Notes to Financial Statements
Kelly Services, Inc. and Subsidiaries
(In thousands of dollars except share and per share items)

1. Summary of Significant Accounting Policies

The Company's fiscal year ends on the Sunday nearest to December 31. The three most recent years ended on January 3, 1999 (1998), December 28, 1997 (1997) and December 29, 1996 (1996).

The financial statements consolidate the accounts and operations of the Company and its subsidiaries, all of which are wholly owned, after elimination of all intercompany accounts and transactions.

The Company divides its operations into three segments: (1) U.S. Commercial Staffing, (2) Professional, Technical and Staffing Alternatives and (3) International. The accounts of the Company's foreign operations are translated at appropriate rates of exchange. Revenues, costs and expenses of foreign subsidiaries are translated to U.S. dollars at average-period exchange rates. Assets and liabilities of foreign subsidiaries are translated to U.S. dollars at year-end exchange rates with the effects of these translation adjustments being reported as a separate component of accumulated other comprehensive income in stockholders' equity.

Foreign operations are conducted in Australia, Belgium, Canada, Denmark, France, Germany, Ireland, Italy, Luxembourg, Mexico, the Netherlands, New Zealand, Norway, Puerto Rico, Russia, Spain, Switzerland and the United Kingdom. Refer to the Segment Disclosures footnote for additional information.

Revenue from sales of services is recognized as services are provided by the temporary, contract or leased employees. Revenue from permanent placement fees is recognized at the time the permanent placement candidate begins full-time services.

The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses. Actual results could differ from those estimates.

Certain prior year amounts have been reclassified to conform with the current presentation.

2. Current Assets

Cash and equivalents are stated at cost, which approximates market. Included are highly liquid debt instruments with original maturities of three months or less.

Short-term investments are debt instruments having original maturities of more than three months and are classified as available for sale. Of these investments, federal, state and local government obligations comprised approximately 80% in 1998, 70% in 1997 and 90% in 1996. Short-term investments due within one year totaled $64,000 in 1997 with the balance due within two years. The entire short-term investments balance in 1998 and 1996 was due within one year. The difference between carrying amounts and market was not material at January 3, 1999, December 28, 1997 and December 29, 1996.

Interest income was $6,206, $4,390 and $4,204, respectively, for the years 1998, 1997 and 1996.

3. Supplemental Cash Flow Information

Changes in certain working capital components, as disclosed in the statements of cash flows, for the years 1998, 1997 and 1996 were as follows:

Cash flows from short-term investments for 1998, 1997 and 1996 were as follows:

4. Property and Equipment

Properties are stated at cost and include expenditures for additions and major improvements. Fully depreciated assets are eliminated from the accounts. For financial reporting purposes, assets are depreciated over their estimated useful lives, principally by the straight-line method. Estimated useful lives range from 15 to 45 years for land improvements, buildings and building improvements, 5 years for equipment, furniture and leasehold improvements and 3 to 12 years for computer hardware and software. Depreciation expense was $25,400 for 1998, and $22,900 for 1997 and 1996.

The Company conducts its field operations primarily from leased facilities. The following is a schedule by fiscal year of future minimum lease commitments as of January 3, 1999:

Lease expense for 1998, 1997 and 1996 amounted to $38,600, $35,900 and $32,900, respectively.

5. Intangibles and Other Assets

Intangibles and other assets include goodwill of $64,100, $56,000 and $58,000 at year-ends 1998, 1997 and 1996, respectively. Goodwill, which represents the excess of cost over net assets of businesses acquired, is amortized on a straight-line basis over periods not exceeding 40 years. Accumulated amortization of goodwill at 1998, 1997 and 1996 was $6,900, $5,300 and $4,200, respectively.

The Company periodically reviews the specific carrying amounts of goodwill and has determined that no impairments have occurred. Such reviews are based on various analyses including profitability projections and management's judgment of the related business' ability to achieve sufficient profitability.

Other assets include deposits and cash values of life insurance on the lives of officers and key employees.

6. Capitalization

The authorized capital stock of the Company is 100,000,000 shares of Class A common stock and 10,000,000 shares of Class B common stock. Class A shares have no voting rights and are not convertible. Class B shares have voting rights and are convertible into Class A shares on a share-for-share basis at any time. Both classes of stock have identical rights in the event of liquidation.

On September 29, 1998 and November 24, 1998, the Company repurchased 1,500,000 and 1,000,000 shares of its Class A common stock, respectively, in negotiated transactions from the William R. Kelly Trust. The total value of the Class A shares repurchased was $75,886. In addition, the Company repruchased 1,937 Class B shares at a total cost of $63.

7. Earnings Per Share

The reconciliations of earnings per share computations for the fiscal years 1998, 1997 and 1996 were as follows:

Stock options to purchase 458,000, 423,000 and 618,000 shares of common stock at a weighted average price per share of $35.17, $31.02 and $30.46 were outstanding during 1998, 1997 and 1996, respectively, but were not included in the computation of diluted earnings per share. The options' exercise price was greater than the average market price of the common shares and was anti-dilutive.

8. Short-term Borrowings

Short-term borrowings of $47,629, $54,958 and $41,616 were outstanding at year-ends 1998, 1997 and 1996, respectively. Weighted average interest rates were 5.3%, 7.8% and 6.8% at year ends 1998, 1997 and 1996, respectively. Interest expense and payments related to the short-term borrowings for 1998, 1997 and 1996 were as follows:

During the fourth quarter of 1998 the Company entered into a committed $100 million, five year multi-currency revolving credit facility to be used to fund working capital, acquisitions, and for general corporate purposes. The interest rate applicable to borrowings under the line of credit is 20 basis points over LIBOR and may include additional costs if the funds are drawn from certain countries. All of the borrowings are foreign currency denominated and support the Company's international working capital position. The carrying amounts of the Company's borrowings under the lines of credit described above approximate their fair value.

9. Retirement Benefits

The Company provides a qualified defined contribution plan covering substantially all full-time employees, except officers and certain other management employees. Upon approval by the Board of Directors, a contribution based on eligible wages is funded annually. The plan offers a savings feature with Company matching contributions. Assets of this plan are held by an independent trustee for the sole benefit of participating employees.

A nonqualified benefit plan is provided for officers and certain other management employees. Upon approval by the Board of Directors, a contribution based on eligible wages is set aside annually. This plan also includes provisions for salary deferrals and Company matching contributions. Amounts provided for retirement benefits totaled $7,000 in 1998, $6,300 in 1997 and $4,900 in 1996.

10. Income Taxes

Pretax income for the years 1998, 1997 and 1996 was taxed under the following jurisdictions:

The provision for income taxes was as follows:

Deferred tax assets (liabilities) are comprised of the following:

The differences between income taxes for financial reporting purposes and the U.S. statutory rate are as follows:

The Company has loss carryforwards at January 3, 1999 totaling $3,453 which expire as follows:

A valuation allowance of $3,063 has been recorded against the loss carryforwards.

Provision has not been made for U.S. or additional foreign income taxes on an estimated $5,400 of undistributed earnings of foreign subsidiaries which are permanently reinvested. If such earnings were to be remitted, management believes that U.S. foreign tax credits would largely eliminate any such U.S. and foreign income taxes.

The Company paid income taxes of $65,700 in 1998, $64,300 in 1997 and $46,500 in 1996.

11. Performance Incentive Plan

Under the 1992 Performance Incentive Plan as amended and restated in 1996 (the "Plan"), the Company may grant stock options (both incentive and nonqualified), Stock Appreciation Rights (SARs), restricted awards and performance awards to key employees utilizing the Company's Class A stock. Stock options may not be granted at prices less than the fair market value on the date of grant, nor for a term to exceed 10 years. The Plan provides that the maximum number of shares available for grants is 7-1/2 percent of the outstanding Class A stock, adjusted for Plan activity over the preceding five years. Shares available for future grants at the end of 1998, 1997 and 1996 were 1,213,000, 1,149,000 and 1,394,000, respectively.

The Company applies Accounting Principles Board Opinion 25 and related Interpretations in accounting for the Plan. Accordingly, no compensation cost has been recognized for incentive and nonqualified stock options. If compensation cost had been determined based on the fair value at the grant dates for awards under the Plan consistent with the method of Statement of Financial Accounting Standards 123, Accounting for Stock-Based Compensation, the Company's net income would have been reduced by $1,135, $809 and $497 for 1998, 1997 and 1996, respectively; basic earnings per share would have been reduced by $.03 in 1998, $.02 in 1997 and $.01 in 1996; and diluted earnings per share would have been reduced by $.03 in 1998 and 1997 and $.01 in 1996.

Since stock options generally become exercisable over several years and additional grants are likely to be made in future years, the pro forma amounts for compensation cost may not be indicative of the effects on net income and earnings per share for future years. The fair value of each option included in the following tables is estimated on the date of grant using the Black-Scholes option-pricing model with the following weighted average assumptions used for grants in 1998, 1997 and 1996, respectively: dividend yield of 3.0 percent in all three years, expected volatility of 31, 30 and 31 percent, risk-free interest rates of 5.3, 5.9 and 5.7 percent and expected lives of six years in 1998 and seven years in 1997 and 1996.

A summary of the status of stock option grants under the Plan as of January 3, 1999, December 28, 1997 and December 29, 1996, and changes during the years ended on those dates, is presented as follows:

The following table summarizes information about options outstanding at January 3, 1999:

As of January 3, 1999, no SARs have been granted under the Plan. Restricted awards are issued to certain key employees and are subject to forfeiture until the end of an established restriction period. Restricted awards totaling 14,500, 38,900 and 2,400 shares were granted under the Plan during 1998, 1997 and 1996, respectively. The weighted average grant date price of such awards was $35.64, $29.58 and $27.38 for 1998, 1997 and 1996, respectively. Restricted awards outstanding totaled 36,200, 52,800 and 55,700 shares at year-ends 1998, 1997 and 1996, respectively, and have a weighted average remaining life of 2.5 years at January 3, 1999.

Under the Plan, performance awards may be granted to senior executive officers, the payout of which is determined by the degree of attainment of objectively determinable performance goals over the established relevant performance period. Performance awards totaling 51,500, 44,500 and 42,000 shares were granted under the Plan during 1998, 1997 and 1996, respectively. The weighted average grant date prices of such awards were $34.94, $28.06 and $29.75 for 1998, 1997 and 1996, respectively. Unearned performance awards outstanding at year-ends 1998, 1997 and 1996 were 115,200, 76,300 and 38,500, respectively, and have a weighted average remaining life of 1.1 years at January 3, 1999. Total compensation cost recognized for restricted and performance awards was $2,000, $1,400 and $1,300 for 1998, 1997 and 1996, respectively.

12. Contingencies

The Company is subject to various legal proceedings, claims and liabilities which arise in the ordinary course of its business. Litigation is subject to many uncertainties, the outcome of individual litigated matters is not predictable with assurance and it is reasonably possible that some of the foregoing matters could be decided unfavorably to the Company. Although the amount of the liability at January 3, 1999 with respect to these matters cannot be ascertained, the Company believes that any resulting liability will not be material to the financial statements of the Company at January 3, 1999.

13. Segment Disclosures

In 1998, the Company adopted Statement of Financial Accounting Standards (SFAS) 131, Disclosures About Segments of an Enterprise and Related Information. SFAS 131 supersedes SFAS 14, Financial Reporting for Segments of a Business Enterprise, replacing the "industry segment" approach with the "management" approach. The management approach designates the internal organization that is used by management for making operating decisions and assessing performance as the source of the Company's reportable segments. Adoption of SFAS 131 did not affect results of operations or financial position but did affect the disclosure of segment information. Prior years' segment information has been restated to present the Company's reportable segments. The accounting policies of the segments are the same as those described in the "Summary of Significant Accounting Policies."

The Company has determined that its reportable segments are those that are based on the Company's method of internal reporting, which disaggregates its business by segment. The Company's reportable segments are: (1) U.S. Commercial Staffing, (2) Professional, Technical and Staffing Alternatives (PTSA) and (3) International.

The following table presents information about the reported operating income of the Company for the fiscal years 1998, 1997 and 1996. Segment data presented is net of inter-segment revenues. Asset information by reportable segment is not reported, since the Company does not produce such information internally.

Specified items included in segment earnings from operations for the fiscal years 1998, 1997 and 1996 were as follows:

The following is long-lived assets information by geographic area as of the years ended 1998, 1997 and 1996:

Long-lived assets include Property and Equipment and Intangibles and Other Assets. Long-lived assets of no single foreign country were material to the consolidated long-lived assets of the Company. Foreign revenue is based on the country in which the legal subsidiary is domiciled. Revenue from no single foreign country was material to the consolidated revenues of the Company.