Xerox Holdings Corporation Annual Report 2004

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FY2004 Annual Report · Xerox Holdings Corporation

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Smarter. Simpler. Personal. Colorful.
Smarter. Simpler. Personal. Colorful.

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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

Letter to

Shareholders

Delivering

Solutions

Financial

Review

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.

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

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’

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

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.

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)

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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.

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

(273)

(94)

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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

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.

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.

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.

s i n

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

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.

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.

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

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.

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

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.

Delivering

Results…

Financial Review

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

Notes to the

Consolidated

Financial

Statements

Reports of

Report of

Management

Independent

Quarterly

Results of

Operations

Five Years

in Review

Ofﬁcers

Directors

Registered

Public

Accounting

Firm

Corporate

Information

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.

($ 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,

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

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.

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

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.

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

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

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

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

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

6
38

(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

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.

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

(1,293)

(2,470)

(3,292)

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

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

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

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.

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

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.

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-

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.

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.

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

$ 0.11

0.02

$ 0.78

$ 0.86

$ 0.36

$ 0.10

$ 0.02

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.

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.

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)

741
2,477

(197)
10
(53)
35
—
254
–

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)

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

$738

$2,001

9,530
46,000

9
46

41
405

Other

Balance at December 31, 2003

793,884

$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

(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.

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:

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

210

305

134

350

111

36
224

271

299

143

364

108

99
353

115

408

341

249

168

120

(16)

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

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

—

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:

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-

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

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

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.

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

(69)

(85)

(83)

$ 790

$0.94
0.86
$0.86
0.80

$ 275

$ 0.38
0.27
$ 0.36
0.25

$ 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

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.

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

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.

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

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

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.

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

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

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)

(6)

(1)

$(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.

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

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.

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

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.

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) $

(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

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.

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

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

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.

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

897
(1,092)
4
242

(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

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.

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%

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.

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%

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.

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

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%

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

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

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

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

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

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

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.

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

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.

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.

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

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

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)

769,032

731,280

0.38
—
—

0.38

0.11
—
(0.09)

0.02

360
(35)
(30)
—

295
—
—

295

154
(73)
—
—

81
—
(63)

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.

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.

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

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

—
—
—
(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

—
(239)
—
—

(232)

—
386

$ 3,069
522
760

4,351

3,418
(1,630)
—
961

7,100

—
8,355

—
39
(6)

—
(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)

(604)
1,376

$ 1,750
203
(1,293)

741
2,477

772

$ 3,218

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

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

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

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

—
(188)
—
—

(175)

—
—
407

$ 3,648
493
1,431

5,572

4,090
(2,869)
1,066
684

8,543

—
—
7,758

—
—
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

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

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)

$ —
—
—
—

—

—
—
—
—
—
—
—
(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)

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

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.

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

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.

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

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)

$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.

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.

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

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

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

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

Letter to

Shareholders

Delivering

Solutions

Financial

Review

Corporate

Information

IBC

Social

Responsibility

It’s Good

Business

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

• 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

• 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

Smarter. Simpler. Personal. Colorful.
Smarter. Simpler. Personal. Colorful.

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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