Notes to the Consolidated Financial Statements

(Tabular dollars in millions, except per share amounts)
(Unaudited)

Note 1. Basis of Presentation
 

The accompanying unaudited consolidated financial statements reflect all adjustments that, in the opinion of management, are necessary for a fair presentation of the results for the interim periods. Adjustments are of a normal recurring nature. These unaudited consolidated financial statements should be read in conjunction with the consolidated financial statements and related notes of Automatic Data Processing, Inc. and subsidiaries (“ADP” or the “Company”) as of and for the year ended June 30, 2009 (“fiscal 2009”). The results of operations for the three months ended September 30, 2009 may not be indicative of the results to be expected for the fiscal year ending June 30, 2010 (“fiscal 2010”).
 

Note 2. New Accounting Pronouncements
 

In June 2009, the Financial Accounting Standards Board (“FASB”) issued FASB Accounting Standards Codification (“ASC”) 105.10.05, “Generally Accepted Accounting Principles” (“ASC 105.10.05”). ASC 105.10.05 establishes the FASB ASC as the single source of authoritative generally accepted accounting principles (“GAAP”). Pursuant to the provisions of ASC 105.10.05, the Company has updated references to GAAP in its financial statements issued subsequent to September 15, 2009. The adoption of ASC 105.10.05 did not have any impact on the Company’s consolidated results of operations, financial condition or cash flows.

In October 2009, the FASB issued Accounting Standards Update (“ASU”) 2009-13, “Multiple Deliverable Revenue Arrangements.” ASU 2009-13 modifies the guidance related to accounting for arrangements with multiple deliverables by providing an alternative when vendor specific objective evidence (“VSOE”) or third-party evidence (“TPE”) does not exist to determine the selling price of a deliverable. The alternative when VSOE or TPE does not exist is the best estimate of the selling price of the deliverable. Consideration for multiple deliverables is then allocated based upon the relative selling price of the deliverables and revenue is recognized as earned for each deliverable. ASU 2009-13 is effective prospectively for revenue arrangements entered into or materially modified in fiscal years beginning on or after June 15, 2010, unless the election is made to adopt ASU 2009-13 retrospectively. In either case, early adoption is permitted. The Company is currently evaluating the impact, if any, that the adoption of ASU 2009-13 will have on its consolidated results of operations, financial condition or cash flows.
 
In October 2009, the FASB issued ASU No. 2009-14, “Certain Revenue Arrangements that Include Software Elements” (“ASU 2009-14”). ASU 2009-14 modifies the scope of the software revenue recognition guidance to exclude (a) non-software components of tangible products and (b) software components of tangible products that are sold, licensed, or leased with tangible products when the software components and non-software components of the tangible product function together to deliver the tangible product’s functionality. ASU 2009-14 is effective prospectively for revenue arrangements entered into or materially modified in fiscal years beginning on or after June 15, 2010, unless the election is made to adopt ASU 2009-14 retrospectively. In either case, early adoption is permitted. The Company is currently evaluating the impact, if any, that the adoption of ASU 2009-14 will have on its consolidated results of operations, financial condition or cash flows.
 
In August 2009, the FASB issued ASU No. 2009-05, “Measuring Liabilities at Fair Value” (“ASU 2009-05”). ASU 2009-05 provides additional guidance which clarifies measuring liabilities at fair value under ASC 820.10, “Fair Value Measurements and Disclosures.” ASU 2009-05 is effective for the first reporting period (including interim periods) beginning after August 2009. The Company does not anticipate the adoption of ASU 2009-05 will have any impact on its consolidated results of operations, financial condition or cash flows.

In December 2008, the FASB issued ASC 715.20.65, “Retirement Benefits – Defined Benefit Plans.” ASC 715.20.65 requires additional disclosures in relation to plan assets of defined benefit pension or other postretirement plans. ASC 715.20.65 is effective for fiscal years ending after December 15, 2009 with early application permitted. The Company does not anticipate the adoption of ASC 715.20.65 will have a material impact on its consolidated results of operations, financial condition or cash flows.
 

In June 2008, the FASB issued ASC 260.10.45, “Earnings per Share.” ASC 260.10.45 provides that unvested share-based payment awards that contain nonforfeitable rights to dividends or dividend equivalents (whether paid or unpaid) are participating securities and shall be included in the computation of earnings per share pursuant to the two-class method. ASC 260.10.45 is effective for financial statements issued for fiscal years beginning after December 15, 2008, and interim periods within those fiscal years. Upon adoption, companies are required to retrospectively adjust earnings per share data (including any amounts related to interim periods, summaries of earnings and selected financial data) to conform to provisions of ASC 260.10.45. On July 1, 2009, the Company adopted ASC 260.10.45 and the adoption did not have a material impact on its consolidated results of operations, financial condition or cash flows.

In April 2008, the FASB issued ASC 350.30, “Intangibles – Goodwill and Other.” ASC 350.30 amends the factors that should be considered in developing renewal or extension assumptions used to determine the useful life of a recognized intangible asset. ASC 350.30 also requires expanded disclosure related to the determination of intangible asset useful lives. ASC 350.30 is effective for financial statements issued for fiscal years beginning after December 15, 2008, and interim periods within those fiscal years for intangible assets acquired after the effective date. On July 1, 2009, the Company adopted ASC 350.30 and the adoption did not have a material impact on its consolidated results of operations, financial condition or cash flows.

In December 2007, the FASB issued ASC 805.10, “Business Combinations.” ASC 805.10 establishes principles and requirements for how the acquirer in a business combination recognizes and measures in its financial statements the identifiable assets acquired, the liabilities assumed, any controlling interest in the business and the goodwill acquired. ASC 805.10 further requires that acquisition-related costs and costs associated with restructuring or exiting activities of an acquired entity will be expensed as incurred. ASC 805.10 also establishes disclosure requirements that will require disclosure on the nature and financial effects of the business combination. Additionally, in April 2009, the FASB issued ASC 805.20, “Identifiable Assets and Liabilities, and Any Noncontrolling Interest.” ASC 805.20 amends and clarifies ASC 805.10 to address application issues on initial recognition and measurement, subsequent measurement and accounting, and disclosure of assets and liabilities arising from contingencies in a business combination. ASC 805.10 and ASC 805.20 will impact business combinations that may be completed by the Company on or after July 1, 2009. On July 1, 2009, the Company adopted ASC 805.10 and ASC 805.20 and the adoption did not have a material impact on its consolidated results of operations, financial condition or cash flows as no business combinations were completed subsequent to adoption.

In September 2006, the FASB issued ASC 820.10, “Fair Value Measurements and Disclosures.” ASC 820.10 clarifies the definition of fair value, establishes a framework for measuring fair value, and expands the disclosures on fair value measurements. ASC 820.10 is effective for fiscal years beginning after November 15, 2007, except for non-financial assets and liabilities recognized or disclosed at fair value on a non-recurring basis, for which the effective date is fiscal years beginning after November 15, 2008. On July 1, 2008, the Company adopted ASC 820.10 for assets and liabilities recognized or disclosed at fair value on a recurring basis. On July 1, 2009, the Company adopted ASC 820.10 for non-financial assets that are recognized or disclosed on a non-recurring basis. The adoption of ASC 820.10 did not have an impact on its consolidated results of operations, financial condition or cash flows.

Options to purchase 33.7 million and 13.6 million shares of common stock for the three months ended September 30, 2009 and 2008, respectively, were excluded from the calculation of diluted earnings per share because their exercise prices exceeded the average market price of outstanding common shares for the respective period.

Proceeds from sales and maturities of available-for-sale securities were $1,007.8 million and $704.0 million for the three months ended September 30, 2009 and 2008, respectively.

The Company has an outsourcing agreement with Broadridge Financial Solutions, Inc. (“Broadridge”) pursuant to which the Company provides data center outsourcing services, which principally consist of information technology services and service delivery network services. As a result of the outsourcing agreement, the Company recognized income of $26.0 million and $25.8 million for the three months ended September 30, 2009 and 2008, respectively, which is offset by expenses directly associated with providing such services of $25.4 million and $25.2 million, respectively, both of which were recorded in other income, net, on the Statements of Consolidated Earnings. The Company had a receivable on the Consolidated Balance Sheets from Broadridge for the services under this agreement of $8.6 million and $8.7 million as of September 30, 2009 and June 30, 2009, respectively.
 

During the three months ended September 30, 2009, the Company realized impairment losses on available-for-sale securities of $5.3 million in other income, net on the Statements of Consolidated Earnings. Additionally, during the three months ended September 30, 2009, the Company sold a building and, as a result, recorded a gain of $1.5 million in other income, net, on the Statements of Consolidated Earnings. This building was previously reported in assets held for sale on the Consolidated Balance Sheets.
 
During the three months ended September 30, 2008, the Company recorded a $3.3 million loss to other income, net on the Statements of Consolidated Earnings related to the Primary Fund of the Reserve Fund (the “Reserve Fund”).

Note 5 . Divestitures

During the three months ended September 30, 2008, the Company recorded a charge of $1.1 million within earnings from discontinued operations on the Statements of Consolidated Earnings related to a change in estimated taxes on the divestitures of businesses.
 

There were no assets or liabilities of discontinued operations as of September 30, 2009 or June 30, 2009.

At September 30, 2009, U.S. Treasury and direct obligations of U.S. government agencies primarily include debt directly issued by Federal Home Loan Banks, Federal Home Loan Mortgage Corporation (“Freddie Mac”) and Federal National Mortgage Association (“Fannie Mae”) with fair values of $1,734.9 million, $1,300.5 million and $1,306.4 million, respectively. At June 30, 2009, U.S. Treasury and direct obligations of U.S. government agencies primarily include debt directly issued by Federal Home Loan Banks, Freddie Mac and Fannie Mae with fair values of $1,906.4 million, $1,463.6 million and $1,352.5 million, respectively. U.S. Treasury and direct obligations of U.S. government agencies represent senior, unsecured, non-callable debt that carries a credit rating of AAA and has maturities ranging from October 2009 through August 2019.
 
At September 30, 2009, asset-backed securities include senior tranches of securities with predominately prime collateral of fixed rate credit card, rate reduction, auto loan, student loan and equipment lease receivables with fair values of $717.6 million, $348.8 million, $208.6 million, $25.5 million and $28.7 million, respectively. At June 30, 2009, asset-backed securities include senior tranches of securities with predominately prime collateral of fixed rate credit card, rate reduction, auto loan, student loan and equipment lease receivables with fair values of $808.4 million, $384.2 million, $244.9 million, $49.8 million and $34.4 million, respectively. These securities are collateralized by the cash flows of the underlying pools of receivables. The primary risk associated with these securities is the collection risk of the underlying receivables. All collateral on such asset-backed securities has performed as expected through September 30, 2009.
 
At September 30, 2009, other securities and their fair value primarily represent AAA rated commercial mortgage-backed securities of $773.0 million, municipal bonds of $466.1 million, AAA rated mortgage-backed securities of $184.1 million that are guaranteed by Fannie Mae and Freddie Mac, Canadian provincial bonds of $192.3 million, supranational bonds of $244.4 million and corporate bonds backed by the Federal Deposit Insurance Corporation’s Temporary Liquidity Guarantee Program of $131.8 million. At June 30, 2009, other securities and their fair value primarily represent AAA rated commercial mortgage-backed securities of $759.3 million, municipal bonds of $462.0 million, AAA rated mortgage-backed securities of $186.8 million that are guaranteed by Fannie Mae and Freddie Mac, Canadian provincial bonds of $170.2 million, supranational bonds of $160.0 million and corporate bonds backed by the Federal Deposit Insurance Corporation’s Temporary Liquidity Guarantee Program of $137.6 million. The Company’s AAA rated mortgage-backed securities represent an undivided beneficial ownership interest in a group or pool of one or more residential mortgages. These securities are collateralized by the cash flows of 15-year and 30-year residential mortgages and are guaranteed by Fannie Mae and Freddie Mac as to the timely payment of principal and interest.
 
Classification of corporate investments on the Consolidated Balance Sheets is as follows:
 

Funds held for clients represent assets that, based upon the Company’s intent, are restricted for use solely for the purposes of satisfying the obligations to remit funds relating to our payroll and payroll tax filing services, which are classified as client funds obligations on our Consolidated Balance Sheets. Funds held for clients have been invested in the following categories:
 

Client funds obligations represent the Company’s contractual obligations to remit funds to satisfy clients’ payroll and tax payment obligations and are recorded on the Consolidated Balance Sheets at the time that the Company impounds funds from clients. The client funds obligations represent liabilities that will be repaid within one year of the balance sheet date. The Company has reported client funds obligations as a current liability on the Consolidated Balance Sheets totaling $15,633.7 million and $15,992.6 million as of September 30, 2009 and June 30, 2009, respectively. The Company has classified funds held for clients as a current asset since these funds are held solely for the purposes of satisfying the client funds obligations.
 
The Company has reported the cash flows related to the purchases of corporate and client funds marketable securities and related to the proceeds from the sales and maturities of corporate and client funds marketable securities on a gross basis in the investing section of the Statements of Consolidated Cash Flows. The Company has reported the cash inflows and outflows related to client funds investments with original maturities of 90 days or less on a net basis within net (increase) decrease in restricted cash and cash equivalents and other restricted assets held to satisfy client funds obligations in the investing section of the Statements of Consolidated Cash Flows. The Company has reported the cash flows related to the cash received from and paid on behalf of clients on a net basis within net decrease in client funds obligations in the financing section of the Statements of Consolidated Cash Flows.
 
At September 30, 2009, approximately 83% of the available-for-sale securities held an AAA or AA rating, as rated by Moody’s, Standard & Poor’s and, for Canadian securities, Dominion Bond Rating Service. All available-for-sale securities were rated as investment grade at September 30, 2009 with the exception of the Reserve Fund investment discussed below.
 

Available-for-sale securities that have been in an unrealized loss position for periods of less than and greater than 12 months as of September 30, 2009 are as follows:
 

Expected maturities of available-for-sale securities at September 30, 2009 are as follows:
 

The Company has an investment in a money market fund called the Reserve Fund. During the quarter ended September 30, 2008, the net asset value of the Reserve Fund decreased below $1 per share as a result of the full write-off of the Reserve Fund’s holdings in debt securities issued by Lehman Brothers Holdings, Inc., which filed for bankruptcy protection on September 15, 2008. The Reserve Fund has suspended redemptions and is in the process of being liquidated. In fiscal 2009, the Company reclassified $211.1 million of its investment from cash and cash equivalents to short-term marketable securities on the Consolidated Balance Sheet due to the fact that these assets no longer met the definition of a cash equivalent. Additionally, the Company reflected the impact of such reclassification on the Statements of Consolidated Cash Flows for fiscal 2009 as reclassification from cash equivalents to short-term marketable securities. During fiscal 2009, the Company recorded an $18.3 million loss to other income, net, on the Statement of Consolidated Earnings to recognize its pro-rata share of the estimated losses of the Reserve Fund, of which $3.3 million was recorded during the three months ended September 30, 2008. As of September 30, 2009, the Company had received approximately $198.5 million in distributions from the Reserve Fund. As of September 30, 2009, the Company had a remaining balance of $3.9 million in short-term marketable securities related to the Reserve Fund. Any distributions received from the Reserve Fund in excess of the remaining balance of $3.9 million will be recognized as realized gains on available-for-sale securities. During October 2009, the Company received a $4.3 million distribution from the Reserve Fund.

At September 30, 2009, the Company concluded that it had the intent to sell certain securities for which unrealized losses of $5.3 million were previously recorded in accumulated other comprehensive income on the Consolidated Balance Sheets. As such, the Company realized impairment losses of $5.3 million in other income, net on the Statements of Consolidated Earnings during the three months ended September 30, 2009. During October 2009, the Company sold these securities. For the remaining securities in an unrealized loss position at September 30, 2009, the Company concluded that it did not have the intent to sell such securities and that it was not more likely than not that the Company would be required to sell such securities before recovery.
 
At September 30, 2009, the Company evaluated the unrealized losses of $17.2 million related to the debt securities in an unrealized loss position for which the Company did not have the intent to sell such securities and that it was not more likely than not that the Company would be required to sell such securities before recovery in order to determine whether such losses were due to credit losses. The securities with unrealized losses of $17.2 million were primarily comprised of corporate bonds and commercial mortgage backed securities. The Company evaluated such securities utilizing a variety of quantitative and qualitative factors including whether the Company expects to collect all amounts due under the contractual terms of the security, information about current and past events of the issuer, and the length of time and the extent to which the fair value has been less than the cost basis. At September 30, 2009, the Company concluded that unrealized losses on available-for-sale securities held at September 30, 2009 were not credit losses and were attributable to other factors, including changes in interest rates. As a result, the Company concluded that the $17.2 million in unrealized losses on such securities should be recorded in accumulated other comprehensive income on the Consolidated Balance Sheets at September 30, 2009.
 

Not e 7 . Fair Value Measurements

On July 1, 2008, the Company adopted ASC 820.10 for assets and liabilities recognized or disclosed at fair value on a recurring basis. On July 1, 2009, the Company adopted ASC 820.10 for non-financial assets that are recognized or disclosed on a non-recurring basis. The guidance in ASC 820.10 clarifies the definition of fair value, establishes a framework for measuring fair value, and expands the disclosures on fair value measurements. ASC 820.10 defines fair value as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants. ASC 820.10 establishes market or observable inputs as the preferred source of fair value, followed by assumptions based on hypothetical transactions in the absence of market inputs.

The valuation techniques required by ASC 820 .10 are based upon observable and unobservable inputs. Observable inputs reflect market data obtained from independent sources, while unobservable inputs reflect our market assumptions. These two types of inputs create the following three-level hierarchy to prioritize the inputs used in measuring fair value. The levels within the hierarchy are described below with Level 1 having the highest priority and Level 3 having the lowest priority.