Xerox Annual Report 2004

Plain-text annual report

Smarter. Simpler. Personal. Colorful. Smarter. Simpler. Personal. Colorful. X e r o x A n n u a l R e p o r t 2 0 0 4 Xerox Corporation 800 Long Ridge Road PO Box 1600 Stamford, CT 06904 www.xerox.com 2980-AR-04 Annual Report 2004 Annual Report 2004 2004 was another year of continued progress, excellent execution and accelerating marketplace momentum for Xerox. Financial Highlights ($ in millions, except EPS) Equipment Sales Post Sale, Finance Income and Other Revenue Total Revenue 2004 2003 $ 4,480 $ 4,250 11,242 15,722 11,451 15,701 3,267 Total Color Revenue (included in total revenues) 3,903 Total Costs and Expenses 14,757 15,265 Net Income Diluted Earnings per Share Cash Flows from Operating Activities Cash and Cash Equivalents 859 0.86 1,750 3,218 360 0.36 1,879 2,477 Debt 10,124 11,166 01 Letter to Shareholders 05 Delivering Solutions 17 Financial Review 96 Corporate Information IBC Social Responsibility It’s Good Business “We all believe that we are “We all believe that we are part of an on going part of an on going experiment to demonstrate experiment to demonstrate that business success that business success and social responsibility and social responsibility are not mutually exclusive. are not mutually exclusive. In fact, we believe they In fact, we believe they are synergistic.” are synergistic.” Xerox Chairman and CEO Xerox Chairman and CEO Anne Mulcahy at the Business for Anne Mulcahy at the Business for Social Responsibility Conference, Social Responsibility Conference, Nov. 11, 2004 Nov. 11, 2004 Social Responsibility From environmental and diversity programs to community outreach and corporate governance, Xerox continues to be recognized as a leader in all aspects of corporate social responsibility. Some highlights: • The Xerox Foundation invested $12.3 million in 2004. Among its contributions: 40 grants to university science programs, scholarship programs at 140 colleges and universities, and grants to about 400 nonproﬁt organizations. • To ensure Xerox paper is sourced from sustainably managed forests, Xerox deployed a stringent set of requirements to its paper suppliers, obtaining commitments from suppliers that provide more than 90 percent of Xerox paper. • Xerox’s 11-member board is 91 percent independent, following a tough 1 percent independence standard. • In 2004, Xerox spent about $344 million through its supplier diversity program. • FORTUNE, DiversityInc, the Human Rights Campaign, the Toronto Globe and Mail, Exame magazine in Brazil, and several other entities recognized the Xerox workplace as being among the best. • FORTUNE’s 2005 “Global Most Admired Companies” survey ranked Xerox No. 2 in its industry, including a No. 1 rating for “social responsibility.” Business Ethics magazine’s 2005 list of “100 Best Corporate Citizens” ranked Xerox No. 10 among U.S. corporations. • The company diverted more than 160 million pounds of waste from landﬁlls last year and saved Xerox several hundred million dollars through remanufacturing and parts reuse. • Xerox encourages employees to volunteer in their communities through programs like Social Service Leave, which offers paid sabbaticals for community service; the Community Involvement Program, which provides seed money for Xerox teams to fund community projects; and the Science Consultant Program through which employees like Lou Bostic, pictured right, bring real-life science experiments into the classroom. Fellow Shareholders: Fellow Shareholders: Anne M. Mulcahy, Chairman and Chief Executive Ofﬁcer As I write this letter, I am enormously proud of what Xerox people have accomplished over the past few years; galvanized by the opportunities we see immediately ahead of us; sobered by the demands of the marketplace and the strength of our competitors; and humbled by the trust you have placed in us. Our goal is to give you a good return on that trust – and that’s precisely what we are all hard at work doing. Proud of Our Accomplishments Over the past four years, we believe we have put together a rather remarkable track record. We have just about cut our debt in half, more than doubled our equity, taken $2 billion out of our cost base, strengthened our offerings, expanded our distribution channels, articulated a clear vision for the future, made the right strategic investments, and consistently increased earnings – building value for our shareholders. Our progress in 2004 provided more evidence that we are on the right track and building strong momentum: • We brought 40 new products to market – products that set new industry standards for the creation of customer value and which garnered some 230 industry awards. • We were granted 525 utility patents in the United States alone – a sign that our best days are ahead of us. • Sales, administrative and general (SAG) costs declined to 26.7 percent of revenue – the lowest in years. • Cash ﬂow from operations was $1.8 billion. • We reduced debt by another $1 billion. • And we ended the year with a cash balance of $3.2 billion. The charts that accompany this letter tell the story of a company that has returned to good ﬁnancial health. We deliver consistent predictable results. We do what we say we will do. We also realize that as good as we are today, we must be even better tomorrow. So rather than simply rehash the past, I want to take this opportunity to share our plans for the future. Poised for Growth As the story of the Xerox turnaround gets written, I’m conﬁdent that it will say that while we were focused on reducing costs, boosting productivity and slashing debt, we were equally focused on implementing a strategy for growth, investing in our future and creating value for our shareholders. That strategy starts with spending a lot of time with our customers. Many companies preach that; we practice it. Someone just ﬁgured out how much of my own time I spend with our clients. The not-so-surprising answer is about 25 percent. All of my senior team maintains an equally aggressive schedule of customer engagement. We estimate that some 80 percent of our people have regular contact with our customers. And one in ﬁve of our people work on site in our customers’ places of business. Why? Because we’re keenly aware that it takes ﬁve times as much effort and money to attract a new customer as it does to keep an old one. Even more importantly, we know that if we listen to our customers – really listen – they will tell us what we need to do to be successful. What we learn permeates all our decisions. And what we’ve learned is that our customers don’t simply want our products – at least that’s not how they express their needs. 1 18.6 16.7 14.2 Declining Debt as of December 31 ($ billions) 11.2 10.1 Stabilized Gross Margins (Percent) 42.4 42.0 40.6 37.4 38.2 ’00 ’01 ’02 ’03 ’04 ’00 ’01 ’02 ’03 ’04 ’ They want our help in reducing costs, improv- They want our help in reducing costs, ing productivity, growing revenue and creating improving productivity, growing revenue and value for their customers. creating value for their customers. That’s exactly what we’re helping them do. That’s exactly what we’re helping them do. In more and more accounts, large and small, In more and more accounts, large and small, we are becoming strategic partners. The copier we are becoming strategic partners. The copier and hardware company has morphed into a and hardware company has morphed into a technology and services enterprise. technology and services enterprise. Four years ago, we made a series of critical Four years ago we made a series of critical strategic decisions on where to invest. We used strategic decisions on where to invest. We used three simple but profound criteria – areas of three simple but profound criteria – areas of our market that were growing the fastest, areas our market that were growing the fastest, areas where our customers were telling us they where our customers were telling us they needed help and areas where we already had needed help and areas where we already had core competencies on which we could build. core competencies on which we could build. We let go of businesses where we couldn’t We let go of businesses where we couldn’t make money in the short term, or articulate make money in the short term, or articulate a credible plan to make money in the long term. a credible plan to make money in the long term. That freed up resources for investment in three That freed up resources for investment in three critical areas of the document market – the digital critical areas of the document market – the digital ofﬁce, digital production and value-added services. ofﬁce, digital production and value-added services. That’s where we placed our strategic bets. That’s where we placed our strategic bets. We’re glad we did. Last year, three-quarters We’re glad we did. Last year, three-quarters of our revenue came from these businesses of our revenue came from these businesses and revenues from these areas grew 6 percent. and revenues from these areas grew 6 percent. For the ﬁrst time in ﬁve years, growth in our For the ﬁrst time in ﬁve years, growth in our strategic areas of focus, including the effects strategic areas of focus, including the effects of favorable currency, offset declines in older of favorable currency, offset declines in older technology and other non-strategic businesses. technology and other non-strategic businesses. Now, we are positioned for growth in 2005 Now, we are positioned for growth in 2005 and beyond. Here’s why. and beyond. Here’s why. Leading The Digital Revolution in the Ofﬁce Leading The Digital Revolution in the Ofﬁce In the digital ofﬁce, we’re concentrating our In the digital ofﬁce, we’re concentrating our investments on the key growth areas of color, investments on the key growth areas of color, digital multifunction and ofﬁce services. We digital multifunction and ofﬁce services. We continue to expand our portfolio of products at continue to expand our portfolio of products at 2 price points that are highly competitive. As a price points that are highly competitive. As a result, we are participating in more and more result, we are participating in more and more buying decisions. buying decisions. One way we create value for our ofﬁce One way we create value for our ofﬁce customers is through our Ofﬁce Document customers is through our Ofﬁce Document AssessmentSM. A recent industry report indicates AssessmentSM. A recent industry report indicates that two-thirds of all businesses have initiatives that two-thirds of all businesses have initiatives in place that are aimed at reducing the cost in place that are aimed at reducing the cost of document management. You might think of document management. You might think that’s a threat to us; we see it as an opportunity. that’s a threat to us; we see it as an opportunity. Until recently, the costs of documents Until recently, the costs of documents ﬂew under the radar screens of most Chief ﬂew under the radar screens of most Chief Information Ofﬁcers. Once digital technology Information Ofﬁcers. Once digital technology put documents on the network, that dramatically put documents on the network, that dramatically changed the way document management is changed the way document management is viewed. With the help of Xerox, more and more viewed. With the help of Xerox, more and more CIOs are recognizing that they can simultane- CIOs are recognizing that they can simultane- ously reduce costs and improve workﬂows. ously reduce costs and improve workﬂows. Using Xerox Lean Six Sigma methodology, Using Xerox Lean Six Sigma methodology, we analyze in detail all of the document- we analyze in detail all of the document- intensive processes our customers use to run intensive processes our customers use to run their businesses. We identify the exact costs their businesses. We identify the exact costs of the way our customers manage printing, of the way our customers manage printing, copying, faxing and scanning functions. Perhaps copying, faxing and scanning functions. Perhaps even more importantly, we analyze the way even more importantly, we analyze the way real people work with real documents in the real people work with real documents in the real world. real world. We estimate that a typical business spends We estimate that a typical business spends up to 5 percent of its revenue on documents. up to 5 percent of its revenue on documents. We can save 20 to 40 percent of that while We can save 20 to 40 percent of that while improving productivity, speed and worker improving productivity, speed and worker satisfaction. The opportunity for Xerox is satisfaction. The opportunity for Xerox is substantial and we are being very aggressive substantial and we are being very aggressive about seizing it. about seizing it. 1 5,264 4,403 3,970 4,250 4,480 Equipment Sales ($ millions) 5,518 4,728 4,437 4,249 4,203 Improving Selling, Administrative and General Expenses ($ millions) ’00 ’01 ’02 ’03 ’04 ’00 ’01 ’02 ’03 ’04 Building the New Business of Printing Building the New Business of Printing The second area in which we are investing The second area in which we are investing is the digital production market. Our strong is the digital production market. Our strong array of digital systems and solutions – led by array of digital systems and solutions – led by the Xerox iGen3® Digital Production Press the Xerox iGen3® Digital Production Press and augmented by the highly acclaimed Xerox and augmented by the highly acclaimed Xerox Nuvera® family of products – promises to Nuvera® family of products – promises to dramatically expand our market opportunity. dramatically expand our market opportunity. Market response to our new generation Market response to our new generation of color production technology has been very of color production technology has been very encouraging. Increasingly, our commercial encouraging. Increasingly, our commercial print customers are relying on the iGen3 to print customers are relying on the iGen3 to fuel their business growth. In fact, many iGen3 fuel their business growth. In fact, many iGen3 customers own multiple systems – some own customers own multiple systems – some own six or more. We are driving the New Business six or more. We are driving the New Business of Printing® in areas such as one-to-one of Printing® in areas such as one-to-one marketing, print-on-demand, and on-demand marketing, print-on-demand, and on-demand book publishing. book publishing. One example is a large retail customer One example is a large retail customer who maintains many bridal registries. After who maintains many bridal registries. After the couple returns from their honeymoon the couple returns from their honeymoon and settles into married life, they receive a spe- and settles into married life, they receive a spe- cial sales promotion of all the products they cial sales promotion of all the products they had selected for their registry but didn’t receive. had selected for their registry but didn’t receive. The brochure is printed on a Xerox iGen3. The brochure is printed on a Xerox iGen3. Direct mail experts consider a 1-percent Direct mail experts consider a 1-percent response to be quite good. This promotion runs response to be quite good. This promotion runs about 40 percent. That’s the power of one-to-one about 40 percent. That’s the power of one-to-one marketing – power we bring to our customers. marketing – power we bring to our customers. Digital production printing is a huge Digital production printing is a huge market opportunity for Xerox as more and market opportunity for Xerox as more and more customers see that they can augment more customers see that they can augment traditional offset printing and penetrate new traditional offset printing and penetrate new markets with new applications that create new markets with new applications that create new revenue streams. revenue streams. It’s the ultimate win-win-win – for Xerox, for It’s the ultimate win-win-win – for Xerox, for Xerox customers and for their customers. Xerox customers and for their customers. 3 Leading With Value-Added Services Leading With Value-Added Services The third area in which we are investing is The third area in which we are investing is value-added services. Here, too, we are making a value-added services. Here, too, we are making a great deal of progress. In fact, revenue from our great deal of progress. In fact, revenue from our value-added services business grew 20 percent value-added services business grew 20 percent last year and 25 percent in the fourth quarter last year and 25 percent in the fourth quarter from a year ago. from a year ago. More and more, our customers – particularly More and more, our customers – particularly our larger ones – are turning to us for help in our larger ones – are turning to us for help in designing and improving work processes that are designing and improving work processes that are document intensive. We provide consulting, document intensive. We provide consulting, imaging, content management and outsourcing imaging, content management and outsourcing services that help our customers reduce costs services that help our customers reduce costs through processes that deliver the right informa- through processes that deliver the right informa- tion, in the right form, at the right time. tion, in the right form, at the right time. Although we manage our business in Although we manage our business in three areas, we go to market as one Xerox. The three areas, we go to market as one Xerox. The umbrella for much of what we do – the value we umbrella for much of what we do – the value we provide – is something we call Smarter Document provide – is something we call Smarter Document Management™. Just about every organization Management™. Just about every organization you can think of has made signiﬁcant investments you can think of has made signiﬁcant investments in information technology over the past several in information technology over the past several years. In fact, between 1997 and 2003, United years. In fact, between 1997 and 2003, United States companies alone invested an estimated States companies alone invested an estimated $2.5 trillion in the promise of information technol- $2.5 trillion in the promise of information technol- ogy. Many are still looking for the return. They ogy. Many are still looking for the return. They are realizing that more is not necessarily better. are realizing that more is not necessarily better. Xerox is uniquely positioned to help our Xerox is uniquely positioned to help our customers leverage and streamline their customers leverage and streamline their legacy investments and make wise investment legacy investments and make wise investment decisions going forward. Since our earliest decisions going forward. Since our earliest days, we have been on a mission to harness the days, we have been on a mission to harness the marvels of technology to the needs of people. marvels of technology to the needs of people. We take a holistic approach that considers the We take a holistic approach that considers the way people work, the culture they work in, the way people work, the culture they work in, the Return to Profitability Net Income (Loss) ($ in millions) 859 360 91 (273) (94) ’02 ’03 ’04 ’01 ’00 processes they work with, the objectives they strive for. In other words, we help our customers ﬁnd better ways to do great work through the use of Smarter Document Management. It’s an area in which we are uniquely advantaged. These three market areas – digital ofﬁce, digital production and value-added services – total more than $100 billion of market opportunity today. Advances in digital technology, many of them driven by Xerox, are likely to signiﬁcantly expand the market size in the years ahead. We do not want for opportunity. The only thing that stands between Xerox and signiﬁcant growth is execution. And that, fortunately, is entirely within our own control. It’s a good place to be. Shareholder Value Our Mantra If I sound optimistic about our future, it’s because I am. But don’t mistake optimism for hubris. All of us at Xerox recognize that we are in a race without a ﬁnish line. Our competitors are formidable and they are not standing still. Our customers are demanding that we stay on the leading edge of technology and services. Our shareholders are expecting us to deliver premium returns. We don’t shrink from these expectations. We embrace them. This generation of Xerox people has been tested. We’ve learned from our mistakes. At a recent town meeting, a Xerox employee asked me what our greatest strength and weakness was as I looked to the future. My answer: our greatest strength is our people – a highly motivated group of individuals who are committed to their customers, passionate about the success of Xerox and on a mission to drive shareholder value. And our weakness? That we start believing our own press, that we even subconsciously start to behave as though “good enough” really is good enough. That’s something we ferociously guard against. We’re building a culture that is problem curious, that abhors the status quo, that looks at every challenge as an opportunity to improve. All of you have put your trust in us – many of you at a time when others were writing our obituary. It’s something we will never forget. Ever. By the way, just about every Xerox person around the world is a shareowner. We are all in this together. We are all focused on creating shareholder value and we’re making good progress. Xerox’s share price increased 23 percent last year contributing to a three-year cumulative annual growth rate of 18 percent. We’re proud of that, but we also know that it’s yesterday’s news. We realize better than most how easy it is to lose our way. Avoiding that pitfall is what energizes us. We are all focused on a few simple objectives – focusing on our customers with precision and passion, growing revenue and improving proﬁtability. If we do that well, we know we will create value for our shareholders and give you a good return on the trust you place in us. You should expect no less; we aim to deliver no less. Anne M. Mulcahy Chairman and CEO 4 Delivering Solutions Xerox has answered our customers’ call to action through customized solutions, integrated, innovative technology and our unparalleled expertise in document manage- ment. In the pages that follow, you’ll see a few examples of the thousands of customers Xerox is helping to ﬁnd better ways to do great work. 5 Keep it Simple “ABC has proven to be a “ABC has proven to be a simpler way for library simpler way for library users to do business with us. users to do business with us. Staff now spend more time Staff now spend more time helping children and adults helping children and adults ﬁnd what they need. And ﬁnd what they need. And the improved collection the improved collection of library ﬁnes plus fees for of library ﬁnes plus fees for printer use help offset the printer use help offset the costs of this technology costs of this technology upgrade. It’s become an easy, upgrade. It’s become an easy, efﬁcient investment that efﬁcient investment that is reaping rewards for our is reaping rewards for our patrons and our people.” patrons and our people.” Ginnie Cooper, director, Ginnie Cooper, director, Brooklyn Public Library Brooklyn Public Library Brooklyn Public Library With a system of 60 public libraries serving 2.6 million residents, librarians at the Brooklyn Public Library were spending an overwhelming amount of time – at a cost of about $1.6 million a year – helping patrons with administrative tasks like reserving one of the 850 Internet-accessible computers and loading paper in printers provided for free. There had to be a simpler, more efﬁcient way to manage these activities. And, that’s where Xerox came in. Xerox Global Services developed a “paperless” system for library patrons to connect with BPL’s libraries and extensive online resources. In partnership with several technology providers, Xerox created the Access Brooklyn Card (ABC) – a “smart” library card that can be used to reserve computers, pay for printing and copying, check out books and pay library fees – all through kiosks set up throughout the libraries. 6 Through digital imaging, consulting and content management, Xerox Global Services is a burgeoning growth opportunity. Revenue from these value-added services grew 20 percent last year and is expected to continue climbing at a double-digit pace over the next ﬁve years. 7 s s e s i n u o w M y B Vestcom/The Borgata Hotel Casino and Spa G r Vestcom International specializes in creating unique and personalized communication for their clients. They come up with the big ideas on how businesses can cut through the clutter. And, through Xerox technology, they turn the ideas into attention-grabbing marketing materials with response rates that are the envy of any direct marketing campaign. Vestcom’s tool of the trade: the Xerox iGen3® Digital Production Press, a 100 page-per-minute full-color printer that is capable of personalizing each and every page. The iGen3 is market-making technology that has redeﬁned the traditional printing business – once known only for its lithographic presses used for mass produc- tion of static materials like brochures and catalogs. Commercial printers and marketing communication companies like Vestcom are growing their businesses with the iGen3, which is most commonly used for print-on-demand, personalized applications including direct mail promotions, loyalty programs, newsletters, and other marketing appeals. Vestcom placed their bets on the iGen3 to create a campaign that reaches out to visitors of Borgata Hotel Casino and Spa in Atlantic City. Using a sophisticated database of player activity integrated with the Xerox iGen3, Vestcom produces a marketing brochure with variable full-color images and targeted marketing offers based on the guests’ previous dining, entertainment and gambling activities. The response rate to the campaign is signiﬁcantly higher than traditional non-descript mass mailings. “At Vestcom, we’re always seeking new ways to help our customers better reach their customers. The Xerox iGen3 opens opportunities to stretch our creativity – targeting the end-customers’ needs one person at a time. We’ve created a new revenue stream through the iGen3, growing our business while driving growth for our clients. It’s unparalleled technology that is changing the way we do business.” John Mortenson, executive vice president and chief operating ofﬁcer, Vestcom 8 In 2004, 8 billion pages were printed on Xerox production color systems. On average, iGen3 customers print 400,000 color pages per machine per month with several customers exceeding print volumes of 1 million pages per month. 9 M a k e i t Pe r s o n a l Cingular Wireless Cingular Wireless is raising the bar by strengthening its connection to customers. Xerox is helping Cingular do just that with a colorful, personalized print solution. When customers purchase a phone and calling plan from Cingular, they receive a brochure that highlights the speciﬁcs of their individual billing plan, their coverage area and informa- “The Cingular Service Summary allows us to connect in a positive and proactive way with our customers at the point of sale. With Xerox as our partner, we are quickly deliv- ering personalized docu- ments that customers actually read and save. In doing so, the volume of calls to our customer support line has decreased while customer satisfaction has increased.” tion about the features they’ve chosen like John Hedges, director, voice mail, text messaging and Web access. Sales Automation, Cingular Wireless It’s a print-on-demand application that is produced on a Xerox Phaser® solid ink printer right at the Cingular retail store – that’s 1,000 stores in the U.S. and Puerto Rico. By eliminating inven- tory costs and the expense of reprinting dated materials, Xerox provides Cingular with real-time communication that equates to really signiﬁcant cost savings and a personal customer connection. 10 Response rates increase more than 500 percent when marketing pieces are printed in color with personalized content targeting the customer’s interests and requirements. Mel Foster Realty “Location, location, location” is the Realtor’s mantra. At Mel Foster Real Estate, convincing potential home- buyers to check out great locations became much easier when Xerox entered the picture. Mel Foster’s 389 agents cover Eastern Iowa and Western Illinois from 15 ofﬁces. They rely on Xerox WorkCentre Pro® color systems to create personalized promotional materials like postcards with photos of a new property listing and full-color brochures that highlight a home’s best features. The WorkCentre Pro is more than a printer; it also copies, faxes, scans and emails – an all-in-one device that handles all the document needs from ﬁrst listing to ﬁnal closing. Agents order their customized materials through Xerox’s Web-based DocuShare® system. The documents are then printed real time on the Xerox WorkCentre and delivered just in time to make the sale. “In our business, buyers and “In our business, buyers and sellers want to move fast. sellers want to move fast. That’s why we want to be That’s why we want to be the ﬁrst to spread the word the ﬁrst to spread the word about new property listings. about new property listings. The Xerox WorkCentre The Xerox WorkCentre system gives our agents the system gives our agents the ﬂexibility to showcase prop- ﬂexibility to showcase prop- erty listings as soon as they erty listings as soon as they come on the market. By come on the market. By creating colorful promotion- creating colorful promotion- al campaigns, we’re able to al campaigns, we’re able to target the right buyer with target the right buyer with the right home, immediately.” the right home, immediately.” Pryce Boeye, president, Pryce Boeye, president, Real Estate Division, Mel Foster Co. Real Estate Division, Mel Foster Co. M ake it C olorful 12 Color helps sell up to 80 percent more than materials printed in black and white and people are 55 percent more likely to pick up a full-color piece of mail ﬁrst. 13 Sun Microsystems The call to action from Sun Microsystems was to reduce its overall document management costs in Europe and South Africa where Sun operates 190 sites in 31 countries. Xerox Global Services conducted an audit of Sun’s document devices from printers and copiers to fax machines and scanners. The Xerox Ofﬁce Document Assessment SM tool studied Sun employees’ use of devices, such as the number of pages printed in individual workgroups, why certain groups needed full-color printing more than others and why some employees depended heavily on scanning and faxing. Armed with data and a clear understanding of work practices in Sun’s ofﬁces, Xerox applied Lean Six Sigma practices to develop a more efﬁcient document management infrastructure, guaranteeing a 25-percent reduction in Sun’s document costs. Through a multi-million dollar contract, Xerox is now responsible for Sun’s entire ﬂeet of document devices in Europe and South Africa, managing the maintenance and supplies contracts not only for Xerox systems but also for products from other vendors. And, Xerox people serve as the frontline of support when Sun employees need assistance with any document system. “The initial beneﬁts are quite impressive. We’ve moved from processing more than 12,000 invoices each year across Europe to just one invoice per country per month from Xerox. And, our employees have reported a dramatic improvement in customer service. We set Xerox a target of resolv- ing 80 percent of issues immediately, and Xerox is meeting that target.” Larry Matarazzi, director, Workplace Resources, EMEA, Sun Microsystems Reduce 14 My Costs Companies typically spend about $100 per month per employee for printing, copying, faxing and scanning. Xerox reduces these monthly costs on average by $25 per employee. 15 Delivering Results… 16 Financial Review 18 38 39 40 41 Consolidated Statements of Income Consolidated Balance Sheets Consolidated Statements of Cash Flows Consolidated Statements of Common Shareholders’ Equity Management’s Discussion and Analysis of Results of Operations and Financial Condition 42 89 90 Notes to the Consolidated Financial Statements Reports of Report of Management Independent 92 Quarterly Results of Operations 93 Five Years in Review 94 95 Ofﬁcers Directors Registered Public Accounting Firm 96 Corporate Information 17 Management’s Discussion and Analysis of Results of Operations and Financial Condition Financial Overview In 2004, we made signiﬁcant progress in positioning ourselves for revenue growth and earnings expansion while signiﬁcantly improving our overall ﬁnancial condition and liquidity. Our continued focus on invest- ment in the growing areas of digital production and ofﬁce systems contributed to revenue growth as the majority of our equipment sales were generated from products launched in the last two years. Total revenue increased modestly, as equipment sales growth was essentially offset by declines in post sale and other. We maintained our focus on cost management throughout 2004. While gross margins were slightly below our targeted level, we continued to offset lower prices with productivity improvements. Gross margins were impacted by a change in overall product mix, as well as performance in our Developing Markets Operations. We reduced selling, administrative and general (“SAG”) expenses as a result of expense efﬁciencies and reductions in bad debt expense. We continued to invest in research and development, prioritizing our investments in the faster growing areas of the market. In addition, we reduced interest expense by decreasing debt by over $1 billion during the year. Our 2004 balance sheet strategy focused on reduc- ing our total debt, optimizing operating cash ﬂows and utilizing long-term funding agreements to support our customer ﬁnancing operations. The successful implementation of this strategy in 2004 enabled us to signiﬁcantly improve our liquidity and ﬁnish the year with a cash balance of $3.2 billion. Our prospective balance sheet strategy includes: returning our credit rating to investment grade; optimizing operating cash ﬂows; reducing total debt and leverage; achieving an optimal cost of capital; rebalancing secured and unse- cured debt; and effectively deploying cash to deliver and maximize long-term shareholder value. Revenues for the three years ended December 31, 2004 were as follows: Throughout this document, references to “we,” “our” or “us” refer to Xerox Corporation and its subsidiaries. References to “Xerox Corporation” refer to the stand-alone parent company and do not include its subsidiaries. Executive Overview We are a technology and services enterprise and a leader in the global document market, developing, manufacturing, marketing, servicing and ﬁnancing the industry’s broadest portfolio of document equipment, solutions and services. Our industry is undergoing a transformation from older technology light lens devices to digital systems, the transition from black and white to color, as well as an increased reliance on electronic documents. We believe we are well positioned as this transformation plays to our strengths and represent opportunities for future growth, since our research and development investments have been focused on digital and color offerings. We operate in competitive markets and our cus- tomers demand improved solutions, such as the abili- ty to print offset quality color documents on demand; improved product functionality, such as the ability to print, copy, fax and scan from a single device; and lower prices for the same functionality. We deliver advanced technology through focused investment in research and development and offset lower prices through continuous improvement of our cost base. Our revenue is heavily dependent on the amount of equipment installed at customer locations and the uti- lization of those devices. As such, our critical success factors include hardware installation and equipment sales growth to stabilize and grow our installed base of equipment at customer locations. In addition to our installed base, the key factors in delivering growth in our recurring revenue streams (supplies, service, paper, outsourcing and rental, which we collectively refer to as post sale revenue) are page volume growth and higher revenue per page. Connected multifunc- tion devices and new services and solutions are key drivers to increase equipment usage. The transition to color is the primary driver to improve revenue per page, as color documents typically require signiﬁcantly more toner coverage per page than traditional black and white printing. Revenue per color page is approxi- mately ﬁve times higher than revenue per black and white page. 18 ($ in millions) Equipment sales Post sale and other revenue Finance income Total revenues Total color revenue included in total revenues 2004 $ 4,480 10,308 934 $15,722 Year Ended December 31, 2003 2002 Percent Change 2003 2004 $ 4,250 10,454 997 $15,701 $ 3,970 10,879 1,000 $15,849 5% (1)% (6)% — 7% (4)% — (1)% $ 3,903 $ 3,267 $ 2,781 19% 17% The following presentation reconciles the above information to the revenue classiﬁcations included in our Consolidated Statements of Income: ($ in millions) Sales Less: Supplies, paper and other sales Equipment Sales Year Ended December 31, 2002 2003 2004 $ 7,259 $ 6,970 $ 6,752 (2,779) (2,720) (2,782) $ 4,480 $ 4,250 $ 3,970 Service, outsourcing and rentals $ 7,529 Add: Supplies, paper and $ 7,734 $ 8,097 other sales 2,779 2,720 2,782 Post sale and other revenue $10,308 $10,454 $10,879 Total 2004 revenues of $15.7 billion increased modestly as compared to 2003 including a 3-percentage point beneﬁt from currency. Equipment sales increased 5 percent reﬂecting the success of our color and digital light production products and a 3-percentage point beneﬁt from currency. Post sale and other revenues declined 1 percent as declines in older light lens tech- nology products and Developing Market Operations (“DMO”), driven by Latin America, were partially offset by growth in digital ofﬁce and production color, as well as a 3-percentage point beneﬁt from currency. The light lens and DMO declines reﬂect a reduction of equipment at customer locations and related page volume declines. As our equipment sales continue to increase, we expect the effects of post-sale declines will moderate and ultimately reverse over time. Finance income, which reﬂects a decrease in equip- ment lease originations over the past several years, declined 6 percent, including a 4-percentage point beneﬁt from currency. Total 2003 revenues of $15.7 billion declined one percent from 2002, reﬂecting moderating year-over- year revenue declines, as well as a 5-percentage point beneﬁt from currency. Equipment sales increased 7 percent in 2003, reﬂecting a 6-percentage point beneﬁt from currency, as well as the success of our numerous color multifunction and production color products and growth in our Developing Markets Operations (DMO) segment. 2003 Post sale and other revenue declined 4 percent from 2002, primarily due to declines in older technology light lens revenues, 19 DMO and the Small Ofﬁce / Home Ofﬁce (SOHO) business which we exited in the second half of 2001. These declines were partially offset by growth in our digital revenues and a 5-percentage point beneﬁt from currency. Post sale and other revenue declines reﬂect the reduction in our equipment at customer locations and related page volume declines. 2003 Finance income approximated that of 2002, including a 5-percentage point beneﬁt from currency. Net income and diluted earnings per share for the three years ended December 31, 2004 were as follows: ($ in millions, except share amounts) 2004 Year Ended December 31, 2002 2003 Net income Preferred stock dividends Income available to common shareholders Diluted earnings per share $ 859 (73) $ 360 (71) $ 91 (73) $ 786 $0.86 $ 289 $ 0.36 $ 18 $ 0.02 2004 Net income of $859 million, or 86 cents per diluted share, included an after-tax gain of $83 million ($109 million pre-tax) related to the sale of substantially all of our investment in ContentGuard Holdings, Inc. (“ContentGuard”), an after-tax $38 million pension settlement beneﬁt from Fuji Xerox, an after-tax gain of $30 million ($38 million pre-tax) from the sale of our investment in ScanSoft, Inc. (“ScanSoft”) and after-tax restructuring charges of $57 million ($86 million pre-tax). 2003 Net income of $360 million, or 36 cents per diluted share, included after-tax restructuring charges of $111 million ($176 million pre-tax), an after-tax charge of $146 million ($239 million pre-tax) related to the court approved settlement of the Berger v. RIGP litigation, a $45 million after-tax ($73 million pre-tax) loss on early extinguishment of debt and income tax beneﬁts of $35 million from the reversal of deferred tax asset valuation allowances. 2002 Net income of $91 million, or 2 cents per diluted share, included after-tax asset impairment and restructuring charges of $471 million ($670 million pre-tax), a pre-tax and after-tax charge of $63 million for impaired goodwill and an after-tax charge of $72 million ($106 million pre-tax) for permanently impaired internal-use capitalized software, partially offset by $105 million of tax beneﬁts arising from the favorable resolution of a foreign tax audit and tax law changes, as well as a favorable adjustment to compen- sation expense of $31 million ($33 million pre-tax), that was previously accrued in 2001, associated with the reinstatement of dividends for our Employee Stock Ownership Plan (“ESOP”). Application of Critical Accounting Policies In preparing our Consolidated Financial Statements and accounting for the underlying transactions and balances, we apply various accounting policies. We consider the policies discussed below as critical to understanding our Consolidated Financial Statements, as their application places the most signiﬁcant demands on management’s judgment, since ﬁnancial reporting results rely on estimates of the effects of matters that are inherently uncertain. Speciﬁc risks associated with these critical accounting policies are discussed throughout this MD&A where such policies affect our reported and expected ﬁnancial results. For a detailed discussion of the application of these and other accounting policies, see Note 1 to the Consolidated Financial Statements. Senior management has discussed the development and selection of the critical accounting policies, estimates and related disclosures, included herein, with the Audit Committee of the Board of Directors. Preparation of this annual report requires us to make estimates and assumptions that affect the reported amount of assets and liabilities, as well as disclosure of contingent assets and liabilities. These estimates and assumptions also impact revenues and expenses during the reporting period. Although actual results may differ from those estimates, we believe the esti- mates are reasonable and appropriate. In instances where different estimates could reasonably have been used in the current period, we have disclosed the impact on our operations of these different estimates. In certain instances, such as with respect to revenue recognition for leases, because the accounting rules are prescriptive, it would not have been possible to have reasonably used different estimates in the current period. In these instances, use of sensitivity information would not be appropriate. Changes in assumptions and estimates are reﬂected in the period in which they occur. The impact of such changes could be material to our results of operations and ﬁnancial condition in any quarterly or annual period. Revenue Recognition Under Bundled Arrangements: As discussed more fully in Note 1 to the Consolidated Financial Statements, we sell most of our products and services under bundled lease arrangements, which typically include equipment, service, supplies and ﬁnancing components for which the customer pays a single negotiated monthly ﬁxed price for all elements over the contractual lease term. These arrangements typically also include an incre- mental, variable component for page volumes in excess of contractual page volume minimums, which are often expressed in terms of price per page. Revenues under these arrangements are allocated considering the relative fair values of the lease and non-lease deliverables included in the bundled arrangement based upon the estimated relative fair values of each element. Lease deliverables include maintenance and executory costs, equipment and ﬁnancing, while non-lease deliverables generally consist of the supplies and non-maintenance services. Our revenue allocation for the lease deliverables begins by allocating revenues to the maintenance and executory costs plus proﬁt thereon. The remaining amounts are allocated to the equipment and ﬁnancing elements. We perform extensive analyses of available veriﬁable objective evidence of equipment fair value based on cash selling prices during the applicable period. The cash selling prices are compared to the range of values included in our lease accounting systems. The range of cash selling prices must be rea- sonably consistent with the lease selling prices, taking into account residual values that accrue to our beneﬁt, in order for us to determine that such lease prices are indicative of fair value. Our pricing interest rates, which are used in determining customer payments, are developed based upon a variety of factors including local prevailing rates in the marketplace and the customer’s credit history, industry and credit class. Effective in 2004, our pricing rates are reassessed quarterly based on changes in local prevailing rates in the marketplace and are adjusted to the extent such rates vary by twenty-ﬁve basis points or more, cumulatively, from the last rate in effect. The pricing interest rates generally equal the implicit rates within the leases, as corroborated by our comparisons of cash to lease selling prices. Revenue Recognition for Leases: As more fully discussed in Note 1 to the Consolidated Financial Statements, our accounting for leases involves speciﬁc determinations under applicable lease accounting standards which often involve complex and prescrip- tive provisions. These provisions affect the timing of revenue recognition for our equipment. If the leases qualify as sales-type capital leases, equipment revenue is recognized upon delivery or installation of the equipment as sale revenue as opposed to ratably over the lease term. The critical elements that we consider with respect to our lease accounting are the determi- nation of the economic life and the fair value of equip- ment, including the residual value. For purposes of 20 determining the economic life, we consider the most objective measure to be the original contract term, since most equipment is returned by lessees at or near the end of the contracted term. The economic life of most of our products is ﬁve years since this represents the most frequent contractual lease term for our prin- cipal products and only a small percentage of our leases are for original terms longer than ﬁve years. There is no signiﬁcant after-market for our used equipment. We believe ﬁve years is representative of the period during which the equipment is expected to be economically usable, with normal service, for the purpose for which it is intended. Residual values are established at lease inception using estimates of fair value at the end of the lease term and are established with due consideration to forecasted supply and demand for our various products, product retirement and future product launch plans, end of lease customer behavior, remanufacturing strategies, competition and technological changes. Accounts and Finance Receivables Allowance for Doubtful Accounts and Credit Losses: We perform ongoing credit evaluations of our customers and adjust credit limits based upon customer payment history and current creditworthiness. We continuously monitor col- lections and payments from our customers and maintain a provision for estimated credit losses based upon our historical experience and any speciﬁc customer collec- tion issues that have been identiﬁed. While such credit losses have historically been within our expectations and the provisions established, we cannot guarantee that we will continue to experience credit loss rates similar to those we have experienced in the past. Measurement of such losses requires consideration of historical loss experience, including the need to adjust for current conditions, and judgments about the probable effects of relevant observable data, including present economic conditions such as delinquency rates and ﬁnancial health of speciﬁc customers. We recorded bad debt provisions of $110 million, $224 million, and $332 million in selling, administrative and general expenses in our Consolidated Statements of Income for the years ended December 31, 2004, 2003 and 2002, respectively. The declining trend in our provision for doubtful accounts is primarily due to improvements in customer administration, receivables aging, write-off trends, collection practices and credit approval policies. As discussed above, in preparing our Consolidated Financial Statements for the three years ended December 31, 2004, we estimated our provision for doubtful accounts based on historical experience and customer-speciﬁc collection issues. This methodology has been consistently applied for all periods present- ed. During the ﬁve year period ended December 31, 2004, our allowance for doubtful accounts ranged from 4.2 to 5.5 percent of gross receivables. Holding all other assumptions constant, a one percentage point increase or decrease in the allowance from the December 31, 2004 rate of 4.2 percent would change the 2004 provision by approximately $110 million. Historically, about half of the provision for doubtful accounts relates to our ﬁnance receivables portfolio. This provision is inherently more difﬁcult to estimate than the provision for trade accounts receivable because the underlying lease portfolio has an average maturity, at any time, of approximately two to three years and contains past due billed amounts, as well as unbilled amounts. The estimated credit quality of any given customer and class of customer or geographic location can signiﬁcantly change during the life of the portfolio. We consider all available information in our quarterly assessments of the adequacy of the provision for doubtful accounts. Provisions for Excess and Obsolete Inventory Losses: We value our inventories at the lower of average cost or market. Inventories also include equipment that is returned at the end of the lease term. Returned equip- ment is recorded at the lower of remaining net book value or salvage value. Salvage value consists of the estimated market value (generally determined based on replacement cost) of the salvageable component parts, which are expected to be used in the remanufacturing process. We regularly review inventory quantities, including equipment to be leased to customers, which is included as part of ﬁnished goods inventory, and record a provision for excess and/or obsolete inventory based primarily on our estimated forecast of product demand and production requirements. Several factors may inﬂu- ence the realizability of our inventories, including our decision to exit a product line, technological changes and new product development. These factors could result in an increase in the amount of excess or obsolete inventory quantities. Additionally, our estimates of future product demand may prove to be inaccurate, in which case we may have understated or overstated the provision required for excess and obsolete inventories. Although we make every effort to ensure the accuracy of our forecasts of future product demand, including the impact of future product launches and changes in remanufacturing strategies, signiﬁcant unanticipated changes in demand or technological developments could materially impact the value of our inventory and our reported operating results if our estimates prove to be inaccurate. We recorded $73 million, $78 million, and $115 million in inventory write-down charges for the years ended December 31, 2004, 2003 and 2002, respec- tively. The decline in inventory write-down charges is due to the absence of business exiting activities, stabi- lization of our product lines, manufacturing outsourcing related improvements and a lower level of inventories. 21 As discussed above, in preparing our ﬁnancial statements for the three years ended December 31, 2004, we estimated our provision for excess and obsolete inventories based primarily on forecasts of production and service requirements. This methodology has been consistently applied for all periods presented. During the three year period ended December 31, 2004, inventory reserves for net realizable value adjustments as a percentage of gross inventory varied by approximately one percentage point. Holding all other assumptions constant, a one percentage point increase or decrease in our net realizable value adjustments would change the 2004 provision by approximately $13 million. Pension and Post-retirement Beneﬁt Plan Assumptions: We sponsor pension plans in various forms in several countries covering substantially all employees who meet eligibility requirements. Post-retirement beneﬁt plans cover primarily U.S. employees for retirement medical costs. Several statis- tical and other factors that attempt to anticipate future events are used in calculating the expense, liability and asset values related to our pension and post-retirement beneﬁt plans. These factors include assumptions we make about the discount rate, expected return on plan assets, rate of increase in healthcare costs, the rate of future compensation increases and mortality, among others. For purposes of determining the expected return on plan assets, we utilize a calculated value approach in determining the value of the pension plan assets, as opposed to a fair market value approach. The primary difference between the two methods relates to a systematic recognition of changes in fair value over time (generally two years) versus immediate recogni- tion of changes in fair value. Our expected rate of return on plan assets is then applied to the calculated asset value to determine the amount of the expected return on plan assets to be used in the determination of the net periodic pension cost. The calculated value approach reduces the volatility in net periodic pension cost that results from using the fair market value approach. The difference between the actual return on plan assets and the expected return on plan assets is added to, or subtracted from, any cumulative differences that arose in prior years. This amount is a component of the unrecognized net actuarial (gain) loss and is subject to amortization to net periodic pen- sion cost over the average remaining service lives of the employees participating in the pension plan. As a result of cumulative historical asset returns being lower than expected asset returns and declining interest rates, 2005 net periodic pension cost will increase. The total unrecognized actuarial loss as of December 31, 2004 was $1.99 billion, as compared to $1.87 billion at December 31, 2003. The change from December 31, 2003 relates to a decline in the discount rate, partially offset by improved asset returns as com- pared to expected returns. The total unrecognized actuarial loss will be amortized in the future, subject to offsetting gains or losses that will change the future amortization amount. We have recently utilized a weighted average expected rate of return on plan assets of 8.1 percent for 2004 expense, 8.3 percent for 2003 expense and 8.8 percent for 2002 expense, on a worldwide basis. In estimating this rate, we considered the historical returns earned by the plan assets, the rates of return expected in the future and our investment strategy and asset mix with respect to the plans’ funds. The weighted average rate we will utilize to calculate our 2005 expense will be 8 percent. Another signiﬁcant assumption affecting our pension and post-retirement beneﬁt obligations and the net periodic pension and other post-retirement beneﬁt cost is the rate that we use to discount our future anticipated beneﬁt obligations. In estimating this rate, we consider rates of return on high quality ﬁxed- income investments over the period to expected pay- ment of the pension and other beneﬁts. The weighted average rate we will utilize to measure our pension obligation as of December 31, 2004 and calculate our 2005 expense will be 5.6 percent, which is a decrease from 5.8 percent used in determining 2004 expense. As a result of the reduction in the discount rate, the lower cumulative actual return on plan assets during the prior three years and certain other factors, our 2005 net periodic pension cost is expected to be $40 million higher than 2004. On a consolidated basis, we recognized net periodic pension cost of $350 million, $364 million, and $168 million for the years ended December 31, 2004, 2003 and 2002, respectively. Pension cost is included in several income statement components based on the related underlying employee costs. Pension and post-retirement beneﬁt plan assumptions are included in Note 12 to the Consolidated Financial Statements. Holding all other assumptions constant, a 0.25 percent increase or decrease in the discount rate would change the 2005 projected net periodic pension cost by approximately $34 million. Likewise, a 0.25 per- cent increase or decrease in the expected return on plan assets would change the 2005 projected net periodic pension cost by approximately $14 million. Income Taxes and Tax Valuation Allowances: We record the estimated future tax effects of temporary differences between the tax bases of assets and liabili- ties and amounts reported in our Consolidated Balance Sheets, as well as operating loss and tax credit carryfor- wards. We follow very speciﬁc and detailed guidelines in each tax jurisdiction regarding the recoverability of any tax assets recorded in our Consolidated Balance 22 Sheets and provide necessary valuation allowances as required. We regularly review our deferred tax assets for recoverability considering historical proﬁtability, projected future taxable income, the expected timing of the reversals of existing temporary differences and tax planning strategies. If we continue to operate at a loss in certain jurisdictions or are unable to generate sufﬁcient future taxable income, or if there is a material change in the actual effective tax rates or time period within which the underlying temporary differences become taxable or deductible, we could be required to increase the valuation allowance against all or a signiﬁcant por- tion of our deferred tax assets resulting in a substantial increase in our effective tax rate and a material adverse impact on our operating results. Conversely, if and when our operations in some jurisdictions were to become sufﬁciently proﬁtable to recover previously reserved deferred tax assets, we would reduce all or a portion of the applicable valuation allowance in the period when such determination is made. This would result in an increase to reported earnings in such peri- od. Adjustments to our valuation allowance, through charges (credits) to income tax expense, were $12 mil- lion, $(16) million, and $15 million for the years ended December 31, 2004, 2003 and 2002, respectively. Gross deferred tax assets of $3.5 billion and $3.7 billion had valuation allowances of $567 million and $577 million at December 31, 2004 and 2003, respectively. We are subject to ongoing tax examinations and assessments in various jurisdictions. Accordingly, we incur additional tax expense based upon the probable outcomes of such matters. In addition, when applica- ble, we adjust the previously recorded tax expense to reﬂect examination results. Our ongoing assessments of the probable outcomes of the examinations and related tax positions require judgment and can mate- rially increase or decrease our effective tax rate as well as impact our operating results. Legal Contingencies: We are involved in a variety of claims, lawsuits, investigations and proceedings concerning securities law, intellectual property law, environmental law, employment law and ERISA, as discussed in Note 14 to the Consolidated Financial Statements. We determine whether an estimated loss from a contingency should be accrued by assessing whether a loss is deemed probable and can be reasonably estimated. We assess our potential liability by analyzing our litigation and regulatory matters using available information. We develop our views on estimated losses in consultation with outside counsel handling our defense in these matters, which involves an analysis of potential results, assuming a combina- tion of litigation and settlement strategies. Should developments in any of these matters cause a change in our determination as to an unfavorable outcome and result in the need to recognize a material accrual, or should any of these matters result in a ﬁnal adverse judgment or be settled for signiﬁcant amounts, they could have a material adverse effect on our results of operations, cash ﬂows and ﬁnancial position in the period or periods in which such change in determina- tion, judgment or settlement occurs. Summary of Results Segment Revenues As discussed in Note 2 to the Consolidated Financial Statements, operating segment ﬁnancial information for 2003 and 2002 has been restated to reﬂect changes in operating segment structure made during 2004. Our reportable segments are consistent with how we manage the business and view the markets we serve. Our reportable segments are Production, Ofﬁce, DMO and Other. Our offerings include hardware, services, solutions and consumable supplies. The Production segment includes black and white products which operate at speeds over 90 pages per minute and color products over 40 pages per minute. Products include the Xerox iGen3® digital color production press, DocuColor family, Xerox Nuvera™, DocuTech, DocuPrint, and Xerox 2101, as well as older technology light-lens products. The Ofﬁce segment includes black and white products which operate at speeds up to 90 pages per minute and color devices which operate at speeds up to 40 pages per minute. Products include the suite of CopyCentre®, WorkCentre®, and WorkCentre® Pro digital multifunction systems, DocuColor color multifunction products, color laser, solid ink and monochrome laser desktop printers, digital and light-lens copiers and facsimile products. The DMO segment includes our operations in Latin America, Central and Eastern Europe, the Middle East, India, Eurasia, Russia and Africa. This segment includes sales of products that are typical to the Production and Ofﬁce segments, however, management serves and evaluates these markets on an aggregate geographic basis, rather than on a product basis. The segment classiﬁed as Other includes several units, none of which met the thresholds for separate segment reporting. This group includes Xerox Supplies Business Group (predominantly paper), SOHO, Wide Format Systems, Xerox Technology Enterprises and Value-added Services, royalty and license revenues. Other segment proﬁt (loss) includes the operating results from these entities, other less signiﬁcant businesses, our equity income from Fuji Xerox, and certain costs which have not been allocated to the Production, Ofﬁce and DMO segments including non-ﬁnancing interest and other corporate costs. 23 The changes made in 2004 relate to the reclassiﬁ- cation of the operations of our Central and Eastern European entities to DMO to align our segment reporting with how we manage our business. Operating proﬁt was reclassiﬁed for this change, as well as for certain other expense allocations. The adjustments (decreased) increased full year 2003 revenues as follows: Production-$(40) million, Ofﬁce-$(61) million, DMO-$147 million and Other- $(46) million. The full year 2003 segment proﬁt was (decreased) increased as follows: Production-$(21) million, Ofﬁce-$(11) million, DMO-$21 million, and Other-$11 million. The adjustments (decreased) increased full year 2002 revenues as follows: Production-$(40) million, Ofﬁce-$(54) million, DMO-$127 million, and Other-$(33) million. The full year 2002 segment proﬁt was (decreased) increased as follows: Production-$(14) million, Ofﬁce-$(9) million, DMO-$29 million, and Other-$(6) million. Revenues by segment for the years ended 2004, 2003 and 2002 were as follows: ($ in millions) 2004 Equipment sales Post sale and other revenue Finance income Total Revenue 2003 Equipment sales Post sale and other revenue Finance income Total Revenue 2002 Equipment sales Post sale and other revenue Finance income Total Revenue Equipment Sales Production Ofﬁce DMO Other Total $1,358 2,880 352 $4,590 $1,188 2,943 376 $ 4,507 $1,084 3,005 393 $4,482 $2,431 4,644 552 $7,627 $2,426 4,622 594 $7,642 $2,312 4,576 599 $7,487 $ 503 1,194 10 $1,707 $ 466 1,285 12 $1,763 $ 374 1,492 19 $1,885 $ 188 1,590 20 $1,798 $ 170 1,604 15 $1,789 $ 200 1,806 (11) $1,995 $ 4,480 10,308 934 $15,722 $ 4,250 10,454 997 $15,701 $ 3,970 10,879 1,000 $15,849 2004 Equipment sales of $4.5 billion increased 5 per- cent from 2003 reﬂecting a 3-percentage point beneﬁt from currency as well as the success of our color and digital light production products. Additionally, contin- ued equipment sales growth reﬂects the success of numerous products launched in the past two years, as the majority of 2004 equipment sales were generated from these products. Color equipment sales continued to grow rapidly in 2004 and represented approximately one-third of total equipment sales. 2003 Equipment sales of $4.3 billion increased 7 percent from 2002, reﬂecting signiﬁcant growth in DMO, the success of numerous new product introduc- tions and a 6-percentage point beneﬁt from currency. In 2003, approximately 50 percent of equipment sales were generated from products launched in the previ- ous two years. Color equipment sales represented 28 percent of total equipment sales compared with 24 percent in 2002. Production: 2004 equipment sales increased 14 per- cent from 2003, as improved product mix, installation growth and favorable currency of 4-percentage points more than offset price declines of approximately 3 percent. Strong 2004 production color equipment 24 sales growth reﬂected stronger product mix and increased installations driven by the DocuColor 5252 and Xerox iGen3 digital color production press prod- ucts. The Xerox iGen3 digital color production press utilizes next generation color technology which we expect will expand the digital color print on demand market. 2004 production monochrome equipment sales grew as light-production installations, driven by the success of the Xerox 2101 copier/printer and strong demand for the Xerox Nuvera 100 and 120 copier /printers, as well as favorable currency, more than offset declines in production publishing, printing and older technology light lens products. 2003 Production equipment sales grew 10 percent from 2002, as improved product mix, installation growth and favorable currency of 7 percentage points more than offset price declines of approximately 5 per- cent. Strong 2003 production color equipment sales growth reﬂected increased installations and stronger product mix driven by the DocuColor 6060 and Xerox iGen3 digital color production press products. 2003 pro- duction monochrome equipment sales grew modestly as light production installations, driven by the success of the new Xerox 2101 copier/printer, and favorable currency more than offset declines in production publishing, printing and older technology light lens. Ofﬁce: 2004 equipment sales were essentially unchanged from 2003, as installation growth of approximately 20 percent and favorable currency of 3-percentage points were offset by moderating price declines of approximately 6 percent and the impact of weaker product mix. Product mix reﬂected an increased proportion of low-end equipment due to very strong growth in ofﬁce monochrome (“Segments 1 and 2”) as well as monochrome and color printers. Color printer growth primarily reﬂects the success of the solid ink Phaser® 8400, the ﬁrst product launched from our new solid ink platform in January 2004, as well as other color printer introductions. 2003 Ofﬁce equipment sales increased 5 percent from 2002, as favorable currency of 7 percentage points and installation increases more than offset price declines of approximately 10 percent and the impact of weaker product mix. Equipment installation growth of approximately 20 percent reﬂects growth in all mono- chrome digital and color businesses, particularly ofﬁce color printing and monochrome multifunction/copier systems. The CopyCentre, WorkCentre and WorkCentre Pro systems, which were launched in the second quar- ter 2003, expand our market reach and include new entry-level conﬁgurations at more competitive prices. DMO: Equipment sales in DMO consist primarily of segment 1 devices and ofﬁce printers. Equipment sales in 2004 increased 8 percent from 2003, primarily reﬂecting growth in geographies where we operate an indirect distribution model such as Russia and Central and Eastern Europe. This growth was partially offset by declines in Latin America, primarily driven by Brazil, and product mix to lower segments. During 2004, we accelerated our transition to indirect distri- bution channels in Latin America to expand market coverage in that region. DMO 2003 equipment sales grew 25 percent from 2002, reﬂecting volume growth of over 40 percent, partially offset by price declines of approximately 10 percent and unfavorable mix. Other: 2004 equipment sales grew 11 percent from 2003, primarily due to growth in equipment sales associated with our Value-added Services business and a 2-percentage point currency beneﬁt. Other 2003 equipment sales declined 15 percent from 2002 due to general sales declines, none of which were individually signiﬁcant. Post Sale and Other Revenue 2004 post sale and other revenues of $10.3 billion declined 1 percent from 2003, including a 4-percent- age point beneﬁt from currency. These declines reﬂect lower equipment populations, as post sale revenue is largely a function of the equipment placed at customer locations, the volume of prints and copies that our customers make on that equipment, the mix of color pages, as well as associated services. 2004 supplies, paper and other sales of $2.8 billion (included within post sale and other revenue) increased 2 percent from 2003, primarily reﬂecting currency beneﬁts which offset declines in supplies. Supplies sales declined due to our exit from the SOHO business in 2001. 2004 service, outsourcing and rental revenue of $7.5 billion declined 3 percent from 2003, as declines in rental and facilities management revenues more than offset beneﬁts from currency. Declines in rental revenues primarily reﬂect reduced equipment populations within DMO and declines in facilities management revenues reﬂect consolidations by our customers as well as our prioritization of proﬁtable contracts. 2003 post sale and other revenues of $10.5 billion declined 4 percent from 2002, including a 5-percentage point beneﬁt from currency, primarily reﬂecting lower equipment populations. 2003 supplies, paper and other sales of $2.7 billion (included within post sale and other revenue) declined 2 percent from 2002 primarily due to declines in supplies sales resulting from reduced usage in the lower installed base of equipment and declines in our SOHO business. 2003 service, outsourcing and rental revenue of $7.7 billion declined 4 percent from 2002, reﬂecting declines in rental and facilities management revenues. Production: 2004 post sale and other revenue declined 2 percent from 2003, as monochrome declines, driven primarily by lower page volumes, offset favorable mix from color page growth of approx- imately 40 percent as well as favorable currency. Production 2003 post sale and other revenue declined 2 percent from 2002, as favorable currency and improved mix, driven largely by an increased volume of color pages, were offset by the impact of monochrome page volume declines, primarily in older technology light lens products. Ofﬁce: 2004 post sale and other revenue improved modestly from 2003 as favorable mix to color pages, digital page growth, and favorable currency were par- tially offset by declines in older technology light lens products. Ofﬁce 2003 post sale and other revenue grew 1 percent from 2002, as favorable currency and strong digital page growth more than offset declines in older technology light lens products. DMO: 2004 post sale and other revenue declined 7 percent from 2003, primarily reﬂecting Latin America’s rental equipment population declines. In response, we have continued our transition to indirect distribution channels that is intended to increase, over time, the sales of ofﬁce devices and the associated 25 supplies and service revenue. DMO 2003 post sale and other revenue declined 14 percent from 2002, due largely to a lower rental equipment population at cus- tomer locations and related page volume declines. Other: 2004 post sale and other revenue declined 1 percent from 2003, as declines in SOHO were essen- tially offset by currency beneﬁts and growth in Value- added Services as well as other activity. Other 2003 post sale and other revenue declined 11 percent from 2002, reﬂecting supply sale declines in SOHO of $82 million as well as the absence of $50 million of third-party licensing revenue recognized in 2002. 2005 Projected Revenues We expect 2005 equipment sales will continue to grow, as we anticipate that new platforms and products launched in 2003, 2004 and those planned in 2005 will enable us to further strengthen our market position. Compared to 2004, we expect 2005 post sale and other revenue declines to continue to moderate throughout the year and ultimately transition to growth before year-end. Growth in post sale and other revenue will be driven by our success at increasing the amount of our equipment at customer locations and the volume of pages and mix of color pages generated on that equipment. We expect 2005 total revenues to increase approximately 3 percent from 2004 levels. Segment Operating Proﬁt Segment operating proﬁt and operating margin for the three years ended December 31, 2004 were as follows ($ in millions): 2004 Operating Proﬁt Operating Margin 2003 Operating Proﬁt Operating Margin 2002 Operating Proﬁt Operating Margin Production Ofﬁce DMO Other Total $388 8.5% $401 8.9% $436 9.7% $ 798 10.5% $ 742 9.7% $612 8.2% $ 43 2.5% $ (29) $1,200 (1.6)% 7.6% $172 9.8% $ (327) (18.3)% $ 988 6.3% $120 6.4% $ (335) (16.8)% $ 833 5.3% Production: 2004 operating proﬁt declined $13 million and operating margin declined 0.4 percentage points from 2003. The declines primarily reﬂect lower gross margin and investments in selling and marketing expenses, which were partially offset by R&D efﬁcien- cies and lower bad debt expenses. Production 2003 operating proﬁt declined $35 million from 2002, reﬂect- ing lower gross margins related to initial installations of the Xerox iGen3 digital color production press and Xerox 2101. The decrease in gross margins was only partially offset by lower R&D and SAG expenses. Ofﬁce: 2004 operating proﬁt improved $56 million and operating margin improved 0.8 percentage points from 2003. The improvements primarily reﬂect mod- est improvement in gross margins, general and administrative expense productivity, and lower bad debt expense. Ofﬁce 2003 operating proﬁt improved $130 million from 2002, reﬂecting improved gross margins driven primarily by improved manufacturing and service productivity, as well as lower R&D and SAG expenses. DMO: 2004 operating proﬁt declined $129 million from 2003 primarily reﬂecting results in Latin America where the pace of revenue declines have exceeded cost and expense reductions. DMO 2003 operating proﬁt improved $52 million from 2002 due to signiﬁ- cantly lower SAG spending resulting from our cost saving initiatives, lower bad debts and gains on currency exposures compared to currency exposure losses in 2002. These improvements were partially offset by lower gross margins as a result of declining post sale revenue. Other: 2004 Other segment operating loss of $29 mil- lion improved by $298 million as compared to 2003, principally due to reduced non-ﬁnancing interest expense of $159 million, an increase in equity income from Fuji Xerox of $93 million and the gain on sale of our interest in ScanSoft of $38 million. 2003 Other segment operating loss of $327 million decreased by $8 million from 2002. Employee Stock Ownership Plan (ESOP): In 2002, our Board of Directors reinstated the dividend on our ESOP, which resulted in a reversal of previously recorded compensation expense. The reversal of compensation expense corresponded to the line item in the Consolidated Statement of Income for 2002 26 where the charge was originally recorded and included $28 million in both Cost of Sales and Selling, adminis- trative and general expenses and $11 million in Research and Development expenses. Of the total compensation expense originally recorded, $34 mil- lion and $33 million was recognized in 2002 and 2001, respectively. As such, 2002 beneﬁted by the reversal of $33 million of excess compensation expense that was originally recorded in 2001. There is no corresponding earnings per share improvement in 2002 since the EPS calculation requires deduction of dividends declared from reported net income in arriving at net income available to common shareholders. See Note 12 to the Consolidated Financial Statements for a more complete discussion of the ESOP. Gross Margin: Gross margins by revenue classiﬁca- tion were as follows: Total gross margin Sales Service, outsourcing and rentals Finance income Year Ended December 31, 2002 2003 2004 40.6% 35.4% 42.8% 63.1% 42.0% 42.4% 36.4% 37.3% 44.3% 44.5% 63.7% 59.9% 2004 gross margin of 40.6 percent declined 1.4 percentage points from 2003. Approximately 0.8 percentage points of the decline is due to product mix impacts from a greater proportion of lower gross margin products in the Ofﬁce and Production segments. Approximately 0.6 percentage points of the decline reﬂects the impact from DMO results. The declines in DMO relate to Brazil’s revenue, which has declined faster than declines in its cost levels and product mix to lower gross margin products in various DMO geographies. Lower prices were approximately offset by productivity improvements. 2004 sales gross margin of 35.4 percent declined 1 percentage point from 2003. Approximately 0.4 per- centage points of the decline results from product mix and DMO results contributed 0.6 percentage points to the decline. Additionally, productivity improvements offset lower prices and other variances. 2004 service, outsourcing, and rentals gross mar- gin of 42.8 percent declined 1.5 percentage points from 2003. The majority of the decline is attributed to prod- uct mix in the Ofﬁce and Production segments as well as DMO results. Productivity and cost improvements offset lower prices for the year. The 2003 gross margin of 42.0 percent declined 0.4 percentage points from 2002. During 2003, we completed the R&D phase of the Xerox iGen3 digital color production press development and, therefore, beginning in July 2003 ongoing engineering costs associated with initial commercial production were included in cost of sales. Xerox iGen3 digital color production press ongoing engineering costs of $30 million, the absence of the $28 million prior year favorable ESOP adjustment and the absence of $50 million in prior year licensing revenue each contributed 0.2 percentage points to the 2003 gross margin decline. During 2003, manufacturing and service productivity improvements more than offset the impact of lower prices, higher pension and other employee beneﬁt costs and product mix. 2003 sales gross margin declined 0.9 percentage points from 2002, with over half of the decline due to Xerox iGen3 digital color production press ongoing engineering costs and the remainder due to product mix as we increased our penetration of the digital light production market. In 2003, manufacturing productivi- ty more than offset the impact of planned lower prices. 2003 service, outsourcing and rentals margin declined 0.2 percentage points from 2002. Improved productivi- ty and product mix more than offset lower prices and higher pension and other employee expenses. 2002 also included a 0.4 percentage point beneﬁt from a $50 million licensing agreement and a 0.3 percentage point beneﬁt due to favorable ESOP adjustments. 2004 Finance income gross margins decreased 0.6 percentage points from 2003 due to interest costs speciﬁc to equipment ﬁnancing. Equipment ﬁnancing interest expense is determined based on a combination of actual interest expense incurred on ﬁnancing debt, as well as our estimated cost of funds, applied against the estimated level of debt required to support our ﬁnance receivables. The estimate is based on an assumed ratio which ranges from 80-90% of our aver- age ﬁnance receivables. This methodology has been consistently applied for all periods presented. 2003 Finance income gross margins increased 3.8 percent- age points from 2002, in line with declining interest costs speciﬁc to equipment ﬁnancing. Research and Development: 2004 R&D expense of $760 million was $108 million lower than the prior year, primarily due to improved efﬁciencies as we cap- ture beneﬁts from our platform development strategy as well as the commercial launch of the Xerox iGen3. We continue to invest in technological development, particularly in color, and believe that our R&D spend- ing is at an adequate level to remain technologically competitive. We expect 2005 R&D spending to approx- imate 5 percent of total revenue. Our R&D is strategi- cally coordinated with that of Fuji Xerox, which invested $704 million and $724 million in R&D in 2004 and 2003, respectively. 2003 R&D spending of $868 million was $49 mil- lion lower than 2002, primarily due to a $30 million reduction associated with the commercial launch of the Xerox iGen3 digital color production press and 27 improved R&D productivity, partially offset by higher pension and other employee beneﬁt expenses. Selling, Administrative and General Expenses: SAG expense information was as follows ($ in millions): Year Ended December 31, 2003 2004 2002 Total Selling, administrative and general expenses $4,203 $4,249 $4,437 SAG as a percentage of revenue 26.7% 27.1% 28.0% 2004 SAG expense of $4.2 billion declined $46 mil- lion from 2003 as bad debt expense reductions of approximately $115 million and G&A efﬁciencies were partially offset by increased selling and marketing expenses as well as unfavorable currency impacts of $141 million. 2003 SAG expense of $4.2 billion declined $188 million from 2002 including adverse currency impacts of $172 million and $70 million of higher pen- sion and other employee beneﬁt costs. 2003 SAG reduc- tions reﬂect improved productivity and employment reductions associated with our cost base restructuring and lower bad debt expenses of $109 million. Bad debt expense included in SAG was $110 mil- lion, $224 million and $332 million in 2004, 2003 and 2002, respectively. The 2004 reduction reﬂects improved collections performance, receivables aging and write-off trends. Bad debt expense as a percent of total revenue was 0.7 percent, 1.4 percent and 2.1 per- cent for 2004, 2003 and 2002, respectively. Restructuring Programs: For the three years ended December 31, 2004, we have engaged in a series of restructuring programs, resulting in $932 million in charges related to downsizing our employee base, exiting certain activities, outsourcing some internal functions and engaging in other actions designed to reduce our cost structure. In 2004, we recorded restructuring charges of $86 million, primarily consist- ing of ongoing restructuring actions. These ongoing initiatives included downsizing our employee base and the outsourcing of certain internal functions. The initiatives are not individually signiﬁcant and primarily include severance actions and impact all geographies and segments. We expect prospective annual savings associated with 2004 actions to be approximately $88 million. Restructuring and asset impairment charges of $176 million and $670 million in 2003 and 2002, respectively, primarily related to severance and employee beneﬁts related to worldwide severance actions as well as certain costs related to the consolidation of excess facilities. The remaining restructuring reserve balance at December 31, 2004 for all programs was $117 million. The reserve balance for Ongoing Programs as of December 31, 2004 was $93 million, the majority of which will be spent in 2005. The reserve balance for the Legacy programs as of December 31, 2004 was $24 million and the majori- ty of this balance relates to our exit from facilities in Europe and the United States, which are currently leased beyond 2008. Worldwide employment declined by approximately 3,000 in 2004, to approximately 58,100, primarily reﬂecting reductions as part of our restruc- turing programs. Worldwide employment was approx- imately 61,100 and 67,800 at December 31, 2003 and 2002, respectively. Gain on Afﬁliate’s Sale of Stock: In 2003, we recorded cumulative gains on an afﬁliate’s sale of stock of $13 million reﬂecting our proportionate share of the increase in equity of ScanSoft Inc., an equity investment. The gain resulted from ScanSoft’s issuance of stock in connection with its acquisition of Speechworks, Inc. ScanSoft is a developer of digital imaging software that enables users to leverage the power of their scanners, digital cameras and other electronic devices. As discussed in Note 18 to the Consolidated Financial Statements, in April 2004, we completed the sale of our ownership interest in ScanSoft. Other Expenses, Net: Other expenses, net for the three years ended December 31, 2004 consisted of the following ($ in millions): Year Ended December 31, 2002 2003 2004 Non-ﬁnancing interest expense Interest income Net currency losses Legal and regulatory matters Amortization of intangible assets Loss (gain) on early extinguishment of debt Business divestiture and asset sale (gains) losses Minorities’ interests in earnings of subsidiaries All other, net $ 363 (75) 73 9 37 — (61) 8 15 $522 (65) 11 242 36 $495 (77) 77 37 36 73 13 6 38 (1) (1) 3 24 $ 369 $ 876 $593 Non-ﬁnancing interest expense: 2004 non-ﬁnanc- ing interest expense was $159 million lower than 2003 primarily due to lower average debt balances as a result of the full year effect of the June 2003 recapital- ization and other scheduled term debt repayments. 2003 non-ﬁnancing interest expense was $27 million higher than 2002, primarily reﬂecting 2003 net losses of $13 million from the mark-to-market valuation of our interest rate swaps compared to gains of $12 million in 2002. 2003 non-ﬁnancing interest expense also 28 included higher interest rates and borrowing costs in the ﬁrst half of the year associated with the terms of the 2002 Credit Facility. These increased expenses were offset by lower borrowing costs in the second half of 2003 following the June 2003 Recapitalization. Interest income: Interest income is derived primarily from our invested cash and cash equivalent balances and interest resulting from periodic tax settlements. 2004 interest income was $10 million higher than 2003 reﬂecting interest income of $26 million related to a domestic tax refund claim in 2004, partially offset by the absence of $13 million of interest income related to Brazilian tax credits in 2003. 2003 interest income was $12 million lower than 2002 reﬂecting declining interest rates and lower average cash balances, partially offset by the $13 million of interest income related to the Brazilian tax credits. Net currency losses: Net currency losses primarily result from the spot/forward premiums on foreign exchange forward contracts, the re-measurement of unhedged foreign currency-denominated assets and liabilities and the mark-to-market impact of economic hedges of anticipated transactions for which we do not qualify for cash ﬂow hedge accounting treatment. In 2004, the majority of the exchange losses of $73 mil- lion related to spot/forward premiums on foreign exchange forward contracts as well as the mark-to- market of derivatives economically hedging the cost of future inventory purchases. The increase from 2003 was primarily due to the weakening of the U.S. Dollar against the Euro and the Yen. In 2003, exchange losses of $11 million were due largely to spot/forward premi- ums on foreign exchange forward contracts and unfa- vorable currency movements on economic hedges of anticipated transactions not qualifying for hedge accounting treatment. In the ﬁrst half of 2002, we incurred $57 million of exchange losses, primarily in Brazil and Argentina due to the devaluation of the underlying currencies. In the latter half of 2002, we were able to restore hedging capability in the majority of our key markets. Therefore, the $20 million of cur- rency losses in the second half of 2002 primarily rep- resented the spot/forward premiums on foreign exchange forward contracts and unfavorable currency movements on economic hedges of anticipated trans- actions not qualifying for hedge accounting treatment. Legal and regulatory matters: Legal and regulato- ry matters for 2004 reﬂect expenses associated with the resolution of various legal matters, none of which was individually material, partially offset by the adjustment of an estimate associated with a previous- ly recorded litigation accrual. See Note 14 to the Consolidated Financial Statements for additional information regarding litigation against the Company. Legal and regulatory matters for 2003 primarily reﬂects a $239 million provision for litigation relating to the court approved settlement of the Berger v. Retirement Income Guarantee Plan (RIGP) litigation. Legal and regulatory matters for 2002 includes $27 million of expenses related to certain litigation, indemniﬁcations and associated claims, as well as the $10 million penalty incurred in connection with our settlement with the SEC. Loss (gain) on early extinguishment of debt: In 2003, we recorded a $73 million loss on early extinguishment of debt reﬂecting the write-off of the remaining unamortized fees associated with the 2002 Credit Facility. The 2002 Credit Facility was repaid upon completion of the June 2003 Recapitalization. Business divestiture and asset sale losses (gains): Business divestitures and asset sales in all years included miscellaneous land, buildings and equipment sales. The 2004 amount primarily reﬂects the $38 million gain from the sale of our interest in ScanSoft, gains of $14 million primarily related to the sale of certain excess land and buildings in Europe and Mexico and a $7 million favorable purchase price adjustment associated with a prior year business sale. The 2003 amount primarily included losses related to the sale of XES subsidiaries in France and Germany, which were partially offset by a gain on the sale of our investment in Xerox South Africa. Income Taxes: The following table summarizes our consolidated income taxes and the related effective tax rate for each respective period ($ in millions): Pre-tax income Income taxes Effective tax rate (1) Year Ended December 31, 2002 2003 2004 $965 340 35.2% $436 134 30.7% $104 4 3.8% (1) A detailed reconciliation of the consolidated effective tax rate to the U.S. federal statutory income tax rate is included in Note 13. The 2004 consolidated effective income tax rate of 35.2 percent was comparable to the U.S. federal statutory income tax rate. The effective income tax rate reﬂects the impact of nondeductible expenses and $20 million of unrecognized tax beneﬁts primarily related to recurring losses in certain jurisdictions where we continue to maintain deferred tax asset valuation allowances. This tax expense was partially offset by tax beneﬁts from other foreign adjustments, including earnings taxed at different rates, tax law changes of $14 million and other items that are individually insigniﬁcant. 29 The difference between the 2003 consolidated In 2004, we recorded a Gain on sale of effective tax rate of 30.7 percent and the U.S. federal statutory income tax rate of 35 percent relates prima- rily to $35 million of tax beneﬁts arising from the reversal of valuation allowances on deferred tax assets following a re-evaluation of their future realization due to improved ﬁnancial performance, other foreign adjustments, including earnings taxed at different rates, the impact of Series B Convertible Preferred Stock dividends and state tax beneﬁts. Such beneﬁts were partially offset by tax expense for audit and other tax return adjustments, as well as $19 million of unrecognized tax beneﬁts primarily related to recur- ring losses in certain jurisdictions where we continue to maintain deferred tax asset valuation allowances. The difference between the 2002 consolidated effective tax rate of 3.8 percent and the U.S. federal statutory income tax rate of 35 percent relates prima- rily to the recognition of tax beneﬁts resulting from the favorable resolution of a foreign tax audit of approximately $79 million, tax law changes of approximately $26 million and the impact of Series B Convertible Preferred Stock dividends. Such beneﬁts were offset, in part, by tax expense recorded for the on-going examination in India, the sale of our interest in Katun Corporation, as well as recurring losses in certain jurisdictions where we are not providing tax beneﬁts and continue to maintain deferred tax asset valuation allowances. Our consolidated effective income tax rate will change based on discrete events (such as audit settlements) as well as other factors including the geographical mix of income before taxes and the related tax rates in those jurisdictions. We anticipate that our 2005 annual consolidated effective tax rate will approximate 38 percent. Equity in Net Income of Unconsolidated Afﬁliates: Equity in net income of unconsolidated afﬁliates increased $93 million in 2004 as compared to 2003. This account is principally related to our 25 per- cent share of Fuji Xerox income. As discussed in Note 6 to the Consolidated Financial Statements, equity income for 2004 included $38 million related to our share of a pension settlement gain recorded by Fuji Xerox due to a non-recurring opportunity given to Japanese companies by the Japanese government in accordance with the Japan Welfare Pension Insurance Law. This law allowed Japanese companies to transfer a portion of their pension obligations to the Japanese government. The remainder of the 2004 increase is primarily due to the improved operational perform- ance of Fuji Xerox. Our 2003 equity in net income of $58 million was comparable with the 2002 result of $54 million. ContentGuard relating to the sale of all but 2 percent of our 75 percent ownership interest in ContentGuard. The sale, which is disclosed in Note 18 to the Consolidated Financial Statements, resulted in an after-tax gain of approximately $83 million ($109 mil- lion pre-tax). Recent Accounting Pronouncements: See Note 1 of the Consolidated Financial Statements for a full description of recent accounting pronouncements including the respective dates of adoption and effects on results of operations and ﬁnancial condition. Capital Resources and Liquidity Cash Flow Analysis: The following summarizes our cash ﬂows for each of the three years ended December 31, 2004, as reported in our Consolidated Statements of Cash Flows in the accompanying Consolidated Financial Statements ($ in millions): Net cash provided by operating activities Net cash provided by investing activities Net cash used in ﬁnancing activities Effect of exchange rate changes on cash Increase (decrease) in cash and cash equivalents Cash and cash equivalents 2004 2003 2002 $ 1,750 $ 1,879 $ 1,980 203 49 93 (1,293) (2,470) (3,292) 81 132 116 741 (410) (1,103) at beginning of year 2,477 2,887 3,990 Cash and cash equivalents at end of year $ 3,218 $ 2,477 $ 2,887 Operating: For the year ended December 31, 2004, operating cash ﬂows were $1.8 billion, a decrease of $129 million over the same period in 2003. The decrease primarily results from lower ﬁnance receiv- able reductions of $159 million reﬂecting the increase in equipment sale revenue in 2004, higher cash usage related to inventory of $100 million to support new product launches and increased tax payments of $46 million due to increased income. In addition, there was lower cash generation from the early termination of interest rate swaps of $62 million. These cash outﬂows were partially offset by lower pension plan contributions of $263 million. For the year ended December 31, 2003, operating cash ﬂows were $1.9 billion, a decrease of $101 mil- lion over the same period in 2002. The decrease pri- marily reﬂects increased pension plan contributions of $534 million, lower ﬁnance receivable reductions of 30 payments were partially offset by net proceeds of $750 million from the issuance of the 2011 Senior Notes, net proceeds from secured borrowing activity of $155 million and proceeds from stock options exercises of $73 million. Cash usage from ﬁnancing activities for the year ended December 31, 2003 of $2.5 billion included net payments on our 2002 credit facility of $3.5 billion, net payments on term and other debt of $2.0 billion and preferred stock dividends of $57 million. These payments were partially offset by net proceeds from secured borrowing activity of $269 million and the following activity related to the completion of our June 2003 recapitalization plan-net proceeds from the convertible preferred stock offering of $889 million, net proceeds from the common stock offering of $451 million, net proceeds from the 2010 and 2013 Senior Notes of $1.2 billion and net proceeds from the 2003 Credit Facility of $271 million. Customer Financing Activities and Debt: We provide equipment ﬁnancing to the majority of our customers. Because the ﬁnance leases allow our cus- tomers to pay for equipment over time rather than at the date of installation, we maintain a certain level of debt to support our investment in these customer ﬁnance leases. We have funded a signiﬁcant portion of our ﬁnance receivables through third-party secured funding arrangements. Under these arrangements, debt is secured by the ﬁnance receivables it supports, which eliminates certain signiﬁcant reﬁnancing, pric- ing and duration risks associated with our debt. In addition to these third party arrangements, we support our customer ﬁnance leasing with cash generated from operations and through capital markets offerings. During the years ended December 31, 2004 and 2003, we borrowed $2.1 billion and $2.5 billion, respectively, under third-party secured funding arrangements. Approximately 60 percent of our total ﬁnance receivable portfolio has been pledged to secure funding at both December 31, 2004 and December 31, 2003. The following table compares ﬁnance receivables to ﬁnancing-related debt as of December 31, 2004 and 2003 ($ in millions): $258 million reﬂecting the increase in equipment sale revenue in 2003 and an increased on-lease equipment investment of $39 million. These items were partially offset by increased pre-tax income of $332 million, lower tax payments of $235 million and increased cash proceeds from the early termination of interest rate swaps of $80 million. The lower tax payments reﬂect the absence of the $346 million tax payment associated with the 2001 sale of a portion of our ownership interest in Fuji Xerox. We expect operating cash ﬂows to be between $1.0 billion and $1.5 billion in 2005, as compared to $1.8 billion in 2004. The reduction includes the expected change in ﬁnance receivables consistent with expected equipment sales expansion, along with expected on- lease equipment growth as well as the absence of early derivative contract termination cash ﬂow. Investing: Investing cash ﬂows for the year ended December 31, 2004 of $203 million included $191 mil- lion proceeds from the sale of businesses and invest- ments, primarily consisting of $66 million from the ContentGuard sale, $79 million from the ScanSoft sale and $36 million from a preferred stock investment. In addition, $223 million was released from restricted cash during the period primarily related to the renego- tiation of certain secured borrowing arrangements and scheduled releases from an escrow account sup- porting interest payments on our liability to a trust issuing preferred securities. We also received $53 mil- lion of proceeds from the sale of certain excess land and buildings. These aggregate proceeds were partially offset by capital and internal use software spending of $252 million. We expect 2005 capital expenditures to approximate $250 million. Investing cash ﬂows for the year ended December 31, 2003 of $49 million consisted primarily of $235 million released from restricted cash related to former reinsurance obligations associated with our discontinued operations, $35 million of aggregate cash proceeds from the divestiture of our investment in Xerox South Africa, XES France and Germany and other minor investments, partially offset by capital and internal use software spending of $250 million. Financing: Cash usage from ﬁnancing activities for the year ended December 31, 2004 of $1.3 billion included payments of scheduled maturities on Euro and Dollar denominated term debt of $2.1 billion, net payments of other debt totaling $101 million and preferred stock dividends of $83 million. These net 31 GE secured loans: United States Canada United Kingdom Germany Total GE encumbered ﬁnance receivables, net Merrill Lynch Loan – France Asset-backed notes – France DLL – Netherlands, Spain, and Belgium Total encumbered ﬁnance receivables, net (1) Unencumbered ﬁnance receivables, net Total ﬁnance receivables, net (2) December 31, 2004 December 31, 2003 Finance Receivables, Net $2,711 486 771 – 3,968 368 225 436 4,997 3,500 $8,497 Secured Debt $2,486 426 685 – 3,597 287 148 404 $4,436 Finance Receivables, Net Secured Debt $ 2,598 440 570 84 3,692 92 364 277 $ 4,425 $2,939 528 719 114 4,300 138 429 335 5,202 3,611 $8,813 (1) Encumbered ﬁnance receivables represent the book value of ﬁnance receivables that secure each of the indicated loans. (2) Includes (i) Billed portion of ﬁnance receivables, net (ii) Finance receivables, net and (iii) Finance receivables due after one year, net as included in the Consolidated Balance Sheets as of December 31, 2004 and 2003. As of December 31, 2004 and 2003, debt secured by ﬁnance receivables was approximately 44 percent and 40 percent of total debt, respectively. The follow- ing represents our aggregate debt maturity schedule as of December 31, 2004 ($ in millions): Bonds/ Bank Loans $ 1,177 36 528 385 932 2,630 $ 5,688 Secured by Finance Receivables $ 1,897 915 838 656 27 103 $4,436 Total Debt $ 3,074(1) 951 1,366 1,041 959 2,733 $ 10,124 2005 2006 2007 2008 2009 Thereafter Total (1) Quarterly debt maturities (in millions) for 2005 are $681, $1,500, $421 and $472 for the ﬁrst, second, third and fourth quarters, respectively. The following table summarizes our secured and unsecured debt as of December 31, 2004 and 2003 ($ in millions): Term Loan Debt secured by ﬁnance receivables Capital leases Debt secured by other assets Total Secured Debt Senior Notes Subordinated debt Other Debt Total Unsecured Debt Total Debt $ 2004 300 4,436 58 235 5,029 2,936 19 2,140 5,095 $ 2003 300 4,425 29 99 4,853 2,137 19 4,157 6,313 $10,124 $11,166 32 Liquidity: We manage our worldwide liquidity using internal cash management practices, which are sub- ject to (1) the statutes, regulations and practices of each of the local jurisdictions in which we operate, (2) the legal requirements of the agreements to which we are a party and (3) the policies and cooperation of the ﬁnancial institutions we utilize to maintain and provide cash management services. With $3.2 billion of cash and cash equivalents on hand at December 31, 2004, borrowing capacity under our 2003 Credit Facility of $700 million (less $15 mil- lion utilized for letters of credit) and funding available through our secured funding programs, we believe our liquidity (including operating and other cash ﬂows that we expect to generate) will be sufﬁcient to meet operating cash ﬂow requirements as they occur and to satisfy all scheduled debt maturities for at least the next twelve months. Our ability to maintain posi- tive liquidity going forward depends on our ability to continue to generate cash from operations and access to the ﬁnancial markets, both of which are subject to general economic, ﬁnancial, competitive, legislative, regulatory and other market factors that are beyond our control. As of December 31, 2004, we had an active shelf registration statement with $1.75 billion of capacity that enables us to access the market on an opportunistic basis and offer both debt and equity securities. Credit Facility: The 2003 Credit Facility consists of a $300 million term loan and a $700 million revolving credit facility which includes a $200 million sub-facility for letters of credit. Xerox Corporation is the only bor- rower of the term loan. The revolving credit facility is available, without sub-limit, to Xerox Corporation and certain of its foreign subsidiaries, including Xerox Canada Capital Limited, Xerox Capital (Europe) plc and other qualiﬁed foreign subsidiaries (excluding Xerox Corporation, the “Overseas Borrowers”). The 2003 Credit Facility matures on September 30, 2008. As of December 31, 2004, the $300 million term loan and $15 million of letters of credit were outstanding and there were no outstanding borrowings under the revolving credit facility. Since inception of the 2003 Credit Facility in June 2003, there have been no borrowings under the revolving credit facility. The term loan and the revolving loans each bear interest at LIBOR plus a spread that varies between 1.75 percent and 3 percent or, at our election, at a base rate plus a spread that depends on the then-current leverage ratio, as deﬁned, in the 2003 Credit Facility. This rate was 3.92 percent at December 31, 2004. The 2003 Credit Facility contains afﬁrmative and negative covenants as well as ﬁnancial maintenance covenants. Subject to certain exceptions, we cannot pay cash dividends on our common stock during the facility term, although we can pay cash dividends on our preferred stock provided there is then no event of default. In addition to other defaults customary for facilities of this type, defaults on other debt, or bank- ruptcy, of Xerox, or certain of our subsidiaries, and a change in control of Xerox, would constitute events of default. At December 31, 2004, we were in compliance with the covenants of the 2003 Credit Facility and we expect to remain in compliance for at least the next twelve months. Other Financing Activity Financing Business: We currently fund our customer ﬁnancing activity through third-party funding arrange- ments, cash generated from operations, cash on hand, capital markets offerings and securitizations. In the United States, Canada, the U.K., and France, we are currently funding a signiﬁcant portion of our customer ﬁnancing activity through secured borrowing arrange- ments with GE and Merrill Lynch. In The Netherlands, Spain and Belgium, we utilize a consolidated joint ven- ture relationship with De Lage Landen International BV (“DLL”), whereby the joint venture, funded by DLL’s parent, became our primary equipment ﬁnancing partner for new lease originations in those countries. We also have arrangements in Italy, the Nordic coun- tries, Brazil and Mexico in which third party ﬁnancial institutions originate lease contracts directly with our customers. In these transactions, we sell and transfer title to the equipment to these ﬁnancial institutions and generally have no continuing ownership rights in the equipment subsequent to its sale. Several of the more signiﬁcant customer ﬁnancing arrangements are discussed below. See Note 3 to the Consolidated Financial Statements for a more detailed discussion of our customer ﬁnancing arrangements. Secured Borrowing Arrangements: In October 2002, we ﬁnalized an eight-year Loan Agreement with General Electric Capital Corporation (“GECC”). The Loan Agreement provides for a series of monthly secured loans up to $5 billion outstanding at any time ($2.5 billion outstanding at December 31, 2004). The $5 billion limit may be increased to $8 billion subject to agreement between the parties. Additionally, the agreement contains mutually agreed renewal options for successive two-year periods. The Loan Agreement, as well as separate loan agreements with GE in the U.K. and Canada that have similar terms, incorporates the ﬁnancial maintenance covenants contained in the 2003 Credit Facility and contains other afﬁrmative and negative covenants. Under the Loan Agreement, we expect GECC to fund a signiﬁcant portion of new U.S. lease origina- tions at over-collateralization rates, which vary over time, but are expected to approximate 10 percent at the inception of each funding. The secured loans are subject to interest rates calculated at each monthly loan occurrence at yield rates consistent with average rates for similar market based transactions. The funds received under this agreement are recorded as secured borrowings and the associated ﬁnance receiv- ables are included in our Consolidated Balance Sheet. GECC’s commitment to fund under this agreement is not subject to our credit ratings. France Secured Borrowings: In July 2003, we secu- ritized receivables of $443 million, previously funded under a 364-day warehouse ﬁnancing facility estab- lished in December 2002 with subsidiaries of Merrill Lynch, with a three-year public secured ﬁnancing arrangement. In addition, we established a new ware- house ﬁnancing facility to fund future lease origina- tions in France. This facility can provide funding for new lease originations up to ?350 million (U.S. $477 million), outstanding at any time, and balances may be securitized through a similar public offering within two years. The Netherlands Secured Borrowings: Beginning in the second half of 2002, we received a series of fund- ings through our consolidated joint venture with DLL from DLL’s parent, De Lage Landen Ireland Company. The fundings are secured by our lease receivables in The Netherlands which were transferred to the DLL joint venture. In addition, the DLL joint venture also became our primary equipment ﬁnancing provider in the Netherlands for all new lease originations. In the fourth quarter of 2003, the DLL joint venture expanded its operations to include Spain and Belgium. 33 Credit Ratings: Our credit ratings as of February 21, 2005 were as follows: Senior Unsecured Debt Outlook Comments Moody’s (1) (2) Ba2 Stable S&P B+ Stable Fitch BB Positive The Moody’s rating was upgraded from B1 in August 2004. The S&P rating on Senior Secured Debt is BB-. The outlook was upgraded to stable in January 2005. The Fitch rating was upgraded to a positive outlook in February 2005. (1) In December 2003, Moody’s assigned to Xerox a ﬁrst time SGL-1 rating. This rating was afﬁrmed in August 2004. (2) In August 2004, Moody’s upgraded the long-term senior unsecured debt rating of Xerox from B1 to Ba2, a two notch upgrade. The corporate rat- ing was upgraded to Ba1 and the outlook is stable. Both our ability to obtain ﬁnancing and the related cost of borrowing are affected by our credit ratings, which are periodically reviewed by the major rating agencies. Our current credit ratings are below invest- ment grade and we expect our access to the public debt markets to be limited to the non-investment grade segment until our ratings have been restored. Loan Covenants and Compliance: At December 31, 2004, we were in full compliance with the covenants and other provisions of the 2003 Credit Facility, the senior notes and the Loan Agreement and expect to remain in full compliance for at least the next twelve months. Any failure to be in compliance with any material provision or covenant of the 2003 Credit Facility or the senior notes could have a material adverse effect on our liquidity and operations. Failure to be in compliance with the covenants in the Loan Agreement, including the ﬁnancial maintenance covenants incorporated from the 2003 Credit Facility, would result in an event of termination under the Loan Agreement and in such case GECC would not be required to make further loans to us. If GECC were to make no further loans to us and assuming a similar facility was not established, it would materially adversely affect our liquidity and our ability to fund our customers’ purchases of our equipment and this could materially adversely affect our results of opera- tions. We have the right at any time to prepay without penalty any loans outstanding under or terminate the 2003 Credit Facility. Capital Markets Offerings and Other: In August 2004, we issued $500 million aggregate principal amount of Senior Notes due 2011 at par value and, in September 2004, we issued an additional $250 million aggregate principal amount Senior Notes due 2011 at 104.25 percent of par. These notes, which are discussed further in Note 9 to the Consolidated Financial Statements, form a single series of debt. Interest on the Senior Notes accrues at the annual rate of 6.875 percent and, as a result of the premium we received on the second issuance of Senior Notes, have a weight- ed average effective interest rate of 6.6 percent. The weighted average effective interest rate associated with the Senior Notes reﬂects our recently improved liquidity and ability to access the capital markets on more favorable terms. In December 2004, we completed the redemption of our liability to the Xerox trust issuing trust preferred securities. In lieu of cash redemption, holders of sub- stantially all of the securities converted $1.0 billion aggregate principal amount of securities into 113 mil- lion shares of our common stock. As a result of this conversion and redemption, there is no remaining outstanding principal. This redemption, which had no impact on diluted earnings per share, is discussed further in Note 10 to the Consolidated Financial Statements. 34 Contractual Cash Obligations and Other Commercial Commitments and Contingencies: At December 31, 2004, we had the following contractual cash obligations and other commercial commitments and contingencies ($ in millions): Long-term debt, including capital lease obligations (1) Minimum operating lease commitments (2) Liabilities to subsidiary trusts issuing preferred securities (3) Total contractual cash obligations (4) Year 1 2005 $ 3,074 222 – $3,296 Years 2-3 Years 4-5 2006 $ 951 181 88 $1,220 2007 $ 1,366 143 2008 $1,041 109 2009 $ 959 94 – – – $ 1,509 $1,150 $1,053 There- after $2,733 256 629 $3,618 (1) Refer to Note 9 to our Consolidated Financial Statements for interest payments by us as well as for additional information related to long-term debt (amounts above include principal portion only). (2) Refer to Note 5 to our Consolidated Financial Statements for additional information related to minimum operating lease commitments. (3) Refer to Note 10 to our Consolidated Financial Statements for interest payments by us as well as for additional information related to liabilities to subsidiary trusts issuing preferred securities (amounts above include principal portion only). (4) Certain long-term liabilities reﬂected on our balance sheet, such as unearned income, are not presented in this table because they do not require cash set- tlement in the future. Other Commercial Commitments and Contingencies Pension and Other Post-Retirement Beneﬁt Plans: We sponsor pension and other post-retirement beneﬁt plans that require periodic cash contributions. Our 2004 cash fundings for these plans were $409 mil- lion for pensions and $104 million for other post- retirement plans. Our anticipated cash fundings for 2005 are $114 million for pensions and $128 million for other post-retirement plans. Cash contribution requirements for our domestic tax qualiﬁed pension plans are governed by the Employment Retirement Income Security Act (ERISA) and the Internal Revenue Code. Cash contribution requirements for our international plans are subject to the applicable regulations in each country. The expected contributions for pensions for 2005 include no expected contribu- tions to the domestic tax qualiﬁed plans because these plans have already exceeded the ERISA minimum funding requirements for the plans’ 2004 plan year due to funding of approximately $210 million in 2004. Our post-retirement plans are non-funded and are almost entirely related to domestic operations. Cash contributions are made each year to cover medical claims costs incurred in that year. Flextronics: In 2001, we outsourced certain manu- facturing activities to Flextronics under a ﬁve-year agreement. During 2004, we purchased $874 million of products from Flextronics. We anticipate that we will purchase approximately $920 million of products from Flextronics during 2005 and expect this level to be commensurate with our sales in the future. Fuji Xerox: We had product purchases from Fuji Xerox totaling $1.1 billion, $871 million, and $727 mil- lion in 2004, 2003 and 2002, respectively. Our purchase commitments with Fuji Xerox are in the normal course of business and typically have a lead time of three months. We anticipate that we will pur- chase approximately $1.2 billion of products from Fuji Xerox in 2005. Related party transactions with Fuji Xerox are disclosed in Note 6 to the Consolidated Financial Statements. Other Purchase Commitments: We enter into other purchase commitments with vendors in the ordinary course of business. Our policy with respect to all purchase commitments is to record losses, if any, when they are probable and reasonably estimable. We currently do not have, nor do we anticipate, material loss contracts. EDS Contract: We have an information management contract with Electronic Data Systems Corp. (“EDS”) to provide services to us for global mainframe system processing, application maintenance and support, desktop services and helpdesk support, voice and data network management, and server management. On July 1, 2004, we extended the original ten-year contract through June 30, 2009. Although there are no minimum payments required under the contract, we anticipate making the following payments to EDS over the next ﬁve years (in millions): 2005 – $319; 2006 – $309; 2007 – $298; 2008 – $290; 2009 – $141 (for six months). Each framework has a process for estimat- ing projected volumes. Pricing for the services (which are comprised of global mainframe system processing, application maintenance and enhancements, desktop services and help desk support, voice and data man- 35 agement) were established when the contract was signed in 1994 based on our actual costs in preceding years. Prices were renegotiated for the period from July 1, 2004 to July 1, 2009 and, in most cases, are sub- ject to annual revision based upon inﬂation indices. After July 1, 2006, we can terminate the current contract for convenience with six months notice, as deﬁned in the contract, with no termination fee and with payment to EDS for costs incurred as of the ter- mination date. Should we terminate the contract for convenience, we have an option to purchase the assets placed in service under the EDS contract. Off-Balance Sheet Arrangements Although we generally do not utilize off-balance sheet arrangements in our operations, we enter into operat- ing leases in the normal course of business. The nature of these lease arrangements is discussed in Note 5 to the Consolidated Financial Statements. Additionally, we utilize special purpose entities (“SPEs”) in conjunction with certain ﬁnancing trans- actions. The SPEs utilized in conjunction with these transactions are consolidated in our ﬁnancial statements in accordance with applicable accounting standards. These transactions, which are discussed further in Note 3 to the Consolidated Financial Statements, have been accounted for as secured bor- rowings with the debt and related assets remaining on our balance sheets. Although the obligations related to these transactions are included in our balance sheet, recourse is generally limited to the secured assets and no other assets of the Company. Financial Risk Management We are exposed to market risk from foreign currency exchange rates and interest rates, which could affect operating results, ﬁnancial position and cash ﬂows. We manage our exposure to these market risks through our regular operating and ﬁnancing activities and, when appropriate, through the use of derivative ﬁnancial instruments. These derivative ﬁnancial instruments are utilized to hedge economic exposures as well as reduce earnings and cash ﬂow volatility resulting from shifts in market rates. As permitted, certain of these derivative contracts have been desig- nated for hedge accounting treatment under SFAS No. 133. However, certain of these instruments do not qualify for hedge accounting treatment and, accord- ingly, our results of operations are exposed to some level of volatility. The level of volatility will vary with the type and amount of derivative hedges outstanding, as well as ﬂuctuations in the currency and interest rate market during the period. We enter into limited types of derivative contracts, including interest rate and cross currency interest rate swap agreements, foreign currency spot, forward and swap contracts, purchased foreign currency options and interest rate collars to manage interest rate and foreign currency exposures. Our primary foreign cur- rency market exposures include the Japanese yen, Euro, British pound sterling, Brazilian real and Canadian dollar. The fair market values of all our derivative contracts change with ﬂuctuations in inter- est rates and/or currency rates and are designed so that any changes in their values are offset by changes in the values of the underlying exposures. Derivative ﬁnancial instruments are held solely as risk manage- ment tools and not for trading or speculative purposes. By their nature, all derivative instruments involve, to varying degrees, elements of market and credit risk not recognized in our ﬁnancial statements. The market risk associated with these instruments resulting from currency exchange and interest rate movements is expected to offset the market risk of the underlying transactions, assets and liabilities being hedged. We do not believe there is signiﬁcant risk of loss in the event of non-performance by the counterparties associated with these instruments because these transactions are executed with a diversiﬁed group of major ﬁnancial institutions. Further, our policy is to deal with counter- parties having a minimum investment-grade or better credit rating. Credit risk is managed through the contin- uous monitoring of exposures to such counterparties. Some of our derivative and other material contracts at December 31, 2004 require us to post cash collateral or maintain minimum cash balances in escrow. These cash amounts are reported in our Consolidated Balance Sheets within Other current assets or other long-term assets, depending on when the cash will be contractually released, as presented in Note 1 to the Consolidated Financial Statements. Assuming a 10 percent appreciation or deprecia- tion in foreign currency exchange rates from the quot- ed foreign currency exchange rates at December 31, 2004, the potential change in the fair value of foreign currency-denominated assets and liabilities in each entity would not be signiﬁcant because all material currency asset and liability exposures were economi- cally hedged as of December 31, 2004. A 10 percent appreciation or depreciation of the U.S. Dollar against all currencies from the quoted foreign currency exchange rates at December 31, 2004 would have a $496 million impact on our Cumulative Translation Adjustment portion of equity. The amount permanently invested in foreign subsidiaries and afﬁliates, primari- ly Xerox Limited, Fuji Xerox and Xerox do Brasil, and translated into dollars using the year-end exchange rates, was $5.0 billion at December 31, 2004, net of foreign currency-denominated liabilities designated as a hedge of our net investment. 36 Interest Rate Risk Management: The consolidated weighted-average interest rates related to our debt and liabilities to subsidiary trusts issuing preferred securities for 2004, 2003 and 2002 approximated 5.8 percent, 6.0 percent, and 5.0 percent, respectively. Interest expense includes the impact of our interest rate derivatives. Virtually all customer-ﬁnancing assets earn ﬁxed rates of interest. As discussed above, a signiﬁcant portion of those assets has been pledged to secure ﬁnancing loan arrangements and the interest rates on a signiﬁcant portion of those loans are ﬁxed. If we implement additional ﬁnancing arrangements, the proportion of our ﬁnancing assets which is match- funded against related secured debt may increase. As of December 31, 2004, approximately $3.2 billion of our debt bears interest at variable rates, including the effect of pay-variable interest rate swaps we are utiliz- ing to reduce the effective interest rate on our debt. The fair market values of our ﬁxed-rate ﬁnancial instruments are sensitive to changes in interest rates. At December 31, 2004, a 10 percent change in market interest rates would change the fair values of such ﬁnancial instruments by approximately $378 million. Forward-Looking Cautionary Statements This Annual Report contains forward-looking statements and information relating to Xerox that are based on our beliefs, as well as assumptions made by and information currently available to us. The words “anticipate,” “believe,” “estimate,” “expect,” “intend,” “will,” “should” and similar expressions, as they relate to us, are intended to identify forward-looking state- ments. Actual results could differ materially from those projected in such forward-looking statements. Information concerning certain factors that could cause actual results to differ materially is included in our 2004 Annual Report on Form 10-K ﬁled with the SEC. We do not intend to update these forward- looking statements. 37 Consolidated Statements of Income Year ended December 31, (in millions, except per-share data) 2004 2003 2002 Revenues Sales Service, outsourcing and rentals Finance income Total Revenues Costs and Expenses Cost of sales Cost of service, outsourcing and rentals Equipment ﬁnancing interest Research and development expenses Selling, administrative and general expenses Restructuring and asset impairment charges Gain on afﬁliate’s sale of stock Other expenses, net Total Costs and Expenses Income from Continuing Operations before Income Taxes, Equity Income and Cumulative Effect of Change in Accounting Principle Income taxes Equity in net income of unconsolidated afﬁliates Income from Continuing Operations before Cumulative Effect of Change in Accounting Principle Gain on sale of ContentGuard, net of income taxes of $26 Income before Cumulative Effect of Change in Accounting Principle Cumulative effect of change in accounting principle Net Income Less: Preferred stock dividends, net Income available to common shareholders Basic Earnings per Share Income from Continuing Operations before Cumulative Effect of Change in Accounting Principle Net Earnings per Share Diluted Earnings per Share Income from Continuing Operations before Cumulative Effect of Change in Accounting Principle Net Earnings per Share The accompanying notes are an integral part of the Consolidated Financial Statements. $ 7,259 7,529 934 15,722 4,688 4,306 345 760 4,203 86 — 369 $ 6,970 7,734 997 15,701 4,436 4,311 362 868 4,249 176 (13) 876 $ 6,752 8,097 1,000 15,849 4,233 4,494 401 917 4,437 670 – 593 14,757 15,265 15,745 965 340 151 776 83 859 — 859 (73) 436 134 58 360 — 360 – 360 (71) 104 4 54 154 — 154 (63) 91 (73) $ 786 $ 289 $ 18 $ 0.84 $ 0.94 $ 0.38 $ 0.38 $ 0.11 $ 0.02 $ 0.78 $ 0.86 $ 0.36 $ 0.36 $ 0.10 $ 0.02 38 Consolidated Balance Sheets December 31, (in millions) Assets Cash and cash equivalents Accounts receivable, net Billed portion of ﬁnance receivables, net Finance receivables, net Inventories Other current assets Total Current Assets Finance receivables due after one year, net Equipment on operating leases, net Land, buildings and equipment, net Investments in afﬁliates, at equity Intangible assets, net Goodwill Deferred tax assets, long-term Other long-term assets Total Assets Liabilities and Equity Short-term debt and current portion of long-term debt Accounts payable Accrued compensation and beneﬁts costs Unearned income Other current liabilities Total Current Liabilities Long-term debt Liabilities to subsidiary trusts issuing preferred securities Pension and other beneﬁt liabilities Post-retirement medical beneﬁts Other long-term liabilities Total Liabilities Series B convertible preferred stock Series C mandatory convertible preferred stock Common stock, including additional paid in capital Retained earnings Accumulated other comprehensive loss Total Liabilities and Equity 2004 2003 $ 3,218 2,076 377 2,932 1,143 1,182 10,928 5,188 398 1,759 845 297 1,848 1,521 2,100 $ 2,477 2,159 461 2,981 1,152 1,105 10,335 5,371 364 1,827 644 325 1,722 1,526 2,477 $24,884 $24,591 $ 3,074 1,037 637 243 1,309 6,300 7,050 717 1,189 1,180 1,315 17,751 — 889 4,881 2,101 (738) $ 4,236 1,010 632 251 1,540 7,669 6,930 1,809 1,058 1,168 1,278 19,912 499 889 3,239 1,315 (1,263) $24,884 $24,591 Shares of common stock issued and outstanding were (in thousands) 955,997 and 793,884 at December 31, 2004 and December 31, 2003, respectively. The accompanying notes are an integral part of the Consolidated Financial Statements. 39 Consolidated Statements of Cash Flows Year ended December 31, (in millions) Cash Flows from Operating Activities Net income Adjustments required to reconcile net income to cash ﬂows from operating activities: Depreciation and amortization Provisions for receivables and inventory Deferred tax expense (beneﬁt) Net gains on sales of businesses, assets and afﬁliate’s sale of stock Undistributed equity in net income of unconsolidated afﬁliates Loss (gain) on early extinguishment of debt Gain on sale of ContentGuard Impairment of goodwill Restructuring and other charges Cash payments for restructurings Contributions to pension beneﬁt plans Early termination of derivative contracts (Increase) decrease in inventories Increase in on-lease equipment Decrease in ﬁnance receivables Decrease (increase) in accounts receivable and billed portion of ﬁnance receivables Increase in accounts payable and accrued beneﬁts Net change in income tax assets and liabilities Decrease in other current and long-term liabilities Other, net Net cash provided by operating activities Cash Flows from Investing Activities Cost of additions to land, buildings and equipment Proceeds from sales of land, buildings and equipment Cost of additions to internal use software Proceeds from divestitures and investments, net Acquisitions, net of cash acquired Net change in escrow and other restricted investments Other, net Net cash provided by investing activities Cash Flows from Financing Activities Cash proceeds from new secured ﬁnancings Debt payments on secured ﬁnancings Net cash payments on debt Proceeds from issuance of mandatorily redeemable preferred stock Preferred stock dividends Proceeds from issuances of common stock Dividends to minority shareholders Net cash used in ﬁnancing activities Effect of exchange rate changes on cash and cash equivalents Increase (decrease) in cash and cash equivalents Cash and cash equivalents at beginning of year Cash and cash equivalents at end of year The accompanying notes are an integral part of the Consolidated Financial Statements. 40 2004 2003 2002 $ 859 $ 360 $ 91 686 159 155 (61) (89) — (83) — 86 (187) (409) 74 (38) (234) 337 224 333 (68) (79) 85 748 302 (70) (1) (37) 73 — — 176 (345) (672) 136 62 (166) 496 164 408 (3) (37) 285 1,750 1,879 (204) 53 (48) 191 (12) 223 – 203 2,061 (1,906) (1,422) — (83) 73 (16) (1,293) 81 741 2,477 (197) 10 (53) 35 — 254 – 49 2,450 (2,181) (4,044) 889 (57) 477 (4) (2,470) 132 (410) 2,887 $ 3,218 $ 2,477 1,035 468 (178) (1) (23) (1) — 63 670 (392) (138) 56 16 (127) 754 (266) 398 (260) (177) (8) 1,980 (146) 19 (50) 340 — (63) (7) 93 3,055 (1,662) (4,619) – (67) 4 (3) (3,292) 116 (1,103) 3,990 $ 2,887 Consolidated Statements of Common Shareholders’ Equity Common Stock Shares 722,314 Common Stock Amount $724 Additional Paid-In Capital $1,898 Accumulated Retained Other Compre- Earnings hensive Loss(1) $1,008 $(1,833) (in millions, except share data) Balance at December 31, 2001 Net income Translation adjustments(2) Minimum pension liability, net of tax Unrealized gain on securities, net of tax Unrealized gains on cash ﬂow hedges, net of tax Comprehensive income Stock option and incentive plans, net Convertible securities Series B convertible preferred stock dividends ($10.94 per share), net of tax Equity for debt exchanges Other Balance at December 31, 2002 Net income Translation adjustments Minimum pension liability, net of tax Unrealized gain on securities, net of tax Unrealized gains on cash ﬂow hedges, net of tax Comprehensive income Stock option and incentive plans, net Common stock offering Series B convertible preferred stock dividends ($6.25 per share), net of tax Series C mandatory convertible preferred stock dividends ($3.23 per share) 2,385 7,118 6,412 44 738,273 2 7 6 (1) 10 48 45 $738 $2,001 9,530 46,000 9 46 41 405 Other Balance at December 31, 2003 81 793,884 1 $794 (2) $2,445 Net income Translation adjustments Minimum pension liability, net of tax Unrealized gain on securities, net of tax Realized gain on securities, net of tax Unrealized gains on cash ﬂow hedges, net of tax Comprehensive income Stock option and incentive plans, net Series B convertible preferred stock conversion Series B convertible preferred stock dividends ($2.54 per share) Series C mandatory convertible preferred stock dividends ($6.25 per share) Conversion of Liability to Capital Trust II (Note 10) Other Balance at December 31, 2004 11,433 37,040 11 37 113,415 225 955,997 113 1 $956 111 446 922 1 234 (279) 1 6 $(1,871) 547 42 17 2 $(1,263) 453 86 2 (18) 2 91 (73) (1) $1,025 360 (41) (30) 1 $1,315 859 (15) (58) Total $1,797 $ 91 234 (279) 1 6 53 12 55 (73) 51 (2) $1,893 360 547 42 17 2 $ 968 50 451 (41) (30) – $3,291 859 453 86 2 (18) 2 $1,384 122 483 (15) (58) 1,035 2 $6,244 $3,925 $2,101 $ (738) (1) As of December 31, 2004, Accumulated Other Comprehensive Loss is composed of cumulative translation adjustments of $(524), unrealized gain on securities of $1, minimum pension liabilities of $(218) and cash ﬂow hedging gains of $3. (2) Includes reclassiﬁcation adjustments for foreign currency translation losses of $59, that were realized in 2002 due to the sale of businesses. These amounts were included in accumulated other comprehensive loss in prior periods as unrealized losses. Refer to Note 18 for further discussion. The accompanying notes are an integral part of the Consolidated Financial Statements. 41 Notes to the Consolidated Financial Statements (Dollars in millions, except per-share data and unless otherwise indicated) Note 1 – Summary of Signiﬁcant Accounting Policies References herein to “we,” “us” or “our” refer to Xerox Corporation and its subsidiaries unless the context speciﬁcally requires otherwise. Description of Business and Basis of Presentation: We are a technology and services enterprise and a leader in the global document mar- ket, developing, manufacturing, marketing, servicing and ﬁnancing a complete range of document equip- ment, solutions and services. Basis of Consolidation: The Consolidated Financial Statements include the accounts of Xerox Corporation and all of our controlled subsidiary companies. All signiﬁcant intercompany accounts and transactions have been eliminated. Investments in business entities in which we do not have control, but we have the ability to exercise signiﬁcant inﬂuence over operating and ﬁnancial policies (generally 20 to 50 percent own- ership), are accounted for using the equity method of accounting. Upon the sale of stock of a subsidiary, we recognize a gain or loss in our Consolidated Statements of Income equal to our proportionate share of the cor- responding increase or decrease in that subsidiary’s equity. Operating results of acquired businesses are included in the Consolidated Statements of Income from the date of acquisition. We consolidate variable interest entities if we are deemed to be the primary beneﬁciary of the entity. Operating results for variable interest entities in which we are determined to be the primary beneﬁci- ary are included in the Consolidated Statements of Income from the date such determination is made. Certain reclassiﬁcations of prior year amounts have been made to conform to the current year presentation. Income from Continuing Operations before Income Taxes, Equity Income and Cumulative Effect of Change in Accounting Principle: Throughout the Notes to the Consolidated Financial Statements, we refer to the effects of certain changes in estimates and other adjustments on Income from Continuing Operations before Income Taxes, Equity Income and Cumulative Effect of Change in Accounting Principle. For convenience and ease of reference, that caption in our Consolidated Statements of Income is hereafter referred to as “pre-tax income.” Use of Estimates: The preparation of our Consolidated Financial Statements in accordance with accounting principles generally accepted in the United States of America requires that we make estimates and assump- tions that affect the reported amounts of assets and lia- bilities, as well as the disclosure of contingent assets and liabilities at the date of the ﬁnancial statements, and the reported amounts of revenues and expenses during the reporting period. Signiﬁcant estimates and assumptions are used for, but not limited to: (i) allocation of revenues and fair values in leases and other multiple element arrangements; (ii) accounting for residual values; (iii) economic lives of leased assets; (iv) allowance for doubtful accounts; (v) inventory valuation; (vi) restruc- turing and related charges; (vii) asset impairments; (viii) depreciable lives of assets; (ix) useful lives of intangible assets; (x) pension and post-retirement beneﬁt plans; (xi) income tax valuation allowances and (xii) contingency and litigation reserves. Future events and their effects cannot be predicted with certainty; accordingly, our accounting estimates require the exercise of judgment. The accounting estimates used in the preparation of our Consolidated Financial Statements will change as new events occur, as more experience is acquired, as additional information is obtained and as our operating environment changes. Actual results could differ from those estimates. The following table summarizes certain of the more signiﬁcant charges that require management estimates: 42 Year ended December 31, 2002 2003 2004 Restructuring provisions and asset impairments $ 86 $176 $670 Amortization and impairment of goodwill and intangible assets Provisions for receivables Provisions for obsolete and excess inventory Depreciation and obsolescence of equipment on operating leases Depreciation of buildings and equipment Amortization of capitalized software Pension beneﬁts — net periodic beneﬁt cost Other post-retirement beneﬁts — net periodic beneﬁt cost Deferred tax asset valuation allowance provisions 38 86 73 210 305 134 350 111 12 36 224 78 271 299 143 364 108 99 353 115 408 341 249 168 120 (16) 15 Changes in Estimates: In the ordinary course of accounting for items discussed above, we make changes in estimates as appropriate, and as we become aware of circumstances surrounding those estimates. Such changes and reﬁnements in estima- tion methodologies are reﬂected in reported results of operations in the period in which the changes are made and, if material, their effects are disclosed in the Notes to the Consolidated Financial Statements. New Accounting Standards and Accounting Changes Stock-Based Compensation: In December 2004, the FASB issued Statement of Financial Accounting Standards No. 123R, “Share-Based Payment” (“FAS 123R”), an amendment of FAS No. 123, “Accounting for Stock-Based Compensation.” FAS 123R eliminates the ability to account for share-based payments using Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees,” and instead requires companies to recognize compensa- tion expense using a fair-value based method for costs related to share-based payments including stock options and employee stock purchase plans. The expense will be measured as the fair value of the award at its grant date based on the estimated number of awards that are expected to vest, and recorded over the applicable service period. In the absence of an observable market price for a share-based award, the fair value would be based upon a valuation methodol- ogy that takes into consideration various factors, including the exercise price of the award, the expected term of the award, the current price of the underlying 43 shares, the expected volatility of the underlying share price, the expected dividends on the underlying shares and the risk-free interest rate. The requirements of FAS 123R are effective for our third quarter beginning July 1, 2005 and apply to all awards granted, modiﬁed or cancelled after that date. The standard also provides for different transition methods for past award grants, including the restate- ment of prior period results. We have elected to apply the modiﬁed prospective transition method to all past awards outstanding and unvested as of the effective date of July 1, 2005 and will recognize the associated expense over the remaining vesting period based on the fair values previously determined and disclosed as part of our pro-forma disclosures. We will not restate the results of prior periods. Prior to the effective date of FAS 123R, we will continue to provide the pro-forma disclosures for past award grants as required under FAS 123 and as shown below. In January 2005, we implemented changes in our stock-based compensation programs designed to help us continue to attract and retain the best employees, and to better align employee interests with those of our shareholders. In 2005, we began granting employees restricted stock awards with time- and performance- based restrictions in lieu of stock options. The time- based restricted stock awards offer employees the opportunity to earn shares of our stock over time, rather than options that give employees the right to purchase stock at a set price. The performance-based restricted stock awards are a form of stock award in which the number of shares ultimately received depends on our performance against certain speciﬁed and predetermined ﬁnancial performance targets. The issuance of FAS 123R is expected to result in stock option-based compensation expense in 2005 of approximately $28 ($17 after-tax or $0.02 per diluted share). The effect of the changes in our stock-based compensation program is not expected to be material in 2005. Inventory: In November 2004, the FASB issued FAS 151, “Inventory Costs, an amendment of ARB 43, Chapter 4” (“FAS 151”). This statement amends previ- ous guidance as it relates to inventory valuation to clarify that abnormal amounts of idle facility expense, freight, handling costs and spoilage should be record- ed as current-period charges. The effective date of FAS 151 is January 1, 2006. Since the guidance in FAS 151 reﬂects our current practices, we do not expect there to be any impact on our results of operations, ﬁnancial position or liquidity. Goodwill and Other Intangible Assets: Effective January 1, 2002, we adopted SFAS No. 142, “Goodwill and Other Intangible Assets,” whereby goodwill was no longer to be amortized, but instead is to be tested for impairment annually or more frequently if an event or circumstance indicates that an impairment loss may have been incurred. We estimate fair value by considering a number of factors including assess- ing operating results, business plans, economic pro- jections, anticipated future cash ﬂows and market data. In 2002, we recorded an impairment charge of $63 as a cumulative effect of change in accounting principle in the accompanying Consolidated Statements of Income. The following table presents the changes in the carrying amount of goodwill, by operating segment, for the three years ended December 31, 2004: Production Ofﬁce DMO Other Total Balance at January 1, 2002 Foreign currency translation adjustment Impairment charge Divestitures and other Balance at December 31, 2002 Foreign currency translation adjustment Balance at December 31, 2003 Foreign currency translation adjustment Other Balance at December 31, 2004 $605 $710 $ 70 $121 $1,506 82 — 55 — (3) (63) (4) (5) (4) — — — 134 (63) (13) 683 760 — 121 1,564 88 67 — 3 158 771 827 — 124 1,722 77 — 54 — — — 1 (6) 132 (6) $848 $881 $ — $119 $1,848 Intangible assets primarily relate to the Ofﬁce operating segment. Intangible assets were comprised of the following as of December 31, 2004 and 2003: As of December 31, 2004: As of December 31, 2003: Weighted Average Amortization Period Gross Carrying Amount 17 years 25 years 7 years 7 years 7 years $218 123 105 28 23 $497 Accumulated Amortization Net Amount $ 58 25 74 1 15 $173 $160 98 31 27 8 $324 Gross Carrying Amount $209 123 103 — 23 $458 Accumulated Amortization Net Amount $ 45 20 56 — 12 $133 $164 103 47 — 11 $325 Installed customer base Distribution network Existing technology Licensed technology (1) Trademarks (1) Licensed technology is included in Other long-term assets in the Consolidated Balance Sheet at December 31, 2004. Amortization expense related to intangible assets was $38, $36, and $36 for the years ended December 31, 2004, 2003 and 2002, respectively, and is expected to approximate $41 annually through 2009. Amortization expense is primarily recorded in Other expenses, net, with the exception of amortization expense associated with licensed technology, which is recorded in Cost of sales and Cost of service, outsourcing and rentals, as appropriate. Revenue Recognition: In the normal course of business, we generate revenue through the sale and rental of equipment, service and supplies and income associated with the ﬁnancing of our equipment sales. Revenue is recognized when earned. More speciﬁcally, revenue related to sales of our products and services is recognized as follows: 44 Equipment: Revenues from the sale of equipment, including those from sales-type leases, are recognized at the time of sale or at the inception of the lease, as appropriate. For equipment sales that require us to install the product at the customer location, revenue is recognized when the equipment has been delivered to and installed at the customer location. Sales of customer installable products are recognized upon shipment or receipt by the customer according to the customer’s shipping terms. Revenues from equipment under other leases and similar arrangements are accounted for by the operating lease method and are recognized as earned over the lease term, which is generally on a straight-line basis. Service: Service revenues are derived primarily from maintenance contracts on our equipment sold to customers and are recognized over the term of the contracts. A substantial portion of our products are sold with full service maintenance agreements for which the customer typically pays a base service fee plus a variable amount based on usage. As a consequence, other than the product warranty obligations associated with certain of our low end products in the Ofﬁce segment, we do not have any signiﬁcant product warranty obligations, including any obligations under customer satisfaction programs. Revenues associated with professional and value-added services are generally recognized as services are performed. Supplies: Supplies revenue generally is recognized upon shipment or utilization by customer in accordance with sales terms. Revenue Recognition Under Bundled Arrangements: We sell most of our products and services under bundled lease arrangements, which typically include equipment, service, supplies and ﬁnancing components for which the customer pays a single negotiated ﬁxed minimum monthly payment for all elements over the contractual lease term. These arrangements typically also include an incremental, variable component for page volumes in excess of contractual page volume minimums, which are often expressed in terms of price per page. The ﬁxed minimum monthly payments are multiplied by the number of months in the contract term to arrive at the total ﬁxed minimum payments that the customer is obligated to make (“ﬁxed payments”) over the lease term. The payments associated with page volumes in excess of the minimums are contingent on whether or not such minimums are exceeded (“contin- gent payments”). The minimum contractual committed page volumes are typically negotiated to equal the cus- tomer’s estimated page volume at lease inception. In applying our lease accounting methodology, we consid- er the ﬁxed payments for purposes of allocating to the relative fair value elements of the contract. We do not consider the contingent payments for purposes of allo- cating to the elements of the contract or recognizing revenue on the sale of the equipment, given the inher- ent uncertainties as to whether such amounts will ever be realized. Contingent payments are recognized as revenue in the period when the customer exceeds the minimum copy volumes speciﬁed in the contract. Revenues under bundled arrangements are allo- cated considering the relative fair values of the lease and non-lease deliverables included in the bundled arrangement based upon the estimated relative fair values of each element. Lease deliverables include maintenance and executory costs, equipment and ﬁnancing, while non-lease deliverables generally con- sist of the supplies and non-maintenance services. Our revenue allocation for the lease deliverables begins by allocating revenues to the maintenance and executory costs plus proﬁt thereon. The remaining amounts are allocated to the equipment and ﬁnancing elements. We perform extensive analyses of available veriﬁable objective evidence of equipment fair value based on cash selling prices during the applicable period. The cash selling prices are compared to the range of values included in our lease accounting systems. The range of cash selling prices must be reasonably consistent with the lease selling prices, taking into account residual values that accrue to our beneﬁt, in order for us to determine that such lease prices are indicative of fair value. Our pricing interest rates, which are used to determine customer lease payments, are developed based upon a variety of factors including local prevail- ing rates in the marketplace and the customer’s credit history, industry and credit class. Effective in 2004, our pricing rates are reassessed quarterly based on changes in local prevailing rates in the marketplace and are adjusted to the extent such rates vary by twenty- ﬁve basis points or more, cumulatively, from the last rate in effect. The pricing interest rates generally equal the implicit rates within the leases, as corroborated by our comparisons of cash to lease selling prices. Revenue Recognition for Leases: Our accounting for leases involves speciﬁc determinations under SFAS No. 13, which often involve complex provisions and signiﬁ- cant judgments. The two primary criteria of SFAS No. 13 which we use to classify transactions as sales-type or operating leases are (1) a review of the lease term to determine if it is equal to or greater than 75 percent of the economic life of the equipment and (2) a review of the present value of the minimum lease payments to determine if they are equal to or greater than 90 per- cent of the fair market value of the equipment at the inception of the lease. Our sales-type lease portfolios contain only normal credit and collection risks and have no important uncertainties with respect to future costs. Our leases in our Latin America operations have historically been recorded as operating leases given the cancellability of the contract or because the recoverability of the lease investment is deemed not to be predictable at lease inception. The critical elements that we consider with respect to our lease accounting are the determination of the economic life and the fair value of equipment, including the residual value. For purposes of determining the economic life, we consider the most objective measure to be the original contract term, since most equipment is returned by lessees at or near the end of the contracted term. The economic life of most of our products is ﬁve years since this represents the most frequent contractual lease term for our princi- 45 pal products and only a small percentage of our leases have original terms longer than ﬁve years. There is no signiﬁcant after-market for our used equipment. We believe that ﬁve years is representative of the period during which the equipment is expected to be economi- cally usable, with normal service, for the purpose for which it is intended. We continually evaluate the economic life of both existing and newly introduced products for purposes of this determination. Residual values are established at lease inception using estimates of fair value at the end of the lease term. Our residual values are established with due consideration to fore- casted supply and demand for our various products, product retirement and future product launch plans, end of lease customer behavior, remanufacturing strategies, competition and technological changes. The vast majority of our leases that qualify as sales-type are non-cancelable and include cancellation penalties approximately equal to the full value of the lease receivables. A portion of our business involves sales to governmental units. Governmental units are those entities that have statutorily deﬁned funding or annual budgets that are determined by their legislative bodies. Certain of our governmental contracts may have cancellation provisions or renewal clauses that are required by law, such as 1) those dependant on ﬁscal funding outside of a governmental unit’s control, 2) those that can be cancelled if deemed in the best interest of the governmental unit’s taxpayers or 3) those that must be renewed each ﬁscal year, given limitations that may exist on entering into multi-year contracts that are imposed by statute. In these circumstances, we carefully evaluate these contracts to assess whether cancellation is remote because of the existence of substantive economic penalties upon cancellation or whether the renewal is reasonably assured due to the existence of a bargain renewal option. The evaluation of a lease agreement with a renewal option includes an assessment as to whether the renewal is reasonably assured based on the intent of such governmental unit and pricing terms as com- pared to those of short-term leases at lease inception. We further ensure that the contract provisions described above are offered only in instances where required by law. Where such contract terms are not legally required, we consider the arrangement to be cancelable and account for it as an operating lease. Aside from the initial lease of equipment to our customers, we may enter subsequent transactions with the same customer whereby we extend the term. We evaluate the classiﬁcation of lease extensions of sales-type leases using the originally determined eco- nomic life for each product. There may be instances where we enter into lease extensions for periods that are within the original economic life of the equipment. These are accounted for as sales-type leases only when the extensions occur in the last three months of the lease term and they otherwise meet the appropri- ate criteria of SFAS No. 13. All other lease extensions of this type are accounted for as direct ﬁnancing leases or operating leases, as appropriate. Cash and Cash Equivalents: Cash and cash equivalents consist of cash on hand, including money-market funds, and investments with original maturities of three months or less. Restricted Cash and Investments: Several of our borrowing and derivative contracts, as well as other material contracts, require us to post cash collateral or maintain minimum cash balances in escrow. These cash amounts are reported in our Consolidated Balance Sheets, depending on when the cash will be contractually released. At December 31, 2004 and 2003, such restricted cash amounts were as follows: December 31, 2003 2004 Escrow and cash collections related to secured borrowing arrangements $ 372 $462 Escrow related to liability to trusts issuing preferred securities Collateral related to risk management arrangements Other restricted cash Total — 61 97 79 74 114 $530 $729 Of these amounts, $370 and $386 were included in Other current assets and $160 and $343 were included in Other long-term assets, as of December 31, 2004 and 2003, respectively. Provisions for Losses on Uncollectible Receivables: The provisions for losses on uncollectible trade and ﬁnance receivables are determined principally on the basis of past collection experience applied to ongoing evaluations of our receivables and evaluations of the default risks of repayment. Allowances for doubt- ful accounts on accounts receivable balances were $183 and $218, as of December 31, 2004 and 2003, respectively. Allowances for doubtful accounts on ﬁnance receivables were $276 and $315 at December 31, 2004 and 2003, respectively. Inventories: Inventories are carried at the lower of average cost or market. Inventories also include equipment that is returned at the end of the lease term. Returned equipment is recorded at the lower of remaining net book value or salvage value. Salvage value consists of the estimated market value (generally determined based on replacement cost) of the salvage- able component parts, which are expected to be used 46 in the remanufacturing process. We regularly review inventory quantities and record a provision for excess and/or obsolete inventory based primarily on our estimated forecast of product demand, production requirements and servicing commitments. Several factors may inﬂuence the realizability of our invento- ries, including our decision to exit a product line, technological changes and new product development. The provision for excess and/or obsolete raw materials and equipment inventories is based primarily on near term forecasts of product demand and include consideration of new product introductions as well as changes in remanufacturing strategies. The provision for excess and/or obsolete service parts inventory is based primarily on projected servicing requirements over the life of the related equipment populations. Land, Buildings and Equipment and Equipment on Operating Leases: Land, buildings and equipment are recorded at cost. Buildings and equip- ment are depreciated over their estimated useful lives. Leasehold improvements are depreciated over the shorter of the lease term or the estimated useful life. Equipment on operating leases is depreciated to esti- mated residual value over the lease term. Depreciation is computed using the straight-line method. Signiﬁcant improvements are capitalized and maintenance and repairs are expensed. Refer to Notes 4 and 5 for further discussion. Impairment of Long-Lived Assets: We review the recoverability of our long-lived assets, including buildings, equipment, internal-use software and other intangible assets, when events or changes in circum- stances occur that indicate that the carrying value of the asset may not be recoverable. The assessment of possible impairment is based on our ability to recover the carrying value of the asset from the expected future pre-tax cash ﬂows (undiscounted and without interest charges) of the related operations. If these cash ﬂows are less than the carrying value of such asset, an impairment loss is recognized for the differ- ence between estimated fair value and carrying value. Our primary measure of fair value is based on discounted cash ﬂows. The measurement of impair- ment requires management to make estimates of these cash ﬂows related to long-lived assets, as well as other fair value determinations. Research and Development Expenses: Research and development costs are expensed as incurred. Restructuring Charges: Costs associated with exit or disposed activities, including lease termination costs and certain employee severance costs associated with restructuring, plant closing or other activity, are recognized when they are incurred. In those geographies where we have either a formal severance plan or a history of consistently providing severance beneﬁts representing a substantive plan, we recognize severance costs when they are both probable and reasonably estimable. Pension and Post-Retirement Beneﬁt Obligations: We sponsor pension plans in various forms in several countries covering substantially all employees who meet eligibility requirements. Post- retirement beneﬁt plans cover primarily U.S. employees for retirement medical costs. As permitted by existing accounting rules, we employ a delayed recognition feature in measuring the costs and obligations of pen- sion and post-retirement beneﬁt plans. This requires changes in the beneﬁt obligations and changes in the value of assets set aside to meet those obligations to be recognized not as they occur, but systematically and gradually over subsequent periods. All changes are ultimately recognized, except to the extent they may be offset by subsequent changes. At any point, changes that have been identiﬁed and quantiﬁed await subse- quent accounting recognition as net cost components and as liabilities or assets. Several statistical and other factors that attempt to anticipate future events are used in calculating the expense, liability and asset values related to our pen- sion and post-retirement beneﬁt plans. These factors include assumptions we make about the discount rate, expected return on plan assets, rate of increase in healthcare costs, the rate of future compensation increases, and mortality, among others. Actual returns on plan assets are not immediately recognized in our income statement, due to the delayed recognition requirement. In calculating the expected return on the plan asset component of our net periodic pension cost, we apply our estimate of the long term rate of return to the plan assets that support our pension obligations, after deducting assets that are speciﬁcally allocated to Transitional Retirement Accounts (which are account- ed for based on speciﬁc plan terms). For purposes of determining the expected return on plan assets, we utilize a calculated value approach in determining the value of the pension plan assets, as opposed to a fair market value approach. The primary difference between the two methods relates to system- atic recognition of changes in fair value over time (generally two years) versus immediate recognition of changes in fair value. Our expected rate of return on plan assets is then applied to the calculated asset value to determine the amount of the expected return on plan assets to be used in the determination of the net periodic pension cost. The calculated value approach reduces the volatility in net periodic pension cost that results from using the fair market value approach. 47 The difference between the actual return on plan assets and the expected return on plan assets is added to, or subtracted from, any cumulative differences that arose in prior years. This amount is a component of the unrecognized net actuarial (gain) loss and is subject to amortization to net periodic pension cost over the remaining service lives of the employees participating in the pension plan. Another signiﬁcant assumption affecting our pen- sion and post-retirement beneﬁt obligations and the net periodic pension and other post-retirement beneﬁt cost is the rate that we use to discount our future anticipated beneﬁt obligations. In estimating this rate, we consider rates of return on high quality ﬁxed-income investments over the period to expected payment of the pension and other post-retirement beneﬁts. Stock-Based Compensation: We do not recognize compensation expense relating to employee stock options because the exercise price is equal to the market price at the date of grant. If we had elected to recognize compensation expense using a fair value approach, and therefore determined the compensation based on the value as determined by the modiﬁed Black-Scholes option pricing model, our pro forma income and income per share would have been as follows: Net income – as reported (1) Deduct: Stock – based employee compensation expense determined under fair value based method for awards, net of tax Net income – pro forma Basic EPS – as reported Basic EPS – pro forma Diluted EPS – as reported Diluted EPS – pro forma 2004 $ 859 2003 2002 $ 360 $ 91 (69) (85) (83) $ 790 $0.94 0.86 $0.86 0.80 $ 275 $ 0.38 0.27 $ 0.36 0.25 $ 8 $ 0.02 (0.09) $ 0.02 (0.09) (1) Amounts include compensation expense for restricted stock grants of $22 ($13 after-tax), $15 ($9 after-tax) and $17 ($10 after-tax) in 2004, 2003, and 2002, respectively. The pro forma periodic compensation expense amounts are not representative of future amounts since we will begin granting employees restricted stock awards with time-and performance-based restrictions in 2005 in lieu of stock options. As reﬂected in the pro forma amounts in the previous table, the weighted-average fair value of options granted in 2004, 2003 and 2002 was $8.38, $5.39 and $6.34, respectively. The fair values were estimated on the date of grant using the following weighted average assumptions: Risk-free interest rate Expected life in years (1) Expected price volatility Expected dividend yield 2004 2003 2002 3.2% 5.7 66.5% — 3.3% 7.2 4.8% 6.5 66.2% 61.5% — — (1) Options granted in 2004 expire eight years from date of grant, resulting in an expected life shorter than previous grants. Foreign Currency Translation: The functional cur- rency for most foreign operations is the local currency. Net assets are translated at current rates of exchange, and income, expense and cash ﬂow items are translated at average exchange rates for the applicable period. The translation adjustments are recorded in Accumulated Other Comprehensive Loss. The U.S. dollar is used as the functional currency for certain subsidiaries that conduct their business in U.S. dollars or operate in hyperinﬂationary economies. A combina- tion of current and historical exchange rates is used in remeasuring the local currency transactions of these subsidiaries and the resulting exchange adjustments are included in income. Aggregate foreign currency losses were $73, $11 and $77 in 2004, 2003 and 2002, respectively, and are included in Other expenses, net in the accompanying Consolidated Statements of Income. Note 2 – Segment Reporting Our reportable segments are consistent with how we manage the business and view the markets we serve. Our reportable segments are Production, Ofﬁce, Developing Markets Operations (“DMO”) and Other. The Production and Ofﬁce segments are centered around strategic product groups which share common technology, manufacturing and product platforms, as well as classes of customers. The accounting policies of all of our segments are the same as those described in the summary of signiﬁcant accounting policies included in Note 1. The Production segment includes black and white products which operate at speeds over 90 pages per minute and color products which operate at speeds over 40 pages per minute. Products include the Xerox iGen3 digital color production press, Xerox Nuvera, DocuTech, DocuPrint, Xerox 2101 and DocuColor families, as well as older technology light- lens products. These products are sold predominantly through direct sales channels in North America and Europe to Fortune 1000, graphic arts, government, education and other public sector customers. The Ofﬁce segment includes black and white products which operate at speeds up to 90 pages per minute and color devices which operate at speeds up to 40 pages per minute. Products include the suite of CopyCentre, WorkCentre, and WorkCentre Pro digital multifunction systems, DocuColor color multifunction 48 products, color laser, solid ink and monochrome laser desktop printers, digital and light-lens copiers and fac- simile products. These products are sold through direct and indirect sales channels in North America and Europe to global, national and mid-size commercial customers as well as government, education and other public sector customers. The DMO segment includes our operations in Latin America, Central and Eastern Europe, the Middle East, India, Eurasia, Russia and Africa. This segment includes sales of products that are typical to the aforementioned segments; however, management serves and evaluates these markets on an aggregate geographic basis, rather than on a product basis. The segment classiﬁed as Other includes several units, none of which met the thresholds for separate segment reporting. This group primarily includes Xerox Supplies Business Group (predominantly paper), Small Ofﬁce/Home Ofﬁce (“SOHO”), Wide Format Systems, Xerox Technology Enterprises and value-added services, royalty and license revenues. Other segment proﬁt (loss) includes the operating results from these entities, other less signiﬁcant businesses, our equity income from Fuji Xerox, and certain costs which have not been allocated to the Production, Ofﬁce and DMO segments, including non-ﬁnancing interest and other corporate costs. Operating segment ﬁnancial information for 2003 and 2002 has been restated to reﬂect changes in operat- ing segment structure made during 2004. The changes made in 2004 relate to the reclassiﬁcation of the opera- tions of our Central and Eastern European entities to DMO to align our segment reporting with how we manage our business. Operating proﬁt was reclassiﬁed for this change, as well as for certain other expense allocations. The adjustments (decreased) increased full year 2003 revenues as follows: Production-$(40), Ofﬁce- $(61), DMO-$147 and Other-$(46). The full year 2003 segment proﬁt was (decreased) increased as follows: Production-$(21), Ofﬁce-$(11), DMO-$21, and Other- $11. The adjustments (decreased) increased full year 2002 revenues as follows: Production-$(40), Ofﬁce- $(54), DMO-$127, and Other-$(33). The full year 2002 segment proﬁt was (decreased) increased as follows: Production-$(14), Ofﬁce-$(9), DMO-$29, and Other- $(6). Selected ﬁnancial information for our operating segments for each of the three years ended December 31, 2004 was as follows: Production Ofﬁce DMO Other Total 2004 (1) Information about proﬁt or loss: Revenues Finance income Total segment revenues Interest expense (2) Segment proﬁt (loss) (3)(4) Equity in net income of unconsolidated afﬁliates 2003 (1) Information about proﬁt or loss: Revenues Finance income Total segment revenues Interest expense (2) Segment proﬁt (loss) (3)(4) Equity in net income of unconsolidated afﬁliates 2002 (1) Information about proﬁt or loss: Revenues Finance income Total segment revenues Interest expense (2) Segment proﬁt (loss) (3)(4) Equity in net income of unconsolidated afﬁliates $4,238 352 $4,590 $ 115 388 — $4,131 376 $ 4,507 $ 121 401 — $4,089 393 $4,482 $ 157 436 — $ 7,075 552 $ 7,627 $ 163 798 — $7,048 594 $7,642 $ 181 742 1 $6,888 599 $ 7,487 $ 223 612 — $1,697 10 $1,707 $ 12 43 3 $1,751 12 $1,763 $ 34 172 6 $1,866 19 $1,885 $ 17 120 5 $1,778 20 $1,798 $ 418 (29) 148 $1,774 15 $1,789 $ 548 (327) 51 $2,006 (11) $1,995 $ 499 (335) 49 $14,788 934 $15,722 $ 708 1,200 151 $14,704 997 $15,701 $ 884 988 58 $14,849 1,000 $15,849 $ 896 833 54 (1) Asset information on a segment basis is not disclosed as this information is not separately identiﬁed and internally reported to our chief executive ofﬁcer. (2) Interest expense includes equipment ﬁnancing interest as well as non-ﬁnancing interest, which is a component of Other expenses, net. (3) Other segment proﬁt (loss) includes net corporate expenses of $524, $529 and $362 for the years ended December 31, 2004, 2003 and 2002, respectively. (4) Depreciation and amortization expense is recorded in cost of sales, research and development expenses and selling, administrative and general expenses and is included in the segment proﬁt (loss) above. This information is neither identiﬁed nor internally reported to our chief executive ofﬁcer. The separate identiﬁca- tion of this information for purposes of segment disclosure is impracticable, as it is not readily available and the cost to develop it would be excessive. 49 The following is a reconciliation of segment proﬁt to total company pre-tax income: Years ended December 31, 2002 2003 2004 $1,200 $ 988 $ 833 (86) — 2 (176) (73) (245) (670) — (5) Total segment proﬁt Unallocated items: Restructuring and asset impairment charges 2002 credit facility fee write-off (1) Other unallocated expenses, net (2) Allocated item: Equity in net income of unconsolidated afﬁliates (151) (58) (54) Pre-tax income $ 965 $ 436 $ 104 (1) The $73 loss associated with extinguishment of debt on the 2002 Credit Facility, previously reﬂected in Other segment proﬁt (loss), has been reclassiﬁed in the current year presentation. (2) 2003 unallocated expenses include a $239 provision for litigation related to the court approved settlement of the Berger v. RIGP litigation discussed in Note 12. Geographic area data was as follows: United States Europe Other Areas Total 2004 $ 8,346 5,281 2,095 $15,722 Revenues 2003 $ 8,547 4,863 2,291 $15,701 2002 $ 9,096 4,425 2,328 $15,849 Long-Lived Assets (1) 2004 $1,427 585 434 $2,446 2003 2002 $ 1,477 616 460 $ 2,553 $ 1,524 718 379 $ 2,621 (1) Long-lived assets are comprised of (i) land, buildings and equipment, net, (ii) equipment on operating leases, net, (iii) internal use software, net and (iv) capitalized software costs, net. Note 3 – Receivables, Net Finance Receivables: Finance receivables result from installment arrangements and sales-type leases arising from the marketing of our equipment. These receivables are typically collateralized by a security interest in the underlying assets. The components of Finance receivables, net at December 31, 2004 and 2003 follow: Gross receivables Unearned income Unguaranteed residual values Allowance for doubtful accounts Finance receivables, net Less: Billed portion of ﬁnance receivables, net Current portion of ﬁnance receivables not billed, net 2004 2003 $10,267 $10,599 (1,651) 180 (315) (1,619) 125 (276) 8,497 8,813 (377) (461) (2,932) (2,981) Amounts due after one year, net $ 5,188 $ 5,371 Contractual maturities of our gross ﬁnance receivables subsequent to December 31, 2004 follow (including those already billed of $377): 2005 2006 2007 2008 2009 There- after Total $4,045 $2,793 $1,921 $1,097 $377 $34 $10,267 Customer Financing Arrangements GE Secured Borrowings: In 2002, we completed an agreement (the “Loan Agreement”) under which GE Vendor Financial Services, a subsidiary of GE, became the primary equipment ﬁnancing provider in the U.S., through monthly fundings of our new lease origina- tions. In March 2003, this agreement was amended to allow for the inclusion of state and local governmental contracts in future fundings. Under this agreement, GE funds a signiﬁcant portion of new U.S. lease originations at over- collateralization rates, which vary over time, but are expected to approximate 10 percent at the inception of each funding. The secured loans are subject to interest 50 rates calculated at each monthly loan occurrence at yield rates consistent with average rates for similar market based transactions. Refer to Note 9 for further information on interest rates. New lease originations, including the bundled service and supply elements, are transferred to a wholly-owned consolidated subsidiary which receives funding from GE. The funds received under this agreement are recorded as secured borrowings and together with the associated lease receivables are included in our Consolidated Balance Sheet. We and GE intend the transfers of the lease contracts to be “true sales at law” and that the wholly-owned consolidated subsidiary be bankruptcy remote and have received opinions to that effect from outside legal counsel. As a result, the transferred receivables are not available to satisfy any of our other obligations. GE’s funding commitment is not subject to our credit ratings. There are no credit rating defaults that could impair future funding under this agreement. This agreement contains cross default pro- visions related to certain ﬁnancial covenants contained in the 2003 Credit Facility and other signiﬁcant debt facilities. Any default would impair our ability to receive subsequent funding until the default was cured or waived but does not accelerate previous borrowings. However, in the event of a default, we could be replaced as the maintenance service provider for the associated equipment under lease. During 2003, we entered into similar long-term lease funding arrangements with GE in both the U.K. and Canada. These agreements contain similar terms and conditions as those contained in the U.S. Loan Agreement with respect to funding conditions and covenants. The ﬁnal funding date for all facilities is currently December 2010. The following is a summary of the facility amounts for the arrangements with GE in these countries. Facility Amount Maximum Facility Amount (1) U.S. U.K. Canada $5 billion £400 million (U.S. $770) Cdn. $850 million (U.S. $706) $8 billion £600 million (U.S. $1.2 billion) Cdn. $2 billion (U.S. $1.7 billion) (1) Subject to mutual agreement by the parties. France Secured Borrowings: In July 2003, we secu- ritized receivables of $443, previously funded under a 364-day warehouse ﬁnancing facility established in December 2002 with subsidiaries of Merrill Lynch, with a three-year public secured ﬁnancing arrange- ment. In addition, we established a new warehouse ﬁnancing facility to fund future lease originations in France. This facility can provide funding for new lease originations up to ?350 million (U.S. $477), outstand- ing at any time, and balances may be securitized through a similar public offering within two years. The DLL Secured Borrowings: Beginning in the second half of 2002, we received a series of fundings through our consolidated joint venture with DLL from DLL’s parent, De Lage Landen Ireland Company. The fundings are secured by our lease receivables in The Netherlands which were transferred to the DLL joint venture. In addition, the DLL joint venture also became our primary equipment ﬁnancing provider in The Netherlands for all new lease originations and continues to receive funding for those lease originations from DLL’s parent. In the fourth quarter of 2003, the DLL joint venture expanded its operations to include Spain and Belgium. Our DLL joint venture has been consolidated as we are deemed to be the primary beneﬁciary of the joint venture’s ﬁnancial results. Germany Secured Borrowings: In May 2002, we entered into an agreement to transfer part of our ﬁnancing operations in Germany to a GE entity in order to ﬁnance certain prospective leasing business. In conjunction with this transaction, we also received loans from GE secured by existing lease receivables that were transferred to this entity. At December 31, 2003, we consolidated this entity because we retained substantive rights related to the transferred ﬁnance receivables and were therefore deemed to be the primary beneﬁciary. During the ﬁrst quarter 2004, the entity was deconsolidated because we were no longer deemed to be the primary beneﬁciary, as the transferred ﬁnance receivables had been reduced to a level whereby we no longer retained signiﬁcant risks relative to the total assets of the entity. Further, we are not providing loss protection on the new leasing busi- ness entered into by the entity. The entity’s total assets and debt at December 31, 2003 were $114 and $84, respectively. 51 The following table shows ﬁnance receivables and related secured debt as of December 31, 2004 and 2003: GE secured loans: United States Canada United Kingdom Germany Total GE encumbered ﬁnance receivables, net Merrill Lynch Loan – France Asset-backed notes – France DLL – Netherlands, Spain, and Belgium (1) Total encumbered ﬁnance receivables, net Unencumbered ﬁnance receivables, net Total ﬁnance receivables, net (2) December 31, 2004 December 31, 2003 Finance Receivables, Net Finance Secured Receivables, Net Debt Secured Debt $2,711 486 771 — 3,968 368 225 436 4,997 3,500 $ 8,497 $2,486 426 685 — 3,597 287 148 404 $4,436 $2,598 440 570 84 3,692 92 364 277 $4,425 $2,939 528 719 114 4,300 138 429 335 5,202 3,611 $ 8,813 (1)These represent the loans received by our consolidated joint venture with DLL. De Lage Landen Ireland Company is the lender of record. (2) Includes (i) Billed portion of ﬁnance receivables, net (ii) Finance receivables, net and (iii) Finance receivables due after one year, net as included in the condensed consolidated balance sheets as of December 31, 2004 and 2003. As of December 31, 2004, $4,997 of Finance receiv- ables, net are held as collateral in various entities, as security for the borrowings noted above. Total outstand- ing debt secured by these receivables at December 31, 2004 was $4,436. The entities are consolidated in our ﬁnancial statements. Although the transferred assets are included in our total assets, the assets of the entities are not available to satisfy any of our other obligations. We also have arrangements in Italy, The Nordic countries, Brazil and Mexico in which third party ﬁnancial institutions originate lease contracts directly with our customers. In these transactions, we sell and transfer title to the equipment to these ﬁnancial insti- tutions and have no continuing ownership rights in the leased equipment subsequent to its sale. Accounts Receivable Funding Arrangement: In June 2004, we completed a transaction with GE for a three-year $400 revolving credit facility secured by our U.S. accounts receivable. As of December 31, 2004, approximately $200 was drawn, secured by $354 of our accounts receivable. This arrangement is being accounted for as a secured borrowing in our Consolidated Balance Sheets. Note 4 – Inventories and Equipment on Operating Leases, Net The components of inventories at December 31, 2004 and 2003 were as follows: Finished goods Work in process Raw materials Total inventories 2004 2003 $ 900 69 174 $ 911 74 167 $1,143 $1,152 Equipment on operating leases and similar arrangements consists of our equipment rented to cus- tomers and depreciated to estimated salvage value at the end of the lease term. The transfer of equipment on operating leases from our inventories is presented in our Consolidated Statements of Cash Flows in the operating activities section as a non-cash adjustment. Equipment on operating leases and the related accu- mulated depreciation at December 31, 2004 and 2003 were as follows: Equipment on operating leases Less: Accumulated depreciation 2004 2003 $ 1,649 (1,251) $ 1,795 (1,431) Equipment on operating leases, net $ 398 $ 364 52 Depreciable lives generally vary from three to four years consistent with our planned and historical usage of the equipment subject to operating leases. Depreciation and obsolescence expense was $210, $271 and $408 for the years ended December 31, 2004, 2003 and 2002, respectively. Our equipment operating lease terms vary, generally from 12 to 36 months. Scheduled minimum future rental revenues on operating leases with original terms of one year or longer are: 2005 $401 2006 $219 2007 $111 2008 Thereafter $45 $17 Total contingent rentals on operating leases, consisting principally of usage charges in excess of minimum contracted amounts, for the years ended December 31, 2004, 2003 and 2002 amounted to $137, $235 and $187, respectively. Note 5 – Land, Buildings and Equipment, Net The components of land, buildings and equipment, net at December 31, 2004 and 2003 were as follows: Land Buildings and building equipment Leasehold improvements Plant machinery Ofﬁce furniture and equipment Other Construction in progress Subtotal Less: Accumulated depreciation Land, buildings and equipment, net Estimated Useful Lives (Years) 25 to 50 Lease term 5 to 12 3 to 15 4 to 20 2004 2003 $ 53 $ 56 1,167 313 1,667 1,072 74 96 4,442 1,194 383 1,588 1,081 74 114 4,490 (2,683) (2,663) $ 1,759 $ 1,827 Depreciation expense was $305, $299 and $341 for the years ended December 31, 2004, 2003 and 2002, respectively. We lease certain land, buildings and equipment, substantially all of which are accounted for as operating leases. Total rent expense under operating leases for the years ended December 31, 2004, 2003 and 2002 amounted to $316, $287, and $299, respectively. Future minimum operating lease commitments that have remaining non-cancelable lease terms in excess of one year at December 31, 2004 follow: 2005 $222 2006 $181 2007 $143 2008 $109 2009 Thereafter $94 $256 In certain circumstances, we sublease space not currently required in operations. Future minimum sublease income under leases with non-cancelable terms in excess of one year amounted to $17 at December 31, 2004. We have an information technology contract with Electronic Data Systems Corp. (“EDS”) through June 30, 2009. Services to be provided under this contract include support of global mainframe system process- ing, application maintenance, desktop and helpdesk support, voice and data network management and server management. There are no minimum payments due EDS under the contract. Payments to EDS, which are recorded in selling, administrative and general expenses, were $328, $340, and $385 for the years ended December 31, 2004, 2003 and 2002, respectively. In December 2003, STHQ Realty LLC was formed to ﬁnance the acquisition of the Company’s headquar- ters in Stamford, Connecticut. While the assets and liabilities of this special purpose entity are included in the Company’s Consolidated Financial Statements, STHQ Realty LLC is a bankruptcy remote separate legal entity. As a result, its assets of $42 at December 31, 2004, are not available to satisfy the debts and other obligations of the Company. Note 6 – Investments in Afﬁliates, at Equity Investments in corporate joint ventures and other companies in which we generally have a 20 to 50 per- cent ownership interest at December 31, 2004 and 2003 were as follows: Fuji Xerox (1) Investment in subsidiary trusts issuing preferred securities Other investments 2004 $ 772 39 34 2003 $556 69 19 Investments in afﬁliates, at equity $845 $644 (1) Fuji Xerox is headquartered in Tokyo and operates in Japan and other areas of the Paciﬁc Rim, Australia and New Zealand. Our investment in Fuji Xerox of $772 at December 31, 2004, differs from our implied 25 per- cent interest in the underlying net assets, or $840, due primarily to our deferral of gains resulting from sales of assets by us to Fuji Xerox, par- tially offset by goodwill related to the Fuji Xerox investment established at the time we acquired our remaining 20 percent of Xerox Limited from The Rank Group (plc). Such gains would only be realizable if Fuji Xerox sold a portion of the assets we previously sold to it or if we were to sell a portion of our ownership interest in Fuji Xerox. 53 Our equity in net income of our unconsolidated afﬁliates for the three years ended December 31, 2004 was as follows: Fuji Xerox Other investments Total 2004 $134 17 $151 2003 2002 $41 17 $58 $37 17 $54 Equity income for 2004 included $38 related to our share of a pension settlement gain recorded by Fuji Xerox due to a non-recurring opportunity given to Japanese companies by the Japanese government in accordance with the Japan Welfare Pension Insurance Law. This law allowed Japanese companies to transfer a portion of their pension obligations to the Japanese government. Fuji Xerox completed this transfer and recognized a corresponding settlement gain in 2004. Equity in net income of Fuji Xerox is affected by certain adjustments to reﬂect the deferral of proﬁt associated with intercompany sales. These adjustments may result in recorded equity income that is different than that implied by our 25 percent ownership interest. Condensed ﬁnancial data of Fuji Xerox as of and for the three calendar years ended December 31, 2004 follow: 2004 2003 2002 Summary of Operations: Revenues Costs and expenses Income before income taxes Income taxes Minorities’ interests Net income Balance Sheet Data: Assets: Current assets Long-term assets Total assets Liabilities and Shareholders’ Equity: Current liabilities Long-term debt Other long-term liabilities Minorities’ interests in equity of subsidiaries Shareholders’ equity Total liabilities and shareholders’ equity $ 9,461 8,606 $ 8,430 8,011 $ 7,539 7,181 855 331 18 419 194 34 358 134 36 $ 506 $ 191 $ 188 $ 3,613 4,606 $ 3,273 4,766 $ 2,976 3,862 $ 8,219 $ 8,039 $ 6,838 $ 2,757 616 1,383 $ 2,594 443 2,391 $ 2,152 868 1,084 104 3,359 118 2,493 227 2,507 $ 8,219 $ 8,039 $ 6,838 We have a technology agreement with Fuji Xerox whereby we receive royalty payments and rights to access their patent portfolio in exchange for access to our patent portfolio. In 2004, 2003 and 2002, we earned royalty revenues under this agreement of $119, $110 and $99, respectively. Additionally, in 2004, 2003 and 2002, we received dividends of $50, $20 and $29, respectively. We also have arrangements with Fuji Xerox whereby we purchase inventory from and sell inventory to Fuji Xerox. Pricing of the transactions under these arrangements is based upon negotiations conducted at arm’s length. Certain of these inventory purchases and sales are the result of mutual research and development arrangements. Our purchase com- mitments with Fuji Xerox are in the normal course of business and typically have a lead time of three months. Purchases from and sales to Fuji Xerox for the three years ended December 31, 2004 were as follows: Sales Purchases 2004 $ 143 $1,135 2003 2002 $ 129 $ 871 $ 113 $ 727 In addition to the payments described above, in 2004, 2003 and 2002, we paid Fuji Xerox $27, $33 and $20, respectively, and in 2004, 2003 and 2002 Fuji Xerox paid us $9, $9 and $10, respectively, for unique research and development. As of December 31, 2004 and 2003, amounts due to Fuji Xerox were $155 and $111, respectively. Note 7 – Restructuring Programs We have engaged in a series of restructuring programs related to downsizing our employee base, exiting cer- tain activities, outsourcing certain internal functions and engaging in other actions designed to reduce our cost structure and improve productivity. Management continues to evaluate the business and, therefore, there may be supplemental provisions for new plan initiatives as well as changes in estimates to amounts previously recorded, as payments are made or actions are completed. Asset impairment charges were also incurred in connection with these restructuring actions for those assets made obsolete or redundant as a result of these programs. The restructuring and asset impairment charges in the Consolidated Statements of Income totaled $86, $176 and $670 in 2004, 2003 and 2002, respectively. Detailed information related to 54 restructuring program activity during the three years ended December 31, 2004 is outlined below. Restructuring Activity Programs Programs (1) Total Ongoing Legacy Ending Balance December 31, 2001 Provision Reversals of prior accruals Charges against reserve and currency Ending Balance December 31, 2002 Provision Reversals of prior accruals Charges against reserve and currency Ending Balance December 31, 2003 Provision Reversals of prior accruals Charges against reserve and currency Ending Balance December 31, 2004 $ — $ 282 $ 282 357 — 291 (33) 648 (33) (71) (403) (474) $ 286 $ 137 $ 423 193 (16) 11 (13) 204 (29) (284) (93) (377) $ 179 $ 42 $ 221 103 (11) 2 (9) 105 (20) (178) (11) (189) $ 93 $ 24 $ 117 (1) Legacy Programs, as explained further below, include the Turnaround, SOHO and 1998/2000 Programs. Reconciliation to Statements of Income For the year ended December 31, 2004 Restructuring provision Restructuring reversal Asset impairment charges Restructuring and asset impairment charges 2003 $204 (29) 1 2002 $648 (33) 55(1) $105 (20) 1 $ 86 $ 176 $ 670 (1) Asset impairment charges consisted of $45 and $10 for the Ongoing and Legacy Programs, respectively. Reconciliation to Statements of Cash Flows For the year ended December 31, 2004 2003 2002 Charges to reserve Pension curtailment, special termination beneﬁts and settlements Effects of foreign currency and other noncash Cash payments for restructurings $(189) $(377) $ (474) 8 (6) 33 (1) 59 23 $(187) $(345) $(392) Restructuring — Ongoing Programs: Beginning in the fourth quarter of 2002, we initiated a series of ongoing restructuring initiatives designed to continue to achieve the cost savings resulting from realized productivity improvements. These ongoing initiatives included downsizing our employee base and the outsourcing of certain internal functions. These initiatives are not individually signiﬁcant and primarily include severance actions and impact all geographies and segments. We recorded an initial provision of $402 associated with these ongoing programs in the fourth quarter 2002. The provision consisted of $312 for severance and related costs, $45 of net costs associated with lease terminations and future rental obligations and $45 for asset impairments. The severance and related costs related to the elimination of approximately 4,700 positions worldwide. During 2003, we provided an additional $177 for restructuring programs, net of reversals of $16, related to changes in estimates for severance costs from previously recorded actions. The additional provision consisted of net charges of $138 primarily related to the elimination of over 2,000 positions worldwide, $33 for pension settlements and post-retirement medical beneﬁt curtailments and $6 for lease terminations. During 2004, we provided an additional $93 for ongoing restructuring programs, net of reversals of $11 related to changes in estimates for severance costs from previously recorded actions. The additional provision consisted of a net charge of $76 related to the elimination of over 1,900 positions primarily in North America and Latin America, $8 for pension settlements, $8 for lease terminations and $1 for asset impairments. The reserve balance for these Restructuring Programs at December 31, 2004 was $93. The majority of this balance will be spent during 2005 and is summarized as follows: Lease Severance Cancella- tion and Costs Other Costs and Related Initial Provision (1) Charges against reserve Balance at December 31, 2002 Provisions (1) Reversals Charges $ 312 (71) $ 241 186 (15) (269) Total $ 357 (71) $ 45 — $ 45 $ 286 7 (1) (15) 193 (16) (284) Balance at December 31, 2003 $ 143 $ 36 $ 179 Provisions (1) Reversals Charges 95 (11) (157) 8 — (21) 103 (11) (178) Balance at December 31, 2004 $ 70 $ 23 $ 93 (1) These amounts exclude cumulative asset impairment charges of $46 through December 31, 2004. 55 The following tables summarize the total amount of costs expected to be incurred in connection with these restructuring programs and the cumulative amount incurred as of December 31, 2004: Segment Reporting: Production Ofﬁce DMO Other Total Provisions Cumulative amount incurred as of December 31, 2003 Net amount incurred for the year ended December 31, 2004 Cumulative amount incurred as of December 31, 2004 Total expected to be incurred* $228 168 67 116 $ 579 $ 27 30 30 6 $ 93 $255 198 97 122 $ 672 $ 255 198 97 126 $ 676 * The total amount of $676 represents the cumulative amount incurred through December 31, 2004 plus $4 for interest accretion on the liabilities. Major Cost Reporting: Severance and related costs Lease cancellation and other costs Asset impairments Total Provisions Cumulative amount incurred as of December 31, 2003 Amount incurred for the year ended December 31, 2004 Cumulative amount incurred as of December 31, 2004 $483 51 45 $ 579 $ 84 8 1 $ 93 $ 567 59 46 $ 672 Total expected to be incurred* $ 568 62 46 $ 676 Legacy Programs: The following is a summary of past restructuring programs undertaken by the Company: • Turnaround Program: The Turnaround Program was initiated in October 2000 to reduce costs, improve operations, transition customer equipment ﬁnancing to third parties and sell certain assets. This program included the outsourcing of certain Ofﬁce operating segment manufacturing to Flextronics, as discussed in Note 18. Overall, approximately 11,200 positions were eliminated under this program. • SOHO Disengagement: In 2001, we commenced a separate restructuring program associated with the disengagement from our worldwide small ofﬁce/ home ofﬁce (“SOHO”) business. The program included provisions for the elimination of approxi- mately 1,200 positions worldwide by the end of 2001, the closing of facilities and the write down of certain assets to net realizable value. • March 2000/April 1998 Programs: These programs were likewise initiated to reduce overall costs and included reductions in workforce as well as the con- solidation of facilities on a worldwide basis. Overall, approximately 14,200 positions were eliminated under these programs. Reversals of prior period charges were recorded for these programs during the three-year period ended December 31, 2004 primarily as a result of changes in estimates associated with employee severance and related costs. Note 8 – Supplementary Financial Information The components of other current assets and other current liabilities at December 31, 2004 and 2003 were as follows: Other current assets Deferred taxes Restricted cash Prepaid expenses Financial derivative instruments Other Total Other current liabilities Income taxes payable Other taxes payable Interest payable Restructuring reserves Financial derivative instruments Other Total 56 2004 2003 $ 289 370 142 125 256 $ 402 386 35 24 258 $1,182 $1,105 $ 183 234 113 93 46 640 $ 264 289 147 180 51 609 $1,309 $1,540 Performance-Based Instrument: In connection with the 1997 sale of TRG, we received a $462 performance- based instrument as partial consideration. Cash distributions are paid on the instrument, based on 72.5 percent of TRG’s available cash ﬂow as deﬁned in the sale agreement. For the years ended December 31, 2004 and 2003, we received cash distributions of $22 and $23, respectively. The recovery of this instrument is dependent upon the sufﬁciency of TRG’s available cash ﬂows. Such cash ﬂows are supported by TRG’s ultimate parent via a subscription agreement whereby the parent has agreed to purchase from TRG an estab- lished number of shares of this instrument each year through 2017. Based on current cash ﬂow projections, we expect to fully recover the $365 remaining balance of this instrument. Internal Use Software: Capitalized direct costs associated with developing, purchasing or otherwise acquiring software for internal use are amortized on a straight-line basis over the expected useful life of the software, beginning when the software is implemented. Useful lives of the software generally vary from 3 to 5 years. Amortization expense, including applicable impairment charges, was $107, $116, and $215 for the years ended December 31, 2004, 2003 and 2002, respectively. Note 9 – Debt Short-Term Debt: Short-term borrowings at December 31, 2004 and 2003 were as follows: Current maturities of long-term debt Notes payable Total 2004 2003 $3,038 36 $ 4,194 42 $3,074 $4,236 We classify our debt based on the contractual maturity dates of the underlying debt instruments or as of the earliest put date available to the debt holders. We defer costs associated with debt issuance over the applicable term or to the ﬁrst put date, in the case of convertible debt or debt with a put feature. These costs are amortized as interest expense in our Consolidated Statement of Income. Long-Term Debt: Long-term debt, including debt secured by ﬁnance receivables at December 31, 2004 and 2003 was as follows: The components of other long-term assets and other long-term liabilities at December 31, 2004 and 2003 were as follows: Other long-term assets Prepaid pension costs Net investment in discontinued operations Internal use software, net Restricted cash Investments in non-afﬁliated companies Financial derivative instruments Debt issuance costs, net Other 2004 2003 $ 891 440 255 160 — 19 64 271 $ 774 449 307 343 104 89 79 332 Total other long-term assets $2,100 $ 2,477 Other long-term liabilities Deferred and other tax liabilities Minorities’ interests in equity of subsidiaries Financial derivative instruments Other $ 862 80 43 330 $ 809 102 11 356 Total other long-term liabilities $1,315 $1,278 Net investment in discontinued operations: Our net investment in discontinued operations is primarily related to the disengagement from our former insurance holding company, Talegen Holdings, Inc. (“Talegen”), and consists of our net investment in Ridge Reinsurance Limited (“Ridge Re”) and a performance-based instru- ment relating to the 1997 sale of The Resolution Group (“TRG”). In addition to our net investment, Income taxes payable also includes amounts for tax liabilities associ- ated with our discontinued operations. Ridge Re: We provide aggregate excess of loss reinsur- ance coverage (the “Reinsurance Agreement”) to one of the former Talegen units, TRG, through Ridge Re, a wholly-owned subsidiary. The coverage limit for this remaining Reinsurance Agreement is $578. We have guaranteed that Ridge Re will meet all its ﬁnancial obligations under the remaining Reinsurance Agreement. Ridge Re maintains an investment portfo- lio in a trust that is required to provide security with respect to aggregate excess of loss reinsurance obliga- tions under the remaining Reinsurance Agreement. At December 31, 2004 and 2003, the balance of the investments in the trust, consisting of U.S. government, government agency and high quality corporate bonds, was $544 and $531, respectively. Our remaining net investment in Ridge Re was $82 and $77 at December 31, 2004 and 2003, respectively. Based on Ridge Re’s current projections of investment returns and reinsur- ance payment obligations, we expect to fully recover our remaining investment. The projected reinsurance payments are based on actuarial estimates. 57 U.S. Operations Weighted Average Interest Rates at December 31, 2004 Xerox Corporation Notes due 2004 Euro notes due 2004 Notes due 2006 Notes due 2007 Notes due 2008 Senior Notes due 2009 Euro Senior Notes due 2009 Senior Notes due 2010 Notes due 2011 Senior Notes due 2011 Senior Notes due 2013 Convertible Notes due 2014 Notes due 2016 2003 Credit Facility Subtotal Xerox Credit Corporation Yen notes due 2005 Yen notes due 2007 Notes due 2008 Notes due 2012 Notes due 2013 Notes due 2014 Notes due 2018 Subtotal Other US Operations Borrowings secured by ﬁnance receivables (1) Borrowings secured by other assets Subtotal Total U.S. operations International Operations Xerox Capital (Europe) plc: Euros due 2004 Japanese yen due 2005 U.S. dollars due 2004-2008 Subtotal Other International Operations Pound Sterling secured borrowings due 2008 (1) Euro secured borrowings due 2005-2009 (1) Canadian dollars secured borrowings due 2004-2007 (1) Other debt due 2004-2010 Subtotal Total international operations Subtotal Less current maturities Total long-term debt —% $ — 7.25 7.38 1.31 9.75 9.75 7.13 7.01 6.88 7.63 9.00 7.20 3.92 1.50 2.00 6.50 7.12 6.50 6.06 7.00 2004 2003 — $ — 15 25 27 627 297 704 50 758 550 19 252 300 194 377 15 25 27 616 272 701 50 — 548 19 254 300 3,624 3,398 970 292 25 125 59 50 25 936 281 25 125 59 50 25 1,546 1,501 4.81 2,486 2,598 4.18 257 70 2,743 2,668 $ 7,913 $ 7,567 —% $ 1.30 6.25 — $ 97 25 942 93 525 122 1,560 6.95 3.61 5.78 4.93 685 839 426 103 570 817 440 170 2,053 2,175 1,997 3,557 10,088 11,124 (3,038) (4,194) $ 7,050 $ 6,930 (1) Refer to Note 3 for further discussion of borrowings secured by ﬁnance receivables, net. 58 Consolidated Long-Term Debt Maturities: Scheduled payments due on long-term debt for the next ﬁve years and thereafter follow: 2005 2006 2007 2008 2009 Thereafter Total $3,038 $951 $1,366 $1,041 $959 $2,733 $10,088 Credit Facility: In June 2003, we entered into the 2003 Credit Facility. The 2003 Credit Facility consists of a fully drawn $300 term loan and a $700 revolving credit facility that includes a $200 letter of credit sub- facility, under which $15 of letters of credit were out- standing at December 31, 2004. Xerox is the only borrower of the term loan. The revolving credit facility is available, without sub-limit, to Xerox and certain foreign subsidiaries of Xerox, including Xerox Canada Capital Limited, Xerox Capital (Europe) plc and other qualiﬁed foreign subsidiaries (excluding Xerox, the “Overseas Borrowers”). The 2003 Credit Facility matures on September 30, 2008. In conjunction with the 2003 Credit Facility, debt issuance costs of $29 were deferred. As of December 31, 2004, the $300 term loan and $15 of letters of credit were outstanding and there were no outstanding borrowings under the revolving credit facility. Since inception of the 2003 Credit Facility in June 2003, there have been no borrowings under the revolving credit facility. Subject to certain limits described in the following paragraph, the obligations under the 2003 Credit Facility are secured by liens on substantially all the assets of Xerox and each of our U.S. subsidiaries that have a consolidated net worth from time to time of $100 or more (the “Material Subsidiaries”), excluding Xerox Credit Corporation (“XCC”) and certain other ﬁnance subsidiaries, and are guaranteed by certain Material Subsidiaries. Xerox is required to guarantee the obligations of the Overseas Borrowers. At December 31, 2004, Xerox is the only borrower under the 2003 Credit Facility. Under the terms of certain of our outstanding public bond indentures, the amount of obligations under the 2003 Credit Facility that can be (1) secured by assets (the “Restricted Assets”) of (a) Xerox and (b) our non-ﬁnancing subsidiaries that have a consolidat- ed net worth of at least $100, without (2) triggering a requirement to also secure those indentures, is limited to the excess of (x) 20 percent of our consolidated net worth (as deﬁned in the public bond indentures) over (y) the outstanding amount of certain other debt that is secured by the Restricted Assets. Accordingly, the amount of 2003 Credit Facility debt secured by the Restricted Assets will vary from time to time with changes in our consolidated net worth. The amount of security provided under this formula accrues ratably to the beneﬁt of both the term loan and revolving loans under the 2003 Credit Facility. cash dividend does not exceed the then amount avail- able under the restricted payments basket (as deﬁned). The Senior Notes are guaranteed by our wholly-owned subsidiaries, Intelligent Electronics, Inc. and Xerox International Joint Marketing, Inc. Guarantees: At December 31, 2004, we have guaran- teed $206 of indebtedness of our foreign subsidiaries. This debt is included in our Consolidated Balance Sheet as of such date. Interest: Interest paid by us on our short-term debt, long-term debt and liabilities to subsidiary trusts issu- ing preferred securities amounted to $710, $867 and $903 for the years ended December 31, 2004, 2003 and 2002, respectively. Interest expense and interest income consisted of: Year Ended December 31, 2004 2003 2002 Interest expense (1) Interest income (2) $ 708 (1,009) $ 884 (1,062) $ 896 (1,077) (1) Includes Equipment ﬁnancing interest of $345, $362 and $401 for the years ended December 31, 2004, 2003 and 2002, respectively, as well as non-ﬁnancing interest expense of $363, $522 and $495 for the years ended December 31, 2004, 2003 and 2002, respectively, that is included in Other expenses, net in the Consolidated Statements of Income. (2) Includes Finance income, as well as other interest income that is included in Other expenses, net in the Consolidated Statements of Income. Equipment ﬁnancing interest is determined based on a combination of actual interest expense incurred on ﬁnancing debt, as well as an estimated cost of funds, applied against the estimated level of debt required to support our ﬁnanced receivables. The estimate is based on an assumed ratio of debt as compared to our ﬁnance receivables. This ratio ranges from 80-90 percent of our average ﬁnance receivables. This methodology has been consistently applied for all periods presented. A summary of the Net cash payments on debt as shown on the Consolidated Statements of Cash Flows for the three years ended December 31, 2004 follows: Cash (payments) proceeds on notes payable, net Net cash proceeds from 2004 2003 2002 $ (6) $ 22 $ (33) issuance of long-term debt (1) Cash payments on long-term debt 974 (2,390) 1,580 (5,646) 1,053 (5,639) $ (1,422) $(4,044) $(4,619) (1) Includes payment of debt issuance costs. The term loan and the revolving loans bear inter- est at LIBOR plus a spread that varies between 1.75 percent and 3.00 percent or, at our election, at a base rate plus a spread that depends on the then-current Leverage Ratio, as deﬁned, in the 2003 Credit Facility. The interest rate on the debt as of December 31, 2004, was 3.92 percent. The 2003 Credit Facility contains afﬁrmative and negative covenants as well as ﬁnancial maintenance covenants. Subject to certain exceptions, we cannot pay cash dividends on our common stock during the facility term, although we can pay cash dividends on our preferred stock, provided there is then no event of default. Among defaults customary for facilities of this type, defaults on our other debt, bankruptcy of certain of our legal entities, or a change in control of Xerox Corporation, would all constitute events of default. At December 31, 2004, we were in compliance with the covenants of the 2003 Credit Facility and we expect to remain in compliance for at least the next twelve months. 2011 Senior Notes: In August 2004, we issued $500 aggregate principal amount of Senior Notes due 2011, at par value, and received net proceeds of approximately $492. In September 2004, we issued an additional $250 aggregate principal amount Senior Notes due 2011, at 104.25 percent of par, resulting in net proceeds of approximately $258. These notes form a single series of debt. Interest on the Senior Notes accrues at the annual rate of 6.875 percent and is payable semiannu- ally and, as a result of the premium we received on the second issuance of Senior Notes, have a weighted average effective interest rate of 6.6 percent. In conjunction with the issuance of the Senior Notes, debt issuance costs of $11 were deferred. 2010 and 2013 Senior Notes: In June 2003, we issued $700 aggregate principal amount of Senior Notes due 2010 and $550 aggregate principal amount of Senior Notes due 2013. Interest on the Senior Notes due 2010 and 2013 accrues at the rate of 7.125 percent and 7.625 percent, respectively, per annum and is payable semiannually on June 15 and December 15. In conjunction with the issuance of the 2010 and 2013 Senior Notes, debt issuance costs of $32 were deferred. The senior notes also contain negative covenants (but no ﬁnancial maintenance covenants) similar to those contained in the 2003 Credit Facility. However, they generally provide us with more ﬂexibility than the 2003 Credit Facility covenants, except that payment of cash dividends on the Series C Mandatory Convertible Preferred Stock is subject to the conditions that there is then no default under the senior notes, that the ﬁxed charge coverage ratio (as deﬁned) is greater than 2.25 to 1.0, and that the amount of the 59 Note 10 – Liability to Subsidiary Trusts Issuing Preferred Securities The Liability to Subsidiary Trusts Issuing Preferred Securities included in our Consolidated Balance Sheets reﬂects the obligations to our subsidiaries that have issued preferred securities. These subsidiaries are not consolidated in our ﬁnancial statements because we are not the primary beneﬁciary of the trusts. As of December 31, 2004 and 2003, the compo- nents of our liabilities to the trusts were as follows: Trust II Trust I Xerox Capital LLC Total 2004 $ — 629 88 $ 717 2003 $ 1,067 665 77 $1,809 Trust II: In 2001, Xerox Capital Trust II (“Trust II”) issued 20.7 million of 7.5 percent convertible trust pre- ferred securities (the “Trust Preferred Securities”) to investors for $1,035 and 0.6 million shares of common securities to us for $32. With the proceeds from these securities, Trust II purchased $1,067 of 7.5 percent con- vertible junior subordinated debentures due 2021 of one of our wholly-owned consolidated subsidiaries. The subsidiary purchased $1,067 aggregate principal amount of 7.5 percent convertible junior subordinated debentures due 2021 of the Company. Trust II’s assets consisted principally of our subsidiary’s debentures and our subsidiary’s assets consisted principally of our debentures. On a consolidated basis, we received net proceeds of $1,004. Fees of $31 were capitalized as debt issuance costs and were amortized to interest expense over three years to the earliest put date. Interest expense was $83 and $89 in 2004 and 2003, respectively. The Trust Preferred Securities accrued and paid cash distributions quarterly at a rate of 7.5 percent per year of the stated amount of ﬁfty dollars per security. The Trust Preferred Securities were convertible at any time, at the option of the investors, into 5.4795 shares of our common stock per Trust Preferred Security (equivalent share price of $9.125 per common share) (“the Conversion Ratio”). The Trust Preferred Securities were mandatorily redeemable upon the maturity of the debentures on November 27, 2021 at ﬁfty dollars per Trust Preferred Security plus accrued and unpaid distributions. In December 2004, Trust II redeemed 20.7 million of the issued and outstanding Trust Preferred Securities. In lieu of cash redemption, holders of sub- stantially all of the securities converted $1,035 aggre- gate principal amount of securities into 113,414,658 shares of Xerox common stock. As a result of the con- version and redemption, there is no remaining outstanding principal. The issuance of Xerox shares upon conversion had no impact on diluted earnings per share as they were previously included in the company’s diluted EPS calculation in accordance with the “if converted” accounting methodology. Trust I: In 1997, Xerox Capital Trust I (“Trust I”) issued 650 thousand of 8.0 percent preferred securities (the “Preferred Securities”) to investors for $644 ($650 liqui- dation value) and 20,103 shares of common securities to us for $20. With the proceeds from these securities, Trust I purchased $670 principal amount of 8.0 percent Junior Subordinated Debentures due 2027 of the Company (“the Debentures”). The Debentures repre- sent all of the assets of Trust I. On a consolidated basis, we received net proceeds of $637 which was net of fees and discounts of $13. Interest expense, together with the amortization of debt issuance costs and discounts, amounted to $54 and $52 in 2004 and 2003, respectively. In the ﬁrst quarter of 2004, we entered into pay variable /receive ﬁxed interest rate swaps with a notional amount of $600 associated with the 2027 liability to Trust I. These swaps were designated and accounted for as fair value hedges and resulted in a fair value adjustment to reduce the Trust I liability by $36 as of December 31, 2004. As of December 31, 2004, the inter- est rates on these swaps ranged from approximately 5.28% to 5.68% and are based on the 6 month LIBOR rate plus an applicable margin. We have guaranteed (the “Guarantee”), on a subordinated basis, distributions and other payments due on the Preferred Securities. The Guarantee and our obligations under the Debentures and in the indenture pursuant to which the Debentures were issued and our obligations under the Amended and Restated Declaration of Trust governing the trust, taken together, provide a full and unconditional guarantee of amounts due on the Preferred Securities. The Preferred Securities accrue and pay cash distributions semiannually at a rate of 8 percent per year of the stated liquidation amount of one thousand dollars per Preferred Security. The Preferred Securities are mandatorily redeemable upon the matu- rity of the Debentures on February 1, 2027, or earlier to the extent of any redemption by us of any Debentures. The redemption price in either such case will be one thousand dollars per share plus accrued and unpaid distributions to the date ﬁxed for redemption. Xerox Capital LLC: In 1996, Xerox Capital LLC, issued 2 million deferred preferred shares for Canadian (Cdn.) $50 ($42 U.S.) to investors and all of its common shares to us. The total proceeds of Cdn. $63 ($52 U.S.) were loaned to us. The deferred preferred shares are mandatorily redeemable on February 28, 2006 for Cdn. $90 (equivalent to $75 U.S. at December 31, 2004). Our liability to the subsidiary trust of $88 includes the current amount of the deferred preferred shares of $69. 60 Note 11 – Financial Instruments We are exposed to market risk from changes in foreign currency exchange rates and interest rates, which could affect operating results, ﬁnancial position and cash ﬂows. We manage our exposure to these market risks through our regular operating and ﬁnancing activities and, when appropriate, through the use of derivative ﬁnancial instruments. These derivative ﬁnancial instru- ments are utilized to hedge economic exposures as well as reduce earnings and cash ﬂow volatility resulting from shifts in market rates. As permitted, certain of these derivative contracts have been designated for hedge accounting treatment under SFAS No. 133. However, certain of these instruments do not qualify for hedge accounting treatment and, accordingly, our results of operations are exposed to some level of volatility. The level of volatility will vary with the type and amount of derivative hedges outstanding, as well as ﬂuctuations in the currency and interest rate market during the period. We enter into limited types of derivative contracts, including interest rate and cross currency interest rate swap agreements, foreign currency spot, forward and swap contracts, purchased foreign currency options and interest rate collars to manage interest rate and foreign currency exposures. Our primary foreign currency market exposures include the Japanese yen, Euro, British pound sterling, Brazilian real and Canadian dollar. The fair market values of all our derivative contracts change with ﬂuctuations in interest rates and/or currency rates and are designed so that any changes in their values are offset by changes in the values of the underlying exposures. Derivative ﬁnancial instruments are held solely as risk manage- ment tools and not for trading or speculative purposes. By their nature, all derivative instruments involve, to varying degrees, elements of market and credit risk not recognized in our ﬁnancial statements. The market risk associated with these instruments resulting from currency exchange and interest rate movements is expected to offset the market risk of the underlying transactions, assets and liabilities being hedged. We do not believe there is signiﬁcant risk of loss in the event of non-performance by the counterparties associated with these instruments because these transactions are executed with a diversiﬁed group of major ﬁnancial institutions. Further, our policy is to deal with counter- parties having a minimum investment-grade or better credit rating. Credit risk is managed through the contin- uous monitoring of exposures to such counterparties. Some of our derivative and other material contracts at December 31, 2004 require us to post cash collateral or maintain minimum cash balances in escrow. These cash amounts are reported in our Consolidated Balance Sheets within Other current assets or Other long-term assets, depending on when the cash will be contractually released, as presented in Note 1 to the Consolidated Financial Statements. Interest Rate Risk Management: We use interest rate swap agreements to manage our interest rate exposure and to achieve a desired proportion of variable and ﬁxed rate debt. These derivatives may be designated as fair value hedges or cash ﬂow hedges depending on the nature of the risk being hedged. Virtually all customer-ﬁnancing assets earn ﬁxed rates of interest and a signiﬁcant portion of those assets have been matched to secured borrowings through third party funding arrangements which generally bear ﬁxed rates of interest. These borrowings are secured by customer-ﬁnancing assets and are designed to mature as we collect principal payments on the ﬁnancing assets which secure them. The interest rates on a signiﬁcant portion of those loans are ﬁxed. As a result, these funding arrangements create natural match funding of the ﬁnancing assets to the related debt. At December 31, 2004 and 2003, we had outstand- ing single currency interest rate swap agreements with aggregate notional amounts of $2.8 billion and $2.5 billion, respectively. The net (liability) asset fair values at December 31, 2004 and 2003 were $(37) and $46, respectively. Fair Value Hedges: As of December 31, 2004 and 2003, pay variable/receive ﬁxed interest rate swaps with notional amounts of $2.4 billion and $1.7 billion were designated and accounted for as fair value hedges. The swaps were structured to hedge the fair value of related debt by converting them from ﬁxed rate instruments to variable rate instruments. No ineffec- tive portion was recorded to earnings during 2004 or 2003. The following is a summary of our fair value hedges at December 31, 2004: Debt Instrument Senior Notes due 2010 Senior Notes due 2013 Notes due 2016 Senior Notes due 2011 Liability to Capital Trust I Total Year First Designated 2003 2003/2004 2004 2004 2004 Notional Amount $ 700 550 250 250 600 $2,350 61 Weighted- average Interest Rate Paid 6.04% 6.01% 5.44% 5.41% 5.52% Interest Rate Received Basis Maturity 7.13% 7.63% 7.20% 6.88% 8.00% Libor Libor Libor Libor Libor 2010 2013 2016 2011 2027 Cash Flow Hedges: During 2004, pay ﬁxed/receive variable interest rate swaps with notional amounts of £200 million ($385) associated with the Xerox Finance Limited GE Capital borrowing were designated and accounted for as cash ﬂow hedges. The swaps were structured to hedge the LIBOR interest rate of the debt by converting it from a variable rate instrument to a ﬁxed rate instrument. No ineffective portion was recorded to earnings during 2004. Derivatives Marked-to-Market Results: While the remainder of our portfolio of interest rate derivative instruments is intended to economically hedge inter- est rate risks to the extent possible, differences between the contract terms of these derivatives and the underlying related debt reduce our ability to obtain hedge accounting in accordance with SFAS No. 133. This results in mark-to-market valuation of these derivatives directly through earnings, which accord- ingly leads to increased earnings volatility. During 2004 and 2003, we recorded net gains of $4 and net losses of $13, respectively, from the mark-to-market valuation of interest rate derivatives for which we did not apply hedge accounting. Terminated Swaps: During 2004, we terminated interest rate swaps with a notional value of $1.1 billion and a net fair asset value of $68. Interest rate swaps with a notional value of $600 and a fair value of $55 had previously been designated as fair value hedges against the Senior Notes due 2009. Accordingly, the corresponding $55 fair value adjustment to the Senior Notes will be amortized to interest expense over the remaining term of the notes and amounted to $9 dur- ing 2004. During 2003, we terminated interest rate swaps with a notional value of $2.0 billion and a net fair asset value of $136. The remaining derivatives terminated in 2004 as well as those terminated in 2003 had not been previously designated as hedges and accordingly those terminations had no impact on earnings as they were being marked to market through earnings each period. Foreign Exchange Risk Management: In cases where we issue foreign currency denominated debt, we may enter into cross-currency interest rate swap agreements whereby we swap the proceeds and related interest payments with a counterparty. In return, we receive and effectively denominate the debt in local functional currencies. In addition, we may also utilize forward exchange contracts to hedge the currency exposure for interest payments on foreign currency denominated debt. These derivatives may be designated as fair value hedges or cash ﬂow hedges depending on the nature of the risk being hedged. We also utilize forward exchange contracts and purchased option contracts to hedge against the poten- tially adverse impacts of foreign currency ﬂuctuations on foreign currency denominated assets and liabili- ties. Generally, changes in the value of these currency derivatives are recorded in earnings together with the offsetting foreign exchange gains and losses on the underlying assets and liabilities. We also utilize currency derivatives to hedge antic- ipated transactions, primarily forecasted purchases of foreign-sourced inventory. These contracts generally mature in six months or less. Although these contracts are intended to economically hedge foreign currency risks to the extent possible, differences between the contract terms of our derivatives and the underlying forecasted exposures reduce our ability to obtain hedge accounting in accordance with SFAS No. 133. Accordingly, the changes in value for these derivatives are recorded directly through earnings. During 2004, 2003, and 2002, we recorded aggre- gate exchange losses of $73, $11 and $77, respectively. Net currency losses primarily result from the spot/for- ward premiums on foreign exchange forward contracts, the re-measurement of unhedged foreign currency-denominated assets and liabilities and the mark-to-market impact of economic hedges of antici- pated transactions for which we do not qualify for cash ﬂow hedge accounting treatment. At December 31, 2004, we had outstanding forward exchange and purchased option contracts with gross notional values of $5,040. The following is a summary of the primary hedging positions and cor- responding fair values held as of December 31, 2004: Gross Notional Fair Value Asset Value (Liability) $1,817 895 441 371 230 203 190 173 131 108 100 381 $5,040 $ 41 38 (5) (29) (2) — (1) 3 1 1 5 (3) $ 49 Currency Hedged (Buy/Sell) Euro/Pound Sterling Yen/US Dollar Pound Sterling/Euro US Dollar/Euro Canadian Dollar/Euro US Dollar/Pound Sterling Yen/Euro Kronor/Pound Sterling Swiss Franc/Pound Sterling Euro/Canadian Dollar Canadian Dollar/US Dollar All Other Total 62 No amount of ineffectiveness was recorded in the Consolidated Statements of Income during 2004 or 2003 for our designated cash ﬂow hedges and all components of each derivative’s gain or loss was included in the assessment of hedge effectiveness. Accumulated Other Comprehensive Loss (“AOCL”): During 2004, a $16 after-tax increase in the fair value of cash ﬂow hedges was recorded in AOCL while an after-tax amount of $(14) was transferred to earnings as a result of scheduled payments and receipts on our cash ﬂow hedges. This resulted in an ending gain position relating to the cash ﬂow hedges in AOCL of $3 as of December 31, 2004. During 2003, an $8 after- tax increase in the fair value of cash ﬂow hedges was recorded in AOCL while an after-tax amount of $(6) was transferred to earnings as a result of scheduled payments and receipts on our cash ﬂow hedges. This resulted in an ending gain position relating to the cash ﬂow hedges in AOCL of $1 as of December 31, 2003. Fair Value of Financial Instruments: The estimated fair values of our ﬁnancial instruments at December 31, 2004 and 2003 follow: Carrying Amount $ 3,218 2,076 3,074 7,050 717 2004 Fair Value $ 3,218 2,076 3,093 7,442 738 2003 Carrying Amount $2,477 2,159 4,236 6,930 1,809 Fair Value $2,477 2,159 4,281 7,177 2,407 At December 31, 2004 and 2003, we had outstand- ing cross-currency interest rate swap agreements with aggregate notional amounts of $597 and $696, respec- tively. The net asset fair values at December 31, 2004 and 2003 were $44 and $4, respectively. Of the outstanding agreements at December 31, 2004, the Japanese yen was the largest single currency hedged and accounted for over 98 percent of our agreements. Cash Flow Hedges: As of December 31, 2004, cross currency swaps with a notional amount of $589 were used to hedge the currency exposure for interest payments and principal on half of our Japanese yen denominated debt of $1.3 billion. In addition, forward currency contracts were used to hedge the currency exposure for interest payments on the remaining debt. These combined strategies converted the hedged cash ﬂows to U.S. dollar denominated payments and qualiﬁed for cash ﬂow hedge accounting. During 2004 and 2003, certain forward contracts were used to hedge the interest payments on Euro denominated debt of $377. The derivatives were designated and accounted for as cash ﬂow hedges. Cash and cash equivalents Accounts receivable, net Short-term debt Long-term debt Liabilities to trusts issuing preferred securities The fair value amounts for Cash and cash equivalents and Accounts receivable, net approximate carrying amounts due to the short maturities of these instruments. The fair value of Short and Long-term debt, as well as Liabilities to subsidiary trusts issuing preferred securities, was estimated based on quoted market prices for publicly traded securities or on the current rates offered to us for debt of similar maturi- ties. The difference between the fair value and the carrying value represents the theoretical net premium or discount we would pay or receive to retire all debt at such date. 63 Note 12 – Employee Beneﬁt Plans We sponsor numerous pension and other post-retire- ment beneﬁt plans, primarily retiree health, in our U.S. and international operations. September 30 is the measurement date for most of our European plans and December 31 is the measurement date for all of our other post-retirement beneﬁt plans, including all of our domestic plans. Information regarding our beneﬁt plans is presented below: Pension Beneﬁts Other Beneﬁts 2004 2003 2004 2003 $ 8,971 222 660 14 232 272 356 — (2) 2 (699) $10,028 $ 7,301 772 409 14 311 2 (699) $ 8,110 $ (1,918) (1) (23) 1,993 $ $ $ $ 51 897 (1,092) 4 242 51 (20) $ 7,931 197 934 15 1 312 486 (45) 1 — (861) $ 8,971 $ 5,963 1,150 672 15 401 (39) (861) $ 7,301 $(1,670) (2) (24) 1,870 $ 174 $ 756 (850) 6 262 $ 174 $ (200) $ 1,579 22 89 18 — 70 6 — — — (122) $ 1,563 26 91 9 (30) 18 12 — — — (110) $ 1,662 $ 1,579 $ — — 104 18 — — (122) $ — — 101 9 — — (110) $ — $ — $(1,662) — (112) 494 $ (1,579) — (136) 447 $(1,280) $ (1,268) $ — (1,280) — — $ — (1,268) — — $(1,280) $ (1,268) Pension Beneﬁts Other Beneﬁts 2004 $ 9,959 $ 8,019 2003 $8,853 $7,164 2004 $1,662 — $ 2003 $1,579 $ — Change in Beneﬁt Obligation Beneﬁt obligation, January 1 Service cost Interest cost Plan participants’ contributions Plan amendments Actuarial loss Currency exchange rate changes Divestitures Curtailments Special termination beneﬁts Beneﬁts paid/settlements Beneﬁt obligation, December 31 Change in Plan Assets Fair value of plan assets, January 1 Actual return on plan assets Employer contribution Plan participants’ contributions Currency exchange rate changes Divestitures Beneﬁts paid/settlements Fair value of plan assets, December 31 Funded status (including under-funded and non-funded plans) Unamortized transition assets Unrecognized prior service cost Unrecognized net actuarial loss Net amount recognized Amounts recognized in the Consolidated Balance Sheets consist of: Prepaid beneﬁt cost Accrued beneﬁt liability Intangible asset Minimum pension liability included in AOCL Net amount recognized Change in minimum liability included in AOCL Information for beneﬁt plans that are under-fund- ed or non-funded on a Projected Beneﬁt Obligation basis is presented below: Aggregate projected beneﬁt obligation Aggregate fair value of plan assets 64 The accumulated beneﬁt obligation for all deﬁned beneﬁt pension plans was $8,966 and $8,036 at December 31, 2004 and 2003, respectively. Information for pension plans with an accumulated beneﬁt obligation in excess of plan assets is presented below: Aggregate projected beneﬁt obligation Aggregate accumulated beneﬁt obligation Aggregate fair value of plan assets 2004 2003 $ 6,464 $ 5,727 $ 4,668 $5,882 $5,207 $4,367 Our domestic retirement deﬁned beneﬁt plans provide employees a beneﬁt, depending on eligibility, at the greater of (i) the beneﬁt calculated under a high- est average pay and years of service formula, (ii) the beneﬁt calculated under a formula that provides for the accumulation of salary and interest credits during an employee’s work life, or (iii) the individual account balance from the Company’s prior deﬁned contribution plan (Transitional Retirement Account or “TRA”). Components of Net Periodic Beneﬁt Cost Deﬁned beneﬁt plans Service cost Interest cost (1) Expected return on plan assets (2) Recognized net actuarial loss Amortization of prior service cost Recognized net transition asset Recognized curtailment/settlement loss (gain) Net periodic beneﬁt cost Special termination beneﬁts Deﬁned contribution plans Total Pension Beneﬁts Other Beneﬁts 2004 2003 2002 2004 2003 2002 $ 222 660 (678) 104 (1) (1) 44 350 2 69 $ 197 934 (940) 53 — — 120 364 — 62 $ 180 (210) 134 7 3 (1) 55 168 27 10 $ 421 $ 426 $ 205 $ 22 89 — 24 (24) — — 111 — — $111 $ 26 91 — 13 (18) — (4) 108 — — $ 108 $ 26 96 — 3 (5) — — 120 2 — $122 (1)Interest cost includes interest expense on non-TRA obligations of $331, $289, and $238 and interest (income) expense directly allocated to TRA participant accounts of $329, $645, and $(448) for the years ended December 31, 2004, 2003 and 2002, respectively. (2) Expected return on plan assets includes expected investment income on non-TRA assets of $349, $295, and $314 and actual investment income (losses) on TRA assets of $329, $645, and $(448) for the years ended December 31, 2004, 2003 and 2002, respectively. Settlement/curtailment losses and special termi- nation beneﬁts were incurred as a result of our restructuring programs in all periods presented. Refer to Note 7 for that portion included in restructuring charges for each of the three years ended December 31, 2004. Pension plan assets consist of both deﬁned beneﬁt plan assets and assets legally restricted to the TRA accounts. The combined investment results for these plans, along with the results for our other deﬁned beneﬁt plans, are shown above in the actual return on plan assets caption. To the extent that investment results relate to TRA, such results are charged directly to these accounts as a component of interest cost. Plan Assets Current Allocation and Investment Targets: As of the 2004 and 2003 measurement dates, the global pension plan assets were $8.1 billion and $7.3 billion, respectively. These assets were invested among sever- al asset classes. The amount and percentage of assets invested in each asset class as of each of these dates is shown below: Asset Category Equity securities (1) Debt securities (1) Real estate Other Total (1) None of the investments include debt or equity securities of Xerox Corporation. 65 Asset Value Percentage of Total Assets 2004 2003 2004 2003 $ 4,753 2,592 464 301 $ 8,110 $4,222 1,900 366 813 $7,301 58% 32% 6% 4% 58% 26% 5% 11% 100% 100% Investment Strategy: The target asset allocations for our worldwide plans for 2004 were 59 percent invested in equities, 34 percent invested in ﬁxed income, 6 per- cent invested in real estate and 1 percent invested in Other. For 2003, the target asset allocations were 60 per- cent invested in equities, 28 percent invested in ﬁxed income, 4 percent invested in real estate and 8 percent invested in Other. The pension assets outside of the U.S. as of the 2004 and 2003 measurement dates were $4.1 billion and $3.4 billion, respectively. The target asset allocations for the U.S. pension plan include 64 percent invested in equities, 30 percent in ﬁxed income, 5 percent in real estate and 1 percent in other investments. Cash investments are sufﬁcient to handle expected cash requirements for beneﬁt payments and will vary throughout the year. The expected long-term rate of return on the U.S. pension assets is 8.75 percent. We employ a total return investment approach whereby a mix of equities and ﬁxed income investments are used to maximize the long-term return of plan assets for a prudent level of risk. The intent of this strategy is to minimize plan expenses by exceeding the interest growth in long-term plan liabil- ities. Risk tolerance is established through careful consideration of plan liabilities, plan funded status, and corporate ﬁnancial condition. This consideration involves the use of long-term measures that address both return and risk. The investment portfolio contains a diversiﬁed blend of equity and ﬁxed income invest- ments. Furthermore, equity investments are diversiﬁed across U.S and non-U.S. stocks as well as growth, value, and small and large capitalizations. Other assets such as real estate, private equity, and hedge funds are used to improve portfolio diversiﬁcation. Derivatives may be used to hedge market exposure in an efﬁcient and timely manner; however, derivatives may not be used to leverage the portfolio beyond the market value of the underlying investments. Investment risks and returns are measured and monitored on an ongoing basis through annual liability measurements and quarterly investment portfolio reviews. Expected Long Term Rate of Return: We employ a “building block” approach in determining the long-term rate of return for plan assets. Historical markets are studied and long-term relationships between equities and ﬁxed income are assessed. Current market factors such as inﬂation and interest rates are evaluated before long-term capital market assumptions are determined. The long-term portfolio return is established giving consideration to investment diversiﬁcation and rebalancing. Peer data and historical returns are reviewed periodically to assess reasonableness and appropriateness. Contributions: We expect to contribute $114 to our worldwide pension plans and $128 to our other post retirement beneﬁt plans in 2005. The 2005 expected pension plan contributions do not include any planned contribution for the domestic tax qualiﬁed plans because there are no required contributions to these plans for the 2005 ﬁscal year. However, once the January 1, 2005 actuarial valuations and projected results as of the end of the 2005 measurement year are available, the desirability of additional contributions will be assessed. Based on these results, we may vol- untarily decide to contribute to these plans, even though no contribution is required. Estimated Future Beneﬁt Payments: The following beneﬁt payments, which reﬂect expected future serv- ice, as appropriate, are expected to be paid: 2005 2006 2007 2008 2009 Years 2010-2014 Pension Beneﬁts Beneﬁts Other $ 672 444 489 496 571 3,653 $128 122 124 125 127 633 Assumptions Weighted-average assumptions used to determine beneﬁt obligations at the plan measurement dates Discount rate Rate of compensation increase Pension Beneﬁts Other Beneﬁts 2004 2003 2002 2004 2003 5.6% 4.0 5.8% 3.9 6.2% 3.9 5.8% — (1) 6.0% — (1) 2002 6.5% — (1) (1) Rate of compensation increase is not applicable to our other beneﬁts as compensation levels do not impact earned beneﬁts. 66 Weighted-average assumptions used to determine net periodic beneﬁt cost for years ended December 31 Discount rate Expected return on plan assets Rate of compensation increase Pension Beneﬁts Other Beneﬁts 2005 2004 2003 2002 2005 2004 2003 2002 5.6% 8.0 4.0 5.8% 8.1 3.9 6.2% 8.3 3.9 6.8% 8.8 3.8 5.8% — (1) — (2) 6.0% — (1) — (2) 6.5% — (1) — (2) 7.2% — (1) — (2) (1) Expected return on plan assets is not applicable to our other beneﬁts as these plans are unfunded. (2) Rate of compensation increase is not applicable to our other beneﬁts as compensation levels do not impact earned beneﬁts. Assumed health care cost trend rates at December 31 Health care cost trend rate assumed for next year Rate to which the cost trend rate is assumed to decline (the ultimate trend rate) Year that the rate reaches the ultimate trend rate 2004 2003 11.9% 11.4% 5.2% 5.2% 2011 2008 Assumed health care cost trend rates have a signiﬁcant effect on the amounts reported for the health care plans. A one-percentage-point change in assumed health care cost trend rates would have the following effects: One-percentage- point increase One-percentage- point decrease Effect on total service and interest cost components Effect on post-retirement beneﬁt obligation $ 4 $ 60 $ (3) $(52) Medicare Prescription Drug, Improvement and Modernization Act of 2003: In December 2003, the Medicare Prescription Drug, Improvement and Modernization Act of 2003 (“Act”) was signed into law. The Act will provide prescription drug coverage to retirees beginning in 2006 and will provide subsidies to sponsors of post-retirement medical plans that pro- vide actuarially equivalent prescription drug coverage. We currently provide post-retirement beneﬁts to a group of retirees under two plans whereby retirees have little or no cost sharing for the prescription bene- ﬁts. For these retirees, the prescription drug beneﬁt provided by us would be considered to be actuarially equivalent to the beneﬁt provided under the Act. We have reduced our Accumulated Projected Beneﬁt Obligation (“APBO”) by $64 for the subsidy related to beneﬁts attributed to past service under these plans. This reduction will be reﬂected through the reduction of the amortization of actuarial losses over an effective amortization period of 12 years, which reﬂects the average remaining service period of the employees in the plan. We also provide postretirement beneﬁts to another group of retirees. We have not treated the employer paid drug coverage under this plan as actu- arially equivalent to the beneﬁts provided under the Act. This assessment was made prior to the recent issuance of ﬁnal regulations regarding the Act. When we have completed our ﬁnal review of these regula- tions, we may determine that the beneﬁts under this plan are actuarially equivalent for a period of time. Berger Litigation: Our Retirement Income Guarantee Plan (“RIGP”) represents the primary U.S. pension plan for salaried employees. In 2003, we recorded a $239 provision for litigation relating to the court approved settlement of the Berger v. RIGP litiga- tion. The settlement is being paid from RIGP assets and has been reﬂected in our 2004 actuarial valuation. The obligation related to this settlement has been included in plan amendments in the change in the beneﬁt obligation noted above. Employee Stock Ownership Plan (“ESOP”) Beneﬁts: In 1989, we established an ESOP and sold to it 10 million shares of our Series B Convertible Preferred Stock (the “Convertible Preferred”) for a purchase price of $785. Each Convertible Preferred share was convertible into 6 shares of our common stock. The Convertible Preferred had a $1 par value and a guaranteed minimum value of $78.25 per share and accrued annual dividends of $6.25 per share, which were cumulative if earned. The dividends were payable in cash or additional Convertible Preferred shares, or in a combination thereof. In May 2004, all 6.2 million of our Convertible Preferred shares were redeemed for 37 million common shares in accordance with the original con- version provisions of the Convertible Preferred shares. The redemption was accounted for through a transfer of $483 from preferred stock to common stock and additional paid-in-capital. Dividends were paid through the redemption date. The redemption had no impact on net income or diluted earnings per share (“EPS”) as such shares were previously included in our EPS computation in accordance with the “if converted” methodology. 67 Information relating to the ESOP trust for the three years ended December 31, 2004 follows: Dividends declared on Convertible Preferred Stock Cash contribution to the ESOP Compensation expense 2004 2003 2002 $15 — — $ 41 14 8 $ 78 31 10 Note 13 – Income and Other Taxes Income (loss) before income taxes for the three years ended December 31, 2004 follows: Domestic income (loss) Foreign income Income before income taxes 2004 $426 539 $965 2003 2002 $ (299) 735 $ 436 $ 15 89 $104 Provisions (beneﬁts) for income taxes for the three years ended December 31, 2004 follow: Federal income taxes Current Deferred Foreign income taxes Current Deferred State income taxes Current Deferred 2004 2003 2002 $ 26 114 $ 77 (132) $ 39 (35) 178 21 (19) 20 144 72 (17) (10) 145 (141) (2) (2) $ 340 $ 134 $ 4 A reconciliation of the U.S. federal statutory income tax rate to the consolidated effective income tax rate for the three years ended December 31, 2004 follows: U.S. federal statutory income tax rate Nondeductible expenses Effect of tax law changes Change in valuation allowance for deferred tax assets State taxes, net of federal beneﬁt Audit and other tax return adjustments Tax-exempt income Dividends on Series B 2004 2003 2002 35.0% 3.4 (1.5) 35.0% 35.0% 5.0 1.0 17.6 (15.3) 1.3 1.3 0.7 (0.7) (3.8) (2.7) 7.6 (1.0) 14.0 (2.3) (53.7) (9.3) The 2004 consolidated effective income tax rate of 35.2 percent was comparable to the U.S. federal statu- tory income tax rate. The effective income tax rate reﬂects the impact of nondeductible expenses and unrecognized tax beneﬁts primarily related to recur- ring losses in certain jurisdictions where we continue to maintain deferred tax asset valuation allowances. This tax expense was partially offset by tax beneﬁts from other foreign adjustments, including earnings taxed at different rates, tax law changes and other items that are individually insigniﬁcant. The difference between the 2003 consolidated effective income tax rate of 30.7 percent and the U.S. federal statutory income tax rate relates primarily to tax beneﬁts arising from the reversal of valuation allowances on deferred tax assets following a re- evaluation of their future realization due to improved ﬁnancial performance, other foreign adjustments, including earnings taxed at different rates, the impact of dividends on Series B Convertible Preferred Stock and state tax beneﬁts. Such beneﬁts were partially offset by tax expense for audit and other tax return adjustments, as well as recurring losses in certain jurisdictions where we continue to maintain deferred tax asset valuation allowances. The difference between the 2002 consolidated effective income tax rate of 3.8 percent and the U.S. federal statutory income tax rate relates primarily to the recognition of tax beneﬁts from the favorable reso- lution of a foreign tax audit, tax law changes as well as the retroactive declaration of Series B Convertible Preferred Stock dividends. Such beneﬁts were offset, in part, by tax expense recorded for the ongoing examination in India, the sale of our interest in Katun Corporation as well as recurring losses in certain jurisdictions where we are not providing tax beneﬁts and continue to maintain deferred tax asset valuation allowances. On a consolidated basis, we paid a total of $253, $207, and $442 in income taxes to federal, foreign and state jurisdictions in 2004, 2003 and 2002, respectively. Total income tax expense (beneﬁt) for the three years ended December 31, 2004 was allocated as follows: Income taxes on income Common shareholders’ equity (1) Total 2004 $ 340 (20) $ 320 2003 2002 $134 123 $257 $ 4 (173) $(169) (1) For tax effects of items in accumulated other comprehensive loss and convertible preferred stock (0.6) (3.1) (22.7) tax beneﬁts related to stock option and incentive plans. Other foreign, including earnings taxed at different rates Other (2.4) (1.3) (7.0) (0.3) 43.8 (3.3) Effective income tax rate 35.2% 30.7% 3.8% 68 In substantially all instances, deferred income taxes have not been provided on the undistributed earnings of foreign subsidiaries and other foreign investments carried at equity. The amount of such earnings included in consolidated retained earnings at December 31, 2004 was approximately $6 billion. These earnings have been indeﬁnitely reinvested and we currently do not plan to initiate any action that would precipitate the payment of income taxes there- on. However, as discussed below, upon completion of our evaluation of the American Jobs Creation Act of 2004 (“the Act”), we will reassess these plans. It is not practicable to estimate the amount of additional tax that might be payable on the foreign earnings. As a result of the March 31, 2001 disposition of one-half of our ownership interest in Fuji Xerox, the investment no longer qualiﬁed as a foreign corporate joint venture. Accordingly, deferred taxes are required to be provided on the undistributed earnings of Fuji Xerox, arising subsequent to such date, as we no longer have the ability to ensure indeﬁnite reinvestment. The United States Congress passed the Act, which the President signed into law on October 22, 2004. The Act allows a temporary incentive of an 85 percent divi- dends received deduction for certain dividends from controlled foreign corporations. We are in the process of evaluating whether we will repatriate foreign earn- ings under the Act and we are awaiting the issuance of further regulatory guidance with respect to certain provisions prior to making a deﬁnitive decision. Based on our preliminary analysis, we believe there will not be a material beneﬁt from this temporary incentive and accordingly, we do not expect to repatriate foreign earnings as a result of the provision. The Act also pro- vides a deduction for income from qualiﬁed domestic production activities, which will be phased in from 2005 through 2010. Based on guidance received from the U.S. government with respect to this provision of the Act, we do not anticipate recognizing a signiﬁcant tax beneﬁt from this provision for the next several years due to U.S. taxable income limitations. However, we will continue to evaluate this provision as new guidance is issued. The tax effects of temporary differences that give rise to signiﬁcant portions of the deferred taxes at December 31, 2004 and 2003 were as follows: Tax effect of future tax deductions Research and development Post-retirement medical beneﬁts Depreciation Net operating losses Other operating reserves Tax credit carryforwards Deferred compensation Allowance for doubtful accounts Restructuring reserves Other Valuation allowance Total deferred tax assets 2004 2003 $ 1,281 499 247 450 333 289 198 149 43 40 $ 1,238 491 311 442 262 237 182 151 69 340 3,529 (567) 3,723 (577) $ 2,962 $ 3,146 Tax effect of future taxable income Unearned income and installment sales Other $(1,293) $(1,250) (112) (79) Total deferred tax liabilities Total deferred taxes, net (1,372) (1,362) $ 1,590 $ 1,784 The above amounts are classiﬁed as current or long-term in the Consolidated Balance Sheets in accordance with the asset or liability to which they relate or, when applicable, based on the expected timing of the reversal. Current deferred tax assets at December 31, 2004 and 2003 amounted to $289 and $402, respectively. The deferred tax assets for the respective periods were assessed for recoverability and, where applica- ble, a valuation allowance was recorded to reduce the total deferred tax asset to an amount that will, more likely than not, be realized in the future. The valuation allowance for deferred tax assets as of January 1, 2003 was $524. The net change in the total valuation allowance for the years ended December 31, 2004 and 2003 was a decrease of $10 and an increase of $53, respectively. The valuation allowance relates primarily to certain net operating loss carryforwards, tax credit carryforwards and deductible temporary differences for which we have concluded it is more likely than not that these items will not be realized in the ordinary course of operations. Although realization is not assured, we have con- cluded that it is more likely than not that the deferred tax assets for which a valuation allowance was deter- mined to be unnecessary will be realized in the ordinary course of operations based on the available positive and negative evidence, including scheduling of deferred tax liabilities and projected income from oper- ating activities. The amount of the net deferred tax assets considered realizable, however, could be reduced 69 in the near term if actual future income or income tax rates are lower than estimated, or if there are differences in the timing or amount of future reversals of existing taxable or deductible temporary differences. At December 31, 2004, we had tax credit carryfor- wards of $289 available to offset future income taxes, of which $183 is available to carryforward indeﬁnitely while the remaining $106 will begin to expire, if not uti- lized, in 2005. We also had net operating loss carryfor- wards for income tax purposes of $252 that will expire in 2005 through 2024, if not utilized, and $2.4 billion available to offset future taxable income indeﬁnitely. From 1995 through 1998, we incurred capital losses from the disposition of our insurance group operations. Such losses were disallowed under the tax law existing at the time of the respective dispositions. As a result of IRS regulations issued in 2002, some portion of the losses could be claimed subject to cer- tain limitations. We have ﬁled amended tax returns for 1995 through 1998 reporting $1.2 billion of additional capital losses. As of December 31, 2004 we have $474 of capital gains available to be offset by these capital losses and could realize a potential tax and related interest beneﬁt of approximately $195. We could also realize additional income tax and related interest beneﬁts of $55 associated with the further utilization of these capital losses against a prior business sale. The additional losses claimed and related tax beneﬁts are subject to formal review by the U.S. government, which is currently in process. We will not recognize any tax beneﬁt of these losses until this review has reached a stage that we can estimate the probability of a favorable outcome. All remaining capital loss carry- forwards from this matter expired December 31, 2003. The aggregate potential tax beneﬁt of approximately $250 will not result in a signiﬁcant cash refund, but will increase tax credit carryforwards and reduce taxes otherwise potentially due. Note 14 – Contingencies Guarantees, Indemniﬁcations and Warranty Liabilities: As of December 31, 2004, we have accrued our estimate of liability incurred under our indemniﬁcation arrangements and guarantees, if any. The following is a description of arrangements in which we are a guarantor. Indemniﬁcations provided as part of contracts and agreements: We are a party to a variety of agreements pursuant to which we may be obligated to indemnify the other party with respect to certain matters. These obligations arise in the context of con- tracts that we entered into for the sale or purchase of businesses or real estate assets, under which we customarily agree to hold the other party harmless against losses arising from a breach of representations and covenants, including obligations to pay rent. Typically, these relate to such matters as adequate title to assets sold, intellectual property rights, speciﬁed environmental matters and certain income taxes. In addition, we have provided guarantees on behalf of our subsidiaries with respect to real estate leases. In certain instances, these lease guarantees may remain in effect subsequent to the sale of the subsidiary. Furthermore, in certain contracts we have agreed to indemnify various service providers, trustees and bank agents from any third party claims related to their per- formance on our behalf, with the exception of claims that result from their own willful misconduct or gross negligence. Also, in certain sales contracts, we have guaranteed our performance to our customers and indirectly the performance of third parties with whom we have subcontracted for their services. In each of these circumstances, our payment is conditioned on the other party making a claim pursuant to the procedures speciﬁed in the particular contract, which procedures typically allow us to challenge the other party’s claims. In the case of lease guarantees, we may contest the liabilities asserted under the lease. Further, our obligations under these agreements and guarantees may be limited in terms of time and/or amount, and in some instances, we may have recourse against third parties for certain payments we made. Patent indemniﬁcations: In most sales transactions to resellers of our products, we indemnify against pos- sible claims of patent infringement caused by our products or solutions. These indemniﬁcations usually do not include limits on the claims, provided the claim is made pursuant to the procedures required in the sales contract. For the indemniﬁcation agreements discussed above, it is not possible to predict the maxi- mum potential amount of future payments under these or similar agreements due to the conditional nature of our obligations and the unique facts and cir- cumstances involved in each agreement. Historically, payments we have made under these agreements did not have a material effect on our business, ﬁnancial condition or results of operations. Indemniﬁcation of Ofﬁcers and Directors: Our corporate by-laws require that, except to the extent expressly prohibited by law, we must indemnify Xerox Corporation’s ofﬁcers and directors against judgments, ﬁnes, penalties and amounts paid in settlement, including legal fees and all appeals, incurred in connection with civil or criminal action or proceedings, as it relates to their services to Xerox Corporation and our subsidiaries. Although the by-laws provide no 70 limit on the amount of indemniﬁcation, we may have recourse against our insurance carriers for certain payments made by us. The litigation matters and regulatory actions described below involve certain of our current and former directors and ofﬁcers, all of whom are covered by the aforementioned indemnity and if applicable, current and prior period insurance policies. However, certain indemniﬁcation payments may not be covered under our directors’ and ofﬁcers’ insurance coverage. In addition, we indemnify certain ﬁduciaries of our employee beneﬁt plans for liabilities incurred in their service as ﬁduciary whether or not they are ofﬁcers of the Company. The Securities and Exchange Commission (“SEC”) announced on June 5, 2003 that it had reached a settlement with several individuals who are former ofﬁcers of Xerox Corporation regarding the same accounting and disclosure matters which were involved in its investigation of Xerox Corporation. These individuals neither admitted nor denied wrong- doing and agreed to pay ﬁnes, disgorgement and interest. These individuals are responsible for paying their own ﬁnes. However, because all of the individuals who settled were ofﬁcers of Xerox Corporation, we were required under our by-laws to reimburse the individuals for the disgorgement, interest and legal fees of $19. This amount was accrued in 2002. Product Warranty Liabilities: In connection with our normal sales of equipment, including those under sales-type leases, we generally do not issue product warranties. Our arrangements typically involve a separate full service maintenance agreement with the customer. The agreements generally extend over a period equivalent to the lease term or the expected useful life under a cash sale. The service agreements involve the payment of fees in return for our perform- ance of repairs and maintenance. As a consequence, we do not have any signiﬁcant product warranty obligations including any obligations under customer satisfaction programs. In a few circumstances, particularly in certain cash sales, we may issue a limited product warranty if negotiated by the customer. We also issue warranties for certain of our lower-end products in the Ofﬁce segment, where full service maintenance agreements are not available. In these instances, we record warranty obligations at the time of the sale. The following table summarizes product warranty activity for the three years ended December 31, 2004: Balance as of January 1 Provisions and adjustments Payments Balance as of December 31 2004 $ 19 45 (41) $ 23 2003 2002 $ 25 47 (53) $ 19 $ 46 51 (72) $ 25 71 Tax Related Contingencies: At December 31, 2004, our Brazilian operations had received assessments levied against it for indirect and other taxes which, inclusive of interest, were approximately $559. The change since the December 31, 2003 disclosed amount of $449 is primarily due to indexation and interest, additional assessments and currency. The assessments principally relate to the internal transfer of inventory. We are disputing these assessments and intend to vigorously defend our position. Based on the opinion of legal counsel, we do not believe that the ultimate resolution of these assessments will materially impact our results of operations, ﬁnancial position or cash ﬂows. In connection with these proceedings, we may be required to make cash deposits and other security of up to half of the total amount in dispute. Generally, any such amounts would be refundable to the extent the matter is resolved in our favor. We are subject to ongoing tax examinations and assessments in various jurisdictions. Accordingly, we may record incremental tax expense based upon the probable outcomes of such matters. In addition, when applicable, we adjust the previously recorded tax expense to reﬂect examination results. Our ongoing assessments of the probable outcomes of the examina- tions and related tax positions require judgment and can materially increase or decrease our effective tax rate, as well as impact our operating results. Legal Matters: As more fully discussed below, we are involved in a variety of claims, lawsuits, investigations and proceedings concerning securities law, intellectual property law, environmental law, employment law and the Employee Retirement Income Security Act (“ERISA”). We determine whether an estimated loss from a contingency should be accrued by assessing whether a loss is deemed probable and can be reasonably estimated. We assess our potential liability by analyzing our litigation and regulatory matters using available information. We develop our views on estimated losses in consultation with outside counsel handling our defense in these matters, which involves an analysis of potential results, assuming a combination of litigation and settlement strategies. Should developments in any of these matters cause a change in our determination as to an unfavorable outcome and result in the need to recognize a material accrual, or should any of these matters result in a ﬁnal adverse judgment or be settled for signiﬁcant amounts, they could have a material adverse effect on our results of operations, cash ﬂows and ﬁnancial position in the period or periods in which such change in determination, judgment or settlement occurs. In 2002, we reached a settlement with the SEC, in which we neither admitted nor denied wrongdoing, with respect to previously disclosed allegations relat- ing to matters that had been under investigation since 2000. As a result, the SEC ﬁled a complaint, which we simultaneously settled by consenting to the entry of an Order enjoining us from future violations of Section 17(a) of the Securities Act of 1933, Sections 10(b), 13(a) and 13(b) of the 1934 Act and Rules 10b-5, 12b- 20, 13a-1, 13a-13 and 13b2-1 thereunder, requiring payment of a civil penalty of $10, and imposing other ancillary relief. We continue to be subject to the provi- sions of the Order relating to future violations of law. Litigation Against the Company: In re Xerox Corporation Securities Litigation: A con- solidated securities law action (consisting of 17 cases) is pending in the United States District Court for the District of Connecticut. Defendants are the Company, Barry Romeril, Paul Allaire and G. Richard Thoman. The consolidated action purports to be a class action on behalf of the named plaintiffs and all other purchasers of common stock of the Company during the period between October 22, 1998 through October 7, 1999 (“Class Period”). The amended consolidated complaint in the action alleges that in violation of Section 10(b) and/or 20(a) of the Securities Exchange Act of 1934, as amended (“1934 Act”), and SEC Rule 10b-5 thereunder, each of the defendants is liable as a participant in a fraudulent scheme and course of business that operated as a fraud or deceit on purchasers of the Company’s common stock during the Class Period by disseminating materially false and misleading statements and/or concealing material facts relating to the defendants’ alleged failure to dis- close the material negative impact that the April 1998 restructuring had on the Company’s operations and revenues. The amended complaint further alleges that the alleged scheme: (i) deceived the investing public regarding the economic capabilities, sales pro- ﬁciencies, growth, operations and the intrinsic value of the Company’s common stock; (ii) allowed several corporate insiders, such as the named individual defendants, to sell shares of privately held common stock of the Company while in possession of materially adverse, non-public information; and (iii) caused the individual plaintiffs and the other members of the purported class to purchase common stock of the Company at inﬂated prices. The amended consolidated complaint seeks unspeciﬁed compensatory damages in favor of the plaintiffs and the other members of the purported class against all defendants, jointly and severally, for all damages sustained as a result of defendants’ alleged wrongdoing, including interest thereon, together with reasonable costs and expenses incurred in the action, including counsel fees and expert fees. On September 28, 2001, the court denied the defendants’ motion for dismissal of the complaint. On November 5, 2001, the defendants answered the complaint. On or about January 7, 2003, the plaintiffs ﬁled a motion for class certiﬁcation. That motion has not yet been fully briefed or argued before the court. On or about November 8, 2004, the International Brotherhood of Electrical Workers Welfare Fund of Local Union No. 164 ﬁled a motion to intervene as a named plaintiff and class representative. That motion has been fully briefed, but has not been argued before the court. The court has not issued a ruling. The par- ties are currently engaged in discovery. The individual defendants and we deny any wrongdoing and are vigorously defending the action. Based on the stage of the litigation, it is not possible to estimate the amount of loss or range of possible loss that might result from an adverse judgment or a settlement of this matter. Christine Abarca, et al. v. City of Pomona, et al. (Pomona Water Cases): In 1999, a series of complaints was ﬁled against the Company in the Superior Court of the State of California for the County of Los Angeles on behalf of individual plaintiffs, claiming damages as a result of our alleged disposal and/or release of hazardous substances into the soil and groundwater. Plaintiffs alleged that hazardous substances from the Company’s operations entered the municipal drinking water supplied by the City of Pomona and the Southern California Water Company, and as a result they were exposed to the substances by inhalation, ingestion and dermal contact. Plaintiffs’ claims against the Company included personal injury, wrongful death, property damage, negligence, trespass, nuisance, and violation of the California Unfair Trade Practices Act. In November 2004, the parties entered into a conﬁdential settlement agreement, the terms of which were not material to the Company. Carlson v. Xerox Corporation, et al.: A consolidated securities law action (consisting of 21 cases) is pending in the United States District Court for the District of Connecticut against the Company, KPMG and Paul A. Allaire, G. Richard Thoman, Anne M. Mulcahy, Barry D. Romeril, Gregory Tayler and Philip Fishbach. On September 11, 2002, the court entered an endorsement order granting plaintiffs’ motion to ﬁle a third consoli- dated amended complaint. The defendants’ motion to dismiss the second consolidated amended complaint was denied, as moot. According to the third consoli- dated amended complaint, plaintiffs purport to bring this case as a class action on behalf of an expanded class consisting of all persons and/or entities who pur- chased Xerox common stock and/or bonds during the period between February 17, 1998 through June 28, 2002 and who were purportedly damaged thereby (“Class”). The third consolidated amended complaint sets forth two claims: one alleging that each of the 72 Company, KPMG, and the individual defendants vio- lated Section 10(b) of the 1934 Act and SEC Rule 10b-5 thereunder; the other alleging that the individual defendants are also allegedly liable as “controlling persons” of the Company pursuant to Section 20(a) of the 1934 Act. Plaintiffs claim that the defendants par- ticipated in a fraudulent scheme that operated as a fraud and deceit on purchasers of the Company’s com- mon stock and bonds by disseminating materially false and misleading statements and/or concealing material adverse facts relating to various of the Company’s accounting and reporting practices and ﬁnancial condition. The plaintiffs further allege that this scheme deceived the investing public regarding the true state of the Company’s ﬁnancial condition and caused the plaintiffs and other members of the alleged Class to purchase the Company’s common stock and bonds at artiﬁcially inﬂated prices, and prompted a SEC investigation that led to the April 11, 2002 settle- ment which, among other things, required the Company to pay a $10 penalty and restate its ﬁnancials for the years 1997-2000 (including restate- ment of ﬁnancials previously corrected in an earlier restatement which plaintiffs contend was improper). The third consolidated amended complaint seeks unspeciﬁed compensatory damages in favor of the plaintiffs and the other Class members against all defendants, jointly and severally, including interest thereon, together with reasonable costs and expenses, including counsel fees and expert fees. On December 2, 2002, the Company and the individual defendants ﬁled a motion to dismiss the complaint. That motion has been fully briefed, but has not been argued before the court. The court has not issued a ruling. The indi- vidual defendants and we deny any wrongdoing and are vigorously defending the action. Based on the stage of the litigation, it is not possible to estimate the amount of loss or range of possible loss that might result from an adverse judgment or a settlement of this matter. Florida State Board of Administration, et al. v. Xerox Corporation, et al.: A securities law action brought by four institutional investors, namely the Florida State Board of Administration, the Teachers’ Retirement System of Louisiana, Franklin Mutual Advisers and PPM America, Inc., is pending in the United States District Court for the District of Connecticut against the Company, Paul Allaire, G. Richard Thoman, Barry Romeril, Anne Mulcahy, Philip Fishbach, Gregory Tayler and KPMG. The plaintiffs bring this action indi- vidually on their own behalves. In an amended com- plaint ﬁled on October 3, 2002, one or more of the plaintiffs allege that each of the Company, the individ- ual defendants and KPMG violated Sections 10(b) and 18 of the 1934 Act, SEC Rule 10b-5 thereunder, the Florida Securities Investors Protection Act, Fl. Stat. ss. 517.301, and the Louisiana Securities Act, R.S. 51:712(A). The plaintiffs further claim that the individ- ual defendants are each liable as “controlling persons” of the Company pursuant to Section 20 of the 1934 Act and that each of the defendants is liable for common law fraud and negligent misrepresentation. The complaint generally alleges that the defendants participated in a scheme and course of conduct that deceived the investing public by disseminating materi- ally false and misleading statements and/or concealing material adverse facts relating to the Company’s ﬁnancial condition and accounting and reporting practices. The plaintiffs contend that in relying on false and misleading statements allegedly made by the defendants, at various times from 1997 through 2000 they bought shares of the Company’s common stock at artiﬁcially inﬂated prices. As a result, they allegedly suffered aggregated cash losses in excess of $200. The plaintiffs further contend that the alleged fraudulent scheme prompted a SEC investigation that led to the April 11, 2002 settlement which, among other things, required the Company to pay a $10 penalty and restate its ﬁnancials for the years 1997-2000 including restate- ment of ﬁnancials previously corrected in an earlier restatement which plaintiffs contend was false and misleading. The plaintiffs seek, among other things, unspeciﬁed compensatory damages against the Company, the individual defendants and KPMG, jointly and severally, including prejudgment interest thereon, together with the costs and disbursements of the action, including their actual attorneys’ and experts’ fees. On December 2, 2002, the Company and the individual defendants ﬁled a motion to dismiss all claims in the complaint that are in common with the claims in the Carlson action. That motion has been fully briefed, but has not been argued before the court. The court has not issued a ruling. The individual defendants and we deny any wrongdoing and are vigorously defending the action. Based on the stage of the litigation, it is not possible to estimate the amount of loss or range of possible loss that might result from an adverse judgment or a settlement of this matter. In Re Xerox Corp. ERISA Litigation: On July 1, 2002, a class action complaint captioned Patti v. Xerox Corp. et al. was ﬁled in the United States District Court for the District of Connecticut (Hartford) alleging violations of the ERISA. Three additional class actions (Hopkins, Uebele and Saba) were subsequently ﬁled in the same court making substantially similar claims. On October 16, 2002, the four actions were consolidated as In Re Xerox Corporation ERISA Litigation. On November 15, 2002, a consolidated amended complaint was ﬁled. A ﬁfth class action (Wright) was ﬁled in the District of Columbia. It has been transferred to Connecticut and 73 consolidated with the other actions. The purported class includes all persons who invested or maintained investments in the Xerox Stock Fund in the Xerox 401(k) Plans (either salaried or union) during the pro- posed class period, May 12, 1997 through November 15, 2002, and allegedly exceeds 50,000 persons. The defendants include Xerox Corporation and the follow- ing individuals or groups of individuals during the proposed class period: the Plan Administrator, the Board of Directors, the Fiduciary Investment Review Committee, the Joint Administrative Board, the Finance Committee of the Board of Directors, and the Treasurer. The complaint claims that all the foregoing defendants were ﬁduciaries of the Plan under ERISA and, as such, were obligated to protect the Plan’s assets and act in the interest of Plan participants. The complaint alleges that the defendants failed to do so and thereby breached their ﬁduciary duties. Speciﬁcally, plaintiffs claim that the defendants failed to provide accurate and complete material informa- tion to participants concerning Xerox stock, including accounting practices which allegedly artiﬁcially inﬂat- ed the value of the stock, and misled participants regarding the soundness of the stock and the prudence of investing their retirement assets in Xerox stock. Plaintiffs also claim that defendants failed to invest Plan assets prudently, to monitor the other ﬁduciaries and to disregard Plan directives they knew or should have known were imprudent, and failed to avoid conﬂicts of interest. The complaint does not specify the amount of damages sought. However, it asks that the losses to the Plan be restored, which it describes as “millions of dollars.” It also seeks other legal and equitable relief, as appropriate, to remedy the alleged breaches of ﬁduciary duty, as well as interest, costs and attorneys’ fees. We ﬁled a motion to dismiss the complaint. The plaintiffs subsequently ﬁled a motion for class certiﬁcation and a motion to commence discovery. Defendants have opposed both motions, contending that both are premature before there is a decision on their motion to dismiss. In the fall of 2004, the Court requested an updated brieﬁng on our motion to dismiss and update briefs were ﬁled in December. We and the other defendants deny any wrongdoing and are vigorously defending the action. Based on the stage of the litigation, it is not possible to estimate the amount of loss or range of possible loss that might result from an adverse judgment or a settlement of this matter. Digwamaje et al. v. IBM et al: A purported class action was ﬁled in the United States District Court for the Southern District of New York on September 27, 2002. Service of the First Amended Complaint on the Company was deemed effective as of December 6, 2002. On March 19, 2003, Plaintiffs ﬁled a Second Amended Complaint that eliminated a number of corporate defendants but was otherwise identical in all material respects to the First Amended Complaint. The defendants include Xerox and a number of other corpo- rate defendants who are accused of providing material assistance to the apartheid government in South Africa from 1948 to 1994, by engaging in commerce in South Africa and with the South African government and by employing forced labor, thereby violating both interna- tional and common law. Speciﬁcally, plaintiffs claim violations of the Alien Tort Claims Act, the Torture Victims Protection Act and RICO. They also assert human rights violations and crimes against humanity. Plaintiffs seek compensatory damages in excess of $200 billion and punitive damages in excess of $200 bil- lion. The foregoing damages are being sought from all defendants, jointly and severally. Xerox ﬁled a motion to dismiss the Second Amended Complaint. Oral argu- ment of the motion was heard on November 6, 2003. By Memorandum Opinion and Order ﬁled November 29, 2004, the court granted the motion to dismiss. A clerk’s judgment of dismissal was ﬁled on November 30, 2004. On December 27, 2004, the Company received a notice of appeal dated December 24, 2004. On February 16, 2005, the parties ﬁled a stipulation withdrawing the December 24, 2004 appeal on the ground that the November 30, 2004 judgment of dismissal was not appealable. Following the withdrawal, plaintiffs will apply to the district court for the entry of a new, appeal- able judgment. Assuming such judgment is entered, plaintiffs will have the right to ﬁle a new notice of appeal. Xerox denies any wrongdoing and is vigorously defending the action. Based upon the stage of the litiga- tion, it is not possible to estimate the amount of loss or range of possible loss that might result from an adverse judgment or a settlement of this matter. Arbitration between MPI Technologies, Inc. and Xerox Canada Ltd. and Xerox Corporation: A dispute between MPI Technologies, Inc. (“MPI”) and the Company and Xerox Canada Ltd. (“XCL”) is being arbitrated in Ontario, Canada. The dispute arose under a license agreement (“Agreement”) made as of March 15, 1994 between MPI and XCL. Subsequently, the Company became MPI’s primary interface for the Agreement and the activities thereunder. MPI has alleged damages of $93 for royalties owed under the Agreement, $35 for breach of ﬁduciary duty or breach of conﬁdence, $35 in punitive damages and has claimed $4 in damages, dis- gorgement of proﬁts and injunctive relief with respect to a claim of copyright infringement. The Company and XCL have asserted a counterclaim against MPI for overpayment of royalties and breach of contract. In November 2004, MPI’s motion to amend its claim to add its parent, MPI Tech S.A., as a claimant was grant- ed and the motion of the Company and XCL to dismiss 74 MPI’s copyright claim was denied. The hearing of the arbitration commenced on January 18, 2005 and is expected to last approximately three months. The Company and XCL deny any wrongdoing, deny that any damages are owed and are vigorously defending the action. It is not possible at this stage of the arbitra- tion to estimate the amount of loss or the range of pos- sible loss that might result from an adverse ruling or a settlement of this matter. Accuscan, Inc. v. Xerox Corporation: On April 11, 1996, an action was commenced by Accuscan, Inc. (“Accuscan”), in the United States District Court for the Southern District of New York, against the Company seeking unspeciﬁed damages for infringement of a patent of Accuscan which expired in 1993. The suit, as amended, was directed to facsimile and certain other products containing scanning functions and sought damages for sales between 1990 and 1993. On April 1, 1998, a verdict was entered in favor of Accuscan for $40. However, on September 14, 1998, the court grant- ed our motion for a new trial on damages. The trial ended on October 25, 1999 with a verdict of $10. We appealed to the Court of Appeals for the Federal Circuit (“CAFC”) which found the patent was not infringed, thereby terminating the lawsuit subject to an appeal which was ﬁled by Accuscan to the U.S. Supreme Court. The decision of the U.S. Supreme Court was to remand the case back to the CAFC to consider its previous decision based on the U.S. Supreme Court’s May 28, 2002 ruling in the Festo case. On September 17, 2003, the CAFC reconsidered the case and again held that the patent was not infringed. On December 15, 2003, Accuscan ﬁled a petition to the U.S. Supreme Court to appeal the CAFC’s September 17, 2003 deci- sion. This petition was denied on February 23, 2004. The period during which Accuscan could obtain reconsideration of the Supreme Court’s denial of the petition for writ of certiorari has expired. Xerox and Accuscan have ﬁled a joint motion with the District Court to have a judgment (consistent with the mandate issued by the CAFC) entered for Xerox. The parties are awaiting action on the motion by the District Court. National Union Fire Insurance Company v. Xerox Corporation, et al.: On October 24, 2003, a declaratory judgment action was ﬁled in the Supreme Court of the State of New York, County of New York against the Company and several current and former ofﬁcers and/or members of the Board of Directors. Plaintiff claims that it issued an Excess Directors & Ofﬁcers Liability and Corporate Reimbursement Policy to the Company in reliance on information from the Company that allegedly misrepresented the Company’s ﬁnancial condition and outlook. The policy at issue provides for $25 of coverage as a component of the company reimbursement portion of an insurance program that provides for up to $135 coverage (after deductibles and coinsurance and subject to other policy limitations and requirements) over a three-year period. However, $10 of the entire amount may be unavailable due to the liquidation of one of the other insurers. Plaintiff seeks judgment (i) that it is entitled to rescind the policy as void from the outset; (ii) in the alternative, limiting coverage under the policy and awarding plaintiff damages in an unspeciﬁed amount representing that portion of any required payment under the policy that is attributable to the Company’s and the individual defendants’ own misconduct; and (iii) for the costs and disbursement of the action and such other relief as the court deems just and proper. On December 19, 2003, the Company and individual defendants moved to dismiss the complaint. On November 10, 2004, the Court issued an opinion partially granting and partially denying the motions. Among other things, the Court granted the motions to dismiss all of the claims for rescission and denied plaintiff’s request to replead. The Court denied the Company’s and some of the individual defendants’ motions to dismiss certain claims seeking to limit coverage based on particular provisions in the policy. Plaintiff ﬁled notices of appeal on January 10, 2005 and February 11, 2005. The Company and the individual defendants intend to seek dismissal of the remaining claims. The Company and the individual defendants deny any wrongdoing and are vigorously defending the action. Warren, et al. v. Xerox Corporation: On March 11, 2004, the United States District Court for the Eastern District of New York entered an order certifying a nationwide class of all black salespersons employed by Xerox from February 1, 1997 to the present under Title VII of the Civil Rights Act of 1964, as amended, and the Civil Rights Act of 1871. The suit was commenced on May 9, 2001 by six black sales repre- sentatives. The plaintiffs allege that Xerox has engaged in a pattern or practice of race discrimination against them and other black sales representatives by assign- ing them to less desirable sales territories, denying them promotional opportunities, and paying them less than their white counterparts. Although the com- plaint does not specify the amount of damages sought, plaintiffs do seek, on behalf of themselves and the classes they seek to represent, front and back pay, compensatory and punitive damages, and attorneys’ fees. We deny any wrongdoing and are vigorously defending the action. Based on the stage of the litiga- tion, it is not possible to estimate the amount of loss or range of possible loss that might result from an adverse judgment or a settlement of this matter. 75 Compression Labs, Inc. v. Agfa et al. (including Xerox Corporation): In April 2004, Compression Labs, Incorporated (“CLI”) commenced an action in the United States District Court for the Eastern District of Texas, Marshall Division against Xerox, along with 27 other companies, seeking unspeciﬁed damages for patent infringement, injunction and other ancillary relief. According to CLI, the patent covers an aspect of a standard for compressing full-color or gray-scale still images (“JPEG”). We deny any wrongdoing and are vigorously defending this action. In July 2004, along with several of the other defendants in the above named action, we ﬁled a complaint against CLI in Federal Court in Delaware, requesting a declaratory judgment of non-infringement and invalidity; a ﬁnd- ing of an implied license to use the patent; a ﬁnding that CLI is estopped from enforcing the patent; dam- ages and relief under state law for deceptive trade practices, unfair competition, fraud, negligent misrep- resentation, equitable estoppel and patent misuse; and relief under federal anti-trust laws for CLI’s violation of Section 2 of the Sherman Act. On February 16, 2005, the U.S. Multi-District Litigation Panel ordered the subject lawsuit (along with all related lawsuits) be transferred from the District Court of the Eastern District of Texas to the District Court for the Northern District of California. All pre-trial proceedings will occur in the Northern District of California and the lawsuit will, if necessary, be transferred back to the Eastern District of Texas for trial. Discovery for all related cases will continue in the Northern District of California, with document production continuing through the ﬁrst half of 2005. Based on the stage of the litigation, it is not possible to estimate the amount of loss or range of possible loss that might result from an adverse judgment or a settlement of this matter. Tesseron, Ltd. v. Xerox Corporation: On October 28, 2004, an action was commenced by Tesseron, Ltd., in the United States District Court for the Northern District of Ohio against Xerox seeking unspeciﬁed damages for alleged infringement of seven U.S. patents. Tesseron asserts that its patents cover Xerox’s variable imaging software sold with Xerox’s production printing systems. Xerox ﬁled an answer on January 28, 2005. We deny any wrongdoing and intend to vigorously defend the action. Based upon the stage of the litigation, it is not possible to estimate the amount of loss or range of possible loss that might result from an adverse judgment or a settlement of this matter. Derivative Litigation Brought on Behalf of the Company: In re Xerox Derivative Actions: A consolidated putative shareholder derivative action is pending in the Supreme Court of the State of New York, County of New York against several current and former mem- bers of the Board of Directors including William F. Buehler, B.R. Inman, Antonia Ax:son Johnson, Vernon E. Jordan, Jr., Yotaro Kobayashi, Hilmar Kopper, Ralph Larsen, George J. Mitchell, N.J. Nicholas, Jr., John E. Pepper, Patricia Russo, Martha Seger, Thomas C. Theobald, Paul Allaire, G. Richard Thoman, Anne Mulcahy and Barry Romeril, and KPMG. The plaintiffs purportedly brought this action in the name of and for the beneﬁt of the Company, which is named as a nominal defendant, and its public shareholders. The second consolidated amended complaint alleged that each of the director defendants breached their ﬁduci- ary duties to the Company and its shareholders by, among other things, ignoring indications of a lack of oversight at the Company and the existence of ﬂawed business and accounting practices within the Company’s Mexican and other operations; failing to have in place sufﬁcient controls and procedures to monitor the Company’s accounting practices; know- ingly and recklessly disseminating and permitting to be disseminated, misleading information to share- holders and the investing public; and permitting the Company to engage in improper accounting practices. The plaintiffs further alleged that each of the director defendants breached his/her duties of due care and diligence in the management and administration of the Company’s affairs and grossly mismanaged or aided and abetted the gross mismanagement of the Company and its assets. The second amended com- plaint also asserted claims of negligence, negligent misrepresentation, breach of contract and breach of ﬁduciary duty against KPMG. Additionally, plaintiffs claimed that KPMG is liable to Xerox for contribution, based on KPMG’s share of the responsibility for any injuries or damages for which Xerox is held liable to plaintiffs in related pending securities class action litigation. On behalf of the Company, the plaintiffs seek a judgment declaring that the director defendants violated and/or aided and abetted the breach of their ﬁduciary duties to the Company and its shareholders; awarding the Company unspeciﬁed compensatory damages against the director defendants, individually and severally, together with pre-judgment and post- judgment interest at the maximum rate allowable by law; awarding the Company punitive damages against the director defendants; awarding the Company com- pensatory damages against KPMG; and awarding plaintiffs the costs and disbursements of this action, including reasonable attorneys’ and experts’ fees. On 76 December 16, 2002, the Company and the individual defendants answered the complaint. The plaintiffs ﬁled a third consolidated and amended derivative action complaint on July 23, 2003 adding factual alle- gations relating to subsequent acts and transactions, namely indemniﬁcation of six former ofﬁcers for disgorgements imposed pursuant to their respective settlements with the SEC and related legal fees, and adding a demand for injunctive relief with respect to that indemniﬁcation. On September 12, 2003, Xerox and the individuals ﬁled an answer to the third con- solidated and amended derivative action complaint. Discovery in this case has been stayed, to the extent it is duplicative of discovery in Carlson, as discussed herein, pending determination of the motion to dismiss in Carlson. The individual defendants deny any wrongdoing and are vigorously defending the action. Pall v. KPMG, et al.: On May 13, 2003, a shareholder commenced a derivative action in the United States District Court for the District of Connecticut against KPMG and four of its current or former partners. The Company was named as a nominal defendant. The plaintiff had ﬁled an earlier derivative action against certain current and former members of the Xerox Board of Directors and KPMG. That action, captioned Pall v. Buehler, et al., was dismissed for lack of juris- diction. Plaintiff purports to bring this current action derivatively on behalf and for the beneﬁt of the Company seeking damages allegedly caused to the Company by KPMG and the named individual defen- dants. The plaintiff asserts claims for contribution under the securities laws, negligence, negligent misrep- resentation, breach of contract, breach of ﬁduciary duty and indemniﬁcation. The plaintiff seeks unspeciﬁed compensatory damages (together with pre-judgment and post-judgment interest), a declaratory judgment that defendants violated and/or aided and abetted the breach of ﬁduciary and professional duties to the Company, an award of punitive damages for the Company against the defendants, plus the costs and disbursements of the action. On November 7, 2003, the Company ﬁled a limited motion to dismiss the complaint on jurisdictional grounds and reserved its right to seek dismissal on other grounds, if the court denies the initial motion. KPMG and the individual defendants also ﬁled limited motions to dismiss on the same grounds. The motions have not been fully briefed or argued before the court. Other Litigation: Xerox Corporation v. 3Com Corporation, et al.: On April 28, 1997, we commenced an action in U.S. District Court for the Western District of New York against Palm, formerly owned by 3Com Corporation, for infringement of the Xerox “Unistrokes” handwrit- ing recognition patent by the Palm Pilot using “Grafﬁti.” Upon reexamination, the U.S. Patent and Trademark Ofﬁce conﬁrmed the validity of all 16 claims of the original Unistrokes patent. On June 6, 2000, the District Court found the Palm Pilot with Grafﬁti did not infringe the Unistrokes patent claims, and on October 5, 2000, the Court of Appeals for the Federal Circuit reversed the ﬁnding of no infringement and sent the case back to the lower court to continue toward trial on the infringement claims. On December 20, 2001, the District Court granted our motions on infringement and for a ﬁnding of validity, thus establishing liability. In January 2003, Palm announced that it would stop including Grafﬁti in its future operating systems. On February 20, 2003, the Court of Appeals for the Federal Circuit afﬁrmed the infringement of the Unistrokes patent by Palm’s handheld devices and remanded the validity issues to the District Court for further analysis. On December 5, 2003 Palm moved for sanctions, alleging that Xerox withheld production of material information. Xerox has since responded to the motion denying the basis of claims. On December 10, 2003 the District Court heard oral arguments on summary judg- ment motions from both parties directed solely to the issue of validity. A decision denying Xerox’s motions and granting Palm’s motion of summary judgment for invalidity (“SJ”) was granted on May 21, 2004. In June 2004, Palm ﬁled a motion requesting clariﬁcation of the grant of SJ, Xerox has responded to that motion, and also ﬁled a motion to reconsider the SJ. On February 16, 2005, the District Court denied Xerox’s motion to reconsider and granted Palm’s motion to clarify. Pursuant to granting Palm’s motion, the District Court supplemented its decision of May 21, 2004. Xerox plans to appeal the grant of summary judgment of invalidity in due course. Other Matters: It is our policy to promptly and carefully investigate, often with the assistance of outside advisers, allega- tions of impropriety that may come to our attention. If the allegations are substantiated, appropriate prompt remedial action is taken. When and where appropri- ate, we report such matters to the U.S. Department of Justice and to the SEC, and/or make public disclosure. 77 U.S. Attorney’s Ofﬁce Investigation: We previously reported that the U.S. attorney’s ofﬁce in Bridgeport, Connecticut was conducting an investigation into matters relating to Xerox, namely accounting and disclosure issues during the period 1998 to 2000, particularly relating to the Company’s operations in Latin America. The accounting matters upon which the U.S. Attorney’s ofﬁce appeared to be focusing were the ones that were investigated by the SEC and addressed in the Company’s restatements. The Company cooperated with the investigation and pro- vided documents as requested. On October 15, 2004 the U.S. Attorney’s ofﬁce informed the Company that it has completed its investigation and declined to bring charges against the Company or any individuals in connection with the investigation. India: In recent years we have become aware of a number of matters at our Indian subsidiary, Xerox Modicorp Ltd., that occurred over a period of several years much of which occurred before we obtained majority ownership of these operations in mid 1999. These matters include misappropriations of funds and payments to other companies that may have been inaccurately recorded on the subsidiary’s books and certain improper payments in connection with sales to government customers. These transactions were not material to the Company’s ﬁnancial statements. We have reported these transactions to the Indian authori- ties, the U.S. Department of Justice and to the SEC. The private Indian investigator engaged by the Indian Ministry of Company Affairs has completed an investigation of these matters. The Indian Ministry of Company Affairs has provided our Indian subsidiary with a portion of the investigator’s report which addresses the previously disclosed misappropriation of funds and improper payments and has requested comments, which the Indian subsidiary intends to provide in due course. The report includes allegations that Xerox Modicorp Ltd.’s senior ofﬁcials and the Company were aware of such activities. The report also asserts the need for further investigation into potential criminal acts related to the improper activities addressed by the report. The matter is now pending in the Indian Ministry of Company Affairs. The Company has reported these developments and furnished a copy of the portion of the report received by Xerox Modicorp Ltd. to the U.S. Department of Justice and the SEC. In October 2004, we increased our ownership interest in our Indian subsidiary to 86 percent, further increasing our controlling interest over this subsidiary. Note 15 – Preferred Stock As of December 31, 2004, we have one class of preferred stock outstanding as well as one class of preferred stock purchase rights. In total, we are authorized to issue approximately 22 million shares of cumulative preferred stock, $1.00 par value. Series C Mandatory Convertible Preferred Stock: In June 2003, we issued 9.2 million shares of 6.25 per- cent Series C Mandatory Convertible Preferred Stock with a stated liquidation value of $100 per share for net proceeds of $889. The proceeds from these securi- ties were used to repay a portion of our indebtedness. Annual dividends of $6.25 per share are cumulative and payable quarterly in cash, shares of our common stock or a combination thereof. On July 1, 2006, each share of Series C Mandatory Convertible Preferred Stock will automatically convert into between 8.1301 and 9.7561 shares of our common stock, depending on the then 20-day average market price of our common stock. At any time prior to July 1, 2006, holders may elect to convert each share of Series C Mandatory Convertible Preferred Stock into 8.1301 shares of our common stock. If at any time prior to July 1, 2006, the closing price per share of our common stock exceeds $18.45 for at least 20 trading days within a period of 30 consecutive trading days, we may elect, subject to certain limitations, to cause the conversion of all, but not less than all, the shares of Series C Mandatory Convertible Preferred Stock then outstanding for shares of our common stock at a conversion rate of 8.1301 shares of our common stock for each share of Series C Mandatory Convertible Preferred Stock. Preferred Stock Purchase Rights: We have a shareholder rights plan designed to deter coercive or unfair takeover tactics and to prevent a person or persons from gaining control of us without offering a fair price to all shareholders. Under the terms of this plan, one-half of one preferred stock purchase right (“Right”) accompanies each share of outstanding common stock. Each full Right entitles the holder to purchase from us one three-hundredth of a new series of preferred stock at an exercise price of $250. Within the time limits and under the circumstances speciﬁed in the plan, the Rights entitle the holder to acquire either our common stock, the stock of the surviving company in a business combination, or the stock of the purchaser of our assets, having a value of two times the exercise price. The Rights, which expire in April 2007, may be redeemed prior to becoming exercisable by action of the Board of Directors at a redemption price of $.01 per Right. The Rights are non-voting and, until they become exercisable, have no dilutive effect on the earnings per share or book value per share of our common stock. 78 Note 16 – Common Stock We have 1.75 billion authorized shares of common stock, $1 par value. At December 31, 2004, 131 million shares were reserved for issuance under our incentive compensation plans. In addition, at December 31, 2004, 90 million common shares were reserved for the con- version of the Series C Mandatory Convertible Preferred Stock, 48 million common shares were reserved for debt to equity exchanges, and 2 million common shares were reserved for the conversion of convertible debt. Stock Option and Long-term Incentive Plans: We have a long-term incentive plan whereby eligible employees may be granted non-qualiﬁed stock options, shares of common stock (restricted or unrestricted) and stock appreciation rights (“SARs”). Stock options and stock awards are settled with newly issued shares of our common stock, while SARs are settled with cash. We granted 2.5 million, 1.6 million and 1.6 million shares of restricted stock to key employees for the years ended December 31, 2004, 2003 and 2002, respectively. No monetary consideration is paid by employees who receive restricted shares. Compensation expense for restricted grants is based upon the grant date market price and is recorded over the vesting period, which is generally three years. Compensation expense recorded for restricted grants was $22, $15 and $17 in 2004, 2003 and 2002, respectively. Stock options generally vest over a period of three years and expire between eight and ten years from the date of grant. The exercise price of the options is equal to the market value of our common stock on the effec- tive date of grant. At December 31, 2004 and 2003, 33.9 million and 21.4 million shares, respectively, were available for grant of options or awards. The following table provides information relating to the status of, and changes in, stock options granted for each of the three years ended December 31, 2004 (stock options in thousands): Employee Stock Options Outstanding at January 1 Granted Cancelled Exercised Outstanding at December 31 Exercisable at end of year 2004 2003 2002 Average Option Price $21 14 32 7 $21 Stock Options 97,839 11,216 (8,071) (9,151) 91,833 65,199 Stock Options 76,849 31,106 (6,840) (3,276) 97,839 58,652 Average Option Price $26 10 21 6 $21 Average Option Price $ 29 10 34 5 $ 26 Stock Options 68,829 14,286 (5,668) (598) 76,849 45,250 Options outstanding and exercisable at December 31, 2004 were as follows (stock options in thousands): Range of Exercise Prices $4.75 to $6.98 7.13 to 10.69 10.70 to 15.27 16.91 to 22.88 25.38 to 36.70 41.72 to 60.95 Options Outstanding Options Exercisable Weighted Number Average Remaining Contractual Life Outstanding Weighted Average Exercise Price Number Weighted Average Exercise Price Exercisable $ 4.86 9.09 13.66 21.77 31.58 52.60 $20.98 7,348 21,342 396 11,310 7,830 16,973 65,199 $ 4.82 9.30 13.06 21.77 31.58 52.60 $24.93 8,058 34,920 11,507 12,545 7,830 16,973 91,833 5.97 7.34 6.97 5.00 2.93 2.72 5.62 79 Note 17 – Earnings Per Share Basic earnings per share is computed by dividing income available to common shareholders (the numerator) by the weighted-average number of com- mon shares outstanding (the denominator) for the period. Diluted earnings per share assumes that any dilutive convertible preferred shares, convertible subordinated debentures, and convertible securities outstanding were converted, with related preferred stock dividend requirements and outstanding common shares adjusted accordingly. It also assumes that outstanding common shares were increased by shares issuable upon exercise of those stock options for which market price exceeds the exercise price, less shares which could have been purchased by us with the related proceeds. In periods of losses, diluted loss per share is computed on the same basis as basic loss per share as the inclusion of any other potential shares outstanding would be anti-dilutive. The detail of the computation of basic and diluted EPS follows (shares in thousands): Basic Earnings per common share: Income from continuing operations before cumulative effect of change in accounting principle Accrued dividends on: Series C Mandatory Convertible Preferred Stock Series B Convertible Preferred Stock, net Adjusted income from continuing operations before cumulative effect of change in accounting principle Gain on sale of ContentGuard, net Cumulative effect of change in accounting principle Adjusted net income available to common shareholders Weighted average common shares outstanding Basic earnings per share: Income from continuing operations before cumulative effect of change in accounting principle Gain on sale of ContentGuard, net Cumulative effect of change in accounting principle Basic earnings per share Diluted Earnings per common share: Income from continuing operations before cumulative effect of change in accounting principle ESOP expense adjustment, net Accrued dividends on Series C Mandatory Convertible Preferred Stock Interest on Convertible Securities, net of tax Adjusted income from continuing operations before cumulative effect of change in accounting principle Gain on sale of ContentGuard, net Cumulative effect of change in accounting principle Adjusted net income available to common shareholders Weighted Average Common Shares Outstanding Common shares issuable with respect to: Stock options Series B Convertible Preferred Stock Convertible Securities Series C Mandatory Convertible Preferred Stock Adjusted Weighted Average Shares Outstanding Diluted earnings per share: Income from continuing operations before cumulative effect of change in accounting principle Gain on sale of ContentGuard, net of income taxes Cumulative effect of change in accounting principle Diluted earnings per share 80 2004 2003 2002 $ 776 $ 360 $ 154 (57) (16) 703 83 — 786 834,321 0.84 0.10 — 0.94 776 (6) — 51 821 83 — 904 $ $ $ $ $ (30) (41) 289 — — 289 $ — (73) 81 — (63) 18 769,032 731,280 0.38 — — 0.38 $ 0.11 — (0.09) $ 0.02 360 (35) (30) — 295 — — 295 $ $ 154 (73) — — 81 — (63) 18 $ $ $ $ $ 834,321 769,032 731,280 14,198 17,359 106,272 74,797 8,273 51,082 — — 5,401 70,463 — — 1,046,947 828,387 807,144 $ $ 0.78 0.08 — 0.86 $ $ 0.36 — — 0.36 $ 0.10 — (0.08) $ 0.02 The 2004, 2003 and 2002 computation of diluted earnings per share did not include the effects of 38 million, 63 million and 64 million stock options, respectively, because their respective exercise prices were greater than the corresponding market value per share of our common stock. In addition, in 2003 and 2002 the following potentially dilutive securities were not included in the computation of diluted EPS because to do so would have been anti-dilutive (in thousands of shares on weighted-average basis): Series C Mandatory Convertible Preferred Stock Liability to subsidiary trust issuing preferred securities – Trust II Convertible subordinated debentures Total 2003 2002 43,656 — 113,426 1,992 113,426 9,121 159,074 122,547 All such securities were dilutive or converted to common stock in 2004. Note 18 – Divestitures and Other Sales During the three years ended December 31, 2004, the following signiﬁcant transactions occurred: ScanSoft: In April 2004, we completed the sale of our ownership interest in ScanSoft, Inc. (“ScanSoft”) to afﬁliates of Warburg Pincus for approximately $79 in cash, net of transaction costs. Prior to the sale, we beneﬁcially owned approximately 15% of ScanSoft’s outstanding equity interests. The sale resulted in a pre-tax gain of $38. Prior to this transaction, our investment in ScanSoft was accounted for as an “available for sale” investment. The gain is classiﬁed within Other expenses, net in the accompanying Consolidated Statements of Income. ContentGuard: In March 2004, we sold all but 2 percent of our 75 percent ownership interest in ContentGuard Inc, (“ContentGuard”) to Microsoft Corporation and Time Warner Inc. for $66 in cash. The sale resulted in a pre-tax gain of $109 as our investment reﬂected the recognition of cumulative operating losses. The gain on sale has been presented within the accompanying consolidated statements of income considering the reporting requirements related to discontinued operations of SFAS No. 144, “Accounting for the Impairment or Disposal of Long- Lived Assets.” The revenues, operating results and net assets of ContentGuard were immaterial for all periods presented. ContentGuard, which was originally creat- ed out of research developed at the Xerox Palo Alto Research center (PARC), licenses intellectual property and technologies related to digital rights management. Xerox Engineering Systems: In the second quarter 2003, we sold our XES subsidiaries in France and Germany for a nominal amount and recognized a loss of $12. Nigeria: In December 2002, we sold our remaining investment in Nigeria for a nominal amount and recognized a loss of $35, primarily representing cumulative translation adjustment losses which were previously unrealized. Licensing Agreement: In September 2002, we signed a license agreement with a third party, related to a nonexclusive license for the use of certain of our existing patents. In October 2002, we received proceeds of $50 and granted the license. We have no continuing obligation or other commitments to the third party and recorded the income associated with this transaction as revenue in Service, outsourcing and rentals in the accompanying Consolidated Statement of Income. Katun Corporation: In July 2002, we sold our 22 percent investment in Katun Corporation, a supplier of aftermarket copier/printer parts and supplies, for net proceeds of $67. This sale resulted in a pre-tax gain of $12, which is included in Other expenses, net, in the accompanying Consolidated Statements of Income. After-tax, the sale was essentially break- even, as the taxable basis of Katun was lower than our carrying value on the sale date resulting in a high rate of income tax. Italy Leasing Business: In April 2002, we sold our leasing business in Italy to a company now owned by GE for $200 in cash plus the assumption of $20 of debt. This sale is part of an agreement under which GE, as successor, provides ongoing, exclusive equipment ﬁnancing to our customers in Italy. The total pre-tax loss on this transaction, which is included in Other expenses, net, in the accompanying Consolidated Statements of Income, was $27 primarily related to recognition of cumulative translation adjustment losses and ﬁnal sale contingency settlements. 81 Note 19 – Financial Statements of Subsidiary Guarantors The Senior Notes due 2009, 2010, 2011 and 2013 are jointly and severally guaranteed by Intelligent Electronics, Inc. and Xerox International Joint Marketing, Inc. (the “Guarantor Subsidiaries”), each of which is wholly-owned by Xerox Corporation (the “Parent Company”). The following supplemental ﬁnancial information sets forth, on a condensed con- solidating basis, the balance sheets, statements of income and statements of cash ﬂows for the Parent Company, the Guarantor Subsidiaries, the non- guarantor subsidiaries and total consolidated Xerox Corporation and subsidiaries as of December 31, 2004 and December 31, 2003 and for the years ended December 31, 2004, 2003 and 2002. Prudential Insurance Company Common Stock: In the ﬁrst quarter of 2002, we sold common stock of Prudential Insurance Company, associated with that company’s demutualization. In connection with this sale, we recognized a pre-tax gain of $19 that is included in Other Expenses, net, in the accompanying Consolidated Statements of Income. Flextronics Manufacturing Outsourcings: In the fourth quarter of 2001, we entered into purchase and supply agreements with Flextronics, a global electronics manufacturing services company. Under the agreements, Flextronics purchased related inventory, property and equipment. Pursuant to the purchase agreement, we sold our operations in Toronto, Canada; Aguascalientes, Mexico, Penang, Malaysia, Venray, The Netherlands and Resende, Brazil to Flextronics in a series of transactions, which were completed in 2002. In total, approximately 4,100 Xerox employees in certain of these operations transferred to Flextronics. Total proceeds from the sales in 2002 and 2001 were $167, plus the assumption of certain liabilities. Under the supply agreement, Flextronics manu- factures and supplies equipment and components, including electronic components, for the Ofﬁce seg- ment of our business. This represents approximately 50 percent of our overall worldwide manufacturing operations. The initial term of the Flextronics supply agreement is through December 2006 subject to our right to extend for two years. Thereafter it will auto- matically be renewed for one-year periods, unless either party elects to terminate the agreement. We have agreed to purchase from Flextronics most of our requirements for certain products in speciﬁed product families. We also must purchase certain electronic components from Flextronics, so long as Flextronics meets certain pricing requirements. Flextronics must acquire inventory in anticipation of meeting our fore- casted requirements and must maintain sufﬁcient manufacturing capacity to satisfy such forecasted requirements. Under certain circumstances, we may become obligated to repurchase inventory that remains unused for more than 180 days, becomes obsolete or upon termination of the supply agreement. Our remaining manufacturing operations are primarily located in Rochester, NY for our high end production products and consumables and Wilsonville, OR for consumable supplies and components for the Ofﬁce segment products. 82 Condensed Consolidating Statements of Income For the Year Ended December 31, 2004 Parent Company Guarantor Non-Guarantor Subsidiaries Subsidiaries Eliminations Revenues Sales Service, outsourcing and rentals Finance income Intercompany revenues Total Revenues Cost and Expenses Cost of sales Cost of service, outsourcing and rentals Equipment ﬁnancing interest Intercompany cost of sales Research and development expenses Selling, administrative and general expenses Restructuring and asset impairment charges Other (income) expenses, net Total Cost and Expenses Income from Continuing Operations before Income Taxes and Equity Income Income taxes Equity in net income of unconsolidated afﬁliates Equity in net income of consolidated afﬁliates Income (Loss) from Continuing Operations Gain on sale of ContentGuard, net of income taxes of $26 Net Income (Loss) $3,469 4,050 314 713 8,546 2,399 2,248 106 619 669 2,321 51 (35) 8,378 168 100 15 693 776 $ — — — — — — — — — — — — (19) (19) 19 7 — (33) (21) $4,081 3,696 713 365 8,855 2,715 2,075 332 297 127 2,088 35 424 8,093 762 229 131 — 664 Total Company $ 7,259 7,529 934 — 15,722 4,688 4,306 345 — 760 4,203 86 369 $ (291) (217) (93) (1,078) (1,679) (426) (17) (93) (916) (36) (206) — (1) (1,695) 14,757 16 4 5 (660) (643) 965 340 151 — 776 83 $ 859 — $(21) — $ 664 — $ (643) 83 $ 859 83 Condensed Consolidating Balance Sheets As of December 31, 2004 Assets Cash and cash equivalents Accounts receivable, net Billed portion of ﬁnance receivables, net Finance receivables, net Inventories Other current assets Total Current Assets Finance receivables due after one year, net Equipment on operating leases, net Land, buildings and equipment, net Investments in afﬁliates, at equity Investments in and advances to consolidated subsidiaries Intangible assets, net Goodwill Other long-term assets Total Assets Liabilities and Equity Parent Guarantor Non-Guarantor Company Subsidiaries Subsidiaries Eliminations Total Company $ 2,446 358 206 581 669 457 4,717 1,099 229 979 61 9,050 289 490 1,106 $ — — — — — — — — — — — (136) — 290 — $ 772 1,718 171 2,351 514 672 6,198 4,089 169 780 801 (165) 8 1,060 2,515 $ — — — — (40) 53 13 — — — (17) (8,749) — 8 — $ 3,218 2,076 377 2,932 1,143 1,182 10,928 5,188 398 1,759 845 — 297 1,848 3,621 $18,020 $ 154 $15,455 $(8,745) $24,884 Short-term debt and current portion of long-term debt Accounts payable Other current liabilities $ Total Current Liabilities Long-term debt Intercompany payables, net Liabilities to subsidiary trusts issuing preferred securities Other long-term liabilities Total Liabilities Series C mandatory convertible preferred stock Common shareholders’ equity 5 476 1,428 1,909 3,632 1,891 717 2,738 10,887 889 6,244 $ — — 7 7 — (239) — — (232) — 386 $ 3,069 522 760 4,351 3,418 (1,630) — 961 7,100 — 8,355 $ — 39 (6) 33 — (22) — (15) (4) — (8,741) $ 3,074 1,037 2,189 6,300 7,050 — 717 3,684 17,751 889 6,244 Total Liabilities and Equity $18,020 $ 154 $15,455 $(8,745) $24,884 Condensed Consolidating Statements of Cash Flows For the Year Ended December 31, 2004 Parent Company Guarantor Non-Guarantor Subsidiaries Subsidiaries Total Company Net cash provided by operating activities Net cash provided by investing activities Net cash provided by (used in) ﬁnancing activities Effect of exchange rate changes on cash and cash equivalents Increase (decrease) in cash and cash equivalents Cash and cash equivalents at beginning of period $ $ 1,122 72 153 (2) 1,345 1,101 Cash and cash equivalents at end of period $ 2,446 $ — — — — — — — $ 628 131 (1,446) 83 (604) 1,376 $ 1,750 203 (1,293) 81 741 2,477 $ 772 $ 3,218 84 Condensed Consolidating Statements of Income For the Year Ended December 31, 2003 Parent Company Guarantor Non-Guarantor Subsidiaries Subsidiaries Eliminations Revenues Sales Service, outsourcing and rentals Finance income Intercompany revenues Total Revenues Cost and Expenses Cost of sales Cost of service, outsourcing and rentals Equipment ﬁnancing interest Intercompany cost of sales Research and development expenses Selling, administrative and general expenses Restructuring and asset impairment charges Gain on afﬁliate’s sale of stock Other expenses (income), net Total Cost and Expenses (Loss) Income before Income Taxes (Beneﬁts) and Equity Income Income taxes (beneﬁts) Equity in net income of unconsolidated afﬁliates Equity in net income of consolidated afﬁliates $3,326 4,257 337 535 8,455 2,155 2,314 88 473 765 2,485 105 (13) 517 8,889 (434) (108) — 686 $ — — – – — — — – – — — – – (18) (18) 18 7 — (28) $3,704 3,680 750 427 8,561 2,487 2,019 364 342 116 1,955 71 — 371 7,725 836 224 61 — Total Company $ 6,970 7,734 997 — 15,701 4,436 4,311 362 — 868 4,249 176 (13) 876 $ (60) (203) (90) (962) (1,315) (206) (22) (90) (815) (13) (191) — — 6 (1,331) 15,265 16 11 (3) (658) 436 134 58 — Net Income (Loss) $ 360 $ (17) $ 673 $ (656) $ 360 85 Condensed Consolidating Balance Sheets As of December 31, 2003 Assets Cash and cash equivalents Accounts receivable, net Billed portion of ﬁnance receivables, net Finance receivables, net Inventories Other current assets Total Current Assets Finance receivables due after one year, net Equipment on operating leases, net Land, buildings and equipment, net Investments in afﬁliates, at equity Investments in and advances to consolidated subsidiaries Intangible assets, net Goodwill Other long-term assets Total Assets Liabilities and Equity Parent Guarantor Non-Guarantor Company Subsidiaries Subsidiaries Eliminations Total Company $ 1,101 717 270 454 669 466 3,677 834 212 1,024 73 7,849 325 491 1,611 $ — — — — — — — — — — — (64) — 296 — $ 1,376 1,442 191 2,527 520 639 6,695 4,537 176 803 571 192 – 935 2,392 $ — — — — (37) — (37) — (24) — — (7,977) — — — $ 2,477 2,159 461 2,981 1,152 1,105 10,335 5,371 364 1,827 644 — 325 1,722 4,003 $16,096 $ 232 $16,301 $(8,038) $24,591 Short-term debt and current portion of long-term debt Accounts payable Other current liabilities $ Total Current Liabilities Long-term debt Intercompany payables, net Liabilities to subsidiary trusts issuing preferred securities Other long-term liabilities Total Liabilities Series B convertible preferred stock Series C mandatory convertible preferred stock Common shareholders’ equity 588 517 968 2,073 2,840 3,042 743 2,719 11,417 499 889 3,291 $ — — 13 13 — (188) — — (175) — — 407 $ 3,648 493 1,431 5,572 4,090 (2,869) 1,066 684 8,543 — — 7,758 $ — — 11 11 — 15 — 101 127 — — (8,165) $ 4,236 1,010 2,423 7,669 6,930 — 1,809 3,504 19,912 499 889 3,291 Total Liabilities and Equity $16,096 $ 232 $16,301 $(8,038) $24,591 Condensed Consolidating Statements of Cash Flows For the Year Ended December 31, 2003 Parent Company Guarantor Non-Guarantor Subsidiaries Subsidiaries Total Company Net cash provided by (used in) operating activities Net cash (used in) provided by investing activities Net cash (used in) provided by ﬁnancing activities Effect of exchange rate changes on cash and cash equivalents (Decrease) increase in cash and cash equivalents Cash and cash equivalents at beginning of period $ $ 2,673 (475) (2,769) — (571) 1,672 Cash and cash equivalents at end of period $ 1,101 $ — — — — — — — $ (794) 524 299 132 161 1,215 $1,376 $ 1,879 49 (2,470) 132 (410) 2,887 $ 2,477 86 Condensed Consolidating Statements of Income For the Year Ended December 31, 2002 Parent Guarantor Non-Guarantor Company Subsidiaries Subsidiaries Eliminations Revenues Sales Service, outsourcing and rentals Finance income Intercompany revenues Total Revenues Cost and Expenses Cost of sales Cost of service, outsourcing and rentals Equipment ﬁnancing interest Intercompany cost of sales Research and development expenses Selling, administrative and general expenses Restructuring and asset impairment charges Other expenses (income), net Total Cost and Expenses (Loss) Income before Income Taxes (Beneﬁts), Equity Income and Cumulative Effect of Change in Accounting Principle Income taxes (beneﬁts) Equity in net income of unconsolidated afﬁliates Equity in net income of consolidated afﬁliates Income (Loss) before Cumulative Effect of Change in Accounting Principle Cumulative effect of change in accounting principle Net Income (Loss) $3,396 4,589 294 327 8,606 2,055 2,471 119 294 804 2,607 95 255 8,700 (94) (17) (6) 237 154 (63) $ 91 $ — — — — — — — — — — — — (25) (25) 25 10 — (18) (3) — $ (3) Total Company $ 6,752 8,097 1,000 — 15,849 4,233 4,494 401 — 917 4,437 670 593 $ (71) (149) (100) (840) (1,160) (225) (23) (100) (676) (12) (140) — 3 (1,173) 15,745 13 6 (5) (219) (217) 62 104 4 54 — 154 (63) $ 3,427 3,657 806 513 8,403 2,403 2,046 382 382 125 1,970 575 360 8,243 160 5 65 — 220 (62) $ 158 $ (155) $ 91 Condensed Consolidating Statements of Cash Flows For the Year Ended December 31, 2002 Net cash provided by (used in) operating activities Net cash (used in) provided by investing activities Net cash used in ﬁnancing activities Effect of exchange rate changes on cash and cash equivalents Decrease in cash and cash equivalents Cash and cash equivalents at beginning of period Cash and cash equivalents at end of period Parent Company Guarantor Non-Guarantor Subsidiaries Subsidiaries Total Company $ 2,812 (1,718) (1,836) — (742) 2,414 $ 1,672 $ 4 (1) (3) — — — $ — $ (836) 1,812 (1,453) 116 (361) 1,576 $ 1,215 $ 1,980 93 (3,292) 116 (1,103) 3,990 $ 2,887 87 Note 20 – Subsequent Event In February 2005, we entered into an agreement to sell our entire ownership interest in Integic Corporation (“Integic”) for which we will receive an estimated $96 in cash at closing. The sale, which we expect to close in the ﬁrst half of 2005, is expected to result in a pre- tax gain of approximately $92 ($57 after-tax). These amounts, however, are subject to change based on ﬁnal closing adjustments, which are not expected to be material. Our investment in Integic is currently accounted for on the equity method and is included in Investments in afﬁliates, at equity in our consolidated balance sheets. Integic is an information technology provider specializing in enterprise health and business process management solutions. 88 Reports of Management Management’s Responsibility for Financial Statements Management’s Report on Internal Control Over Financial Reporting Our management is responsible for the integrity and objectivity of all information presented in this annual report. The consolidated ﬁnancial statements were prepared in conformity with accounting principles generally accepted in the United States of America and include amounts based on management’s best estimates and judgments. Management believes the consolidated ﬁnancial statements fairly reﬂect the form and substance of transactions and that the ﬁnancial statements fairly represent the Company’s ﬁnancial position and results of operations. The Audit Committee of the Board of Directors, which is composed solely of independent directors, meets regularly with the independent auditors, PricewaterhouseCoopers LLP, the internal auditors and representatives of management to review accounting, ﬁnancial reporting, internal control and audit matters, as well as the nature and extent of the audit effort. The Audit Committee is responsible for the engagement of the independent auditors. The independent auditors and internal auditors have free access to the Audit Committee. Our management is responsible for establishing and maintaining adequate internal control over ﬁnancial reporting, as such term is deﬁned in the rules promul- gated under the Securities Exchange Act of 1934. Under the supervision and with the participation of our management, including our principal executive, ﬁnancial and accounting ofﬁcers, we have conducted an evaluation of the effectiveness of our internal con- trol over ﬁnancial reporting based on the framework in “Internal Control-Integrated Framework” issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on the above evaluation, our management has concluded that, as of December 31, 2004, we did not have any material weaknesses in our internal control over ﬁnancial reporting and our internal control over ﬁnancial reporting was effective. Our management’s assessment of the effectiveness of our internal control over ﬁnancial reporting as of December 31, 2004 has been audited by PricewaterhouseCoopers LLP, an independent registered public accounting ﬁrm (independent auditors), as stated in their report which is included herein. Anne M. Mulcahy Chief Executive Ofﬁcer Lawrence A. Zimmerman Chief Financial Ofﬁcer Gary R. Kabureck Chief Accounting Ofﬁcer 89 Report of Independent Registered Public Accounting Firm To the Board of Directors and Shareholders of Xerox Corporation: We have completed an integrated audit of Xerox Corporation’s 2004 consolidated ﬁnancial statements and of its internal control over ﬁnancial reporting as of December 31, 2004 and audits of its 2003 and 2002 consolidated ﬁnancial statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Our opinions, based on our audits, are presented below. Consolidated ﬁnancial statements In our opinion, the accompanying consolidated balance sheets and the related consolidated statements of income, cash ﬂows and common shareholders’ equity present fairly, in all material respects, the ﬁnancial position of Xerox Corporation and its subsidiaries at December 31, 2004 and 2003, and the results of their operations and their cash ﬂows for each of the three years in the period ended December 31, 2004 in con- formity with accounting principles generally accepted in the United States of America. These ﬁnancial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these ﬁnancial statements based on our audits. We conducted our audits of these statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the ﬁnancial statements are free of material misstatement. An audit of ﬁnancial statements includes examining, on a test basis, evidence supporting the amounts and disclosures in the ﬁnancial statements, assessing the accounting principles used and signiﬁcant estimates made by management, and evaluating the overall ﬁnancial statement presentation. We believe that our audits provide a reasonable basis for our opinion. As discussed in Note 1, the Company adopted the provisions of Statement of Financial Accounting Standards No. 142, “Goodwill and Other Intangible Assets” on January 1, 2002. 90 Internal control over ﬁnancial reporting Also, in our opinion, management’s assessment, included in the accompanying Management’s Report on Internal Control Over Financial Reporting, that the Company maintained effective internal control over ﬁnancial reporting as of December 31, 2004 based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”), is fairly stated, in all material respects, based on those criteria. Furthermore, in our opinion, the Company maintained, in all material respects, effective internal control over ﬁnancial reporting as of December 31, 2004, based on criteria established in Internal Control- Integrated Framework issued by the COSO. The Company’s management is responsible for maintain- ing effective internal control over ﬁnancial reporting and for its assessment of the effectiveness of internal control over ﬁnancial reporting. Our responsibility is to express opinions on management’s assessment and on the effectiveness of the Company’s internal control over ﬁnancial reporting based on our audit. We con- ducted our audit of internal control over ﬁnancial reporting in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over ﬁnancial reporting was maintained in all material respects. An audit of internal control over ﬁnancial reporting includes obtaining an understanding of internal con- trol over ﬁnancial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we consider necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinions. A company’s internal control over ﬁnancial reporting is a process designed to provide reasonable assurance regarding the reliability of ﬁnancial report- ing and the preparation of ﬁnancial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over ﬁnancial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reﬂect the transactions and dispositions of the assets of the company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of ﬁnancial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the ﬁnancial statements. Because of its inherent limitations, internal control over ﬁnancial reporting may not prevent or detect misstatements. Also, projections of any evalua- tion of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. PricewaterhouseCoopers LLP Stamford, Connecticut February 21, 2005 91 Quarterly Results of Operations (Unaudited) (in millions, except per-share data) 2004 Revenues Costs and Expenses(1) Income from Continuing Operations before Income Taxes and Equity Income Income taxes Equity in net income of unconsolidated afﬁliates (2) Gain on sale of ContentGuard, net Net Income Basic Earnings per Share(3) Diluted Earnings per Share(3) 2003 Revenues Costs and Expenses(1) (Loss) Income before Income Taxes (Beneﬁts) and Equity Income Income taxes (beneﬁts) Equity in net income of unconsolidated afﬁliates Net (Loss) Income Basic (Loss) Earnings per Share(3) Diluted (Loss) Earnings per Share(3) First Quarter Second Quarter Third Quarter Fourth Quarter $3,827 3,625 202 67 30 83 $ 248 $ 0.28 $ 0.25 $3,757 3,903 (146) (67) 14 $ (65) $ (0.10) $ (0.10) $3,853 3,581 272 91 27 — $ 208 $ 0.23 $ 0.21 $3,920 3,810 110 40 16 $ 86 $ 0.10 $ 0.09 $3,716 3,553 163 62 62 — $ 163 $ 0.18 $ 0.17 $3,732 3,590 142 38 13 $ 117 $ 0.12 $ 0.11 $4,326 3,998 328 120 32 — $ 240 $ 0.26 $ 0.24 $4,292 3,962 330 123 15 $ 222 $ 0.25 $ 0.22 Full Year $15,722 14,757 965 340 151 83 $ 859 $ 0.94 $ 0.86 $15,701 15,265 436 134 58 $ 360 $ 0.38 $ 0.36 (1) Costs and expenses include restructuring and asset impairment charges of $6, $33, $23 and $24 for the ﬁrst, second, third and fourth quarters of 2004, respectively, and $8, $37, $11 and $120 for the ﬁrst, second, third and fourth quarters of 2003, respectively. Costs and expenses include a gain of $38 from the sale of our investment in ScanSoft in the second quarter of 2004. Cost and expenses include a provision relating to the Berger v. Retirement Income Guarantee Plan (RIGP) litigation of $300 and $(61) in the ﬁrst quarter and fourth quarter of 2003, respectively. Cost and expenses include a $73 loss on early extinguishment of debt in the second quarter 2003. (2) Equity in net income of unconsolidated afﬁliates for the third quarter 2004 includes an after-tax $38 pension settlement beneﬁt from Fuji Xerox. (3) The sum of quarterly (loss) earnings per share may differ from the full-year amounts due to rounding, or in the case of diluted earnings per share, because securities that are anti-dilutive in certain quarters may not be anti-dilutive on a full-year basis. 92 Five Years in Review (Dollars in millions, except per-share data) 2004 2003 2002 2001(2) 2000 Per-Share Data(1) Income (Loss) from continuing operations before cumulative effect of change in accounting principle Basic Diluted Earnings (Loss) Basic Diluted Common stock dividends Operations Revenues Sales Service, outsourcing, and rentals Finance Income Research and development expenses Selling, administrative and general expenses Income (Loss) from continuing operations before cumulative effect of change in accounting principle Net income (loss)(1) Financial Position Cash and cash equivalents Accounts and ﬁnance receivables, net Inventories Equipment on operating leases, net Land, buildings and equipment, net Investment in discontinued operations Total assets Consolidated capitalization Short-term debt and current portion of long-term debt Long-term debt Total debt Minorities’ interests in equity of subsidiaries Obligation for equity put options Liabilities to subsidiary trusts issuing preferred securities Series B convertible preferred stock Series C mandatory convertible preferred stock Common shareholders’ equity $ 0.84 0.78 $ 0.94 0.86 — $15,722 7,259 7,529 934 760 4,203 776 859 $ 3,218 10,573 1,143 398 1,759 440 24,884 3,074 7,050 10,124 80 — 717 — 889 6,244 $ $ 0.38 0.36 0.38 0.36 — $15,701 6,970 7,734 997 868 4,249 360 360 $ 2,477 10,972 1,152 364 1,827 449 24,591 4,236 6,930 11,166 102 — 1,809 499 889 3,291 $ $ 0.11 0.10 0.02 0.02 — $15,849 6,752 8,097 1,000 917 4,437 154 91 $ 2,887 11,077 1,231 450 1,757 728 25,550 4,377 9,794 14,171 73 — 1,793 508 — 1,893 $ (0.15) (0.15) $ (0.15) (0.15) 0.05 $17,008 7,443 8,436 1,129 997 4,728 (92) (94) $ 3,990 11,574 1,364 804 1,999 749 27,746 6,637 10,107 16,744 73 — 1,787 470 — 1,797 $ (0.48) (0.48) $ (0.48) (0.48) 0.65 $18,751 8,839 8,750 1,162 1,064 5,518 (273) (273) $ 1,750 13,067 1,983 1,266 2,527 534 28,291 3,080 15,557 18,637 87 32 721 426 — 1,801 Total capitalization $18,054 $17,756 $18,438 $20,871 $21,704 Selected Data and Ratios Common shareholders of record at year-end Book value per common share Year-end common stock market price Employees at year-end Gross margin Sales gross margin Service, outsourcing, and rentals gross margin Finance gross margin Working capital Current ratio Cost of additions to land, buildings and equipment Depreciation on buildings and equipment 55,152 $ 6.53 $ 17.01 58,100 40.6% 35.4% 42.8% 63.1% $ 4,628 1.7 204 305 $ $ 56,326 $ 4.15 $ 13.80 61,100 42.0% 36.4% 44.3% 63.7% $ 2,666 1.4 197 299 $ $ $ $ 57,300 2.56 8.05 67,800 42.4% 37.3% 44.5% 59.9% $ 3,242 1.4 146 341 $ $ 59,830 $ 2.49 $ 10.42 78,900 38.2% 30.5% 42.2% 59.5% $ 2,340 1.2 219 402 $ $ 59,879 $ 2.68 $ 4.63 91,500 37.4% 31.2% 41.1% 57.1% $ 4,928 1.8 452 417 $ $ (1) Net income (loss), as well as Basic and Diluted Earnings per Share for the years ended December 31, 2004, 2003 and 2002 exclude the effect of amortization of goodwill in accordance with the adoption of Statement of Financial Accounting Standards No. 142 “Goodwill and Other Intangible Assets.” Amortization expense, net, related to Goodwill was $59 and $58, in 2001 and 2000, respectively. (2) In March 2001, we sold half of our ownership interest in Fuji Xerox to Fuji Photo Film Co. Ltd. for $1.3 billion in cash. In connection with the sale, we recorded a pre-tax gain of $773. As a result, our ownership percentage decreased from 50 percent to 25 percent. 93 Ofﬁcers Anne M. Mulcahy Chairman and Chief Executive Ofﬁcer Ursula M. Burns Senior Vice President President, Business Group Operations Thomas J. Dolan Senior Vice President President, Xerox Global Services James A. Firestone Senior Vice President President, Xerox North America Hervé J. Gallaire Senior Vice President President, Xerox Innovation Group and Chief Technology Ofﬁcer Michael C. Mac Donald Senior Vice President President, Global Accounts and Marketing Operations Wim T. Appelo Vice President Paper, Supplies and Supply Chain Operations Business Group Operations Harry R. Beeth Vice President and Controller Guilherme M.N. Bettencourt Vice President Chairman, Xerox Comercio e Indústria (Brazil) Developing Markets Operations Michael D. Brannigan Vice President President, North American Solutions Group Xerox North America Richard F. Cerrone Vice President Small and Medium Business Task Force Business Group Operations Jean-Noel Machon Senior Vice President President, Developing Markets Operations M. Stephen Cronin Vice President Chief of Staff, Developing Markets Operations Hector J. Motroni Senior Vice President Chief Staff Ofﬁcer and Chief Ethics Ofﬁcer Brian E. Stern Senior Vice President President, Fuji Xerox Operational Support Corporate Strategy and Alliances Lawrence A. Zimmerman Senior Vice President and Chief Financial Ofﬁcer Quincy L. Allen Vice President President, Production Systems Group Patricia A. Cusick Vice President and Chief Information Ofﬁcer Business Group Operations Kathleen S. Fanning Vice President Worldwide Taxes J. Michael Farren Vice President External and Legal Affairs, General Counsel and Corporate Secretary Anthony M. Federico Vice President Platform Development Unit, Production Systems Group Business Group Operations Emerson U. Fullwood Vice President Chief of Staff and Marketing Xerox North America D. Cameron Hyde Vice President General Manager North American Agent Operations Xerox North America Gary R. Kabureck Vice President and Chief Accounting Ofﬁcer James H. Lesko Vice President Investor Relations John E. McDermott Vice President Corporate Strategy and Alliances Ivy Thomas McKinney Vice President and Deputy General Counsel Patricia M. Nazemetz Vice President Human Resources Russell Y. Okasako Vice President Taxes Rhonda L. Seegal Vice President and Treasurer Leslie F. Varon Vice President Finance and Operational Support Xerox North America Tim Williams Vice President President Xerox Ofﬁce Group Business Group Operations Armando Zagalo de Lima Vice President President, Xerox Europe 94 1 Member of the Audit Committee 2 Member of the Compensation Committee 3 Member of the Corporate Governance Committee 4 Member of the Finance Committee N. J. Nicholas, Jr. 1, 4 Investor New York, New York John E. Pepper 1, 2 Vice President Finance and Administration Yale University New Haven, Connecticut Retired Chairman and Chief Executive Ofﬁcer The Procter & Gamble Company Cincinnati, Ohio Ann N. Reese 4 Executive Director Center for Adoption Policy Rye, New York Stephen Robert 4 Chancellor, Brown University Chairman Robert Capital Management LLC New York, New York Directors Glenn A. Britt 3 Chairman and Chief Executive Ofﬁcer Time Warner Cable Stamford, Connecticut Richard J. Harrington 1 President and Chief Executive Ofﬁcer The Thomson Corporation Stamford, Connecticut William Curt Hunter 1 Dean and Distinguished Professor of Finance University of Connecticut School of Business Storrs, Connecticut Vernon E. Jordan, Jr. 3, 4 Senior Managing Director Lazard Freres & Co., LLC New York, New York Of Counsel Akin, Gump, Strauss, Hauer & Feld, LLP Attorneys-at-Law, Washington, DC Hilmar Kopper 2, 4 Former Chairman and Chief Executive Ofﬁcer Deutsche Bank AG Frankfurt, Germany Ralph S. Larsen 2, 3 Former Chairman and Chief Executive Ofﬁcer Johnson & Johnson New Brunswick, New Jersey Anne M. Mulcahy Chairman and Chief Executive Ofﬁcer Xerox Corporation Stamford, Connecticut 95 How to Reach Us Xerox Corporation 800 Long Ridge Road P.O. Box 1600 Stamford, CT 06904 203 968-3000 Fuji Xerox Co., Ltd. 2-17-22 Akasaka Minato-ku, Tokyo 107 Japan 81 3 3585-3211 Xerox Europe Riverview Oxford Road Uxbridge Middlesex United Kingdom UB8 1HS 44 1895 251133 Products, Services and Support www.xerox.com or by phone: 800 ASK-XEROX (800 275-9376) Additional Information The Xerox Foundation and Community Involvement Program: 203 968-3333 Diversity programs and EEO-1 reports: 585 423-6157 www.xerox.com/diversity Minority and Women-Owned Business Suppliers: 585 422-2295 www.xerox.com/supplierdiversity Ethics Helpline: 866 XRX-0001 email: ethics@xerox.com Environment, Health and Safety Progress Report: 800 828-6571 prompts 1, 3 www.xerox.com/ehs/progressreport Governance: www.xerox.com/investor (Corporate Governance) Questions from Students and Educators: email: Nancy.Dempsey@xerox.com Xerox Innovation: www.xerox.com/innovation Independent Auditors: PricewaterhouseCoopers LLP 300 Atlantic Street Stamford, CT 06901 203 539-3000 Thank you to our customers, and their customers, who participated in this report: Brooklyn Public Library, Borgata Hotel Casino and Spa, Cingular Wireless, Mel Foster Co., Sun Microsystems, and Vestcom International. All of us at Xerox deeply appreciate our relationships and look forward to making them even stronger. © 2005 Xerox Corporation. All rights reserved. XEROX®, CopyCentre®, DocuPrint®, DocuShare®, DocuTech®, iGen3®, New Business of Printing®, Phaser®, WorkCentre®, Xerox Nuvera 2101, and 6060 are trademarks of Xerox Corporation in the U.S. and/or other countries. DocuColor® is used under license. Design: Arnold Saks Associates 96 Shareholder Information For Investor Information, including comprehensive earnings releases: www.xerox.com/investor Earnings releases also available by mail: 800 828-6396 For shareholder services, call 800 828-6396 (TDD: 800 368-0328) or 781 575-3222, or write to EquiServe Trust Company, N.A., P.O. Box 43010, Providence, RI 02940-3010 or use email available at www.equiserve.com. Annual Meeting Thursday, May 19, 2005 10:00 a.m. EDT Hilton Hartford Hotel 315 Trumbull Street Hartford, Connecticut Proxy material mailed by April 11, 2005, to shareholders of record March 24, 2005. Investment professionals may contact: Darlene Caldarelli, Manager, Investor Relations Darlene.Caldarelli@xerox.com Ann Pettrone, Manager, Investor Relations Ann Pettrone@xerox.com Xerox Common Stock Prices and Dividends New York Stock Exchange composite prices 2004 High Low 2003 High Low First Quarter $15.30 13.39 First Quarter $9.45 8.05 Second Quarter $14.96 12.66 Second Quarter $11.57 8.66 Third Quarter $14.37 12.99 Third Quarter $11.49 9.54 Fourth Quarter $17.12 14.14 Fourth Quarter $13.80 10.17 At its July 9, 2001 meeting, the Company’s Board of Directors eliminated the dividend on the common stock. Stock Listed and Traded Xerox common stock (XRX) is listed on the New York Stock Exchange and the Chicago Stock Exchange. It is also traded on the Boston, Cincinnati, Paciﬁc Coast, Philadelphia, London and Switzerland exchanges. We have ﬁled with the SEC the certiﬁcation required by Section 302 of the Sarbanes-Oxley Act as an exhibit to our 2004 Annual Report on Form 10-K, and have submitted to the NYSE in 2004 the CEO certiﬁcation required by the NYSE corporate governance rules. 2004 was another year of continued progress, excellent execution and accelerating marketplace momentum for Xerox. Financial Highlights ($ in millions, except EPS) Equipment Sales Post Sale, Finance Income and Other Revenue Total Revenue 2004 2003 $ 4,480 $ 4,250 11,242 15,722 11,451 15,701 3,267 Total Color Revenue (included in total revenues) 3,903 Total Costs and Expenses 14,757 15,265 Net Income Diluted Earnings per Share Cash Flows from Operating Activities Cash and Cash Equivalents 859 0.86 1,750 3,218 360 0.36 1,879 2,477 Debt 10,124 11,166 01 Letter to Shareholders 05 Delivering Solutions 17 Financial Review 96 Corporate Information IBC Social Responsibility It’s Good Business “We all believe that we are “We all believe that we are part of an on going part of an on going experiment to demonstrate experiment to demonstrate that business success that business success and social responsibility and social responsibility are not mutually exclusive. are not mutually exclusive. In fact, we believe they In fact, we believe they are synergistic.” are synergistic.” Xerox Chairman and CEO Xerox Chairman and CEO Anne Mulcahy at the Business for Anne Mulcahy at the Business for Social Responsibility Conference, Social Responsibility Conference, Nov. 11, 2004 Nov. 11, 2004 Social Responsibility From environmental and diversity programs to community outreach and corporate governance, Xerox continues to be recognized as a leader in all aspects of corporate social responsibility. Some highlights: • The Xerox Foundation invested $12.3 million in 2004. Among its contributions: 40 grants to university science programs, scholarship programs at 140 colleges and universities, and grants to about 400 nonproﬁt organizations. • To ensure Xerox paper is sourced from sustainably managed forests, Xerox deployed a stringent set of requirements to its paper suppliers, obtaining commitments from suppliers that provide more than 90 percent of Xerox paper. • Xerox’s 11-member board is 91 percent independent, following a tough 1 percent independence standard. • In 2004, Xerox spent about $344 million through its supplier diversity program. • FORTUNE, DiversityInc, the Human Rights Campaign, the Toronto Globe and Mail, Exame magazine in Brazil, and several other entities recognized the Xerox workplace as being among the best. • FORTUNE’s 2005 “Global Most Admired Companies” survey ranked Xerox No. 2 in its industry, including a No. 1 rating for “social responsibility.” Business Ethics magazine’s 2005 list of “100 Best Corporate Citizens” ranked Xerox No. 10 among U.S. corporations. • The company diverted more than 160 million pounds of waste from landﬁlls last year and saved Xerox several hundred million dollars through remanufacturing and parts reuse. • Xerox encourages employees to volunteer in their communities through programs like Social Service Leave, which offers paid sabbaticals for community service; the Community Involvement Program, which provides seed money for Xerox teams to fund community projects; and the Science Consultant Program through which employees like Lou Bostic, pictured right, bring real-life science experiments into the classroom. Smarter. Simpler. Personal. Colorful. Smarter. Simpler. Personal. Colorful. X e r o x A n n u a l R e p o r t 2 0 0 4 Xerox Corporation 800 Long Ridge Road PO Box 1600 Stamford, CT 06904 www.xerox.com 2980-AR-04 Annual Report 2004 Annual Report 2004

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