s results of operations.

      Failure of third-party service providers to perform their functions could harm the business: As part of providing services to clients, Paychex relies on a number of third-party service providers. These providers include, but are not limited to, couriers used to deliver client payroll checks and banks, which electronically transfer funds from clients to their employees. Failure by these providers, for any reason, to deliver their services in a timely manner could result in material interruptions to Company operations, impact client relations, and result in significant penalties or liabilities to the Company.

      Failure of the Company’s Business Continuity Plan in the event of a catastrophe could result in the loss of client data and adversely interrupt operations: The Company’s operations are dependent on its ability to protect its infrastructure against damage from catastrophe or natural disaster, security breach, power loss, telecommunications failure, terrorist attack, or similar event. The Company has a Business Continuity Plan in place in the event of system failure due to any of these events. If the Business Continuity Plan was unsuccessful in a disaster recovery scenario, the Company could potentially lose client data or experience material adverse interruptions to its operations.

      Integration of acquisitions: The effective integration of acquired companies may be difficult to achieve. It is also possible that the Company may not realize any or all expected benefits from recent acquisitions or achieve benefits from acquisitions in a timely manner. In addition, the Company may incur significant costs and impact existing internal resources in connection with the integration of acquisitions. Failure to effectively integrate recent and future acquisitions could affect the Company’s results of operations.

      Legal matters: The Company is subject to various claims and legal matters that arise in the normal course of business. These include disputes related to breach of contract, employment-related claims, intellectual property infringement, and other matters. In light of the legal reserve recorded, the Company’s management currently believes that resolution of these matters will not have a material adverse effect on the Company’s financial position or results of operations. However, these matters are subject to inherent uncertainties and there exists the possibility that their ultimate resolution could have a material adverse impact on the Company’s financial position and results of operations in the period in which any such effect is recorded.

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      Any of the above risk factors could cause damage to the Company’s business reputation, which is important to the Company’s ability to attract new clients and retain existing clients. Other risk factors include the following:

      Paychex clients could have insufficient funds to cover payments the Company has made on their behalf to taxing authorities and employees: As part of the payroll processing service, Paychex is authorized by its clients to transfer money from their bank accounts to fund amounts owed to their employees and various taxing authorities. It is possible that the Company would be held liable for such amounts in the event the client has insufficient funds to cover them. The Company has in the past, and may in the future, make payments on its clients’ behalf for which it is not reimbursed, resulting in a loss to the Company.

      Interest earned on funds held for clients could be impacted by changes in government regulations mandating the amount of tax withheld or timing of remittance: The Company receives interest income from investing client funds collected but not yet remitted to taxing authorities or to client employees. A change in regulations either decreasing the amount of taxes to be withheld or allowing less time to remit taxes to government authorities would adversely impact this interest income.

      Stock price volatility: The market price of the Company’s common stock may be influenced by factors such as quarterly variations in operating results, announcements of new services or technological innovations by the Company or its competitors, market conditions in the business process outsourcing industry, changes in ratings or financial estimates by securities analysts, general economic conditions, fluctuations in the stock market that are not directly related to the Company’s operating performance, and other factors and events that are beyond the Company’s control. These and other factors can lead to fluctuations in the price of the Company’s stock.

      Quantitative and qualitative disclosures about market risk: Refer to Item 7A of this Form 10-K for discussion on Market Risk Factors.

      The Company’s headquarters are located at 911 Panorama Trail South, Rochester, New York 14625 in a 140,000-square-foot building complex owned by the Company. In addition, within the Rochester area, the Company owns four facilities, which account for a combined total of 435,000 square feet, and leases approximately 67,000 square feet in two office complexes. These facilities house various administrative and technology functions, certain ancillary service functions, and a telemarketing unit.

      In addition, outside of Rochester, New York, the Company leases approximately 1,768,000 square feet of space for its regional, branch, and sales offices, and data processing centers at various locations throughout the United States, concentrating on major metropolitan areas. The Company owns branch facilities located in Syracuse, New York; Philadelphia, Pennsylvania; Auburn, Maine; and Rock Hill, South Carolina, which together account for approximately 105,000 square feet. The Company leases approximately 3,500 square feet of space for an office in Germany. The Company believes that adequate, suitable lease space will continue to be available for its needs.

      The Company is subject to various claims and legal matters that arise in the normal course of business. These include disputes related to breach of contract, employment-related claims, intellectual property infringement, and other matters.

      The Company and its wholly owned subsidiary, Rapid Payroll, Inc., are defendants in twenty-two lawsuits pending in Los Angeles Superior Court and the United States District Court for the Central District of California brought by licensees of payroll processing software owned by Rapid Payroll. In August of 2001, Rapid Payroll informed seventy-six licensees that it intended to stop supporting the software in August of 2002. Thereafter, thirty lawsuits were commenced by licensees asserting various claims, including breach of contract and related tort and fraud causes of action. These lawsuits seek compensatory damages, punitive damages, and injunctive relief against Rapid Payroll, the Company, its Chief Executive Officer, and its Senior

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      On June 18, 2004, a Superior Court jury found that Rapid Payroll had breached its license agreement with Payroll Partnership, L.P. and two related entities. The jury awarded approximately $6.4 million in compensatory damages against Rapid Payroll, which plans to file post-trial motions and, if necessary, to appeal. The Superior Court dismissed other claims against Rapid Payroll, the Company, and the individual defendants, including fraud and tort causes of action. The six remaining state court cases are to be tried one after the other in Superior Court, beginning with a jury trial currently scheduled to begin on August 23, 2004. Discovery and motions are continuing in the federal court cases, with the first trial currently scheduled to start in January 2005.

      Based on the application of Statement of Financial Accounting Standard (SFAS) No. 5, “Accounting for Contingencies,” the Company is required to record a reserve if it believes an unfavorable outcome is probable and the amount of the probable loss can be reasonably estimated. During the third and fourth quarters of fiscal 2004, the Company recorded $9.2 million and $26.6 million, respectively, in expense to increase the reserve for the estimated costs associated with the resolution of pending legal matters. The legal reserve totaled $35.0 million and $1.1 million at May 31, 2004 and May 31, 2003, respectively, and is included in other current liabilities on the Consolidated Balance Sheets. This reserve may change in the future due to new developments or changes in the Company’s strategies.

      In light of the legal reserve recorded, the Company’s management currently believes that resolution of these matters will not have a material adverse effect on the Company’s financial position or results of operations. However, these 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.

      No matter was submitted to a vote of security holders, through the solicitation of proxies or otherwise, during the fourth quarter of the fiscal year ended May 31, 2004.

PART II

      The Company’s common stock trades on The NASDAQ Stock Market® under the symbol “PAYX.” Dividends have historically been paid in August, November, February, and May. The level and continuation of future dividends are dependent on the Company’s future earnings and cash flows, and are subject to the discretion of the Board of Directors.

      On June 30, 2004, there were 19,201 holders of record of the Company’s common stock, which includes registered holders and participants in the Paychex, Inc. Dividend Reinvestment and Stock Purchase Plan. There were also 8,222 participants in the Paychex, Inc. Employee Stock Purchase Plan and 6,045 participants in the Paychex, Inc. Employee Stock Ownership Plan.

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      The high and low sale prices for the Company’s common stock as reported on The NASDAQ Stock Market and dividends for the two fiscal years ended May 31, 2004 and 2003, are as follows:

      The closing price of the Company’s common stock on May 28, 2004, as reported on The NASDAQ Stock Market, was $37.51 per share.

      Management’s Discussion and Analysis of Financial Condition and Results of Operations reviews the Company’s operating results for each of the three fiscal years in the period ended May 31, 2004 (fiscal 2004, 2003, and 2002), and its financial condition at May 31, 2004. This review should be read in conjunction with the accompanying Consolidated Financial Statements and the related Notes to Consolidated Financial Statements contained in Item 8 of this Form 10-K and risk factors discussed in Item 1 of this Form 10-K. Forward-looking statements in this review are qualified by the cautionary statement under the heading “Safe Harbor” Statement under the Private Securities Litigation Reform Act of 1995 contained at the beginning of this Form 10-K.

Overview

      Paychex is a leading, national provider of comprehensive payroll and integrated human resource and employee benefits outsourcing solutions for small-to medium-sized businesses. The Company has a broad portfolio of products and services that allows its clients to meet their diverse payroll and human resource needs. These include payroll processing, tax filing and payment, employee payment, time and attendance systems, regulatory compliance (new-hire reporting and garnishment processing), retirement services administration, employee benefits administration, workers’ compensation insurance, and comprehensive bundled human resource administrative services. The Company’s strategy is focused on growing its client base, increasing utilization of ancillary services, and leveraging its technological and operating infrastructure. The Company earns its revenues primarily through recurring fees for repetitive services performed related to these products. Service revenues are largely driven by the number of clients, utilization of ancillary services, and

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      In fiscal 2004, the Company completed its fourteenth consecutive year of record total revenues, net income, and diluted earnings per share. For fiscal 2004, total revenues grew 18% year-over-year to $1,294.3 million. This in turn generated net income of $303.0 million, or $.80 diluted earnings per share. In comparison, revenues for fiscal 2003 increased 15% year-over-year to $1,099.1 million. Net income in fiscal 2003 was $293.5 million, or $.78 diluted earnings per share. Year-over-year growth in net income was 3% and 7% for fiscal 2004 and fiscal 2003, respectively. Operating income increased 8% year-over-year in fiscal 2004 to $433.3 million, compared with a year-over-year increase in fiscal 2003 of 10% to $401.0 million.

      During fiscal 2004, the Company’s results of operations were impacted by expense charges to increase the reserve for pending legal matters of Rapid Payroll, Inc. (a wholly owned subsidiary of the Company). These charges totaled $35.8 million, reflecting $9.2 million recorded in the third quarter and $26.6 million recorded in the fourth quarter. The expense charges reduced diluted earnings per share for fiscal 2004 by approximately $.06 per share.

      The fiscal 2004 results of operations were also impacted by approximately $6.4 million of net incremental PEO revenue resulting from a refund of PEO workers’ compensation insurance premiums and a reduction of the estimated claims loss exposure under the fiscal 2003 insurance policy, which was recorded in the third quarter.

      The Company’s results of operations for fiscal 2004 and fiscal 2003 were also impacted by the acquisitions in fiscal 2003 of two payroll service providers servicing small- to medium-sized businesses in the United States. On September 20, 2002, Paychex acquired Advantage Payroll Services, Inc. (“Advantage”) for $314 million in cash. On April 1, 2003, Paychex acquired InterPay, Inc. (“InterPay”) for $182 million in cash. These two acquisitions provided Paychex with over 80,000 new clients. The Company’s results of operations for fiscal 2004 include the results of Advantage and InterPay for the entire period. The results of operations for fiscal 2003 include the results of Advantage and InterPay from the respective dates of acquisition. In April 2004, the Company acquired substantially all of the assets and certain liabilities of Stromberg LLC (“Stromberg”), a provider of time and attendance software solutions, for $13.6 million. The Company paid $12.6 million in the fourth quarter of fiscal 2004 and an additional $1.0 million is expected to be paid in the fourth quarter of fiscal 2005. The Stromberg acquisition did not have a material impact on the results of operations of the Company for fiscal 2004. For additional information related to these acquisitions refer to Note B in the Notes to Consolidated Financial Statements, contained in Item 8 of this Form 10-K.

      During fiscal 2002, fiscal 2003, and fiscal 2004, the Company, and the industry as a whole, experienced lower growth rates as a result of challenging economic conditions and the effect of lower interest rates. The downturn in the economy impacted payroll service revenues as a result of lower checks per client as existing clients reduced their work forces. Checks per client (excluding Advantage and InterPay) decreased 3.0% and ..5% year-over-year in fiscal 2002 and fiscal 2003, respectively. For fiscal 2004, checks per client (excluding Advantage and InterPay) were relatively comparable with the prior year period.

      In response to economic conditions, the Federal Reserve lowered the Federal Funds rate thirteen times from January 2001 through May 31, 2004 to 1.00%, for a cumulative 550-basis-point reduction. Lower interest rates have adversely impacted income earned on the Company’s funds held for clients and corporate investment portfolios. During the last three fiscal years, the Company was able to offset some of the impact of lower interest rates by realizing gains from the sale of available-for-sale investments in both the client funds and corporate investment portfolios.

      Due to the impact of fluctuations in interest rates earned on funds held for clients and corporate investments, the Company also focuses on operating income excluding interest on funds held for clients in evaluating the results of operations. Operating income excluding interest on funds held for clients experienced year-over-year growth of 9% in fiscal 2004 and 16% in fiscal 2003, increasing to $379.1 million and $347.9 million, respectively. Operating income was also impacted by the $35.8 million of expense charges to increase the reserve for pending legal matters and the $6.4 million of net incremental PEO revenue. Operating

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      Paychex continues to make investments in the business as part of its growth strategy. Some of these investments include the following:

      Growing the client base and increasing utilization of ancillary services: In fiscal 2004, the Company reached a milestone as its client base increased to approximately 505,000 clients at May 31, 2004. This compares with approximately 490,000 clients at May 31, 2003, and over 390,000 clients at May 31, 2002. The acquisitions of Advantage and InterPay in fiscal 2003 accounted for over 80,000 clients. Year-over-year client growth was approximately 3% for fiscal 2004. Client growth excluding the impact of the acquisitions was approximately 7% for fiscal 2004 and slightly less than 5% for fiscal 2003.

      Paychex has continued to invest in its direct sales force, as the Company believes there is opportunity for growth within the target market of small- to medium-sized businesses. The approximate composition of the Company’s direct sales force is summarized in the following table:

      The Company believes there are opportunities for growth within the current client base, as well as with new clients, through increased utilization of the Company’s payroll-related and human resource ancillary services. Ancillary services effectively leverage the payroll processing data and, therefore, are beneficial to the Company’s operating margin. Penetration of the Company’s tax filing and payment services and employee payment services has continued to increase, and totals 89% and 63%, respectively, at May 31, 2004. Client bases in the human resource and employee benefits areas have continued to grow, as shown in the following table:

      Effective integration of acquired businesses: During fiscal 2003 and fiscal 2004, the Company has been integrating Advantage and InterPay into the operations of Paychex. These integration efforts will lead to efficiencies in operations and services provided to clients. By the end of fiscal 2003, the sales forces of these companies were combined with the Paychex sales force, and the responsibility for their operations and corporate support had been integrated into the management structure of Paychex. By the end of fiscal 2004, most branch operations had been integrated into existing Paychex locations. The Company’s primary integration focus continues to be on client service and retention. The Advantage payroll system is being retained for the foreseeable future in order to service clients affiliated with independently owned associate offices and Advantage co-branded products. Approximately one-half of the InterPay clients were converted to Paychex software platforms by the end of May 2004, with the remaining clients expected to be converted by December 2004.

      Focus on customer service: The Company has always focused on customer service and minimizing client losses, and in fiscal 2004, client satisfaction survey results improved over fiscal 2003. Client losses, which are slightly higher than 20% of the beginning client base, are near historical lows. The most significant factor contributing to client losses is companies going out of business. In addition, Paychex has invested in efforts to reduce turnover of payroll specialists, who are the primary contact with the clients, through improvements in

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      Other initiatives: Other initiatives during fiscal 2004 include the following:

	•	Paychex expanded its product line to include time and attendance solutions products.
	•	In the fourth quarter of fiscal 2004, Paychex began operating a start-up payroll sales and operations facility in Germany. This represents the first expansion of Paychex outside of the United States.
	•	Paychex expanded its network of offices within the United States by opening four new offices in mid-tier markets. The Company anticipates opening additional offices in similar-sized markets in fiscal 2005.

      None of these initiatives, either individually or in the aggregate, had a material impact on the Company’s results of operations.

      In fiscal 2003, the Company placed into service a $30 million consolidated data center in Rochester, New York. This data center was designed to enhance data processing and disaster recovery capabilities.

      At May 31, 2004, the Company maintains a strong financial position with total cash and corporate investments of $523.8 million. The Company’s primary source of cash is its ongoing operations. Cash flow from operations was $390.1 million in fiscal 2004 and $373.7 million in fiscal 2003, year-over-year increases of 4% and 23%, respectively. Historically, the Company has funded its operations, capital purchases, purchases of corporate investments, and dividend payments from its operating activities. The acquisitions of Advantage and InterPay in fiscal 2003 and Stromberg in fiscal 2004, were funded from the Company’s cash and corporate investments. It is anticipated that current cash and corporate investment balances, along with projected operating cash flows, will support normal business operations, capital purchases, and current dividend payments for the foreseeable future.

      For further analysis of the Company’s results of operations for fiscal years 2004, 2003, and 2002, and financial position at May 31, 2004, refer to the discussion of “Critical Accounting Policies” and the charts and analysis in the “Results of Operations” and “Liquidity and Capital Resources” sections of this review.

Critical Accounting Policies

      Note A to the Consolidated Financial Statements, included in Item 8 of this Form 10-K, discusses the significant accounting policies of Paychex, Inc. The Company’s discussion and analysis of its financial condition and results of operations are based upon its Consolidated Financial Statements, which have been prepared in accordance with U.S. generally accepted accounting policies. The preparation of these financial statements requires the Company’s management to make estimates, judgments, and assumptions that affect reported amounts of assets, liabilities, revenues, and expenses. On an ongoing basis, the Company evaluates the accounting policies and estimates used to prepare the Consolidated Financial Statements, including, but not limited to, those related to revenue recognition, PEO workers’ compensation insurance, investments, goodwill and intangible assets, fixed assets, potential losses resulting from its clients’ inability to meet their payroll obligations, contingencies, allowance for doubtful accounts, and income taxes. The Company bases its estimates on historical experience, future expectations, and assumptions believed to be reasonable under current facts and circumstances. Actual amounts and results could differ from these estimates. Certain accounting policies that are deemed critical to the Company’s results of operations or financial position are discussed below.

      Revenue recognition: Service revenues are recognized in the period services are rendered and earned under service arrangements with clients where service fees are fixed or determinable and collectibility is reasonably assured. Certain processing services are provided under annual service arrangements with revenue recognized ratably over the annual service period. The Company’s service revenues are largely attributable to payroll-related processing services where the fee is based on a fixed amount per processing period or a fixed amount per processing period plus a fee per employee or transaction processed. Paychex provides delivery service for the distribution of certain client payroll checks and reports. The revenue earned from delivery

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      Professional Employer Organization (PEO) revenues are included in service revenues and are 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 for PEO worksite employees were $1,846.1 million, $1,460.7 million, and $1,056.9 million for fiscal 2004, 2003, and 2002, respectively.

      Interest on funds held for clients is earned primarily on funds that are collected from clients before due dates, for payroll tax filing and payment services and employee payment services, and invested (funds held for clients) until remittance to the applicable tax agencies or client employees. These collections from clients are typically remitted between one and thirty days after receipt, with some items extending to ninety days. The interest earned on these funds is included in total revenues on the Consolidated Statements of Income because the collection, holding, and remittance of these funds are critical components of providing these services. Interest on funds held for clients also includes net realized gains and losses from the sale of available-for-sale securities.

      PEO workers’ compensation insurance: In fiscal 2003, workers’ compensation insurance for PEO worksite employees was provided under a pre-funded, deductible workers’ compensation policy with a national insurance company. Under this policy, the Company’s maximum individual claims liability was $250,000 and the aggregate claims exposure was based on a percentage of premium rates as applied to workers’ compensation payroll.

      Based on claims experience, during the third quarter of fiscal 2004, the Company recorded approximately $6.4 million of net incremental PEO revenue resulting from a refund of insurance premiums and a reduction in estimated claims loss exposure under the fiscal 2003 policy. The fiscal 2004 policy is similar to the fiscal 2003 policy, except that the Company’s maximum individual claims liability is $500,000. At May 31, 2004, the Company has recorded $1.8 million in current liabilities for workers’ compensation claims cost based on the estimated loss exposure under the fiscal 2003 policy, and an estimated prepayment of $5.0 million under the fiscal 2004 policy in prepaid expenses and other current assets. These estimates may change in the future based on claims experience trends.

      Valuation of investments: The Company’s investments in debt securities are reported at fair value. Unrealized gains related to increases in the fair value of investments and unrealized losses related to decreases in the fair value are included in comprehensive income as reported on the Company’s Consolidated Statements of Stockholders’ Equity. However, changes in the fair value of investments impact the Company’s net income only when such investments are sold or impairment is recognized. Realized gains and losses on the sale of securities are determined by specific identification of the security’s cost basis. On the Consolidated Statements of Income, realized gains and losses from funds held for clients are included in interest on funds held for clients, whereas realized gains and losses from corporate investments are included in investment income, net.

      The Company is exposed to credit risk in connection with these investments through the possible inability of the borrowers to meet the terms of the bonds. The Company attempts to mitigate this risk by investing primarily in high-credit-quality securities. The Company periodically reviews its investment port