Xerox Holdings Corporation

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20

06

Documenting any communication
used to mean committing it to
paper, getting it down in black
and white. Now communication 
is generally scanned, sent,
searched, archived, merged, 
personalized – often in color. It
can move back and forth, many
times, from physical to digital.
So when we say our mission 
is to help people be smarter
about their documents, it really
means giving them a range of
tools and techniques to capture,
organize, facilitate and enhance
how they communicate. In any
form. To an audience of one 
or many millions.

01
Financial Overview

02
Chairman’s Letter

08
Citizenship

09
Customer Features

12
Board of Directors

15
Description of Business

26
Management’s
Discussion and Analysis 
of Results of Operations 
and Financial Condition

Inside Back Cover
Corporate Information 
and Officers

0

06

Financial Overview ($ millions, except EPS)

Total Revenue

Equipment Sales

Post Sale, Finance Income and Other Revenue

Net Income

Diluted Earnings Per Share

Net Cash Provided by Operating Activities

2006

2005

$ 15,895

$ 15,701

4,457

4,519

11,438

11,182

1,210

1.22

1,617

978

0.94

1,420

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C H A I R M A N ’ S L E T T E R

“I am pleased to report that 2006 was another
year of good progress for Xerox. The strategic
investments we made several years ago 
are paying off and we are confident in our 
continued ability to give you good returns on
the trust you have placed in us.”

Our progress in 2006 provided more 
evidence that we are on track and that 
we are building momentum.

Our results

In 2006, our financial results included:

• Net income of $1.2 billion or earnings 
per share of $1.22, compared to EPS 
of 94 cents for full-year 2005.

• Adjusted EPS of $1.05, an increase of 
17 percent from full-year 2005 adjusted
EPS of 90 cents.*

• Total revenue of $15.9 billion, an 

increase of 1 percent or $194 million 
from full-year 2005.

• Operating cash flow of $1.6 billion.

• Year-end cash and short-term investments

balance of $1.5 billion.

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We met our full-year expectations on earnings growth and cash generation, increased 
post-sale revenue and strengthened our industry-leading portfolio of products and 
services. We purchased two well-performing companies – XMPie® and Amici – that are 
contributing revenue growth and helping us build value for our customers. We managed 
our operations efficiently, giving us the flexibility to compete effectively while generating 
strong bottom-line results.

We returned to investment grade and bought back $1.1 billion of Xerox shares in 2006. 
We’ve committed $2.5 billion to share repurchase since the program launched in October 
2005. Our healthy cash position allows us to deliver value for shareholders by buying back 
stock and investing in growth through acquisitions, innovation and a services-led approach 
to winning in the marketplace. In fact, Xerox stock appreciated 16 percent in 2006. It was 
a good year and we have every reason to believe we are on our way to a better one.

Our growth strategy

While we’re proud of our accomplishments, what gives me the greatest pride in our 
leadership team is that we’re not satisfied. Hubris is not a part of our vocabulary. Good 
enough is simply not good enough for Xerox. We’re keenly aware that the last frontier we 
need to tame is accelerating revenue growth. There are several reasons to believe this is 
within our reach.

While we’re justifiably known for our technology, we’re running an annuity-based business 
that generates more than 70 percent of revenue from what we call “post sale.” This is the 
sale of supplies – like ink and toner – and technical services that are needed to support 
our products, as well as revenue from financing our customers’ purchases. It also includes 
consulting and outsourcing services such as document imaging and archiving, managing 
our customers’ print shops, simplifying their work processes and much more.

Last year was a turning point in growing our post-sale revenue – up 2 percent for the 
year – as the annuity from our digital, color and services businesses helped to offset 
losses from our older light lens business. This positive trend is expected to continue; 
in fact, we expect it will accelerate as light lens becomes less and less of the total and 
the annuity from our strong growth markets kicks in.

We have four planks in our growth strategy. Each builds on our core competencies. 
Each responds to customer need with customer value. Each is designed to fuel our 
annuity stream through long-term contracts. And each is yielding good results. Here’s 
a snapshot of how we’re doing in each of our four growth strategies.

The first is to lead in color. We’ve been investing heavily in leading with the transition 
to color in the office and in expanding our leadership position in the production market. 
Last year we brought eight new color products to market, strengthening what was already 
the broadest and deepest set of technologies in our industry. We’ve already announced 
five more color products this year and we’re just getting started. The competition doesn’t 
stand still and neither do we.

The power of color is in the pages. Color pages generate significantly more revenue and 
profit than black-and-white pages. We’re already seeing this benefit flow through to our 
annuity. Post-sale revenue from color was up 16 percent in 2006. Much of that is due 
to the 38 percent increase in color pages. More than 30 billion color pages were printed 
on Xerox color systems last year; that’s close to double what we were doing two years ago.

Color now represents nine percent of total Xerox pages. As that percentage grows, so too 
will our all important post-sale revenue stream. It’s a great business model and it’s working.

* See Page 7 for the reconciliation of the difference between this financial measure that is not in compliance with

Generally Accepted Accounting Principles (GAAP) and the most directly comparable financial measure calculated 
in accordance with GAAP.

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C H A I R M A N ’ S L E T T E R

Our second strategic platform for growth is what we call the New Business of Printing.®
It’s a market where Xerox is competitively advantaged. Our customers in this space are 
typically commercial printers, marketing and graphic arts companies and large enterprises.
They depend on digital printing to print on demand, produce short runs of books, personalize
documents as they come off the press and leverage the power of our digital technology in a
myriad of other ways. Our digital presses, sophisticated workflow capabilities and expanding
set of solutions and applications help our customers grow their businesses.

New products helped drive a 74 percent increase in installs of Xerox’s production color 
publishing systems and printers – that’s actual placements in a customer’s workplace. 
We closely track install data as an indicator of what’s to come in post-sale revenue. The
more color products we sell, the more pages printed on Xerox systems. More pages 
mean more profitable annuity, all adding up to sustainable growth.

One especially satisfying trend: the acceptance of the Xerox iGen3® Digital Production Press,
our flagship and unparalleled product that creates up to 110 full-color impressions per
minute with the ability to personalize each and every one. The iGen3 is a winner with our
customers. In fact, some 180 customers now own more than one. And, about 70 of our
customers’ iGens produce more than 1 million images per month.

Last year we acquired XMPie for $54 million. XMPie provides software that enables 
multimedia campaigns with personalized e-mail, Web sites, catalogs, brochures and other
documents. When applied to direct marketing campaigns, these capabilities significantly
increase standard response rates and open up new ways for marketing professionals to
communicate with their customers.

Net Income
($ millions)

Post-Sale and 
Financing Revenue
(Included in Total Revenue – 
$ millions)

Color Revenue 
(Included in Total Revenue – 
$ millions)

Net Cash from
Operating Activities
($ millions)

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’02 ’03 ’04 ’05 ’06

’02 ’03 ’04 ’05 ’06

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You’ve probably received marketing materials in the mail that are targeted to your personal
buying needs – like postcards from car dealers with an image of the new version of your 
car including a license plate with your initials or a travel itinerary from a cruise line featuring
activities that appeal to your individual interests.

These marketing campaigns cut through the clutter. They’re personalized, colorful and 
most likely printed on Xerox color systems using XMPie software. The market for variable
data jobs that capture individual information such as name, address, account information
and photographs is projected to grow from 49 billion pages in 2004 to 138 billion pages 
in 2009. That’s an annual compounded growth rate of 23 percent. Xerox is in the forefront
of driving that market opportunity.

Our third strategy for growth is to lead in services in our major accounts – and here, 
too, we’re making good progress. Our services signings last year were up over 15 
percent from the previous year. Customers who are entrusting us to manage large 
enterprise systems include the likes of Medco and Honeywell, the University of Calgary
and Microsoft, OfficeMax and United Technologies and more.

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And we believe it’s the tip of the iceberg. More and more large customers are turning to us
for help in simplifying their document-intensive work processes; bridging the divide between
paper and digital documents; managing their infrastructure; and creating digital systems 
that allow them to easily store, search and retrieve their digital files.

We call this Smarter Document Management™. It’s a market where Xerox is uniquely 
advantaged – drawing upon our heritage in understanding how people work with documents
and adding our rich portfolio of digital applications and technology.

During 2006, we acquired Amici LLC for $175 million. Amici is the market leader in 
e-discovery technology, which involves the identification, filtering, production and storage 
of relevant data from paper or electronic documents, such as e-mail, text files, memos,
databases, presentations and spreadsheets. Projected to grow at an annual compounded
rate of close to 40 percent, e-discovery services could be a nearly $2.5 billion market 
in the United States alone by 2009. Now a part of Xerox Litigation Services, Amici helps
position us to go after this burgeoning market.

The fourth plank in our growth strategy is to aggressively attack the small and medium 
business (SMB) market. It’s a $44 billion opportunity where our presence has been modest.
Segments of the market, however, are growing – especially in developing countries, in color
and in multifunction devices.

Here, too, we are making excellent progress. Last year we introduced four products 
targeted to this segment and earlier this year we launched seven more. At the same time,
we continue to expand our distribution channels. We recently announced our most significant

Gross Margins
(Percent)

Selling, Administrative
and General Expenses
($ millions)

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investment in resellers and inde-
pendent agents since launching
these sales channels several years
ago. That means there will be more
“feet on the street” selling Xerox
systems and services and greater
Xerox brand visibility in the SMB
market. Our strategy is straight-for-
ward: more technology plus more
distribution equals more growth.

We’re attacking a $117 billion 
market opportunity through our
focus on these growth strategies.
We can compete for every dollar 
of it – and we are.

Our people

Our success is dependent on contributions from Xerox’s 54,000 worldwide employees who
impress me every day with their passion for creating great experiences for our customers.
They’re led by a deeply committed executive team with a fierce will to win. We have a wealth
of talent across our enterprise and spend significant time developing this talent – spreading
that wealth throughout our operations and preparing our next generation of leadership. 
Our recent appointment of Ursula Burns to president of Xerox and a member of the Board of
Directors reflects this commitment. Ursula joined Xerox in 1980 as an engineering intern and
earned her stripes through product development and business division management roles
to her most recent position as head of Business Group Operations with full responsibility for
Xerox’s research and product groups through to manufacturing and distribution. She’s been
instrumental in fine tuning Xerox’s business model so we’re more cost competitive, and
accelerating our time to market with the launch of more than 100 products in the last three
years. Ursula now brings her deep knowledge of our business to the president role, where
she’ll work closely with me and our leadership team to aggressively drive our well-defined

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C H A I R M A N ’ S L E T T E R

growth strategy. With a lot of heavy lifting behind us, our operations are in good shape.
We’re now well positioned – with the best people and best products and services – to 
build on our momentum in the marketplace both in the near term and for your long-term
investment in Xerox.

Our innovation

Including our partner Fuji Xerox, we invested a combined $1.4 billion last year in research
and development, with a similar amount planned for 2007. Our returns on that investment
are excellent. Last year we launched 14 products that together earned 208 industry 
awards. We expect to more than double the number of product announcements this year.
We measure the success of our R&D investments through a metric called “Time to Revenue”
– how long it takes for new ideas to become new revenue. We believe our progress in this
area is among the best in the industry. About two-thirds of Xerox’s equipment sales come
from products launched in the past two years.

Thanks to our scientists and engineers, the future is bright as well. Last year, the Xerox
innovation community received nearly 560 U.S. utility patents. That’s up 24 percent over the
previous year. With our research partner, Fuji Xerox, the total was over 800. We hold more
than 8,000 active patents, many that are the foundation of breakthrough technology like:

• Self-erasable paper that uses a combination of light and ink to automatically erase marks 

on a page about 16-24 hours after the page is printed.

• E-Agent, a special chemical ingredient that reduces the amount of energy needed to make

certain Xerox toners by up to 22 percent.

• Advancements in natural language search technology which uses familiar phrases and 

sentences to simplify search results.

Our customers

One of the hallmarks of the new Xerox is deep relationships with our customers.
Increasingly, we are strategic partners. One of them recently referred to Xerox as 
a combination painkiller and steroid. We’ve been called lots of things, but never 
that, so I asked him what he meant. His answer went something like this:

“Before Xerox came along, document management was a huge headache. We had no idea
what we were spending. We had lots of vendors but no partners. We kept investing in the
promise that the next new thing would be the right thing. Xerox has made my life simpler. 
I talk to one person who saves me money and boosts my productivity. That’s the painkiller.
The steroid part comes from leveraging documents to reach customers more effectively, to
make it easier for customers to do business with us and to grow our business. That’s the
steroid part. Xerox gives me both in ways no one else can.”

That’s music to my ears. It’s also a novel way to express our value proposition – painkiller
and steroid, streamlining document processes to reduce costs and leveraging documents 
to grow revenue. No one does that better than Xerox – no one.

Our operations

We also have a business model that works – in part because it’s flexible. We react quickly
and decisively to marketplace challenges and opportunities. In today’s world, every quarter
seems to present its own unique dynamics. Pricing pressures may put pressures on our
margins. Economic slowdowns may slow our revenue pipeline. Competitive threats may
cause us to bulk up our investments in marketing.

Whatever the circumstances, we adjust. We do it quickly. And we do it in a way that keeps
our business model aligned with our financial objectives. As a result, we are a company that
is known for consistency. We know that’s important to you so it’s critical to us.

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Our commitment to citizenship

So, too, is our continued focus on being a good corporate citizen. It’s a cherished part 
of our heritage and an essential part of our future. I urge you to read the snapshot 
description of our activities in this report. We’re making progress in reducing greenhouse
gas emissions. We supported more than 500 non-profit organizations; spent more than
$370 million with minority-, women- and veteran-owned businesses; strengthened our 
efforts to protect our forests; sent thousands of volunteers into the communities in which
we work and live; and much more.

Last year, we published our first Report on Global Citizenship. It provides a comprehensive
look at how we run our company – from serving our customers and taking care of the 
environment to conducting our business with integrity and giving back to our communities.
The report is available in its entirety at www.xerox.com/citizenship.

Our commitment to you

We believe our track record is good, our strategy is sound and our business model is
robust. We’re participating in a $117 billion market and we’re positioned to compete 
aggressively for every dollar of it. In 2007 you’ll see continued activity that strengthens 
our leadership in color, accelerates the New Business of Printing, expands our offerings 
in services, and broadens our offerings and distribution in the small and medium business
market. All this fuels our profitable annuity stream, which accounts for more than 
70 percent of our revenue.

At the same time, you can expect us to remain diligent on reducing costs, generating cash
and prioritizing profitability and earnings growth. We know that you have invested in Xerox
because you have confidence in us. It’s an awesome responsibility that we embrace and
take very seriously.

The thing I love the most about this company is the people. They have what I like to call 
a “steely optimism.” They do whatever it takes to make Xerox successful, to help our 
customers be successful and to give you a good return on your investment. Because of
them, I have every confidence that 2007 will be another good year for Xerox – and for you.

Anne M. Mulcahy
Chairman and Chief Executive Officer

Non-GAAP Reconciliation
(in $ millions, except per-share data)

As Reported

Adjustments

Restructuring and Asset Impairment

Tax Audit Benefits

Litigation Matters

Credit Facility Fee

Integic Gain

EU Waste Directive

Hurricane Katrina Loss

Accounting Change

Adjusted

Full-Year ’06

Full-Year ’05

Net Income

Diluted EPS

Net Income Diluted EPS

$1,210

$ 1.22

$ 978

$ 0.94

254

(494)

68

9

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(0.50)

0.07

0.01

247

(343)

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(58)

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0.08

(0.06)

0.02

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0.01

$1,047

$ 1.05

$ 943

$ 0.90

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C I T I Z E N S H I P

Citizenship at Xerox 

Over the past 40 years, Xerox has demonstrated leadership by 
supporting educational and community projects around the world,
designing “waste-free” products built in “waste-free” plants, investing 
in innovation that delivers measurable benefits to the environment, 
and many other integrated initiatives that touch Xerox communities,
employees and stakeholders.

2006

Through our Social Service 
Leave program, eight Xerox 
employees volunteered full 
time and at full pay to support 
community service agencies. 
Xerox marketing professional, 
Katelyn Dyer, pictured here, 
spent her Social Service Leave 
with Junior Achievement of 
Rochester, N.Y., helping to 
increase its base of funding 
and volunteers to support more 
educational programs. 

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Some highlights from 2006 include:

• Launched the company’s first Report on Global Citizenship, which

includes information on ethics and governance, customer privacy and
satisfaction, employee diversity and development, waste-free initiatives,
philanthropy, community involvement and more. The full report is 
available at www.xerox.com/citizenship.

• Adopted the Electronics Industry Code of Conduct, a standards-based
approach for monitoring suppliers’ compliance across several areas 
of social responsibility.

• Continued progress toward reducing Xerox’s global greenhouse gas

emissions 10 percent by 2012 from a 2002 baseline.

• Xerox’s Palo Alto Research Center partnered with SolFocus to develop
technology that will break price barriers in the solar electricity market.

• Contributed $1 million to The Nature Conservancy to develop 

science-based tools and systems that will help the paper industry 
better manage ecologically important forest land. The funding focuses
on the Canadian Boreal Forest as well as the forests of the southern
United States, Indonesia and Brazil’s Atlantic Forest.

• Invested just over $12 million in the non-profit sector through the 
Xerox Foundation, supporting about 500 organizations last year.

• More than 20,000 elementary students benefited from science lessons
taught by Xerox employees who volunteer their time in classrooms 
to inspire the next generation of scientists and inventors. 

• Hispanic Business, National Association of Female Executives, 

Hispanic Magazine, Black Enterprise and Asian Enterprise were just
some of the external endorsements Xerox received for its focus on
diversity and nurturing an inclusive workplace environment. Xerox was
also honored by the Families and Work Institute for our progressive
work-life practices.

Understanding customers 
better – serving them best.

The leading European IT provider, Fujitsu Siemens
Computers (FSC) has customers in more than 170
countries. So, as you might expect, communicating
effectively in its customers’ many languages is 
tantamount to fulfilling its corporate vision of
“Understanding you better – serving you best.”

When you multiply these many languages by FSC’s
extensive portfolio of products that includes PCs, 
notebooks, workstations, pen tablet PCs and 
handhelds, you can begin to appreciate the enormity 
of the task of producing user manuals for these 
many devices. Not only do the manuals need to be
technically precise, they also need to be engaging,
conversational and easy to understand.

Xerox introduced a content management system 
that instantly refreshes informational copy across all
languages by identifying and translating key common
words and phrases. If a phrase is repeated in context,
it automatically updates all versions. If a phrase is out
of context, it applies logic to adapting it. The system
also refreshes and integrates diagrams and pictures 
to suit evolving content.

To reduce time to market, Xerox also introduced 
local operations close to each FSC plant so that 
100 percent of all printed material could be delivered
within hours of the times requested.

The translation of manuals is one of many projects
Xerox undertakes on behalf of FSC. As with other 
key global accounts, Xerox has appointed a Client
Managing Director for Siemens group of companies,
who, as the one go-to point of ownership, leads all
partnership endeavors.

That’s why FSC chose Xerox for the lifecycle 
management of its user manuals, which includes 
consulting on design and editorial content, translating
the manuals into as many as 29 languages and 
managing all print fulfillment.

After a flawless conversion from the existing method,
the initiative immediately delivered cost savings of 
25-30 percent, with recent savings approaching 45
percent. Just as significant has been the nonexistent
disruption to customer satisfaction.

Those are results worth noting. In any language.

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Katrina and Rita are no match
for Xavier and Xerox.

offsite University command centers and executive
offices. Within days, the critical work of remediation
and reconstruction was underway.

Xavier University of Louisiana has been a top producer
of the nation’s Black pharmacists for eight decades,
and since 1993 it has placed more African Americans
into medical schools each year than any college 
in America. But like much of New Orleans in the 
late summer of 2005, its campus was under water. 
And most of its administrative offices – along with 
the equipment and technology to run them – were
completely disabled.

Fortunately, Dr. Norman Francis wasn’t about to let 
the weather get in the way of the mission he has been
fulfilling as Xavier’s president for nearly 40 years. He
vowed that the University would reopen on January 9,
2006, a scant four months after the storms’ ravages.

Accepting Dr. Francis’s mandate that delay was not 
an option, Xerox sprung into action. It immediately 
provided Xerox WorkCentre multifunction systems for

Once floodwaters had receded, a Xerox team toured
the stricken campus only to find that water and mold
had damaged virtually all of the equipment that it had
placed. The University print shop managed by Xerox
was a total loss.

Again Xerox went to work. It conducted an inventory 
to assess the status of all equipment throughout the
campus, ordered replacements, and by early January
had installed all of it, at no cost to the University. 
Xerox also provided five of its associates to manage
the 84 replaced Xerox systems. When Xavier reopened
its doors on January 9, so did the print shop. 

Today, student enrollment is about 80 percent of what
it was before Katrina, Dr. Francis has been awarded
the United States Medal of Freedom by President Bush
and Xavier University of Louisiana has reaffirmed its
academic, civic and humanitarian leadership.

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Magical photographic stories, 
told perfectly every time.

In 1999, they started as an online resource to 
help photography enthusiasts print the photos from
their new digital cameras. They have become the 
preeminent Internet-based service for social expression
and personal publishing.

They’re Shutterfly. And every year they help millions of 
people tell the stories of their lives by making it easy
and fun for them to upload, edit, enhance, organize,
find, share, print and preserve their digital photos.
Shutterfly’s printed products include personalized
photo books, children’s story books, greeting cards,
calendars and other custom photo gifts.

Imagine an enormous room full of presses – the
largest all-digital lab in the world – operating around
the clock with periodic maintenance being attended to
with the speed of racecar pit crews. That’s Shutterfly
at the height of their busiest seasons. They’re not
about to trust the timeliness and quality of all those
cherished images to just anyone.

Shutterfly was looking for a strategic partner who
could help sustain their staggeringly high volumes 
with the highest quality and consistency. They wanted
experts who could show their team how to minimize
downtime and maximize throughput. They wanted 
a business partner who shared their relentless pursuit
of delighting customers. 

Shutterfly chose Xerox, and its iGen3® 110 
Digital Production Presses with recently introduced
image-improving software. It captures the deepest
blues in beach vacation photos to the palest 
pinks in a newborn’s first close-up. And it makes 
it easier for Shutterfly’s people to know when to 
make adjustments to maintain these many hues.

“Tough customers” by their own admission, the
Shutterfly team is intently focused on preserving 
the smiles on the millions of family faces entrusted to
them. In Xerox they have found a kindred spirit – every
bit as demanding, and equally single-minded about
keeping the customer smiling. 

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X
O
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E
X

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B O A R D O F D I R E C T O R S

9

10

11

8

2

3

1

4

5

7

6

1. Anne M. Mulcahy
Chairman and Chief Executive Officer
Xerox Corporation
Stamford, CT

2. Richard J. Harrington A
President and Chief Executive Officer
The Thomson Corporation
Stamford, CT

3. Robert A. McDonald A
Vice Chairman-Global Operations
The Procter & Gamble Company
Cincinnati, OH

4. Mary Agnes Wilderotter D
Chairman and Chief Executive Officer
Citizens Communications
Stamford, CT

5. Ralph S. Larsen B, C
Former Chairman and Chief Executive Officer 
Johnson & Johnson
New Brunswick, NJ

6. N. J. Nicholas, Jr.B, D
Investor
New York, NY

7. Ann N. Reese C, D
Executive Director
Center for Adoption Policy 
Rye, NY

8. Glenn A. Britt A, C
President and Chief Executive Officer
Time Warner Cable
Stamford, CT

9. Hilmar Kopper B, D*
Former Chairman and Chief Executive Officer
Deutsche Bank AG
Frankfurt, Germany

10. Vernon E. Jordan, Jr. B, C
Senior Managing Director
Lazard Frères & Co., LLC
New York, NY
Of Counsel, Akin, Gump, Strauss, 
Hauer & Feld, LLP Attorneys-at-Law 
Washington, DC

11. William Curt Hunter A, C
Dean, Tippie College of Business
University of Iowa
Iowa City, IA

Ursula M. Burns**
President
Xerox Corporation
Stamford, CT

A: Member of the Audit Committee
B: Member of the Compensation Committee
C: Member of the Corporate Governance Committee
D: Member of the Finance Committee

* Mr. Kopper is not standing for reelection at the 

2007 Annual Meeting of Shareholders.

** Ms. Burns (not pictured) was elected to the 

Xerox Board on April 2, 2007.

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INDEX TO ANNUAL REPORT

Description of Business

Management’s Discussion and Analysis of Results of Operations and Financial Condition

Executive Overview

Financial Overview

Currency Impacts

Summary Results

Application of Critical Accounting Policies

Results of Operations

Segment Revenue

Segment Operating Profit

Gross Margins

Research, Development and Engineering

Selling, Administrative and General Expenses

Restructuring and Asset Impairment Charges

Other Expenses, Net

Income Taxes

Equity in Net Income of Unconsolidated Affiliates

Income from Discontinued Operations

Recent Accounting Pronouncements

Capital Resources and Liquidity

Cash Flow Analysis

Customer Financing Activities and Secured Debt

Liquidity, Financial Flexibility and Other Financing Activity

Contractual Cash Obligations and Other Commercial Commitments and Contingencies

Off-Balance Sheet Arrangements

Financial Risk Management

Forward-Looking Statements

Audited Consolidated Financial Statements

Consolidated Statements of Income

Consolidated Balance Sheets

Consolidated Statements of Cash Flows

Consolidated Statements of Common Shareholders’ Equity

13

15

26

26

26

27

27

29

32

32

36

37

37

38

38

39

40

41

41

41

41

41

43

45

47

48

49

49

50

50

51

52

53

54
63
65
66
69
69
70
72
73
75
76
80
80
85
89
92
100
101
104
105
105
106

107

108

110
111
112

Notes to Consolidated Financial Statements

Investments in Affiliates, at Equity

Inventories and Equipment on Operating Leases, Net

1. Summary of Significant Accounting Policies
2. Segment Reporting
3. Short-Term Investments
4. Receivables, Net
5.
6. Land, Buildings and Equipment, Net
7.
8. Goodwill and Intangible Assets, Net
9. Restructuring and Asset Impairment Charges
10. Supplementary Financial Information
11. Debt
12. Liability to Subsidiary Trusts Issuing Preferred Securities
13. Financial Instruments
14. Employee Benefit Plans
15.
Income and Other Taxes
16. Contingencies
17. Preferred Stock
18. Common Stock
19. Earnings Per Share
20. Acquisitions
21. Divestitures and Other Sales
22. Subsequent Event

Reports of Management

Report of Independent Registered Public Accounting Firm

Quarterly Results of Operations
Five Years in Review
Certifications Pursuant to Rule 13a - 14 under the Securities Exchange Act of 1934, as amended

14

DESCRIPTION OF BUSINESS

Global Overview

Xerox is a $15.9 billion
technology and services enterprise
and a leader in the global docu-
ment market.
We develop, manufacture, market, service and finance a complete
range of document equipment, software, solutions, and services.

Revenues by  Geography

in millions

U.S.
$8,406

Europe
$5,378

Other Areas
$2,111

We operate
in over
160
countries
worldwide

Globally, we have 53,700 direct employees.

We have over 6,500 Sales Professionals, over 12,500
Managed Service Employees at customer sites and
12,000 Technical Service Employees. In addition, we
have over 7,000 Agents and Concessionaires and over
10,000 Resellers.

Markets

We serve a  $117 billion  market.

This estimate, and the market estimates that follow, is calculated by leveraging third-party forecasts from firms such as International Data
Corporation and InfoSource in conjunction with our assumptions about our markets.

$21
Services
Our value-added services deliver
solutions, which not only optimize
enterprise output spend and
infrastructure, but also streamline,
simplify and digitize our
customers’ document-intensive
business processes.

$17
Eligible Offset
We are creating new market
opportunities with digital printing
as a complement to traditional
offset printing. (This is an estimate
for this Eligible Offset market.)

$8
Production
We are the only manufacturer in
the market that offers a complete
family of monochrome production
systems from 65 to 180 impressions
per minute and color production
systems from 40 to 110 pages per
minute (“ppm”).

$71
Office
We are well placed to capture
growth by leading the transition
to color and by reaching new
customers with our broadened
offerings and expanded
distribution channels.

15

Overview

References in this section to “we,” “us,” “our,” the
“Company” and “Xerox” refer to Xerox Corporation and
its subsidiaries unless the context specifically states or
implies otherwise.

North America

DMO

Europe

Fuji Xerox

Xerox markets and supports
document management systems,
supplies, and services through a
variety of distribution channels
around the world.

Xerox North America operates
across the United States and Canada.

Xerox Europe covers 17 countries
across Europe.

Developing Markets Operations
supports more than 130 countries.

Fuji Xerox, an unconsolidated
entity of which we own 25%,
develops, manufactures, and
distributes document management
systems, supplies, and services.

The document industry is transitioning to digital

systems, to color, and to an increased reliance on
electronic documents. More and more, businesses are
creating and storing documents digitally and using the
Internet to exchange electronic documents. We believe
these trends play to the strengths of our product and
service offerings and represent opportunities for future
growth in the $117 billion market we serve.

In our core markets of Production and Office, we are
well-placed to grow by leading the transition to color and
by reaching new customers with our broadened offerings
and expanded distribution channels. Within these
markets, the fastest growing segment is color, which we
estimate is a $21 billion opportunity. At the same time,
we continue to compete to capture growth opportunities
within the black-and-white segment of our core markets,
which we estimate is a $58 billion market.

We are expanding our core markets with Document

Management Services, which is the combination of
managed services and value-added services. We have
organized our Document Management Services around
three offerings: 1. Xerox Office Services, where we help
our customers reduce costs and improve productivity by
optimizing their global print infrastructure through
analyzing the most efficient ways to create and share
documents in the office; 2. Document Outsourcing and
Communication Services, which focuses on optimizing
the production environment as well as operating in-house
production centers; and 3. Business Process Services,
where we show our customers how to use digital
workflow and develop online document repositories.
Our products include high-end printing and
publishing systems; digital multifunctional devices
(“MFDs”) which can print, copy, scan and fax; digital
copiers; laser and solid ink printers; fax machines;
document-management software; and supplies such as
toner, paper and ink. We provide software and workflow
solutions with which businesses can easily and affordably
print books, create personalized documents for their
customers, and scan and route digital information. We
are creating new market opportunities with digital
printing as a complement to traditional offset printing,
which we refer to as the Eligible Offset market. Within
the Eligible Offset market we offer leading digital
technology, led by our market-making Xerox iGen3®
technology, which meets the increasing demand for
short-run, customized and quick-turnaround offset
quality printing.

Our business model is an annuity model, based on

increasing equipment installations and Document
Management Services in order to increase the number of
machines in the field (“MIF”) that will produce pages

16

and generate post sale and financing revenue.
Seventy-two percent of our 2006 total revenue was post
sale and financing revenue that includes equipment
maintenance and consumable supplies, among other
elements. We sell the majority of our equipment through
sales-type leases that we record as equipment sale
revenue. Equipment sales represented 28% of our 2006
total revenue.

We expect this large, recurring post sale revenue
stream to be approximately three times the equipment sale

Acquisitions

To further our business goals, we made two
acquisitions in 2006. We completed the purchase of
Amici LLC, (“Amici”), a provider of electronic-
discovery (“e-discovery”) services, primarily supporting
litigation and regulatory compliance. E-discovery is the
identification, filtering, production, and storage of
relevant data from paper or electronic documents, such as
e-mail, text files, memos, databases, presentations and
spreadsheets. Amici, now branded Xerox Litigation
Services, provides comprehensive litigation discovery
management services, including the conversion, hosting
and production of electronic and hard copy documents.
They also provide consulting and professional services to
assist attorneys in the discovery process.

Segment Information

revenue over the life of a lease. Thus, the number of
equipment installations is a key indicator of post sale and
financing revenue trends. The mix of color pages is
another significant indicator of post sale revenue trends
because color pages use more consumables per page than
black-and-white. In addition, market development,
particularly within the Eligible Offset market, is key to
increasing pages and we have leading tools and resources
to develop this large market opportunity.

We also purchased XMPie, Inc. (“XMPie”) to
further strengthen our position in the growing market for
personalized communications and cross-media marketing
campaigns involving digital printing, e-mail and
customized websites. XMPie helps graphic designers,
marketing companies and print providers develop
creative, customized marketing programs. XMPie
provides software for variable data publishing ranging
from the desktop to servers, from print to multi-channel
campaigns, from personalized images to personalized
booklets, and from out-of-the-box solutions to a platform
for creating custom solutions that fit unique business,
integration and workflow requirements.

Our reportable segments are Production, Office,
Developing Markets Operations (“DMO”), and Other. We
present operating segment financial information in
Note 2 – Segment Reporting to the Consolidated
Financial Statements, which we incorporate by reference
here. We have a very broad and diverse base of
customers, both geographically and demographically,

ranging from small and medium businesses to graphic
communications companies, governmental entities,
educational institutions and large (Fortune 1000)
corporate accounts. None of our business segments
depends upon a single customer, or a few customers, the
loss of which would have a material adverse effect on our
business.

Reviews by Business Segment

47.97%

28.81%

12.19%

11.03%

Office $7,625 million
Our Office segment serves global, national and small to medium-size commercial
customers as well as government, education, and other public sector customers.

Production $4,579 million
We provide high-end digital monochrome and color systems designed for customers
in the graphic communications industry and for large enterprises.

DMO $1,938 million
DMO includes the marketing, sales, and servicing of Xerox products, supplies, and
services in Latin America, Brazil, the Middle East, India, Eurasia and Central-Eastern
Europe, and Africa.

Other $1,753 million
The Other segment primarily includes revenue from paper sales, wide-format systems,
and value-added services.

17

Production

We provide high-end digital monochrome and
color systems designed for customers in the graphic
communications industry and for large enterprises.
These high-end devices enable digital on-demand
printing, digital full-color printing, and enterprise
printing. We are the only manufacturer in the market
that offers a complete family of monochrome
production systems from 65 to 180 pages per minute
and color production systems from 40 to 110 pages per
minute (“ppm”). In addition, we offer a variety of

pre-press and post-press options and the industry’s
broadest set of workflow software.

With our Freeflow™ digital workflow collection
our customers can improve everything from content
creation and management to production and
fulfillment. Our digital technology, combined with
total document solutions and services that enable
personalization and printing on demand, delivers value
that improves our customers’ business results.

Our 2006 Production Goals

Our 2006 goals for our Production segment were to continue strengthening our leadership position in

monochrome and color and to build on the power of digital printing in the Eligible Offset market. Our “New Business
of Printing®” strategy complements the traditional offset market with digital printing and workflow capabilities, which
include the introduction of innovative production systems and development of applications and solutions to expand our
leadership position and focus on the higher growth applications and digital color opportunities. Here are the
accomplishments that enabled us to reach our 2006 goals.

Our 2006 Production Accomplishments

We continued to build on our unmatched product breadth, world class market and business development tools and

integrated end-to-end applications.

– Xerox iGen3 90: We expanded our offerings within the color print on-demand market with the April launch of
our iGen3 90 Digital Press, a 90 ppm full-color production system with improved productivity, image quality,
personalization and running cost.

– Xerox DocuColor® 5000: In June, we launched the DocuColor 5000 Digital Press, a 50 ppm full-color

production system, which provides excellent print resolution, color reproduction, and reliability for a wide range
of applications.

– Xerox 4590 EPS and 4110® EPS: In April, we expanded our presence in light production with the launch of our
4590 and 4110 Enterprise Printing Systems, two robust digital production monochrome systems at 90 ppm and
110 ppm, respectively.

– Xerox DocuTech® Highlight Color 180 Publishing System: In October, we launched our DocuTech Highlight

Color 180 Publishing System for print on-demand applications. This system prints both black-and-white, as well
as highlight color, at the rated speed of 180 ppm.

– Highlight Custom Blended Color Program: In October, we announced additional standard colors for a total of
eight. We also expanded the range of colors with Custom Colors, enabling customers to match their company
logos for brand identity applications.

– Applications: We continued to increase installations of our flagship Digital Color Production Presses. In addition
to the launch of the iGen3 90, in June we launched Auto Image Enhancement Software, which intelligently
adjusts images to improve photo submission problems. We followed this with an October announcement of
another release that improves photo rendering, color profiling and color checking. In October, we also introduced
a series of solutions that included workflow and marketing support to enable such applications as teacher edition
books, photo memory books and greeting cards. In July, we launched FreeFlow Web Services 5.0, which makes
it simpler for our customers to procure, print, access or order documents. We continued to build our marketplace

18

leading Profit Accelerator Program, which helps customers get the most from their digital technology
investments. We offer over 50 tools for graphic communication and in-plant environments to help our customers
increase and improve their digital business.

– XMPie Acquisition: In November, we acquired XMPie, a leading provider of variable information software with
which users can create cross media, personalized marketing programs. With this acquisition we can provide
complete, measurable solutions for multi-media marketing campaigns.

– Xerox Nuvera™ 288 Digital Perfecting System: In October at Graph Expo, we demonstrated a tandem engine

architecture Xerox Nuvera 288 Digital Perfecting System. This high-end, cut sheet printer will be the fastest on
the market at 288 ppm. The quality, productivity, and ability to run two engines in parallel, as well as run one
engine while the other is idle, is the result of a unique tandem architecture developed by Xerox research and
engineering. This product will be available in 2007.

Office

Our Office segment serves global, national, and

small to medium-size commercial customers as well as
government, education and other public sector customers.
Office systems and services, which include monochrome
devices at speeds up to 90 ppm and color devices up to 50
ppm, include our family of CopyCentre®, WorkCentre®
and WorkCentre® Pro digital multifunction systems;
DocuColor printer/copiers; color laser, LED (light
emitting diode), solid ink and monochrome laser desktop
printers; digital copiers; light-lens copiers and facsimile

products. We have transitioned to digital by joining our
laser and solid ink MFDs to powerful scanning
technology, which enables our customers to maximize
their document workflow. We offer a range of solutions
including the Office Document Assessment, in which we
analyze a business’ workflow and document needs, and
then we identify the most efficient, productive mix of
office equipment and software for that business, helping
to reduce the customer’s document-related costs.

Our 2006 Office Goals

Our 2006 Office goals were to drive the transition to color in the office and to build on our 2005 product launches,

to extend our reach in the market and increase our capture of pages. Our objective was to complement our broadened
product line with expanded distribution capacity to increase our population of systems, building the foundation for
future post sale revenue growth. Here are the accomplishments that enabled us to reach our 2006 goals.

Our 2006 Office Accomplishments

We continued to drive color by making it more affordable, easier to use, faster and more reliable. Our color-
capable laser devices provide an attractive entry point into color. Our patented solid ink technology offers unmatched
ease of use, vibrant color image quality and economic color run costs.

– Phaser™ 7760: With the May introduction of the Phaser 7760, we further strengthened our position in the

graphics art segment. A 35 ppm color printer, the Phaser 7760, delivers the color output and media handling and
finishing options required by this market segment.

– WorkCentre 7132: In May, we introduced the WorkCentre 7132, an eight ppm (32 ppm black-and-white) color-

capable multi-function printer.

– WorkCentre 7128/7135/7145: In May, we introduced the restriction on the use of hazardous substances

(“ROHS”) compliant product family in Europe. Offering 28, 35 or 45 ppm, these color-capable MFDs expand
our reach into a rapidly growing market segment.

– WorkCentre 7655/7665: In May, we introduced the WorkCentre 7655 and 7665 color capable MFDs, offering

color pages at 40 and 50 ppm, respectively, along with superior image quality, excellent productivity, extensive
media handling and professional in-line finishing capabilities.

19

We also extended our black-and-white MFD series, broadening our already extensive product line.

– WorkCentre 4118: Introduced in June, the 4118 is designed for small workgroups and has the strongest set of

features that we offer on a low-end, black-and-white desktop MFD.

– WorkCentre 4150: With the introduction in September of this 50 ppm A4 monochrome MFD, we entered a new,
rapidly growing market segment, offering an economical alternative to large enterprises interested in replacing
their printer fleet.

– WorkCentre 4590: Introduced in January, the 4590, which runs at 90 ppm, rounds out the high-end of our office

monochrome fleet.

– Extensible Interface Platform: In October, we introduced our Extensible Interface Platform (“EIP”) with a

configurable user interface. With EIP, customers can access document-related software applications on a Xerox
MFD user interface, improving workflow and productivity.

DMO

DMO includes the marketing, sales and servicing of
Xerox products, supplies, and services in Latin America,
Brazil, the Middle East, India, Eurasia and Central-
Eastern Europe and Africa. In countries with developing
economies, DMO manages the Xerox business through
operating companies, subsidiaries, joint ventures, product
distributors, affiliates, concessionaires, value-added
resellers and dealers. Our two-tiered distribution model
has proven very successful in the high-growth

Other

Our Other segment primarily includes revenue from

paper sales, value-added services and wide-format
systems.

We sell cut-sheet paper to our customers for use in

their document processing products. The market for
cut-sheet paper is highly competitive and revenues are
significantly affected by pricing. Our strategy is to charge
a premium over mill wholesale prices, which is adequate
to cover our costs and the value we add as a distributor, as
well as to provide unique products that enhance the “New
Business of Printing” and color output.

An increasingly important part of our offering is
value-added services, which uses our document industry
knowledge and experience. Our value-added services
deliver solutions that optimize our customers’ document
output and infrastructure costs while streamlining,
simplifying, and digitizing their document-intensive
business processes. In July, we acquired Amici, officially

geographies of Russia and Central-Eastern Europe, and in
2006 we completed implementing this business model
throughout the remainder of DMO. We manage our DMO
operations separately as a segment because of the political
and economic volatility, and the unique nature of its
markets. Our 2006 DMO goals included revenue growth,
a continued focus on improving the entire cost base and
providing a foundation for profitable growth.

launching the Xerox Litigation Services line of electronic
discovery (“e-discovery”) and records management
services. E-discovery is the identification, filtering,
production and storage of relevant data from paper or
electronic documents, like e-mail, text files, memos,
databases, presentations and spreadsheets. Often our
value-added services solutions lead to larger managed
services contracts, including our equipment, supplies,
service, and labor. We report the revenue from managed
services contracts in the Production, Office, or DMO
segments. In 2006, the combined value-added services
and managed services revenue, including equipment,
totaled $3.5 billion.

We offer document processing products and devices

in our wide-format systems business designed to
reproduce large engineering and architectural drawings up
to three feet by four feet in size.

20

Revenue

Revenue Stream

Research and Development

R, D&E Expenses
(in millions)

28%

72%

Approximately 28% of our
revenue comes from equipment
sales, from either lease
arrangements that qualify as
sales for accounting purposes,
or outright cash sales.

The remaining 72% of our
revenue, “Post sale and
financing,” includes annuity-
based revenue from maintenance,
services, supplies, and financing,
as well as revenue from rentals
or operating lease arrangements.

We sell most of our products and services under
bundled lease arrangements, in which our customers pay a
monthly amount for the equipment, maintenance,
services, supplies and financing over the course of the
lease agreement. These arrangements are beneficial to our
customers and us since, in addition to customers receiving
a bundled offering, these arrangements allow us to
maintain the customer relationship for future sales of
equipment and services.

R&D

Sustaining Engineering

$922

$161

$943

$188

$914

$154

$761

$755

$760

2006

2005

2004

1000

800

600

400

200

0

Investment in R&D is critical for competitiveness in
Xerox’s fast paced markets where more than two-thirds of
our equipment sales are from products launched during
the past two years.

We are required, for accounting purposes, to analyze

Xerox’s R&D drives innovation and customer value

these arrangements to determine whether the equipment
component meets certain accounting requirements so that
the equipment should be recorded as a sale at lease
inception, that is, a sales-type lease. Under a sales-type
lease we are required to allocate a portion of the monthly
minimum payments attributable to the fair value of the
equipment to equipment sales. We allocate the remaining
portion of the monthly minimum payments to the various
remaining elements based on fair value – service,
maintenance, supplies and financing – that we generally
recognize over the term of the lease agreement, and that
we report as “post sale and other revenue” and “finance
income” revenue. In those arrangements that do not
qualify as sales-type leases, which have increased as a
result of our services-led strategy, we recognize the entire
monthly payment over the term of the lease agreement,
whether rental or operating lease, and report it in “post
sale and other revenue.” Our accounting policies for
revenue recognition for leases and bundled arrangements
are included in Note 1 – Summary of Significant
Accounting Policies to the Consolidated Financial
Statements in our 2006 Annual Report.

by:

– Creating new differentiated products and services.
– Enabling cost competitiveness through disruptive

products and services.

– Enabling new ways to serve customers.
– Creating new business opportunities to drive future

growth by reaching out to new customers.

To ensure our success, we have aligned our R&D
investment portfolio with our strategic planks: leading the
color transition, enabling the “New Business of Printing”,
and enhancing customer value through services. 2006
R&D spending focused primarily on the development of
high-end business applications to drive the “New
Business of Printing”, on extending our color capabilities,
and on lower-cost platforms and customer productivity
enablers that drive the digitization of the office. The
Xerox iGen3, an advanced next-generation digital
printing press that produces photographic-quality prints
indistinguishable from offset, and Xerox’s proprietary
Solid Ink technology for the office are examples of the
type of breakthrough technology we developed and that

21

we expect will drive future growth. We include in our
R,D&E expenses our sustaining engineering expenses,
which are the hardware engineering and software
development costs we incur after we launch a product.

In the U.S., we own approximately 560 trademarks,
either registered or applied for. These trademarks have a
perpetual life, subject to renewal every ten years. We
vigorously enforce and protect our trademarks. We hold a
perpetual trademark license for “DocuColor.”

Competition

Although we encounter aggressive competition in all

areas of our business, we are the leader or among the
leaders in each of our principal business segments. Our
competitors range from large international companies to
relatively small firms. We compete primarily on the basis
of technology, performance, price, quality, reliability,
brand, distribution, and customer service and support. To
remain competitive, we invest in and develop new
products and services and continually improve our
existing offerings. Our key competitors include Canon,
Ricoh, IKON, Hewlett-Packard, and, in certain areas of
the business, Pitney Bowes, Kodak, Océ, Konica-Minolta
and Lexmark. We believe that our brand recognition,
reputation for document knowledge and expertise,
innovative technology, breadth of product offerings,
global distribution channels, our customer relationships
and large customer base are important competitive
advantages. We and our competitors continue to develop
and market new and innovative products at competitive
prices, and, at any given time, we may set new market
standards for quality, speed and function.

Our R&D is strategically coordinated
with that of Fuji Xerox, which
invested $660 million in R&D in
2006, $720 million in 2005 and
$704 million in 2004.

Patents, Trademarks and Licenses

We are a technology company. With our Xerox Palo

Alto Research Center (“PARC”) subsidiary, we were
awarded nearly 560 U.S. utility patents in 2006. We were
ranked 39th on the list of companies that were awarded
the most U.S. patents during the year and would have
been ranked 36th with the inclusion of PARC patents.
With our research partner, Fuji Xerox, we were awarded
over 800 U.S. utility patents in 2006. Our patent portfolio
evolves as new patents are awarded to us and as older
patents expire. As of December 31, 2006, we held
approximately 8,300 design and utility U.S. patents.
These patents expire at various dates up to 20 years or
more from their original filing dates. While we believe
that our portfolio of patents and applications has value, in
general no single patent is essential to our business or
any individual segment. In addition, any of our
proprietary rights could be challenged, invalidated, or
circumvented or may not provide significant competitive
advantages.

In the U.S., we are party to numerous patent-

licensing agreements, and in a majority of them, we
license or assign our patents to others, in return for
revenue and/or access to their patents. Most of the patent
licenses expire concurrently with the expiration of the
last patent identified in the license. In 2006, with our
PARC subsidiary, we added approximately 25
agreements to our portfolio of patent licensing
agreements, and either we or our PARC subsidiary was a
licensor in 22 of the agreements. We also have a number
of cross-licensing agreements with companies with
substantial patent portfolios, including Canon, Microsoft,
IBM, Hewlett Packard and Océ. Those agreements vary
in subject matter, scope, compensation, significance and
time.

22

Department of State and are subject to U.S. economic
sanctions. We maintain an export and sanctions
compliance program and believe that we have been and
are in compliance with U.S. laws and government
regulations for these countries. In addition, we had no
assets, liabilities, or operations in these countries other
than liabilities under the distribution agreements. After
observing required prior notice periods, Xerox Limited
terminated its distribution agreements related to Sudan
and Syria in August 2006 and terminated its distribution
agreement related to Iran in December 2006, and now has
only legacy obligations such as providing spare parts and
supplies to these third parties. In 2006, we had total
revenues of $15.9 billion, of which approximately $9.6
million was attributable to Iran and less than $0.7 million
in total was attributable to Sudan and Syria. As a result of
the termination of these agreements, we anticipate that
our revenues attributable to these countries will decline.
In January 2006, Xerox Limited entered into a five-

year distribution agreement with an unaffiliated third
party covering distribution of our products in Libya.
Libya is also designated as a state sponsor of terrorism by
the U.S. Department of State. The decision to enter into
this distribution agreement was made in light of recent
U.S. federal government actions that have lifted the
countrywide embargo previously imposed on Libya. Our
sales in Libya through this distribution agreement will be
subject to our export and sanctions compliance program
and will be according to the U.S. laws and government
regulations that relate to Libya.

Service

As of December 31, 2006, we had a worldwide
service force of approximately 12,000 employees and an
extensive variable contract service force. We are
expanding our use of cost-effective remote service
technology for basic product offerings while utilizing our
direct service force and a variable contract service force
to address customers’ more advanced technology
requirements. The increasing use of a variable contract
service force is consistent with our strategy to reduce
service costs while maintaining high-quality levels of
service. We believe that our service force represents a
significant competitive advantage in that the service force

Marketing and Distribution

Our brand is a valuable resource and
continues to be recognized in the
top ten percent of all U.S. brands.

We manage our business based on the principal
business segments described above. However, we have
organized the marketing and selling of our products and
solutions according to geography and channel types. We
sell our products and solutions directly to customers
through our worldwide sales force and through a network
of independent agents, dealers, value-added resellers and
systems integrators. Increasingly, we use our direct sales
force to address our customers’ more advanced
technology, solutions and services requirements, while
expanding our use of cost-effective, indirect distribution
channels, for basic product offerings.

We market our Phaser line of color and

monochrome laser-class and solid ink printers through
office information technology industry resellers, who
typically access our products through distributors. In
2006, we increased the product offerings available
through a two-tiered distribution model in Europe and
DMO. Through a multi-phased rollout, we will continue
to increase offerings through this lower-cost distribution
channel for our Office portfolio.

We are increasing our use of partners to improve our

market coverage. Through alliances with Premier
Partners and Fuji Ennovation, we expanded coverage to
market our DocuColor series to commercial printers. Our
alliance with Electronic Data Systems (“EDS”) is
designed to integrate EDS’ information technology
(“IT”) services with our document management systems
and services to provide customers with full IT
infrastructure support.

In Europe, Africa, the Middle East, India, and parts

of Asia, we distribute our products through Xerox
Limited, a company established under the laws of
England, and related non-U.S. companies all of which we
refer to as Xerox Limited. Xerox Limited enters into
distribution agreements with unaffiliated third parties
covering distribution of our products in some of the
countries located in these regions, and previously entered
into agreements with unaffiliated third parties covering
distribution of our products in Iran, Sudan, and Syria.
Iran, Sudan, and Syria, among others, have been
designated as state sponsors of terrorism by the U.S.

23

is continually trained on our products and their diagnostic
equipment is state-of-the-art. We offer service 24 hours a
day, 7 days a week, in major metropolitan areas around
the world, providing a consistent and superior level of
service worldwide.

Manufacturing Outsourcing

We are currently in the first one-year automatic

renewal period under a five year master supply
agreement with Flextronics, a global electronics
manufacturing services company, to outsource portions
of manufacturing for our Office segment. Our inventory
purchases from Flextronics currently represent
approximately 20% of our overall worldwide inventory
procurement. We have agreed to purchase from
Flextronics some products and consumables within
specified product families. Flextronics must acquire
inventory in anticipation of meeting our forecasted
requirements and must maintain sufficient manufacturing
capacity to satisfy these requirements. Under certain
circumstances, we may be obligated to repurchase
inventory that remains unused for more than 180 days or
becomes obsolete, or on the termination of the supply
agreement.

We acquire other Office products from various third

parties, to increase the breadth of our product portfolio,
and to meet channel requirements. We also have
arrangements with Fuji Xerox under which we purchase
some products from and sell other products to Fuji Xerox.
Some of these purchases and sales are the result of mutual
research and development arrangements. Our remaining
manufacturing operations are primarily located in
Rochester, New York and Dundalk, Ireland for our
high-end production products and consumables, and in
Wilsonville, Oregon for solid ink products, consumable
supplies, and components for our Office segment products.

Fuji Xerox

Fuji Xerox Co., Limited is an unconsolidated entity
in which we currently own 25% and FUJIFILM Holdings
Corporation (“FujiFilm”) owns 75%. Fuji Xerox
develops, manufactures and distributes document
processing products in Japan, China, Hong Kong and
other areas of the Pacific Rim, Australia and New
Zealand. We retain significant rights as a minority
shareholder. Our technology licensing agreements with
Fuji Xerox ensure that the two companies retain
uninterrupted access to each other’s portfolio of patents,
technology and products.

International Operations

We are incorporating by reference the financial
measures by geographical area for 2006, 2005 and 2004
that are included in Note 2 – Segment Reporting to the
Consolidated Financial Statements in our 2006 Annual
Report.

Contract Signings

We believe that contract signings provide a
meaningful measure of future business prospects for
document management services. Contract signings
represent management’s estimate of the total contract life
value of managed services and value-added services
contracts signed within the period. This estimate includes
new contracts, renewals, extensions, and amendments to
existing contracts. The total contract life value is defined
as the average monthly commitment minimum multiplied
by the number of months in the contract, plus an estimate
of any other revenue related to the contract, but not
included in the minimum. If a contract does not have a
monthly commitment minimum, management develops
an estimate based on historical and expected usage
patterns and other relevant information. Our contracts
have terms that generally range from 3 to 5 years. During
2006, signings for document management services were
up about 15% from 2005.

Backlog

We believe that backlog, or the value of unfilled

orders, is not a meaningful indicator of future business
prospects because of the significant proportion of our
revenue that follows equipment installation, the large
volume of products we deliver from shelf inventories,
and the shortening of product life cycles.

Seasonality

Our revenues are affected by such factors as the
introduction of new products, the length of the sales
cycles, and the seasonality of technology purchases. As a
result, our operating results are difficult to predict. These
factors have historically resulted in lower revenue in the
first quarter than in the immediately preceding fourth
quarter.

24

Other Information

Xerox is a New York corporation, organized in
1906, and our principal executive offices are located at
800 Long Ridge Road, P. O. Box 1600, Stamford,
Connecticut 06904-1600.

Our telephone number is (203) 968-3000.

On the Investor Information section of our Internet
website, you will find our annual reports on Form 10-K,
quarterly reports on Form 10-Q, current reports on Form
8-K, and any amendments to these reports. We make
these documents available as soon as we can after we
have filed them with, or furnished them to, the Securities
and Exchange Commission.

Our Internet address is http://www.xerox.com.

25

Management’s Discussion and Analysis of Results of Operations and Financial
Condition

The following Management’s Discussion and
Analysis (“MD&A”) is intended to help the reader
understand the results of operations and financial
condition of Xerox Corporation. MD&A is provided as a
supplement to, and should be read in conjunction with,
our consolidated financial statements and the
accompanying notes.

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 series
of transformations from older technology light lens
devices to digital systems, from black-and-white to color,
and from paper documents to an increased reliance on
electronic documents. We believe we are well positioned
as these transformations play to our strengths and
represent opportunities for future growth, since our
research and development investments have been focused
on digital and color offerings and our acquisitions have
focused on expanding our services and software
capabilities.

We operate in competitive markets and our

customers demand improved solutions, such as the ability
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. Customers are also
increasingly demanding document services such as

Financial Overview

Throughout this document, references to “we,”

“our,” the “Company” and “Xerox” refer to Xerox
Corporation and its subsidiaries. References to “Xerox
Corporation” refer to the stand-alone parent company and
do not include its subsidiaries.

consulting and assessments, managed services, imaging
and hosting, and document intensive business process
improvements.

We deliver advanced technology through focused
investment in research and development and offset lower
prices through continuous improvement of our cost base.
The majority of our revenue is recurring revenue
(supplies, service, paper, outsourcing and rentals), which
we collectively refer to as post sale revenue. Post sale
revenue is heavily dependent on the amount of equipment
installed at customer locations and the utilization of those
devices. As such, our critical success factors include
hardware installations, which stabilize and grow our
installed base of equipment at customer locations, page
volume growth and higher revenue per page. Connected
multifunction devices, 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.

In 2006, we grew revenue, expanded earnings and
significantly improved our overall financial condition and
liquidity. Our continued investments in the growing areas
of digital production and office systems, particularly with
respect to color products, contributed to the majority of our
equipment sales being generated from products launched in
the last two years. Total revenue increased 1% over the
prior year, as growth in our post sale annuities more than
offset declines in equipment sales and finance income. Post
sale and other revenues increased 3% as compared to prior
year. Total color revenue was up 13% over the prior year
reflecting our investments in this market.

We maintained our focus on cost management

throughout 2006. While 2006 gross margins of 40.6% were
0.6-percentage points below 2005, we continued to more
than offset lower prices with productivity improvements.
Gross margins continued to be impacted by a change in
overall product mix reflecting a higher proportion of sales
of products with lower gross margins. We reduced selling,
administrative and general (“SAG”) expenses as
administrative and general expense efficiencies more than
offset increased bad debt expense. We continued to invest
in research and development, prioritizing our investments
to the faster growing areas of the market.

26

Our 2006 balance sheet strategy focused on

optimizing operating cash flows, maintaining debt levels
primarily to support our customer financing operations,
replacing secured debt collaterized by our finance
receivables with new unsecured debt, and returning
value to shareholders through acquisitions and our
announced share repurchase programs. The successful
implementation of this strategy in 2006 enabled us to
significantly improve our financial position, return to
investment grade and finish the year with a cash, cash
equivalents and short-term investments

Currency Impacts

balance of $1.5 billion. Our prospective balance
sheet strategy includes: optimizing operating cash flows;
maintaining our investment grade credit ratings;
achieving an optimal cost of capital; rebalancing secured
and unsecured debt; and effectively deploying cash to
deliver and maximize long-term shareholder value. Our
strategy also includes maintaining an appropriate
leverage of our financing assets (finance receivables and
equipment on operating leases) and an appropriate level
of non-financing debt.

To understand the trends in the business, we believe

that it is helpful to analyze the impact of changes in the
translation of foreign currencies into U.S. dollars on
revenues and expenses. We refer to this analysis as
“currency impact” or “the impact from currency”.
Revenues and expenses from our Developing Markets
Operations (“DMO”) are analyzed at actual exchange
rates for all periods presented, since these countries
generally have volatile currency and inflationary
environments, and our operations in these countries have
historically implemented pricing actions to recover the
impact of inflation and devaluation. We do not hedge the

translation effect of revenues or expenses denominated in
currencies where the local currency is the functional
currency.

Approximately half of our consolidated revenues are

derived from operations outside of the United States
where the U.S. dollar is not the functional currency.
When compared with the average of the major European
currencies on a revenue-weighted basis, the U.S. dollar
was unchanged in both 2006 and 2005 and 10% weaker in
2004. As a result, the foreign currency translation impact
on revenue was negligible in 2006 and 2005.

Summary Results:

Revenues for the three years ended December 31, 2006 were as follows:

(in millions)

Year Ended December 31,

Percent Change

2006

2005

2004

2006

2005

Equipment sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Post sale and other revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Finance income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$ 4,457
10,598
840

$ 4,519
10,307
875

$ 4,480
10,308
934

1%

(1)%
3% —
(4)% (6)%

Total Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$15,895

$15,701

$15,722

1% —

Total Color revenue included in total revenue . . . . . . . . . . . . . . . . . . . . .

$ 5,578

$ 4,928

$ 4,188

13% 18%

The following presentation reconciles the above information to the revenue classifications included in our

Consolidated Statements of Income:

(in millions)

Year Ended December 31,

2006

2005

2004

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Less: Supplies, paper and other sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$ 7,464
(3,007)

$ 7,400
(2,881)

$ 7,259
(2,779)

Equipment sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Service, outsourcing and rentals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Add: Supplies, paper and other sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$ 4,457
$ 7,591
3,007

$ 4,519
$ 7,426
2,881

$ 4,480
$ 7,529
2,779

Post sale and other revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$10,598

$10,307

$10,308

27

Total 2006 Revenue of $15,895 million increased
1% from the prior year comparable period. There was a
negligible impact from currency on total revenue for the
year ended December 31, 2006 as compared to the prior
year. Total revenue included the following:

•

•

•

•

1% decline in equipment sales, including a benefit
from currency of 1-percentage point, primarily
reflecting revenue declines in Office and
Production black-and-white products, which were
partially offset by revenue growth from color
products and growth in DMO.
3% growth in post sale and other revenue, including
a benefit from currency of 1-percentage point,
primarily reflecting growth in digital Office and
Production products and DMO, offset by declines
in light lens and licensing revenue.
13% growth in color revenue. Color revenue of
$5,578 million comprised 35% of total revenue for
the year ended December 31, 2006 compared to
31% for the year ended December 31, 2005.
4% decline in Finance income, including a benefit
from currency of 1-percentage point, reflecting
lower average finance receivables.

• Overall our 2006 post-sale annuity revenue,

including Post sale and other revenue and Finance
income, increased 2% and comprised 72% of total
revenue.

Total 2005 Revenue of $15,701 million was

comparable to the prior year period. Currency impacts on
total revenue were negligible for the year. Total 2005
revenue included the following:

•

1% growth in Equipment sales, including a
negligible impact from currency, primarily
reflecting revenue growth from color in Office and
Production, low-end black-and-white office
products as well as growth in DMO. These growth
areas were partially offset by revenue declines in
higher-end office black-and-white products, and
black-and-white production products.

• Comparable Post sale and other revenues, including

a negligible impact from currency, primarily
reflecting revenue growth from digital products and
in DMO which were partially offset by declines in
light lens.
6% decline in Finance income, including benefits
from currency of 1-percentage points, which
reflects lower finance receivables.

•

Net income and diluted earnings per share for the three years ended December 31, 2006 were as follows:

(in millions, except share amounts)

2006

2005

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$1,210

$ 978

Diluted earnings per share . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$ 1.22

$0.94

2004

$ 859

$0.86

Year Ended December 31,

2006 Net income of $1,210 million, or $1.22 per

2005 Net income of $978 million, or $0.94 per

diluted share, included the following:

diluted share, included the following:

•

•

•

•

•

$472 million income tax benefit related to the
favorable resolution of certain tax matters from the
1999-2003 IRS audit.
$68 million (pre-tax and after-tax) for litigation
matters related to probable losses on Brazilian
labor-related contingencies.
$46 million tax benefit resulting from the resolution
of certain tax matters associated with foreign tax
audits.
$9 million after-tax ($13 million pre-tax) charge
from the write-off of the remaining unamortized
deferred debt issuance costs as a result of the
termination of our 2003 Credit Facility.
$257 million after-tax ($385 million pre-tax)
restructuring and asset impairment charges.

•

•

•

•

$343 million after-tax benefit related to the
finalization of the 1996-1998 IRS audit.
$84 million after-tax ($115 million pre-tax) charge
for litigation matters relating to the MPI arbitration
panel decision and probable losses for other legal
matters.
$58 million after-tax ($93 million pre-tax) gain
related to the sale of our entire equity interest in
Integic Corporation (“Integic”).
$247 million after-tax ($366 million pre-tax)
restructuring and asset impairment charges.

2004 Net income of $859 million, or $0.86 per

diluted share, included the following:

•

$83 million after-tax ($109 million pre-tax) gain
related to the sale of substantially all of our
investment in ContentGuard Holdings, Inc.
(“ContentGuard”).

28

•

•

$38 million after-tax pension settlement benefit
from Fuji Xerox.
$30 million after-tax ($38 million pre-tax) gain
from the sale of our investment in ScanSoft, Inc.
(“ScanSoft”).

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, refer to
Note 1 – Summary of Significant Accounting Policies, 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 impacted
revenues and expenses during the reporting period.
Although actual results may differ from those estimates,
we believe the estimates 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 for Leases: Our accounting for

leases involves specific determinations under applicable
lease accounting standards, which often involve complex
and prescriptive provisions. These provisions affect the
timing of revenue recognition for our equipment. If the

29

•

$57 million after-tax ($86 million pre-tax)
restructuring and asset impairment charges.

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 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 principal 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.

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 monthly fixed price 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. 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 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 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. Our pricing interest 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.

Residual Values for Equipment under Lease:
Residual values represent the recorded estimated fair
value of equipment as of the end of the lease. Residual
values associated with equipment under sales-type leases
are included as a component of our net finance
receivables balance and amounted to $89 million and $87
million at December 31, 2006 and 2005. Residual values
associated with equipment under operating leases
represent the recorded estimated salvage value at the end
of the lease term and are included as a component of
equipment on operating leases, net and amounted to $41
million and $48 million at December 31, 2006 and 2005.
Equipment under operating leases and similar
arrangements are depreciated to estimated salvage value
over their estimated useful lives.

We review residual values regularly and, when
appropriate, adjust them based on estimates of expected
market conditions at the end of the lease, including the
impacts of future product launches, changes in
remanufacturing strategies and the expected lessee
behavior at the end of the lease term. Impairments to
residual values occur when available information
indicates that the decline in recorded value is other than
temporary and we would therefore not be able to fully
recover the recorded values. Impairments on residual
values are recognized as losses in the period in which the
estimate is changed or as a revision in depreciation
estimates for sales-type leases and operating leases,
respectively. We did not record any residual value
impairment charges for the year ended December 31,
2006. We recorded $4 million and $3 million in residual
value impairment charges for the years ended
December 31, 2005 and 2004, respectively.

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
collections and payments from our customers and
maintain a provision for estimated credit losses based
upon our historical experience and any specific customer
collection 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 $87 million, $72 million, and $110
million in SAG expenses in our Consolidated Statements
of Income for the years ended December 31, 2006, 2005
and 2004, respectively. The current level of our provision
for doubtful accounts reflects 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 year period ended
December 31, 2006, 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 presented.
During the five year period ended December 31, 2006,
our allowance for doubtful accounts ranged from 3.0% to
5.2% of gross receivables. Holding all other assumptions
constant, a 1-percentage point increase or decrease in the
allowance from the December 31, 2006 rate of 3.0%
would change the 2006 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.

30

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 statistical 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 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 can result 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 net actuarial (gain) loss and is subject
to amortization to net periodic pension cost over the
average remaining service lives of the employees
participating in the pension plan.

Total actuarial losses as of December 31, 2006 were
$1.6 billion, as compared to $1.9 billion at December 31,
2005. The change from December 31, 2005 relates to
improved asset returns as compared to expected returns
and an increase in the discount rate. The total actuarial
loss will be amortized in the future, subject to offsetting
gains or losses that will change the future amortization
amount. We have utilized a weighted average expected
rate of return on plan assets of 7.8% for 2006 expense,
8.0% for 2005 expense and 8.1% for 2004 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 expected rate of return on plan
assets we will utilize to calculate our 2007 expense will
be 7.6%.

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. The discount rate reflects
the current rate at which the pension liabilities could be
effectively settled considering the timing of expected
payments for plan participants. In estimating this rate, we
consider rates of return on high quality fixed-income
investments included in various published bond indexes,
adjusted to eliminate the effects of call provisions and
differences in the timing and amounts of cash outflows
related to the bonds. In the U.S. and the U.K., which
comprise approximately 80% of our projected benefit
obligations, we consider the Moody’s Aa Corporate Bond
Index and the International Index Company’s iBoxx
Sterling Corporate AA Cash Bond Index, respectively in
the determination of the appropriate discount rate
assumptions. The weighted average rate we will utilize to
measure our pension obligation as of December 31, 2006
and calculate our 2007 expense will be 5.3%, which is an
increase from 5.2% used in determining 2006 expense.
Assuming settlement losses in 2007 are consistent with
2006; our 2007 net periodic pension cost is expected to
be approximately $50 million lower than 2006 primarily
as a result of plan design changes and an increase in the
discount rate.

On a consolidated basis, we recognized net periodic

pension cost of $425 million, $414 million, and $421
million for the years ended December 31, 2006, 2005 and
2004, respectively. The costs associated with our defined
contribution plans, which are included in net periodic
pension cost, were $70 million, $71 million and $69
million for the years ended December 31, 2006, 2005 and
2004, 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 14 –
Employee Benefit Plans to the Consolidated Financial
Statements. Holding all other assumptions constant, a
0.25% increase or decrease in the discount rate would
change the 2007 projected net periodic pension cost by
approximately $33 million. Likewise, a 0.25% increase
or decrease in the expected return on plan assets would
change the 2007 projected net periodic pension cost by
approximately $19 million.

Refer to Note 1 – “New Accounting Standards and

Accounting Changes” to the Consolidated Financial
Statements for further information regarding adoption of
SFAS No. 158, “Employers’ Accounting for Defined
Benefit Pension and Other Postretirement Plans, on
amendment of FASB Statements No. 87, 88, 106 and
132(R).”

31

Income Taxes and Tax Valuation Allowances: We

record the estimated future tax effects of temporary
differences between the tax bases of assets and liabilities
and amounts reported in our Consolidated Balance
Sheets, as well as operating loss and tax credit
carryforwards. 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 portion 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 period.
Adjustments to our valuation allowance, through (credits)
charges to income tax expense, were $12 million, $(38)
million, and $12 million for the years ended
December 31, 2006, 2005 and 2004, respectively. There
were other increases/(decreases) to our valuation
allowance, including the effects of currency, of $45
million, $61 million, and $(21) million for the years
ended December 31, 2006, 2005 and 2004, respectively,
that did not affect income tax expense in total as there
was a corresponding adjustment to deferred tax assets or
other comprehensive income. Gross deferred tax assets of
$3.9 billion and $3.6 billion had valuation allowances of
$647 million and $590 million at December 31, 2006 and
2005, respectively. We plan on adopting FASB

Results of Operations

Segment Revenue

Interpretation No. 48, “Accounting for Uncertainty in
Income Taxes – an Interpretation of FASB Statement
No. 109,” beginning January 1, 2007. The adoption of this
interpretation will change the way we evaluate
recognition and measurement of uncertain tax positions.
Refer to Note 1 – “New Accounting Standards and
Accounting Changes” to the Consolidated Financial
Statements for further information regarding the adoption
of this interpretation.

We are subject to ongoing tax examinations and
assessments in various jurisdictions. Accordingly, we
may incur additional tax expense based upon our
assessment of 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
examinations and related tax positions require judgment
and can materially 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 16 – Contingencies 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 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.

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 (“ppm”) and color
products which operate at speeds over 40 ppm, excluding

32

50 ppm products with an embedded controller. Products
include the Xerox iGen3® digital color production press,
Xerox Nuvera™, DocuTech®, DocuPrint®, Xerox 4110™
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
that operate at speeds up to 90 ppm, and color devices up
to 40 ppm, as well as, 50 ppm color devices with an
embedded controller. 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. These products are sold through direct
and indirect sales channels in North America and Europe
to global, national, small and mid-size commercial
customers as well as government, education and other
public sector customers. The DMO segment includes our

operations in Latin America, Brazil, the Middle East,
India, Eurasia, Central and Eastern Europe and Africa.
This segment’s sales consist of office and production
products including a large proportion of office devices
and printers which operate at speeds of 11-40 ppm.
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), value-
added services, Wide Format Systems, Xerox Technology
Enterprises, royalty and licensing revenues, equity net
income and non-allocated Corporate items. Paper sales
were approximately 60% of Other segment revenues in
2006. Other segment profit includes the operating results
from these entities, other less significant businesses, our
equity income from Fuji Xerox, and certain costs that
have not been allocated to the Production, Office and
DMO segments, including non-financing interest as well
as other items included in Other expenses, net.

Revenue by segment for the years ended 2006, 2005 and 2004 were as follows:

(in millions)

2006

Production

Office

DMO

Other

Total

Equipment sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Post sale and other revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Finance income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$1,343
2,913
323

$2,368
4,760
497

$ 605
1,327
6

$ 141
1,598
14

$ 4,457
10,598
840

Total Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$4,579

$7,625

$1,938

$1,753

$15,895

2005

2004

Equipment sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Post sale and other revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Finance income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$1,368
2,830
342

$2,436
4,670
512

$ 558
1,245
9

$ 157
1,562
12

$ 4,519
10,307
875

Total Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$4,540

$7,618

$1,812

$1,731

$15,701

Equipment sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Post sale and other revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Finance income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$1,358
2,880
352

$2,431
4,644
552

$ 503
1,194
10

$ 188
1,590
20

$ 4,480
10,308
934

Total Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$4,590

$7,627

$1,707

$1,798

$15,722

Equipment Sales

Equipment sales reflect the results of our technology

2006 Equipment sales of $4,457 million declined 1%

investments and the associated product launches as
approximately two-thirds of 2006 equipment sales were
generated from products launched in the past 24 months.

from 2005 reflecting:

• Currency benefit of 1-percentage point.
• Growth in color products and DMO offset by

declines in high-end black-and-white Production
products.

33

•

Strong install activity in Color products and Office
black-and-white products including, entry
production color, iGen3 and office multifunction
color products, were partially offset by overall price
declines.

• Growth in color equipment sales of 9%. The pace
of color equipment sales growth was impacted by
lower OEM color printer sales. Color sales
represented approximately 45% of total equipment
sales in the year ended December 31, 2006 versus
41% in the comparable prior period.

Production
2006 Equipment sales declined 2% including a benefit
from currency of 1-percentage point, as price declines of
less than 5% were partially offset by strong color install
activity. Production system install activity for 2006,
included the following:

•

•

74% growth in installs of production color products
largely driven by strong activity in the DocuColor®
240/250, DocuColor 5000 and DocuColor
7000/8000, as well as an increase in iGen3 installs.
Installs of production black-and-white systems
were flat year-over-year. This included 16% growth
in installs of black-and-white light production
systems, reflecting continued success of the 4110
light production system, which was more than
offset by 21% declines in installs of high-end
black-and-white systems.

Office
2006 Equipment sales declined 3% including a benefit
from currency of 1-percentage point, reflecting price
declines of less than 10%, which more than offset the
growth in office color multifunction and black-and-white
products. In addition, an increased proportion of Office
equipment installed under operating lease contracts are
recognized in post sale revenue. Office product install
activity for 2006 included the following:

•

•

•

35% install growth in office color multifunction
systems.
8% install growth in black-and-white digital copiers
and multifunction devices. Install growth was
driven by 15% growth in Segments 3-5 devices
(31-90 ppm) and 7% growth in Segments 1-2
devices (11-30 ppm).
5% decline in color printers as compared to 111%
growth in the comparable 2005 periods. The
decline reflects lower 2006 OEM sales.

34

2005 Equipment sales of $4,519 million increased

1% from 2004 reflecting:

• Negligible impact from currency.
• Growth in lower-end office black-and-white
devices, color printers, as well as office and
production color systems, which more than offset
declines in other monochrome office and
monochrome production products.

• Growth in color equipment sales of $329 million or
22%, from the prior comparable period. Color
equipment sales represented 41% of total
equipment sales versus 34% for the prior year
comparable period.

2005 Equipment sales increased 1% from 2004,

primarily reflecting install growth with a negligible
impact from currency, partially offset by price declines of
approximately 5% and product mix. Production system
install activity for 2005 included the following:

•

•

30% growth in installs of production color products
largely driven by strong iGen3, DocuColor
240/250, and DocuColor 7000/8000 activity.
9% growth in installs of black-and-white
production systems reflecting the success of the
4110 light production system, as well as growth in
production publishing systems.

2005 Equipment sales were comparable to 2004,

•

including a negligible impact from currency. Strong
install growth was offset by price declines of
approximately 7% and product mix, which reflected an
increased proportion of lower-end equipment sales. Office
product install activity for 2005 included the following:
22% install growth in black-and-white digital
copiers and multifunction devices driven by strong
sales of Segments 1-2 devices (11-30 ppm), which
more than offset declines of Segments 3-5 devices
(31-90 ppm).
51% install growth in office color multifunction
systems driven in part by strong sales of the
DocuColor 240/250, which was announced during
the second quarter of 2005.
111% improvement in install activity for color
printers driven by OEM sales.

•

•

DMO
DMO Equipment sales consist of office and production
products, including a large proportion of sales of
Segments 1-2 office devices. Equipment sales in 2006
increased 8% from 2005, reflecting strong sales of
Segments 1-2 devices, as well as install growth in light

production black-and-white and production color systems.
Equipment sales in 2005 increased 11% from 2004,
primarily reflecting strong growth in Eurasia and Central
and Eastern Europe.

Other
2006 and 2005 Equipment sales declined 11% and 16%,
respectively from prior years comparable periods, driven

by lower component sales included in value-added
services offerings.

Post Sale and Other Revenue

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 and the mix of color pages, as well as
associated services.

2006 Post sale and other revenues of $10,598 million

grew 3% from 2005, with our growth areas (“digital
office, digital production and value-added services”)
collectively growing 5% and DMO growing 7%, partially
offset by a 39% decline in analog light lens products.
Analog revenues of $302 million represented 3% of 2006
post sale revenue compared to $494 million or 5% of
2005 post sale revenue. Color post sale and other revenue
grew 16% for 2006. Color sales represented 31% of post
sale and other revenue in 2006 versus 28% in 2005. In
2006, approximately 9% of our pages were printed on
color devices, which is up from 7% in 2005.

2005 Post sale and other revenues of $10,307 million
were comparable to the prior year period, with our growth
areas (“digital office, digital production and value-added
services”) collectively growing 5% and DMO growing
4%, more than offsetting a 40% decline in analog light
lens products. Color post sale and other revenue grew
15% for 2005, and color sales represented 28% of post
sale and other revenue in 2005 versus 24% in 2004. In
2005, approximately 7% of our pages were printed on
color devices, which is up from 5% in 2004.

Production: 2006 Post sale and other revenue
increased 3% from 2005, including a benefit from
currency of 1-percentage point, primarily reflecting
growth in color products which was partially offset by
declines in revenue from high-end black-and-white digital

2007 Projected Revenues

products and older light lens technology. 2005 post sale
and other revenue declined 2% from 2004, as declines in
older light lens technology were only partially offset by
revenue growth from digital products.

Office: 2006 Post sale and other revenue grew 2%

from 2005, including a benefit from currency of
1-percentage point, as growth in revenue from color
multifunction products, black-and-white and color
printers, were partially offset by declines in
black-and-white multifunction and older light lens
technology. 2005 post sale and other revenue increased
1% from 2004, primarily reflecting a 1-percentage point
benefit from currency and growth in digital
black-and-white, color printing and color multifunctional
products. These positive effects were partially offset by
declines in older light lens technology.

DMO: 2006 Post sale and other revenue grew 7%
from 2005, driven primarily by growth in revenue from
supplies, color products and services. 2005 post sale and
other revenue grew 4% from 2004, reflecting growth in
Eurasia and Central and Eastern Europe, more than
offsetting declines in Brazil.

Other: 2006 Post sale and other revenue increased

3% from 2005, including a benefit from currency of
1-percentage point, primarily driven by increased paper
sales and value-added services. Paper comprised
approximately two-thirds of 2006 Other segment post sale
and other revenue. 2005 post sale and other revenue
declined 2% from 2004, including a negligible impact
from currency, as declines in SOHO and other revenues
were partially offset by growth in value-added services.

Excluding currency impacts, we expect 2007
revenue to grow modestly driven by continued increases
in post sale revenue. We anticipate that new launches

combined with products and applications launched during
the past 2 years, and the businesses acquired in 2006, will
enable us to further strengthen our market position.

35

Growth in post sale and other revenue will be driven by
our success at increasing the amount of our equipment at
customer locations, the volume of pages and mix of color

pages generated on that equipment, as well as growth in
document management services.

Segment Operating Profit

Segment Operating profit and operating margin for the three years ended December 31, 2006 were as follows:

(in millions)

2006

Production

Office

DMO

Other

Total

Operating Profit
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Operating Margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$ 403

8.8%

$ 832
10.9% 6.4%

$124

$ 31

$1,390

1.8%

8.7%

2005

2004

Operating Profit
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Operating Margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$ 427

$ 819

$ 64

$ 151

$1,461

9.4%

10.8% 3.5%

8.7%

9.3%

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Operating Profit
Operating Margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$ 511
11.1%

$ 779

$ 35

$(125)

$1,200

10.2% 2.1% (7.0)%

7.6%

Production: 2006 Operating profit declined $24
million from 2005, reflecting reduced gross margins
impacted by product mix, price declines and higher bad
debt expense, partially offset by both lower R,D&E
spending and selling expenses. The reduction in R,D&E
reflects benefits from our platform strategy to launch new
technology and lower spending related to environmental
compliance activities.

2005 Operating profit declined $84 million from

2004, primarily reflecting reduced gross margins
impacted by mix, and higher selling expenses, which
were partially offset by improvements in G&A and
R,D&E efficiencies.

•

$13 million pre-tax write-off of the remaining
unamortized deferred debt issuance costs associated
with the termination of our 2003 Credit Facility that
occurred in 2006.

• Lower 2006 interest income of $12 million and
increased non-financing interest expense of $8
million.
The above were partially offset by the following:
Increased paper profit due to increased sales as well
as reduced SAG expenses primarily from
organizational streamlining.
$44 million in gains on sale of assets.

•

•

2005 Operating profit increased $276 million as

Office: 2006 Operating profit increased $13 million

compared to 2004, principally due to:

from 2005, reflecting reduction in SAG expenses partially
offset by lower gross profit. 2005 Operating profit
increased $40 million primarily reflecting lower SAG,
partially offset by lower gross margins impacted by mix
and higher R,D&E.

DMO: 2006 Operating profit increased $60 million
from 2005, reflecting higher gross profit and reduction in
SAG expenses, including improvement in bad debt
expenses. 2005 Operating profit increased $29 million
from 2004, primarily reflecting increasing revenues and
operating margin contributions from Eurasia and Central
and Eastern Europe.

Other: 2006 Operating profit declined $120 million

from 2005, principally due to:

• Absence of the 2005 $93 million gain related to the
sale of Integic and the 2005 $57 million interest
income benefit from the finalization of the 1996-
1998 Internal Revenue Service tax audit.

• Reduced interest expense of $157 million, primarily

due to lower average debt balances.

• Higher interest income of $63, which includes $57
million associated with the finalization of the 1996-
1998 IRS audit.

• An improvement in aggregate currency gains and

losses of $68 million.

• A gain on the sale of Integic of $93 million.
• These items were partially offset by the absence of
the $38 million pension settlement gain from Fuji
Xerox in 2004, as well as the absence of the $38
million gain from the 2004 sale of our ownership
interest in ScanSoft.

Refer to Note 2 – Segment Reporting in the

Consolidated Financial Statements, for further discussion
on our reportable segment operating revenue and
operating profit.

36

Gross Margins

Gross margins by revenue classification were as

follows:

(in millions)

Year Ended December 31,

2006

2005

2004

Total Gross margin . . . . . . . . . . 40.6% 41.2% 41.6%
Sales . . . . . . . . . . . . . . . . . 35.7% 36.6% 37.4%
Service, outsourcing and

rentals . . . . . . . . . . . . . . 43.0% 43.3% 43.0%
Finance income . . . . . . . . 63.7% 62.7% 63.1%

2006 Gross margin of 40.6% decreased by
0.6-percentage points from 2005 due to product mix.
Price declines of 1.4-percentage points were offset by
productivity improvements and other variances of
1.4-percentage points. 2005 Gross margin of 41.2%
decreased 0.4-percentage points from 2004 reflecting a
decline in product mix of 1.3-percentage points reflecting
a higher proportion of sales in office printers and light
production systems. Price declines of 1.5-percentage
points were more than offset by cost improvements of
2.3-percentage points.

2006 Sales gross margin of 35.7% decreased

0.9-percentage points from 2005 as price declines of
2.1-percentage points exceeded the combined impacts of
productivity improvements, product mix and other
variances of 1.2-percentage points. 2005 Sales gross
margin of 36.6% decreased 0.8-percentage points from
2004 driven by product mix declines of 1.5-percentage
points. Price declines of 2.2-percentage points were more
than offset by cost improvements of 2.4-percentage points.
Product mix reflects a higher proportion of sales of
products with lower gross margins, including office
printers and light production systems, and a lower
proportion of sales of products with higher gross margins
such as higher end office black-and-white multifunction
devices and high-end production black-and-white systems.

2006 Service, outsourcing and rentals margin of
43.0% decreased 0.3-percentage points from 2005 as
product mix decline of 1.3-percentage points exceeded
the impact of productivity improvements, price and other
variances of 1.0-percentage points. 2005 Service,
outsourcing and rental margin of 43.3% increased
0.3-percentage points driven by cost improvements of
2.6-percentage points, which more than offset by prices
declines of 1.1-percentage points and product mix
declines of 0.9-percentage points.

2006 Finance income gross margin of 63.7%
improved 1.0-percentage point and 2005 Finance income
gross margin of 62.7% declined 0.4-percentage points due
to changes in interest costs specific to equipment
financing. Equipment financing interest is determined
based on an estimated cost of funds, applied against the
estimated level of debt required to support our net finance
receivables. Prior to 2006, the estimated cost of funds was
primarily based on our secured borrowing rates. As a
result of the reduction in our level of secured borrowings,
effective January 1, 2006 the estimated cost of funds is
based on a blended rate for term and duration comparable
to available borrowing rates for a BBB rated company as
of the end of each period. This change in basis did not
materially impact the calculated amount of Equipment
finance interest expense and accordingly did not impact
comparability between the periods. The estimated level of
debt is based on an assumed 7 to 1 leverage ratio of debt/
equity as compared to our average finance receivable
balance during the applicable period.

Research, development and engineering
(“R,D&E”) of $922 million in 2006 was $21 million
lower than the prior year primarily due to lower
environmental compliance spending. We expect 2007
R,D&E spending to approximate 5-6% of total revenue.

Research and development (“R&D”) of $761 million

in 2006 increased from the prior year by $6 million
reflecting higher expenditures in the Production and
Office segments primarily related to expected 2007
product launches. We invest in technological
development, particularly in color, and believe our R&D
spending is sufficient to remain technologically
competitive. Our R&D is strategically coordinated with
that of Fuji Xerox, which invested $660 million and $720
million in R&D in 2006 and 2005, respectively. 2005
R&D expense of $755 million was $5 million lower than
the prior year, primarily reflecting lower expenditures in
the Production segment, which were partially offset by
increased spending in the Office segment. The lower
spending in the Production segment was as a result of
product launches, and cost efficiencies that we captured
from our platform development strategy.

Sustaining engineering costs of $161 million
decreased by $27 million from the prior year, reflecting
lower spending related to environmental compliance
activities and maturing product platforms. Refer to
Note 1 – “Basis of Presentation” in the Consolidated
Financial Statements for additional information.

37

Selling, administrative and general expenses
(“SAG”) SAG expense information was as follows (in
millions):

Year Ended December 31, Amount Change

2006

2005

2004

2006

2005

Total SAG

expenses . . . . . $4,008 $4,110 $4,203 $(102) $(93)

SAG as a

percentage
of revenue . . . 25.2% 26.2% 26.7% (1.0)% (0.5)%

In 2006, SAG expenses decreased primarily as a

result of the following:

•

•

•

$58 million reduction in selling expenses compared
to 2005 included lower marketing spending and
headcount reductions.
$59 million reduction in general and administrative
(“G&A”) expenses as the result of continued
expense management initiatives, including benefits
from restructuring.
$15 million increase in bad debt expense to $87
million for 2006.

In 2005, SAG expenses decreased primarily as a

result of the following:

• An $86 million reduction in G&A expenses due to

continued expense management initiatives.
• A $38 million decrease in bad debt expense.
• A partially offsetting increase in selling expenses of
$31 million from 2004 due to additional spending
for advertising and marketing programs to support
product launches and other selling expenses, as
well as, special compensation payments related to
the 2005 merit increase process. These increases in
selling expenses were partially offset by the
absence of $28 million Olympic marketing expense
that occurred in 2004.

Bad debt expense included in SAG was $87 million,

$72 million and $110 million in 2006, 2005 and 2004,
respectively. The 2005 reduction in bad debt expense
reflected the benefits associated with recoveries and

adjustments to the reserves, as the result of improvements
in write-offs and aging. This favorable trend in write-offs,
receivables aging and collections continues to be reflected
in our current year bad debt expense. Bad debt expense as
a percent of total revenue was 0.5%, 0.5% and 0.7% for
2006, 2005 and 2004, respectively.

For the three years ended December 31, 2006, 2005

and 2004 we recorded restructuring and asset
impairment charges of $385 million, $366 million and
$86 million, respectively, primarily related to headcount
reductions of approximately 3,400, 3,900 and 1,900
employees, respectively, across all geographies and
segments. 2006 actions associated with these changes
primarily include the following: technical service; service
infrastructure and global back-office optimization;
continued R&D efficiencies and productivity
improvements; supply chain optimization to ensure, for
example, alignment to our global two-tier model
implementation; and selected off-shoring opportunities.
Lease termination and asset impairment charges of $67
million included within these charges primarily relate to
the relocation of certain manufacturing operations as well
as an exit from certain leased and owned facilities. The
remaining restructuring reserve balance as of
December 31, 2006, for all programs was $337 million.
We expect prospective annualized savings associated with
the 2006 actions to be approximately $300 million, with
over half of the savings expected to be in gross margin
and the rest in SAG and R,D&E. Refer to Note 9 –
Restructuring and Asset Impairment Charges in the
Consolidated Financial Statements for further information
regarding our restructuring programs.

Worldwide employment of 53,700 as of

December 31, 2006 declined approximately 1,500 from
December 31, 2005, primarily reflecting reductions
attributable to our restructuring programs and other
attrition partially offset by hiring in strategic business
areas and the hiring of former contract employees in
certain Latin American subsidiaries. Worldwide
employment was approximately 55,200 and 58,100 at
December 31, 2005 and 2004, respectively.

38

Other Expenses, Net: Other expenses, net for the three years ended December 31, 2006 consisted of the

following:

(in millions)

Non-financing interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Gain on sales of businesses and assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Currency losses, net
Amortization of intangible assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Legal matters . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Minorities’ interests in earnings of subsidiaries . . . . . . . . . . . . . . . . . . . . . . . . . . . .
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Loss on extinguishment of debt
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
All other expenses, net

Total Other expenses, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Year Ended December 31,

2006

$239
(69)
(44)
39
41
89
22
15
4

$336

2005

$ 231
(138)
(97)
5
38
115
15
—
55

$ 224

2004

$363
(75)
(61)
73
37
9
8

—
15

$369

Non-financing interest expense: In 2006

non-financing interest expense increased due to higher
interest rates partially offset by lower average debt
balances. 2005 non-financing interest expense decreased
due to lower average debt balances as a result of
scheduled term debt repayments and medium-term note
redemptions, as well as the full-year effect of the
December 2004 Capital Trust II liability conversion.

Interest income: Interest income is derived primarily
from our invested cash and cash equivalent balances and
interest resulting from periodic tax settlements. In 2006,
interest income decreased primarily due to:

• Absence of $57 million of interest income

associated with the 2005 settlement of the 1996-
1998 IRS audit. (Refer to Note 15 – Income and
Other Taxes in the Consolidated Financial
Statements).

• Lower average cash balances partially offset by

higher rates of return.

In 2005, interest income increased primarily due to:
• A $57 million increase associated with the

previously disclosed settlement of the 1996-1998
IRS audit.

• A $23 million increase primarily reflecting higher
rates of return from our money market funds.
Partially offset by the absence of $26 million of
interest income related to a 2004 domestic tax
refund.

•

Gain on sales of businesses and assets: 2006 gain on

sales of businesses and assets primarily consisted of the
following:

•

$15 million on the sale of our Corporate
headquarters. (Refer to Note 6 – Land, buildings
and equipment, net in the Consolidated Financial
Statements for further information.)

•
•

$11 million on the sale of a manufacturing facility.
$10 million receipt from escrow of additional
proceeds related to our first quarter 2005 sale of
Integic. The proceeds were placed in escrow upon
the sale of Integic pending completion of an
indemnification period, which ended in 2006.

In 2005, gain on sales of businesses and assets
primarily consist of the $93 million gain on the sale of
Integic. In 2004, gains on the sale of businesses and assets
primarily reflect the $38 million pre-tax gain from the
sale of our ownership interest in ScanSoft, as well as,
gains totaling $14 million related to the sale of certain
excess land and buildings in Europe and Mexico.

Currency gains and losses: Currency gains and

losses primarily result from the re-measurement of
foreign currency-denominated assets and liabilities, the
cost of hedging foreign currency-denominated assets and
liabilities, the mark-to-market of any foreign exchange
contracts utilized to hedge those foreign currency-
denominated assets and liabilities and the mark-to-market
impact of hedges of anticipated transactions, primarily
future inventory purchases, for which we do not generally
apply cash flow hedge accounting treatment.

In 2006, 2005 and 2004 currency losses totaled $39

million, $5 million and $73 million respectively. The 2006
increase in currency losses primarily reflected the
mark-to-market of derivative contracts which are
economically hedging anticipated foreign currency
denominated payments. The mark-to-market losses were
primarily due to the strengthening of the Euro against other
currencies, in particular the Canadian Dollar, U.S. Dollar
and Japanese Yen, as compared to the weakening Euro in
2005. The decrease in 2005 from 2004 was primarily due
to the strengthening of the U.S. and Canadian Dollars

39

against the Euro and the Yen in 2005, as compared to the
weakening U.S. Dollar in 2004, and decreased costs of
hedging foreign currency denominated assets and liabilities
due to lower spot/forward premiums in 2005.

Legal matters: In 2006 legal matters expenses

consisted of the following:

•

•

$68 million for probable losses on Brazilian labor-
related contingencies – see Note 16 –
Contingencies within the Consolidated Financial
Statements for additional details.
$33 million associated with probable losses from
various legal matters partially offset by $12 million
of proceeds from the Palm litigation matter. The
remaining proceeds from the Palm litigation matter
of $11 million are associated with a license and are
recorded in Sales as licensing revenue.

In 2005, legal matters expenses consisted of the

following:

•

•

$102 million, including $13 million for interest
expense, related to the MPI arbitration panel ruling.
$13 million related to other legal matters, primarily
reflecting charges for probable losses on cases that
have not yet been resolved.

•

In 2004, legal matters expenses consisted of costs

associated with the resolution of legal and regulatory
matters, none of which was individually material,
partially offset by the adjustment of an estimate
associated with a previously recorded litigation accrual.

Refer to Note 16 – Contingencies in the
Consolidated Financial Statements for additional
information regarding litigation against the Company.

Loss on extinguishment of debt: 2006 loss of $15
million includes the $13 million write-off of remaining
unamortized deferred debt issuance costs associated with
the termination of our 2003 Credit Facility and a $2
million loss associated with the mortgage repayment in
connection with the sale of our Corporate headquarters.

All other expenses, net: In 2006 all other expenses,
net decreased due to the absence of the following 2005
items:
•

$15 million for losses sustained from Hurricane
Katrina related to property damage and impaired
receivables.
$26 million charge related to the European Union
Waste Directive.

Income tax (benefits) expenses were as follows (in millions):

Pre-tax income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Income tax (benefits) expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Effective tax rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$ 808
(288)
(35.6)% (0.6)%

$830
(5)

$ 965
340
35.2%

The 2006 effective tax rate of (35.6%) was lower

The 2005 effective tax rate of (0.6)% was lower than

than the U.S. statutory rate primarily due to:

the U.S. statutory tax rate primarily due to:

Year Ended December 31,

2006

2005

2004

• Tax benefits of $518 million from the resolution of
tax issues associated with domestic and foreign tax
audits.

• Tax benefits of $19 million as a result of tax law

•

changes and tax treaty changes.
$11 million from the reversal of a valuation
allowance on deferred tax assets associated with
foreign net operating loss carryforwards.
• The geographical mix of income and related
effective tax rates in those jurisdictions.

• These benefits were partially offset by losses in

certain jurisdictions where we are not providing tax
benefits and continue to maintain deferred tax
valuation allowances.

• Tax benefits of $253 million, associated with the

finalization of the 1996-1998 IRS audit.

• Tax benefits of $42 million primarily from the
realization of foreign tax credits offset by the
geographical mix of income and the related tax
rates in those jurisdictions.

• Tax benefits of $31 million from the reversal of a

valuation allowance on deferred tax assets
associated with foreign net operating loss
carryforwards. This reversal followed a
re-evaluation of their future realization resulting
from a refinancing of a foreign operation.
• These impacts were partially offset by losses in

certain jurisdictions where we are not providing tax
benefits and continue to maintain deferred tax
valuation allowances.

40

The 2004 effective tax rate of 35.2% was
comparable to the U.S. statutory tax rate primarily
reflecting:

• The impact of nondeductible expenses and $20
million of unrecognized tax benefits primarily
related to recurring losses in certain jurisdictions
where we maintained deferred tax asset valuation
allowances.
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.

•

Our effective tax rate will change based on

nonrecurring events as well as recurring factors including the
geographical mix of income before taxes and the related tax
rates in those jurisdictions as well as available foreign tax
credits. In addition, our effective tax rate will change based
on discrete or other nonrecurring events (such as audit
settlements) that may not be predictable. We anticipate that
our effective tax rate for 2007 will approximate 33%,
excluding the effect of any discrete items.

Equity in Net Income of Unconsolidated
Affiliates: Equity in net income of unconsolidated
affiliates of $114 million, principally related to our 25%
share of Fuji Xerox income, which increased by $16
million in 2006 as compared to 2005, primarily due to
improved operational performance.

Income from Discontinued Operations: Income
from discontinued operations, net of tax, for the years
ended December 31, 2005 and 2004 was as follows (in
millions):

2005

2004

Insurance Group Operations tax

benefits . . . . . . . . . . . . . . . . . . . . . . . . . .

$ 53

$—

Gain on sale of ContentGuard, net of

income taxes of $26 . . . . . . . . . . . . . . . . —

83

Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$ 53

$ 83

As disclosed in Note 15 – Income and Other Taxes,

in June 2005 the 1996-1998 Internal Revenue Service
(“IRS”) audit was finalized. Of the total tax benefits
realized, $53 million was attributed to our discontinued
operations. In the first quarter 2004, we sold all but 2% of
our 75% ownership interest in ContentGuard Inc,
(“ContentGuard”) to Microsoft Corporation and Time
Warner Inc. for $66 million in cash. The sale resulted in
an after-tax gain of approximately $83 million ($109
million pre-tax) and reflects our recognition of
cumulative operating losses. The revenues, operating
results and net assets of ContentGuard were immaterial
for all periods presented. ContentGuard, which was
originally created out of research developed at the Xerox
Palo Alto Research Center (“PARC”), licenses
intellectual property and technologies related to digital
rights management. During 2005, we sold our remaining
interest in ContentGuard.

Recent Accounting Pronouncements: Refer to
Note 1 – Summary of Significant Accounting Policies in
the Consolidated Financial Statements for a description of
recent accounting pronouncements including the
respective dates of adoption and the 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, 2006, 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 (used in) provided by investing activities . . . . . . . . . . . . . .
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 period . . . . . . . . . . . . . . .
Cash and cash equivalents at end of period . . . . . . . . . . . . . . . . . .

Amount Change

2006

2005

2004

2006

2005

$ 1,617
(143)
(1,428)
31

77
1,322
$ 1,399

$ 1,420
(295)
(2,962)
(59)

(1,896)
3,218
$ 1,322

$ 1,750
203
(1,293)
81

741
2,477
$ 3,218

$

197
152
1,534
90

1,973
(1,896)
77

$

$ (330)
(498)
(1,669)
(140)

(2,637)
741
$(1,896)

41

Cash, cash equivalents and Short-term investments reported in our Consolidated Financial Statements were as

follows:

Cash and cash equivalents . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Short-term investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$1,399
137

$1,322
244

Total Cash, cash equivalents and Short-term investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$1,536

$1,566

2006

2005

For the year ended December 31, 2006, net cash
provided by operating activities, increased $197 million
from 2005 primarily as a result of the increased net
income of $232 million, as well as the following
additional items:

•
•

•

•

•

•

$173 million increase due to lower inventories.
$87 million increase due to lower net tax payments
including a $34 million refund associated with the
settlement of the 1999 to 2003 IRS tax audit.
$62 million decrease due to a lower net run-off of
finance receivables.
$51 million decrease due to higher restructuring
payments related to previously reported actions.
$96 million decrease due to a lower year-over-year
reduction in other current and long-term assets.
$77 million decrease due to a reduction in other
current and long-term liabilities, primarily
reflecting the $106 million payment relating to the
previously disclosed MPI legal matter.

For the year ended December 31, 2005, net cash
provided by operating activities, decreased $330 million
from 2004 primarily as a result of the following:

•

•

•

•

•

$258 million decrease due to modest growth in
accounts receivable in 2005 compared to a decline
in 2004.
$83 million decrease due to lower finance
receivable run-off.
$124 million decrease due to higher inventory
growth in 2005 compared to 2004 reflecting an
increase in the number of new products.
Partially offsetting these items were lower tax
payments of $96 million due to refunds from audit
and other tax settlements, as well as, the timing of
payments associated with restructuring.
Partially offsetting lower pension contributions of
$21 million.

We expect 2007 operating cash flows in the range of
$1.2 billion to $1.5 billion, as compared to $1.6 billion in
2006.

For the year ended December 31, 2006, net cash
from investing activities increased $152 million from
2005 primarily as a result of the following:

$354 million due to an increase in proceeds from
the net sale of short-term investments in 2006 of
$107 million, as compared to the net purchases of
$247 million in 2005, as 2005 represented the
initial year we purchased short-term investments to
supplement our investment income.
$77 million due to higher proceeds from the sale of
our Corporate headquarters and other excess land
and buildings.
$48 million due to higher proceeds from
divestitures and investments, reflecting:
•

$122 million related to the sale of investments
held by Ridge Re* in 2006.
$21 million distribution from the liquidation of
our investment in Xerox Capital LLC in 2006.
$96 million of proceeds from the sale of Integic
in 2005.

•

•

Partially offsetting these items were the following:
$229 million due to payments related to the
•
acquisition of Amici, LLC and XMPie, Inc.
$57 million increase in capital expenditures and
internal use software.

•

• Lower cash generation of $42 million due to a

*

lower net reduction of escrow and other
restricted investments.
In March 2006 Ridge Re, a wholly owned
subsidiary included in discontinued operations,
executed an agreement to complete its exit from
the insurance business. As a result of this
agreement and pursuant to a liquidation plan,
excess cash held by Ridge Re was distributed
back to the Company (Refer to Note 21 –
Divestitures and Other Sales in the
Consolidated Financial Statements for further
information).

•

•

•

•

42

For the year ended December 31, 2005, net cash
from investing activities decreased $498 million from
2004 primarily as a result of the following:

•

$247 million from the net purchases of short-term
investments which were intended to increase our
return on available cash.

• Decrease of $143 million due to a lower net
reduction of escrow and other restricted
investments due to the 2004 renegotiation of certain
secured borrowing arrangements and scheduled
releases from an escrow account of supporting
interest payments on our prior liability to a trust
issuing preferred securities.

• Decrease of $86 million due to lower proceeds

from divestitures and investments, net reflecting:
2005 proceeds of $105 million primarily
•
consisting of $96 million from the sale of our
equity interest in Integic Corporation.
2004 proceeds of $191 million primarily
consisting of $66 million from the
ContentGuard sale, $79 million from the
ScanSoft sale and $36 million from a preferred
stock investment.

•

• Decrease of $48 million due to lower proceeds
from the sale of excess land and buildings.
Partially offsetting these items was a $15 million
decrease in capital and internal use software
expenditures.

•

We expect 2007 capital expenditures including

internal use software to approximate $300 million.

For the year ended December 31, 2006, net cash
used in financing activities decreased $1.5 billion from
2005 primarily as a result of the following:

•

$2,463 million lower usage primarily resulting
from the 2005 net repayments on term and other

Financing Activity

•

•

unsecured debt, of $1,187 million, as contrast to the
2006 net borrowings of term and other unsecured
debt of $1,276 million. The 2006 net borrowings
primarily reflect the 2016 Senior Notes borrowing
of $700 million in March 2006, 2017 Senior Notes
borrowing of $500 million in August 2006 and the
2009 Senior Notes borrowing of $150 million in
August 2006.
$42 million due to higher proceeds from the
issuance of common stock, resulting from increases
in exercised stock options.
Partially offsetting these items were the following:
•

$636 million higher cash usage for the
acquisition of common stock under the
authorized share repurchase programs.
$269 million higher net repayments on secured
borrowings.
$100 million payment of liability to Xerox
Capital LLC in connection with their
redemption of Canadian deferred preferred
shares in February 2006.

•

•

For the year ended December 31, 2005, net cash

used in financing activities increased $1.7 billion from
2004 primarily as a result of the following:

• A $1.5 billion reduction in proceeds from new

•

secured financings, reflecting a rebalancing of our
secured and unsecured debt portfolio.
$433 million cash usage for the acquisition of
common stock under the authorized October 2005
share repurchase program.

• A partially offsetting $235 million decrease in net
payments on term and other debt reflecting lower
debt maturity obligations.

Customer Financing Activities and Secured Debt:

We provide equipment financing to the majority of our
customers. Because the finance leases allow our
customers 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 currently fund our customer financing activity
through cash generated from operations, cash on hand,
capital markets offerings and third-party secured funding
arrangements.

In the United States, Canada, the U.K., the
Netherlands, and France, we are currently funding a

portion of our customer financing activity through
secured borrowing arrangements with GE, De Lage
Landen Bank (“DLL”) and Merrill Lynch. While terms
and conditions vary somewhat between countries, in
general these arrangements call for the financial
counterparty to provide loans secured by lease
originations in the country for which it has been
contracted to be the funding source. Most arrangements
are transacted through bankruptcy remote special purpose
entities and the transfers of receivables and equipment to
these entities are generally intended to be true sales at
law. Under these arrangements, secured debt matches the

43

terms of the underlying finance receivables it supports,
which eliminates certain significant refinancing, pricing
and duration risks associated with our financing. As part
of our continued objective to reduce our level of secured
debt, in November 2006, we delivered notice to GE, our
secured lender in the U.K., moving the final funding date
for that program from June 2010 to June 2007.

At December 31, 2006 and 2005, all of the lease

receivables and related secured debt are consolidated in
our financial statements because we are determined to be
the primary beneficiary of the arrangements and
frequently the counterparties have various types of
recourse to us. The lease receivables sold represent the
collateral for the related secured debt and are not
available for general corporate purposes until the related
debt is paid off. All of these arrangements are subject to
usual and customary conditions of default including
cross-defaults. In the remote circumstance that an event
of default occurs and remains uncured, in general, the
counterparty can cease providing funding for new lease
originations.

Information on restricted cash that is the result of

these third party secured funding arrangements is
included in Note 1 – “Restricted Cash and Investments”
to the Consolidated Financial Statements and disclosure
of the amounts for new funding and debt repayments are
included in the accompanying Consolidated Statement of
Cash Flows.

We also have arrangements in certain countries in

which third party financial institutions originate lease

contracts directly with our customers. In these
arrangements, 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, as such the related receivable and debt are not
included in our Consolidated Financial Statements.

The following represents our total finance assets

associated with our lease or finance operations as of
December 31, 2006 and 2005, respectively:

2006

2005

Total Finance receivables, net(1) . . . . . .
. . .
Equipment on operating leases, net

$7,844
481

$7,849
431

Total Finance Assets, net . . . . . . . . . .

$8,325

$8,280

(1)

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,
2006 and 2005.
Refer to Note 4 – Receivables, Net in the

Consolidated Financial Statements for further information
regarding our third party secured funding arrangements as
well as a comparison of finance receivables to our
financing-related debt as of December 31, 2006 and 2005.
As of December 31, 2006, approximately 31% of total
finance receivables were encumbered as compared to
44% at December 31, 2005.

The following represents our aggregate debt maturity schedule as of December 31, 2006:

(in millions)

Unsecured
Debt

Debt Secured
by Finance
Receivables

Other
Secured
Debt

Total
Debt

2007 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
2008 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
2009 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
2010 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
2011 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Thereafter . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$ 295
9
1,055
687
800
2,212

Total

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$5,058

$1,178
722
109
44
6

—

$2,059

$ 12
5
5
2

—

4

$1,485(1)
736
1,169
733
806
2,216

$ 28

$7,145

(1) Quarterly secured and unsecured total debt maturities for 2007 are $215 million, $421 million, $626 million and

$223 million for the first, second, third and fourth quarters, respectively.

44

The following table summarizes our secured and

unsecured debt as of December 31, 2006 and 2005:

Liquidity, Financial Flexibility and
Other Financing Activity:

(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

2006

2005

$ — $ 300

2,059
28
—

2,087

4,224
19
815

2,982
38
213

3,533

2,862
19
864

5,058
$7,145

3,745
$7,278

At December 31, 2006, approximately 29% of total
debt was secured by finance receivables and other assets
compared to 49% at December 31, 2005. Consistent with
our objective to rebalance the ratio of secured and unsecured
debt, we expect payments on secured loans will continue to
exceed proceeds from new secured loans in 2007.

Credit Facility: In April 2006, we entered into a
$1.25 billion unsecured revolving credit facility including
a $200 million letter of credit subfacility (the “2006
Credit Facility” or “facility”). The facility allows us to
increase from time to time, with willing lenders, the
overall size of the 2006 Credit Facility to an aggregate
amount not to exceed $2 billion. The facility is available,
without sublimit, to certain of our qualifying subsidiaries.
The facility replaces our 2003 Credit Facility that was
terminated upon effectiveness of the 2006 Credit Facility.
As of December 31, 2006, we had outstanding letters of
credit of $15 million and no borrowings under the 2006
Credit Facility. In conjunction with the 2006 Credit
Facility, debt issuance costs of $5 million were deferred.
In connection with the effectiveness of the 2006
Credit Facility, we terminated the 2003 Credit Facility in
April 2006 and repaid all advances outstanding
thereunder, including a $300 million secured term loan,
with a combination of cash on hand and proceeds from
the capital markets offerings. The termination of the 2003
Credit Facility resulted in the second quarter 2006
write-off of the remaining unamortized deferred debt
issuance costs of $13 million ($9 million after-tax).

Refer to Note 11 – Debt to the Consolidated
Financial Statements for further information regarding
our 2006 Credit Facility.

Liquidity: We manage our worldwide liquidity
using internal cash management practices, which are
subject 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.

As of December 31, 2006, we had $1.5 billion of
cash, cash equivalents and short-term investments, and
borrowing capacity under our 2006 Credit Facility of
approximately $1.235 billion. Our ability to maintain
positive liquidity going forward depends on our ability to
continue to generate cash from operations and access the
financial markets, both of which are subject to general
economic, financial, competitive, legislative, regulatory
and other market factors that are beyond our control.

Share Repurchase Programs: The board of
directors has authorized programs for the repurchase of
the Company’s common stock totaling $2.0 billion as of
December 31, 2006. Since launching our stock buyback
program in October 2005, we have repurchased
100.6 million shares, totaling approximately $1.5 billion
of the $2.0 billion authorized.

Refer to Note 18 – Common Stock and Note 22 –

Subsequent Event in the Consolidated Financial
Statements for further information regarding our share
repurchase programs.

Loan Covenants and Compliance: At December 31,

2006, we were in full compliance with the covenants and
other provisions of the 2006 Credit Facility, the senior
notes and the Loan Agreement. Any failure to be in
compliance with any material provision or covenant of the
2006 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 2006 Credit Facility, would result in
an event of termination under the Loan Agreement and in
such case General Electric Capital Corporation (“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 and that we were
unable to obtain replacement financing in the public debt
markets, it could 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 operations. We have the right at any time to

45

prepay without penalty any loans outstanding under or
terminate the 2006 Credit Facility.

Financial Instruments: Refer to Note 13 –
Financial Instruments in the Consolidated Financial
Statements for additional information regarding our
derivative financial instruments.

Capital Markets Offerings and Other: Refer to

Note 11 – Debt in the Consolidated Financial Statements
for additional information regarding the 2006 issuance of
our 2016 Senior Notes, 2017 Senior Notes and Floating
2009 Senior Notes, which raised aggregate net proceeds
of $1.3 billion.

Credit Ratings: During 2006, Moody’s and Fitch upgraded our credit rating to investment grade. Our credit

ratings as of January 30, 2007 were as follows:

Senior Unsecured
Debt

Outlook

Comments

Moody’s(1)

. . . . . . . . . . . . . .

Baa3

Positive The Moody’s rating was upgraded from Ba1 in November
2006. The outlook remains positive since being upgraded
in November 2006.

Standard & Poors

BB+

Positive The S&P rating was upgraded from BB- in March 2006

(“S&P”)(2) . . . . . . . . . . . . .

and the outlook was revised from stable to positive in
January 2007.

Fitch(3)

. . . . . . . . . . . . . . . . .

BBB-

Stable The Fitch rating was upgraded from BB+ in August 2006.

(1)

(2)

(3)

In November 2006, Moody’s upgraded the Senior Unsecured rating from Ba1 to Baa3, a one notch upgrade.
Moody’s maintains a Positive Outlook on the credit. In conjunction with the upgrade to investment grade ratings
for the senior unsecured debt, Moody’s has withdrawn all Loss Given Default assessments and Speculative Grade
Liquidity ratings as they are only appropriate for non-investment grade issuers. Moody’s ratings upgrades also
included: Senior unsecured shelf registration to Baa3 from Ba1; Trust preferred to Ba1 from Ba2; subordinated
shelf registration to Ba1 from Ba2 and preferred shelf registration to Ba1 from Ba2.
In March 2006, S&P upgraded the Senior Unsecured and Corporate Credit rating from BB- to BB+, a two notch
upgrade. At the same time, S&P revised its outlook from Positive to Stable on all associated ratings, affirmed the
short-term speculative-grade rating at B-1 and upgraded the ratings on Subordinated debt from B to BB- and
Preferred Stock from B- to B+. As a result of the rating change, S&P removed Xerox from Credit Watch in March
2006. In January 2007, S&P revised its outlook from Stable to Positive on all associated ratings.
In August 2006, Fitch upgraded its debt ratings and assigned a stable outlook on Xerox. Fitch had upgraded the
senior unsecured debt of Xerox from BB+ to BBB- and also upgraded the Trust Preferred securities from BB- to
BB, both one notch upgrades. In March 2006, Fitch affirmed its ratings and positive outlook on Xerox in
conjunction with its 2016 Senior Notes offering. Fitch had upgraded the senior unsecured debt of Xerox from BB
to BB+, and also upgraded the Trust Preferred securities from B+ to BB-, both one notch upgrades in August
2005.

Our credit ratings, which are periodically reviewed

by major rating agencies, have substantially improved
over the past three years. Even though as of January 30,
2007, our current S&P credit rating still remains below

investment grade, we expect effective implementation of
our management strategies will return the company’s
senior unsecured debt to investment grade by all major
rating agencies in the future.

46

Contractual Cash Obligations and Other Commercial Commitments and Contingencies: At December 31, 2006,
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) . . .
Retiree Health Payments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Purchase Commitments

Year 1

2007

$1,485
189
—
102

Years 2-3

Years 4-5

2008

2009

2010

2011

Thereafter

$ 736
161
—
115

$1,169
124
—
123

$733
102
—
127

$ 806
84
—
128

$2,216
158
624
665

Flextronics(4) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
EDS Contracts(5) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Other(6)

644
277
39

—
270
30

—
—
132 —
30 —

—
—
—

—
—
—

Total Contractual Cash Obligations . . . . . . . . . . . . . . . . . . .

$2,736

$1,312

$1,578

$962

$1,018

$3,663

(1) Refer to Note 11 – Debt 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 6 – Land, Buildings and Equipment, net to our Consolidated Financial Statements for additional

information related to minimum operating lease commitments.

(3) Refer to Note 12 – Liability to Subsidiary Trusts Issuing Preferred Securities 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) Flextronics: We outsource certain manufacturing activities to Flextronics and are currently operating under a

one-year automatically renewed agreement which may expire on November 30, 2007, but is subject to automatic
renewal for an additional one year period. We expect to enter into a negotiated renewal agreement in 2007 which
has a term of at least three years.

(5) EDS Contracts: 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 through June 30,
2009. There are no minimum payments required under the contract. 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 termination date. Should we terminate the contract for convenience, we have an option
to purchase the assets placed in service under the EDS contract.

(6) 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.

Other Commercial Commitments and Contingencies

Pension and Other Post-Retirement Benefit Plans:

We sponsor pension and other post-retirement benefit
plans that may require periodic cash contributions. Our
2006 cash fundings for these plans were $355 million for
pensions and $98 million for other post-retirement plans.
Our anticipated cash fundings for 2007 are approximately
$130 million for defined benefit pensions and
approximately $100 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 2007
pension contributions do not include contributions to the
domestic tax-qualified plans because these plans currently
exceed the ERISA minimum funding requirements for the
plans’ 2006 plan year. However, once the January 1, 2007
actuarial valuations and projected results as of the end of
the 2007 measurement year are available, the desirability
of additional contributions will be assessed. Based on
these results, we may voluntarily decide to contribute to
these plans, even though no contribution is required. In
prior years, after making this assessment, we decided to
contribute $228 million and $230 million in 2006 and
2005, respectively, to our domestic tax qualified plans in

47

order to make them 100% funded on a current liability
basis under the ERISA funding rules. In addition, our debt
ratings, which are periodically reviewed by major rating
agencies, have steadily improved over the past three
years. Since the rating on the Company’s senior
unsecured debt has now reached investment grade, the
Company will have increased flexibility when
considering these funding decisions.

Our other post-retirement benefit 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. The
amounts reported in the above table as retiree health
payments represent our estimated future benefit
payments.

Fuji Xerox: We had product purchases from Fuji
Xerox totaling $1.7 billion, $1.5 billion, and $1.1 billion
in 2006, 2005 and 2004, 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 purchase approximately $1.7
billion of products from Fuji Xerox in 2007. Related party
transactions with Fuji Xerox are discussed in Note 7 –
Investments in Affiliates, at Equity to the Consolidated
Financial Statements.

Brazil Tax and Labor Contingencies: At
December 31, 2006, our Brazilian operations were
involved in various litigation matters and have been the
subject of numerous governmental assessments related to
indirect and other taxes as well as disputes associated
with former employees and contract labor. The tax
matters, which comprise a significant portion of the total
contingencies, principally relate to claims for taxes on the
internal transfer of inventory, municipal service taxes on
rentals and gross revenue taxes. We are disputing these

Off-Balance Sheet Arrangements

Although we generally do not utilize off-balance

sheet arrangements in our operations, we enter into
operating leases in the normal course of business. The
nature of these lease arrangements is discussed in Note
6 – Land, Buildings and Equipment, Net to the
Consolidated Financial Statements. Additionally, we
utilize special purpose entities (“SPEs”) in conjunction
with certain financing transactions. The SPEs utilized in
conjunction with these transactions are consolidated in
our financial statements in accordance with applicable
accounting standards. These transactions, which are

tax matters and intend to vigorously defend our position.
Based on the opinion of legal counsel, we do not believe
that the ultimate resolution of these matters will
materially impact our results of operations, financial
position or cash flows. The labor matters principally
relate to claims made by former employees and contract
labor for the equivalent payment of all social security and
other related labor benefits, as well as consequential tax
claims, as if they were regular employees. Following our
assessment of a negative trend in recent settlements and a
decision to change our legal strategy, we reassessed the
probable estimated loss on these matters and, as a result,
recorded an additional provision of $68 million in 2006.
As of December 31, 2006, the total amounts related to the
unreserved portion of the tax and labor contingencies,
inclusive of any related interest, amounted to
approximately $960 million, with the increase from
December 31, 2005 balance of $900 million primarily
related to indexation, interest and currency partially offset
by the additional provision. In connection with the above
proceedings, customary local regulations may require us
to make escrow cash deposits or post other security of up
to half of the total amount in dispute. As of December 31,
2006 we had $154 million of escrow cash deposits for
matters we are disputing and there are liens on certain
Brazilian assets with a net book value of $18 million and
additional letters of credit of approximately $60 million.
Generally, any escrowed amounts would be refundable
and any liens would be removed to the extent the matters
are resolved in our favor. We routinely assess all these
matters as to probability of ultimately incurring a liability
against our Brazilian operations and record our best
estimate of the ultimate loss in situations where we assess
the likelihood of an ultimate loss as probable of
occurring.

discussed further in Note 4 – Receivables, Net to the
Consolidated Financial Statements, have been accounted
for as secured borrowings 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.

Refer to Note 16 – Contingencies for further
information regarding our guarantees, indemnifications
and warranty liabilities.

48

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. Refer to Note
13 – Financial Instruments to the Consolidated
Financial Statements for further discussion on our
financial risk management.

Assuming a 10% appreciation or depreciation in

foreign currency exchange rates from the quoted
foreign currency exchange rates at December 31, 2006,
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
economically hedged as of December 31, 2006. A 10%
appreciation or depreciation of the U.S. dollar against
all currencies from the quoted foreign currency
exchange rates at December 31, 2006 would have a
$596 million impact on our Cumulative translation
adjustment portion of equity. The amount permanently
invested in foreign subsidiaries and affiliates, primarily

Forward-Looking Statements

This Annual Report contains forward-looking

statements as defined in the Private Securities
Litigation Reform Act of 1995. The words
“anticipate,” “believe,” “estimate,” “expect,” “intend,”
“will,” “should” and similar expressions, as they relate
to us, are intended to identify forward-looking
statements. These statements reflect management’s
current beliefs, assumptions and expectations and are

Xerox Limited, Fuji Xerox, Xerox Canada Inc. and
Xerox do Brasil, and translated into dollars using the
year-end exchange rates, was $6.0 billion at
December 31, 2006.

Interest Rate Risk Management: The consolidated
weighted-average interest rates related to our debt and
liabilities to subsidiary trusts issuing preferred
securities for 2006, 2005 and 2004 approximated
6.8%, 6.0%, and 5.8%, 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 as collateral
for secured financing arrangements and the interest
rates on a significant portion of those loans are fixed.

As of December 31, 2006, approximately $2.2
billion of our debt and liabilities to subsidiary trusts
issuing preferred securities carried variable interest
rates, including the effect of pay-variable interest rate
swaps we are utilizing with the intent 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, 2006, a 10% change in market
interest rates would change the fair values of such
financial instruments by approximately $233 million.

subject to a number of factors that may cause actual
results to differ materially. Information concerning
these factors is included in our 2006 Annual Report on
Form 10-K filed with the Securities and Exchange
Commission (“SEC”). We do not intend to update
these forward-looking statements, except as required
by law.

49

XEROX CORPORATION

CONSOLIDATED STATEMENTS OF INCOME

(in millions, except per-share data)

Year ended December 31,

2006

2005

2004

Revenues
Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Service, outsourcing and rentals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Finance income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$ 7,464
7,591
840

$ 7,400
7,426
875

$ 7,259
7,529
934

Total Revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

15,895

15,701

15,722

Costs and Expenses
Cost of sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Cost of service, outsourcing and rentals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Equipment financing interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Research, development and engineering expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Selling, administrative and general expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Restructuring and asset impairment charges . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Other expenses, net

4,803
4,328
305
922
4,008
385
336

4,695
4,207
326
943
4,110
366
224

4,545
4,295
345
914
4,203
86
369

Total Costs and Expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

15,087

14,871

14,757

Income from Continuing Operations before Income Taxes, Equity Income,

Discontinued Operations and Cumulative Effect of Change in Accounting
Principle . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Income tax (benefits) expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Equity in net income of unconsolidated affiliates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

808
(288)
114

Income from Continuing Operations before Discontinued Operations and

Cumulative Effect of Change in Accounting Principle . . . . . . . . . . . . . . . . . . . . . .
Income from Discontinued Operations, net of tax . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Cumulative Effect of Change in Accounting Principle, net of tax . . . . . . . . . . . . . . . . . .

1,210
—
—

830
(5)
98

933
53
(8)

Net Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$ 1,210

$

978

$

965
340
151

776
83
—

859

Basic Earnings per Share

Income from Continuing Operations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Basic Earnings per Share . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Diluted Earnings per Share

Income from Continuing Operations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Diluted Earnings per Share . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$
$

$
$

1.25
1.25

1.22
1.22

$
$

$
$

0.91
0.96

0.90
0.94

$
$

$
$

0.84
0.94

0.78
0.86

The accompanying notes are an integral part of these Consolidated Financial Statements.

50

XEROX CORPORATION

CONSOLIDATED BALANCE SHEETS

(in millions, except share data in thousands)

Assets
Cash and cash equivalents . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Short-term investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$

Total cash, cash equivalents and short-term investments . . . . . . . . . . . . . . . . . . . . . . . . . . . .
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 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

December 31,

2006

2005

1,399
137

1,536
2,199
273
2,649
1,163
934

8,754
4,922
481
1,527
874
286
2,024
1,790
1,051

$

1,322
244

1,566
2,037
296
2,604
1,201
1,032

8,736
4,949
431
1,627
782
289
1,671
1,547
1,921

Total Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$ 21,709

$ 21,953

Liabilities and Equity
Short-term debt and current portion of long-term debt
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Accrued compensation and benefits costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
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 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

1,485
1,133
663
1,417

4,698
5,660
624
1,336
1,490
821

$

1,139
1,043
621
1,543

4,346
6,139
626
1,151
1,188
1,295

Total liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Series C mandatory convertible preferred stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Common stock, including additional paid-in-capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Treasury stock, at cost
Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Accumulated other comprehensive loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

14,629
—
4,666
(141)
4,202
(1,647)

14,745
889
4,741
(203)
3,021
(1,240)

Total Liabilities and Equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$ 21,709

$ 21,953

Shares of common stock issued . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Treasury stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

954,568
(8,363)

945,106
(13,917)

Shares of common stock outstanding . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

946,205

931,189

The accompanying notes are an integral part of these Consolidated Financial Statements.

51

XEROX CORPORATION

CONSOLIDATED STATEMENTS OF CASH FLOWS

(in millions)

Year ended December 31,

2006

2005

2004

Cash Flows from Operating Activities:
Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 1,210
Adjustments required to reconcile net income to cash flows from operating activities:

$

978

$

859

Depreciation and amortization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Provisions for receivables and inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Deferred tax expense (benefit)
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Net gain on sales of businesses and assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Undistributed equity in net income of unconsolidated affiliates . . . . . . . . . . . . . . . . . . . . . . . . . . .
Income from discontinued operations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Stock-based compensation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Restructuring and asset impairment charges . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Cash payments for restructurings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Contributions to pension benefit plans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Decrease (increase) in inventories . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Increase in equipment on operating leases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Decrease in finance receivables . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
(Increase) decrease in accounts receivable and billed portion of finance receivables . . . . . . . . . .
Decrease in other current and long-term assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Increase in accounts payable and accrued compensation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Net change in income tax assets and liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Net change in derivative assets and liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
(Decrease) increase in other current and long-term liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Other, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

636
145
99
(44)
(70)
—
64
385
(265)
(355)
11
(271)
192
(30)
64
330
(459)
9
(70)
36

641
107
(15)
(97)
(54)
(53)
40
366
(214)
(388)
(162)
(248)
254
(34)
160
313
(211)
38
7
(8)

688
159
155
(61)
(89)
(83)
22
86
(187)
(409)
(38)
(234)
337
224
107
333
(68)
(23)
(79)
51

Net cash provided by operating activities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

1,617

1,420

1,750

Cash Flows from Investing Activities:

Purchases of short-term investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Proceeds from sales of short-term investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
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 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Net cash (used in) provided by investing activities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Cash Flows from Financing Activities:

Cash proceeds from new secured financings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Debt payments on secured financings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Net cash proceeds (payments) on other debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Payments of liability to subsidiary trusts issuing preferred securities . . . . . . . . . . . . . . . . . . . . . . .
Preferred stock dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Proceeds from issuances of common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Excess tax benefits from stock-based compensation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Payments to acquire treasury stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

(162)
269
(215)
82
(79)
153
(229)
38

(143)

121
(1,712)
1,276
(100)
(43)
82
25
(1,069)
(8)

(386)
139
(181)
5
(56)
105
(1)
80

(295)

557
(1,879)
(1,187)
—
(58)
40
—
(433)
(2)

—
—
(204)
53
(48)
191
(12)
223

203

2,061
(1,906)
(1,422)
—
(83)
73
—
—
(16)

Net cash used in financing activities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

(1,428)

(2,962)

(1,293)

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 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

31

77
1,322

(59)

(1,896)
3,218

81

741
2,477

Cash and cash equivalents at end of year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 1,399

$ 1,322

$ 3,218

The accompanying notes are an integral part of these Consolidated Financial Statements.

52

XEROX CORPORATION

CONSOLIDATED STATEMENTS OF COMMON SHAREHOLDERS’ EQUITY

(in millions, except share data in thousands)

Common
Stock
Shares

Common
Stock
Amount

Additional
Paid-In-
Capital

Treasury
Stock
Shares

Treasury
Stock
Amount

Retained
Earnings

Accumulated
Other
Comprehensive
Loss(1)

Total

Balance at December 31, 2003 . . . . . . . . . . . . . . . 793,884

$794

$ 2,445

—

—

$1,315

$(1,263)

$ 3,291

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Translation adjustments . . . . . . . . . . . . . . . . . . . . .
Minimum pension liability . . . . . . . . . . . . . . . . . . .
Other unrealized gains . . . . . . . . . . . . . . . . . . . . . . .
Other realized gains . . . . . . . . . . . . . . . . . . . . . . . . .

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) . . . . . . . . . . . . . . . . .

11,433
37,040

11
37

Conversion of liability to subsidiary trust . . . . . . . . 113,415
225
Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

113
1

111
446

922
1

859

(15)

(58)

453
86
4
(18)

859
453
86
4
(18)

$ 1,384

122
483

(15)

(58)
1,035
2

Balance at December 31, 2004 . . . . . . . . . . . . . . . 955,997

$956

$ 3,925

—

—

$2,101

$ (738)

$ 6,244

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Translation adjustments . . . . . . . . . . . . . . . . . . . . .
Minimum pension liability . . . . . . . . . . . . . . . . . . .
Other unrealized losses . . . . . . . . . . . . . . . . . . . . . .

Comprehensive income . . . . . . . . . . . . . . . . . . . . .

Stock option and incentive plans, net . . . . . . . . . . .
Series C mandatory convertible preferred stock

dividends ($6.25 per share) . . . . . . . . . . . . . . . . .
Payments to acquire treasury stock . . . . . . . . . . . . .
Cancellation of treasury stock . . . . . . . . . . . . . . . . .
Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

5,548

6

84

(17)

(213)

(30,502)
16,585

(433)
230

(16,585)
146

978

(58)

(493)
(6)
(3)

978
(493)
(6)
(3)

$

476

90

(58)
(433)
—
—

Balance at December 31, 2005 . . . . . . . . . . . . . . . 945,106

$945

$ 3,796

(13,917)

$ (203)

$3,021

$(1,240)

$ 6,319

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Translation adjustments . . . . . . . . . . . . . . . . . . . . .
Minimum pension liability . . . . . . . . . . . . . . . . . . .
Other unrealized gains . . . . . . . . . . . . . . . . . . . . . . .

Comprehensive income . . . . . . . . . . . . . . . . . . . . .

Adjustment to initially apply FAS No. 158, net

(Refer to Note 1) . . . . . . . . . . . . . . . . . . . . . . . . .
Stock option and incentive plans, net . . . . . . . . . . .
Series C mandatory convertible preferred stock

dividends ($6.25 per share) . . . . . . . . . . . . . . . . .

Series C mandatory convertible preferred stock

conversion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Payments to acquire treasury stock . . . . . . . . . . . . .
Cancellation of treasury stock . . . . . . . . . . . . . . . . .
Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

10,256

11

156

74,797

75

814

(75)

(1,056)

(70,111)
75,665

(1,069)
1,131

(75,665)
74

485
131
1

(1,024)

1,210

(29)

1,210
485
131
1

$ 1,827

(1,024)
167

(29)

889
(1,069)
—
—

Balance at December 31, 2006 . . . . . . . . . . . . . . . 954,568

$956

$ 3,710

(8,363)

$ (141)

$4,202

$(1,647)

$ 7,080

(1) As of December 31, 2006, Accumulated other comprehensive loss is composed of cumulative translation adjustments of $(532), other unrealized

gains of $2, benefit plans net unfunded status of $(1,097) and Fuji Xerox’s minimum pension liabilities of $(20).

The accompanying notes are an integral part of these Consolidated Financial Statements.

53

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,” “our,” the

“Company,” and Xerox refer to Xerox Corporation and its
consolidated 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 market, developing,
manufacturing, marketing, servicing and financing a
complete range of document equipment, solutions and
services. Certain reclassifications have been made to prior
year financial information to conform to the current year
presentation.

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% ownership), 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 corresponding 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 beneficiary are included
in the Consolidated Statements of Income from the date
such determination is made.

For convenience and ease of reference, we refer to

the financial statement caption “Income from Continuing
Operations before Income Taxes, Equity Income,
Discontinued Operations and Cumulative Effect of
Change in Accounting Principle” as “pre-tax income,”
throughout the notes to the Consolidated Financial
Statements.

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
assumptions that affect the reported amounts of assets and
liabilities, 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) restructuring 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 reserves and 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.

54

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

(Dollars in millions, except per-share data and unless otherwise indicated)

The following table summarizes certain significant charges that require management estimates:

(in millions)

Restructuring provisions and asset impairments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Amortization of intangible assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Provisions for receivables . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Provisions for obsolete and excess inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Provisions for litigation and regulatory matters . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
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 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Year ended December 31,

2006

$385
45
76
69
89
230
277
84
355
117
12

2005

$366
42
51
56
115
205
280
114
343
117
(38)

2004

$ 86
38
86
73
9
210
305
134
350
111
12

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 estimation 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:

In September 2006, the FASB issued SFAS No. 158,
“Employers’ Accounting for Defined Benefit Pension and
Other Postretirement Plans, an amendment of FASB
Statements No. 87, 88, 106 and 132(R)” (“FAS 158”).
FAS 158 requires the recognition of an asset or liability
for the funded status of defined pension and other
postretirement benefit plans in the statement of financial
position of the sponsoring entity. The funded status of a
benefit plan is measured as the difference between plan
assets at fair value and the benefit obligation. For a
defined benefit pension plan, the benefit obligation is the
projected benefit obligation or PBO; for any other defined
benefit postretirement benefit plan, such as a retiree
health care plan, the benefit obligation is the accumulated
postretirement benefit obligation. The initial incremental
recognition of the funded status under FAS 158 of our
defined pension and other post retirement benefit plans,
as well as subsequent changes in our funded status that
are not included in net periodic benefit cost will be
reflected in shareholders’ equity and other comprehensive
loss, respectively. As of December 31, 2006, the net
unfunded status of our benefit plans was $2,842 and
recognition of this status upon the adoption of FAS 158

resulted in an after-tax charge to equity of $1,024. Prior to
the adoption of FAS 158, we recorded an after-tax credit
to our minimum pension liability of $(131), for a total
equity charge in 2006 related to the funded status of our
benefit plans of $893. Amounts recognized in
Accumulated other comprehensive loss are adjusted as
they are subsequently recognized as a component of net
periodic benefit cost. The method of calculating net
periodic benefit cost will not change from existing
guidance. FAS 158 also prescribes enhanced disclosures,
including current and long-term components of plan
assets and liabilities, as well as amounts recognized in
Accumulated other comprehensive loss that will
subsequently be recognized as a component of net
periodic benefit cost in the following year. Refer to Note
14 – Employee Benefit Plans for additional information.
The funded status recognition and certain disclosure
provisions of FAS 158 are effective as of our fiscal year
ending December 31, 2006. Retrospective application of
FAS 158 is not permitted. FAS 158 also requires the
consistent measurement of plan assets and benefit
obligations as of the date of our fiscal year-end statement
of financial position effective for the year ending

55

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

(Dollars in millions, except per-share data and unless otherwise indicated)

December 31, 2008, with early adoption permitted. Since
several of our international plans currently have a
September 30th measurement date, this standard will
require us to change, in 2008, that measurement date to
December 31st. At this time, we do not anticipate early
adoption of this requirement. FAS 158 is not effective for

our equity investment in Fuji Xerox until its annual
year-end of March 31, 2007. Upon Fuji Xerox’s adoption,
we will record our share of their after-tax charge to equity
which we currently estimate at $60. The adoption of this
standard is not expected to impact financial covenant
compliance included in our debt agreements.

The following represents the effect of FAS 158 adoption within the Consolidated Balance Sheets as of

December 31, 2006:

Before Application
of FAS 158

Adjustments
Increase/(Decrease)

After Application
of FAS 158

Other current assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Total current assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Deferred tax assets, long-term . . . . . . . . . . . . . . . . . . . . . . . . . . .
Other long-term assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Total Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Pension and other benefit liabilities . . . . . . . . . . . . . . . . . . . . . . .
Post-retirement medical benefits . . . . . . . . . . . . . . . . . . . . . . . . .
Other long-term liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Total Liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Accumulated other comprehensive loss . . . . . . . . . . . . . . . . . . . .
Total Liabilities and Equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$

923
8,743
1,446
2,048
22,351
1,120
1,205
940
14,247
(623)
22,351

$

11
11
344
(997)
(642)
216
285
(119)
382
(1,024)
(642)

$

934
8,754
1,790
1,051
21,709
1,336
1,490
821
14,629
(1,647)
21,709

In September 2006, the FASB issued SFAS No. 157,

“Fair Value Measurements” (“FAS 157”). FAS 157
defines fair value, establishes a market-based framework
or hierarchy for measuring fair value, and expands
disclosures about fair value measurements. FAS 157 is
applicable whenever another accounting pronouncement
requires or permits assets and liabilities to be measured at
fair value. FAS 157 does not expand or require any new
fair value measures, however the application of this
statement may change current practice. The requirements
of FAS 157 are effective for our fiscal year beginning
January 1, 2008. We are in the process of evaluating this
guidance and therefore have not yet determined the
impact that FAS 157 will have on our financial statements
upon adoption.

In July 2006, the FASB issued FASB Interpretation
No. 48, “Accounting for Uncertainty in Income Taxes –
an Interpretation of FASB Statement No. 109” (“FIN
48”). FIN 48 clarifies the accounting for uncertainty in

income taxes by prescribing a minimum recognition
threshold for a tax position taken or expected to be taken
in a tax return that is required to be met before being
recognized in the financial statements. FIN 48 also
provides guidance on derecognition, measurement,
classification, interest and penalties, accounting in interim
periods, disclosure and transition. The requirements of
FIN 48 are effective for our fiscal year beginning
January 1, 2007. At this stage, we do not believe the
adoption of FIN 48 will have a material effect on our
financial condition or results of operations. However, the
FASB has indicated that they expect to issue additional
FIN 48 implementation guidance regarding the ultimate
settlement of a tax audit, which may impact the timing of
certain liability adjustments. Accordingly, such guidance
may impact the amount we would record upon adoption
of this statement. We continue to evaluate the effects of
adopting this standard.

56

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

(Dollars in millions, except per-share data and unless otherwise indicated)

In June 2006, the FASB ratified the consensus

reached on EITF Issue No. 06-03, “How Sales Taxes
Collected from Customers and Remitted to Governmental
Authorities Should Be Presented in the Income Statement
(that is, Gross Versus Net Presentation)” (“EITF 06-03”).
The EITF reached a consensus that the presentation of
taxes on either a gross or net basis is an accounting policy
decision that requires disclosure. EITF 06-03 is effective
for our fiscal year beginning January 1, 2007. Sales tax
amounts collected from customers have been recorded on
a net basis. The adoption of EITF 06-03 will not have any
effect on our financial position or results of operations.
In February 2006, the FASB issued SFAS No. 155,
“Accounting for Certain Hybrid Financial Instruments”
(“FAS 155”), which amends SFAS No. 133, “Accounting
for Derivative Instruments and Hedging Activities”
(“FAS 133”) and SFAS No. 140, “Accounting for
Transfers and Servicing of Financial Assets and
Extinguishments of Liabilities” (“FAS 140”). FAS 155
provides guidance to simplify the accounting for certain
hybrid instruments by permitting fair value
remeasurement for any hybrid financial instrument that
contains an embedded derivative, as well as, clarifies that
beneficial interests in securitized financial assets are
subject to FAS 133. In addition, FAS 155 eliminates a
restriction on the passive derivative instruments that a
qualifying special-purpose entity may hold under FAS
140. FAS 155 is effective for all financial instruments
acquired, issued or subject to a new basis occurring after
the start of our fiscal year beginning January 1, 2007. We
believe that the adoption of this statement will not have a
material effect on our financial condition or results of
operations.

In March 2005, the FASB issued Interpretation
No. 47, “Accounting for Conditional Asset Retirement
Obligations – an interpretation of FASB Statement
No. 143” (“FIN 47”). FIN 47 requires an entity to
recognize a liability for the fair value of a conditional
asset retirement obligation if the fair value can be
reasonably estimated. A conditional asset retirement
obligation is a legal obligation to perform an asset
retirement activity in which the timing or method of
settlement are conditional upon a future event that may or
may not be within control of the entity. The adoption of

FIN 47 in 2005 resulted in an after-tax charge of $8 ($12
pre-tax) and was recorded as a cumulative effect of
change in accounting principle. This charge represented
conditional asset retirement obligations associated with
leased facilities where we are required to remove certain
leasehold improvements and restore the facility to its
original condition at lease termination.

Stock-Based Compensation: In December 2004, the

FASB issued SFAS No. 123(R), “Share-Based Payment”
(“FAS 123(R)”), which requires companies to recognize
compensation expense using a fair value based method for
costs related to all share-based payments, including stock
options. On January 1, 2006, we adopted FAS 123(R)
using the modified prospective transition method and
therefore we did not restate the results of prior periods.
Prior to the adoption of FAS 123(R), under previous
accounting guidance, we did not expense stock options, as
there was no intrinsic value associated with the options
granted because the exercise price was set equal to the
market price at the date of grant. The adoption of FAS
123(R) was immaterial to our results of operations
primarily as a result of changes made in our stock-based
compensation programs in 2005 as well as the accelerated
vesting of substantially all outstanding unvested stock
options prior to the adoption of FAS 123(R).

In January 2005, we implemented changes in our

stock-based compensation programs that included
expanded use of restricted stock grants with time- and
performance-based restrictions in lieu of stock options.
Prior to this change, our stock-based compensation
programs primarily consisted of stock option grants.
These new restricted stock awards are reflected as
compensation expense in our results of operations in both
2005 and 2006 and the adoption of FAS 123(R) did not
materially affect the expense recognized for these awards.

In May 2005, we accelerated the vesting of

approximately 3.6 million stock options granted in 2004
that would have been scheduled to vest on January 1,
2007, to December 31, 2005. The accelerated vesting
resulted in substantially all outstanding stock options
being vested at the date of the adoption of FAS 123(R).
The primary purpose of this accelerated vesting was to
reduce our pre-tax compensation expense in 2006 by
approximately $31 or $0.02 per diluted share.

57

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

(Dollars in millions, except per-share data and unless otherwise indicated)

Stock-based compensation expense for the three

years ended December 31, 2006 was as follows (in
millions):

2006

2005

2004

Stock-based compensation expense,

pre-tax . . . . . . . . . . . . . . . . . . . . . . .

$64

$40

$22

Stock-based compensation expense,

net of tax . . . . . . . . . . . . . . . . . . . . .

39

25

13

FAS 123(R) requires that the cash flows from the tax

benefits resulting from tax deductions in excess of the
compensation cost recognized for stock-based awards
(excess tax benefits) be classified as financing cash flows.
Prior to the adoption of FAS 123(R), such excess tax
benefits were presented as operating cash flows.
Accordingly, $25 excess tax benefits has been classified as

a financing cash inflow for the year ended December 31,
2006 in the Consolidated Statements of Cash Flows. Such
excess tax benefits amounted to $12 and $23 for the years
ended December 31, 2005 and 2004, respectively and are
included in operating cash flows.

Prior to January 1, 2006, in accordance with APB

Opinion No. 25 “Accounting for Stock Issued to
Employees,” we did not recognize compensation expense
relating to employee stock options because the exercise
price was equal to the market price at the date of grant. If
we had elected to recognize compensation expense using
a fair value approach as required by FAS 123(R), and
therefore determined the compensation based on the value
as determined by the modified Black-Scholes option
pricing model, our pro forma income and earnings per
share would have been as follows:

(in millions, except per share data)

Net income – as reported . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Add: Stock-based employee compensation expense included in reported net income, net of tax . . . . . . .
Deduct: Total stock-based employee compensation expense determined under fair value based method
for all awards, net of tax . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

2005

2004

$ 978
25

$ 859
13

(113)

(82)

Net income – pro forma . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$ 890

$ 790

Basic EPS – as reported . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Basic EPS – pro forma . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Diluted EPS – as reported . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Diluted EPS – pro forma . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$0.96
0.87
$0.94
0.85

$0.94
0.86
$0.86
0.80

The weighted-average fair value of options granted
in 2004 was $8.38. The 2004 fair values were estimated
on the date of grant using the following weighted average
assumptions: risk-free interest rate of 3.2%; expected life

of 5.7 years; expected price volatility of 66.5%; and no
expected dividend yield.

Refer to Note 18 – Common Stock for additional

disclosures regarding our stock compensation programs.

Summary of Accounting Policies:

Revenue Recognition: 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

58

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

(Dollars in millions, except per-share data and unless otherwise indicated)

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 outsourcing services as

well as professional and value-added services are
generally recognized as such services are performed. In
those service arrangements where final acceptance of a
system or solution by the customer is required, revenue is
deferred until all acceptance criteria have been met. Costs
associated with service arrangements are generally
recognized as incurred. Initial direct costs of an
arrangement are capitalized and amortized over the
contractual service period. Long-lived assets used in the
fulfillment of the arrangements are capitalized and
depreciated over the shorter of their useful life or the
term of the contract. Losses on service arrangements are
recognized in the period that the contractual loss
becomes probable and estimable.

Sales to distributors and resellers: We utilize
distributors and resellers to sell certain of our products to
end-users. We refer to our distributor and reseller
network as our two-tier distribution model. Sales to
distributors and resellers are recognized as revenue when
products are sold to such distributors and resellers, as
long as all requirements for revenue recognition have
been met. Distributors and resellers participate in various
cooperative marketing and other programs, and we record
provisions for these programs as a reduction to revenue
when the sales occur. We also similarly account for our
estimates of sales returns and other allowances when the
sales occur based on our historical experience.

Supplies: Supplies revenue generally is recognized
upon shipment or utilization by customer in accordance
with sales terms.

Software: Software included within our equipment

and services is generally considered incidental and is
therefore accounted for as part of the equipment sales or
services revenues. Software accessories sold in
connection with our equipment sales as well as free-
standing software revenues are accounted for in
accordance with AICPA Statement of Position (“SOP”)
No. 97-2, “Software Revenue Recognition.” In most

cases, these software products are sold as part of multiple
element arrangements and include software maintenance
agreements for the delivery of technical service as well as
unspecified upgrades or enhancements on a
when-and-if-available basis. In those software accessory
and free-standing software arrangements that include
more than one element, we allocate the revenue among
the elements based on vendor-specific objective evidence
(“VSOE”) of fair value. VSOE of fair value is based on
the price charged when the deliverable is sold separately
by us on a regular basis and not as part of the multiple-
element arrangement. Revenue allocated to software is
normally recognized upon delivery while revenue
allocated to the software maintenance element is
recognized ratably over the term of the arrangement.

Revenue Recognition for Leases: Our accounting for

leases involves specific determinations under SFAS
No. 13, which often involve complex provisions and
significant 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% 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% of the
fair market value of the equipment at the inception of the
lease. 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 principal products and only a small
percentage of our leases have original terms longer than
five years. 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

59

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

(Dollars in millions, except per-share data and unless otherwise indicated)

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.

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 compared 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.

After the initial lease of equipment to our customers,

we may enter subsequent transactions with the same
customer whereby we extend the term. Revenue from
such lease extensions is typically recognized over the
extension period.

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 (“contingent payments”).
The minimum contractual committed page volumes are
typically negotiated to equal the customer’s estimated
page volume at lease inception. In applying our lease
accounting methodology, we only consider the fixed
payments for purposes of allocating to the relative fair
value elements of the contract. Contingent payments, if
any, are inherently uncertain and therefore are recognized
as revenue in the period when the customer exceeds the
minimum copy volumes specified in the contract.
Revenues under bundled 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.

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.

60

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

(Dollars in millions, except per-share data and unless otherwise indicated)

Restricted Cash and Investments: Several of our
secured financing arrangements 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, 2006 and 2005,
such restricted cash amounts were as follows (in millions):

December 31,

2006

2005

Escrow and cash collections related to

secured borrowing arrangements . . . . . .

$214

$254

Collateral related to risk management

arrangements . . . . . . . . . . . . . . . . . . . . .
Other restricted cash . . . . . . . . . . . . . . . . .

13
199

43
149

Total

. . . . . . . . . . . . . . . . . . . . . . . . .

$426

$446

Of these amounts, $236 and $270 were included in
Other current assets and $190 and $176 were included in
Other long-term assets, as of December 31, 2006 and
2005, 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 doubtful
accounts on accounts receivable balances were $116 and
$136, as of December 31, 2006 and 2005, respectively.
Allowances for doubtful accounts on finance receivables
were $198 and $229 at December 31, 2006 and 2005,
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 salvageable
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 inventories, 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 equipment 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 estimated 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 Note 5 – Inventories and Equipment on
Operating Leases, Net and Note 6 – Land, Buildings and
Equipment, Net for further discussion.

Goodwill and Other Intangible Assets: Goodwill

is tested for impairment annually or more frequently if an
event or circumstance indicates that an impairment loss
may have been incurred. Application of the goodwill
impairment test requires judgment, including the
identification of reporting units, assignment of assets and
liabilities to reporting units, assignment of goodwill to
reporting units, and determination of the fair value of
each reporting unit. We estimate the fair value of each
reporting unit using a discounted cash flow methodology.
This requires us to use significant judgment including
estimation of future cash flows, which is dependent on
internal forecasts, estimation of the long-term rate of
growth for our business, the useful life over which cash
flows will occur, determination of our weighted average
cost of capital, and relevant market data.

Other intangible assets primarily consist of assets

obtained in connection with business acquisitions,
including installed customer base and distribution
network relationships, patents on existing technology and
trademarks. We apply an impairment evaluation
whenever events or changes in business circumstances
indicate that the carry value of our intangible assets may

61

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

(Dollars in millions, except per-share data and unless otherwise indicated)

not be recoverable. Other intangible assets are amortized
on a straight-line basis over their estimated economic
lives. The straight-line method of amortization reflects an
appropriate allocation of the cost of the intangible assets
to earnings in proportion to the amount of economic
benefits obtained annually by the Company.

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
circumstances 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 difference between estimated
fair value and carrying value. Our primary measure of
fair value is based on discounted cash flows. The
measurement of impairment requires management to
make estimates of these cash flows related to long-lived
assets, as well as other fair value determinations.

Treasury Stock: We account for repurchased
common stock under the cost method and include such
treasury stock as a component of our Common
shareholders’ equity. Retirement of Treasury stock is
recorded as a reduction of Common stock and Additional
paid-in-capital.

Research, Development and Engineering
(“R,D&E”): Research, development and engineering
costs are expensed as incurred. R,D&E was $922, $943
and $914, for the three years ended December 31, 2006,
respectively. Research and development (“R&D”) costs
were $761 in 2006, $755 in 2005 and $760 in 2004.
Sustaining engineering costs are incurred with respect to
on-going product improvements or environmental
compliance after initial product launch. Our sustaining
engineering costs were $161, $188, and $154, for the
three years ended December 31, 2006, respectively.

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 of pension 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 as components of net periodic benefit cost,
except to the extent they may be offset by subsequent
changes. At any point, changes that have been identified
and quantified but not recognized as components of net
periodic benefit cost, are recognized in accumulated
other comprehensive loss, net of tax.

Several statistical 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. 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 accounted 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 systematic
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

62

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

(Dollars in millions, except per-share data and unless otherwise indicated)

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.

Each year, the difference between the actual return on
plan assets and the expected return on plan assets is added
to, or subtracted from, any cumulative actuarial gain or loss
that arose in prior years. As of December 31, 2006, this
amount is a component of the net actuarial gain or loss
recognized in accumulated other comprehensive loss and is
subject to subsequent amortization to net periodic pension
cost in future periods over the remaining service lives of
the employees participating in the pension plan.

The discount rate is used to present value our future
anticipated benefit obligations. In estimating our discount
rate, we consider rates of return on high quality fixed-
income investments included in various published bond
indexes, adjusted to eliminate the effects of call
provisions and differences in the timing and amounts of
cash outflows related to the bonds, as well as, the
expected timing of pension and other benefit payments. In
the U.S. and the U.K., which comprise approximately

Note 2 – Segment Reporting

80% of our projected benefit obligation, we consider the
Moody’s Aa Corporate Bond Index and the International
Index Company’s iBoxx Sterling Corporate AA Cash
Bond Index, respectively in the determination of the
appropriate discount rate assumptions. Refer to Note
14-Employee Benefit Plans for further information.

Foreign Currency Translation: The functional
currency 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 combination 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 $39, $5 and $73
in 2006, 2005 and 2004, respectively, and are included in
Other expenses, net in the accompanying Consolidated
Statements of Income.

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 Production segment includes black-and-white

products which operate at speeds over 90 pages per
minute (“ppm”) and color products which operate at
speeds over 40 ppm, excluding 50 ppm products with an
embedded controller. Products include the Xerox iGen3
digital color production press, 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 ppm and color

devices, up to 40 ppm, as well as, 50 ppm color devices
with an embedded controller. Products include the suite of
CopyCentre, WorkCentre, and WorkCentre Pro digital
multifunction systems, DocuColor color multifunction
products, color laser, solid ink color printers and
multifunction devices, monochrome laser desktop
printers, digital and light-lens copiers and facsimile
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, Brazil, the Middle East, India, Eurasia, Central
and Eastern Europe and Africa. This segment’s sales
consist of office and production including a large
proportion of office devices and printers which operate at
speeds of 11-40 ppm. Management serves and evaluates
these markets on an aggregate geographic basis, rather
than on a product basis.

63

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

(Dollars in millions, except per-share data and unless otherwise indicated)

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), value-
added services, Wide Format Systems, Xerox Technology
Enterprises, royalty and licensing revenues, equity net
income and non-allocated Corporate items. Value-added
services includes the results of our 2006 acquisition of

Amici LLC. (Refer to Note 20 – Acquisitions for further
information.) 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 as well as other items included in
Other expenses, net.

Selected financial information for our operating segments for each of the years ended December 31, 2006, 2005

and 2004, respectively, was as follows (in millions):

Production

Office

DMO

Other

Total

2006(1)
Information about profit or loss:
Revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Finance income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$4,256
323

$7,128
497

$1,932
6

$1,739
14

$15,055
840

Total Segment revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$4,579

$7,625

$1,938

$1,753

$15,895

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Interest expense(2)
Segment profit(3)
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Equity in net income of unconsolidated affiliates . . . . . . . . . . . . . . . .
2005(1)
Information about profit or loss:
Revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Finance income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$ 120
403
$ —

$

$ 179
832
$ — $

7
124
5

$ 238
31
$ 109

$

$

544
1,390
114

$4,198
342

$7,106
512

$1,803
9

$1,719
12

$14,826
875

Total Segment revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$4,540

$7,618

$1,812

$1,731

$15,701

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Interest expense(2)
Segment profit(3)
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Equity in net income of unconsolidated affiliates . . . . . . . . . . . . . . . .
2004(1)
Information about profit or loss:
Revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Finance income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$ 121
427
$ —

$

$ 179
819
$ — $

8
64
4

$ 249
151
94

$

$

$

557
1,461
98

$4,238
352

$7,075
552

$1,697
10

$1,778
20

$14,788
934

Total Segment revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$4,590

$7,627

$1,707

$1,798

$15,722

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Interest expense(2)
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Segment profit (loss)(3)
Equity in net income of unconsolidated affiliates . . . . . . . . . . . . . . . .

$ 114
511
$ —

$

$ 176
779
$ — $

12
35
3

$ 406
(125)
$ 148

$

$

708
1,200
151

(1) Asset information on a segment basis is not disclosed as this information is not separately identified and internally

(2)

reported to our chief executive officer.
Interest expense includes equipment financing interest as well as non-financing interest, which is a component of
Other expenses, net.

(3) Depreciation and amortization expense is recorded in cost of sales, research, development and engineering

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 identification
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.

64

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

(Dollars in millions, except per-share data and unless otherwise indicated)

The following is a reconciliation of segment profit to pre-tax income (in millions):

Total Segment profit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Reconciling items:

Restructuring and asset impairment charges . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Provisions for litigation matters(1)
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Initial provision for WEEE Directive . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Hurricane Katrina adjustments (losses) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Other expenses, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Equity in net income of unconsolidated affiliates . . . . . . . . . . . . . . . . . . . . . . . . . . .
Pre-tax income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Years ended December 31,

2006

2005

2004

$1,390

$1,461

$1,200

(385)
(68)
—
8
(23)
(114)
$ 808

(366)
(114)
(26)
(15)
(12)
(98)
$ 830

(86)
—
—
—
2
(151)
$ 965

(1) 2006 provision for litigation includes $68 related to probable losses on Brazilian labor-related contingencies. 2005

provision for litigation primarily includes $102 related to MPI arbitration panel ruling. Refer to Note 16 –
Contingencies for further discussion relating to the 2006 and 2005 annual periods.

Geographic area data was as follows:

(in millions)

Revenues

Long-Lived Assets(1)

2006

2005

2004

2006

2005

2004

United States . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Europe . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Other Areas . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$ 8,406
5,378
2,111
$15,895

$ 8,388
5,226
2,087
$15,701

$ 8,346
5,281
2,095
$15,722

$1,309
572
356
$2,237

$1,386
500
386
$2,272

$1,427
585
434
$2,446

(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 – Short-Term Investments

As of December 31, 2006 and 2005, respectively, we

held $137 and $244 in marketable securities that are
classified within Short-term investments in our
Consolidated Balance Sheets. These securities are
considered available-for-sale and are carried at fair value
based on quoted market prices. Unrealized gains and
losses, net of taxes, are less than $1 and are recorded

within Accumulated other comprehensive loss, a
component of Common shareholders’ equity. The cost of
securities sold is based on the specific identification
method. Gains or losses of less than $1 million were
realized on these sales for the years ended December 31,
2006 and 2005, respectively.

65

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

(Dollars in millions, except per-share data and unless otherwise indicated)

The following table summarizes the maturities and fair market values of our Short-term investments as of

December 31, 2006 and 2005, respectively (in millions):

2006

Description of Securities
Corporate bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Auction rate municipal bonds . . . . . . . . . . . . . . . . . .
US government agency securities . . . . . . . . . . . . . . .
. . . . . . . . . . . . . . . . . . . . . . . .
Certificates of deposit

Total Debt Securities . . . . . . . . . . . . . . . . . . . . . . . . .

Auction rate preferred securities . . . . . . . . . . . . . . . .
Total Short-term investments . . . . . . . . . . . . . . . . .

2005

Description of Securities
Corporate bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Auction rate municipal bonds . . . . . . . . . . . . . . . . . .
US government agency securities . . . . . . . . . . . . . . .

Total Debt Securities . . . . . . . . . . . . . . . . . . . . . . . . .

Auction rate preferred securities . . . . . . . . . . . . . . . .
Total Short-term investments . . . . . . . . . . . . . . . . .

Due In
1 Year or Less

Due After
1 Year Through
5 Years

Due After
5 Years Through
10 Years

Due After
10 Years

Total

$ 65
—
23
8

$ 96

$—
—
—
—

$—

$—
—
—
—

$—

$—
31
—
—

$ 31

$ 65
31
23
8

$127

10
$137

Due In
1 Year or Less

Due After
1 Year Through
5 Years

Due After
5 Years Through
10 Years

Due After
10 Years

Total

$ 93
—
13

$106

$ 51
—
19

$ 70

$—
—
—

$—

$—
45
—

$ 45

$144
45
32

$221

23
$244

Actual maturities may differ from contractual
maturities because borrowers may have the right to
prepay and creditors may have the right to call
obligations. These securities are classified within current
assets because they are highly liquid, traded in active
markets and are available for use, if needed, for current
operations.

Note 4 – 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. Finance receivables, net at December 31, 2006 and 2005 were as follows (in millions):

2006

2005

Gross receivables . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Unearned income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Unguaranteed residual values . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Allowance for doubtful accounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$ 9,389
(1,437)
90
(198)

$ 9,449
(1,458)
87
(229)

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Finance receivables, net
Less: Billed portion of finance receivables, net
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Current portion of finance receivables not billed, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

7,844
(273)
(2,649)

7,849
(296)
(2,604)

Amounts due after one year, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$ 4,922

$ 4,949

66

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

(Dollars in millions, except per-share data and unless otherwise indicated)

Contractual maturities of our gross finance receivables as of December 31, 2006 were as follows (including those

already billed of $273) (in millions):

2007

$3,530

2008

$2,589

2009

$1,813

2010

$1,050

2011

$362

Thereafter

$45

Total

$9,389

Secured Funding Arrangements

GE Secured Borrowings: We have an agreement in
the U.S. (the “Loan Agreement”) under which GE Vendor
Financial Services, a subsidiary of GE, provides secured
funding for our customer leasing activities in the U.S. The
maximum potential level of borrowing under the Loan
Agreement is a function of the size of the portfolio of
finance receivables generated by us that meet GE’s
funding requirements and cannot exceed $5 billion in any
event. There have been no new borrowings under the
Loan Agreement since December 2005.

Under this agreement, 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 provisions related to certain financial covenants
contained in the 2006 Credit Facility and other significant
debt facilities. Any cross default would impair our ability
to receive subsequent funding until the default was cured
or waived but does not accelerate previous borrowings

except in the case of bankruptcy. However, in the event of
a default, we could be replaced as the maintenance
service provider for the associated equipment under lease.

We have 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 U.S. and Canadian facilities is currently
December 2010. In November 2006, we delivered notice
to GE, moving the final funding date for the U.K.
program to June 2007.

France Secured Borrowings: We have an on-going
warehouse financing facility in France with Merrill Lynch
to fund new lease originations up to €420 million ($552
as of December 31, 2006) through July 2007. The Merill
Lynch facility can be extended via the optional extension
provision to 2009.

DLL Secured Borrowings: In 2002, we formed a

joint venture with De Lage Landen Bank (“the DLL Joint
Venture”) which became our primary equipment
financing provider for new lease originations in the
Netherlands through fundings from De Lage Landen
Bank. Our DLL Joint Venture is consolidated as we are
deemed to be the primary beneficiary of the joint
venture’s financial results (Refer to Note 1 – “Basis of
Consolidation”). The funds received by the DLL Joint
Venture are recorded as secured borrowings and together
with the associated lease receivables are included in our
Consolidated Balance Sheets.

67

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

(Dollars in millions, except per-share data and unless otherwise indicated)

The following table shows finance receivables and related secured debt as of December 31, 2006 and 2005.

Although the finance receivables are consolidated assets they are generally not available to satisfy our other
obligations:

(in millions)

Finance Receivables Encumbered by Loans:
GE secured loans:

December 31, 2006

December 31, 2005

Facility Amount

Finance
Receivables, Net

Secured
Debt

Finance
Receivables, Net

Secured
Debt

GE Loans – U.S. . . . . . . . . . . . . . . . . . . . .
GE Loans – U.K. . . . . . . . . . . . . . . . . . . . .

$5 billion
£400 million
(U.S. $785)
GE Loans – Canada . . . . . . . . . . . . . . . . . Cdn. $850 million
(U.S. $733)

$ 941

$ 782

$1,888

$1,701

669

115

609

88

637

258

581

174

Total GE encumbered finance

receivables, net . . . . . . . . . . . . . . .
Merrill Lynch Loan – France . . . . . . . . . . . . . .

DLL – Netherlands . . . . . . . . . . . . . . . . . . . . . .

Total encumbered finance

receivables, net

. . . . . . . . . . . . . .

Unencumbered finance receivables,

net . . . . . . . . . . . . . . . . . . . . . . . . .

Total Finance receivables, net(1)

. . . . . . . . . .

€420 million
(U.S. $552)
N/A

1,725

1,479

2,783

2,456

501
197

419
161

430
216

342
184

2,423

$2,059

3,429

$2,982

5,421

$7,844

4,420

$7,849

(1)

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, 2006 and 2005.

Accounts Receivable Funding Arrangement: We
have a $400 revolving credit facility with GE expiring in
2007, secured by our U.S. accounts receivable. We had no
outstanding borrowings under this arrangement as of
December 31, 2006. Secured accounts receivables, net

and related debt associated with this arrangement as of
December 31, 2005 were $313 and $178, respectively.

In addition, during the fourth quarter of 2006, we sold
approximately $23 of accounts receivable without recourse.
Fees associated with these sales were less than $1.

68

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

(Dollars in millions, except per-share data and unless otherwise indicated)

Note 5 – Inventories and Equipment on Operating Leases, Net

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 $230, $205 and $210 for
the years ended December 31, 2006, 2005 and 2004,
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 (in millions):

2007

2008

2009

2010

2011

Thereafter

$ 332

$ 205

$ 125

$ 58

$ 22

$ 2

Total contingent rentals on operating leases,

consisting principally of usage charges in excess of
minimum contracted amounts, for the years ended
December 31, 2006, 2005 and 2004 amounted to $112,
$136 and $137, respectively.

Inventories at December 31, 2006 and 2005 were as

follows (in millions):

Finished goods . . . . . . . . . . . . . . . . . . .
Work-in-process . . . . . . . . . . . . . . . . . .
Raw materials . . . . . . . . . . . . . . . . . . . .
Total Inventories . . . . . . . . . . . . . . . . .

2006

2005

$ 967
67
129
$1,163

$ 956
99
146
$1,201

Equipment on operating leases and similar

arrangements consists of our equipment rented to
customers and depreciated to estimated residual value at
the end of the lease term. The transfer of equipment from
our inventories to equipment subject to an operating lease
is presented in our Consolidated Statements of Cash
Flows in the operating activities section as a non-cash
adjustment. We recorded $69, $56 and $73 in inventory
write-down charges for the years ended December 31,
2006, 2005 and 2004, respectively. Equipment on
operating leases and the related accumulated depreciation
at December 31, 2006 and 2005 were as follows (in
millions):

Equipment on operating leases . . . . . . .
Less: Accumulated depreciation . . . . .
Equipment on operating leases,

2006

2005

$1,246
(765)

$1,262
(831)

net . . . . . . . . . . . . . . . . . . . . . . . . . . .

$ 481

$ 431

Note 6 – Land, Buildings and Equipment, Net

Land, buildings and equipment, net at December 31, 2006 and 2005 were as follows (in millions):

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 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

69

Estimated
Useful Lives
(Years)

25 to 50
Varies
5 to 12
3 to 15
4 to 20

2006

2005

$

46
1,120
338
1,613
949
73
125

$

51
1,163
326
1,637
967
76
83

4,264
(2,737)
$ 1,527

4,303
(2,676)
$ 1,627

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

(Dollars in millions, except per-share data and unless otherwise indicated)

Depreciation expense was $277, $280 and $305 for the years ended December 31, 2006, 2005 and 2004,

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, 2006, 2005 and 2004 amounted to
$269, $267, and $316, respectively. Future minimum operating lease commitments that have initial or remaining
non-cancelable lease terms in excess of one year at December 31, 2006 were as follows:

2007

$ 189

2008

$ 161

2009

$ 124

2010

$ 102

2011

$ 84

Thereafter

$ 158

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 $30 at December 31,
2006.

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 processing,
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 primarily
recorded in selling, administrative and general expenses,
were $288, $305 and $328 for the years ended
December 31, 2006, 2005 and 2004, respectively.

Note 7 – Investments in Affiliates, at Equity

In December 2006, we sold our Corporate
headquarters facility for $55 and recognized a gain of
$15. In connection with the sale, the secured mortgage on
the facility of $34 was defeased through the purchase of
treasury securities totaling $36. The difference of $2 was
recorded as a loss on extinguishment of debt. The gain on
the sale as well as the loss on extinguishment are included
in Other expenses, net within the Consolidated Statements
of Income. In connection with the sale, we entered into a
two-year lease agreement, which is cancelable upon 90
days notice. We intend to relocate our Corporate
headquarters facility within the surrounding area, when a
suitable replacement facility is identified.

Investments in corporate joint ventures and other
companies in which we generally have a 20% to 50%
ownership interest at December 31, 2006 and 2005 were
as follows (in millions):

2006

2005

Our equity in net income of our unconsolidated

affiliates for the three years ended December 31, 2006
was as follows:

2006

2005

2004

Fuji Xerox(1)
. . . . . . . . . . . . . . . . . . . . . . . .
All other equity investments . . . . . . . . . . . .

$834
40

$725
57

Fuji Xerox . . . . . . . . . . . . . . . . . . . .
Other investments . . . . . . . . . . . . . .

$107
7

Investments in affiliates, at equity . . . . .

$874

$782

Total . . . . . . . . . . . . . . . . . . . . .

$114

$90
8

$98

$134
17

$151

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% ownership interest.

(1) Fuji Xerox is headquartered in Tokyo and operates
in Japan, China, Australia, New Zealand and other
areas of the Pacific Rim. Our investment in Fuji
Xerox of $834 at December 31, 2006, differs from
our implied 25% interest in the underlying net assets,
or $916, due primarily to our deferral of gains
resulting from sales of assets by us to Fuji Xerox,
partially offset by goodwill related to the Fuji Xerox
investment established at the time we acquired our
remaining 20% of Xerox Limited from The Rank
Group plc.

70

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

(Dollars in millions, except per-share data and unless otherwise indicated)

Condensed financial data of Fuji Xerox for the three calendar years ended December 31, 2006 was as follows (in

millions):

2006

2005

2004

Summary of Operations:
Revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Costs and expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$9,859
9,119

$10,009
9,406

$9,450
8,595

Income before income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Minorities’ interests . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

740
281
5

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$ 454

$

603
215
8

380

855
331
18

$ 506

Balance Sheet Data:
Assets:
Current assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Long-term assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$3,731
4,184

$ 3,454
4,168

$3,613
4,606

Total Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$7,915

$ 7,622

$8,219

Liabilities and Shareholders’ Equity:
Current liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Long-term debt
Other long-term liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Minorities’ interests in equity of subsidiaries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Shareholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$2,954
685
590
21
3,665

$ 2,991
434
936
17
3,244

$2,757
616
1,383
104
3,359

Total Liabilities and Shareholders’ Equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$7,915

$ 7,622

$8,219

In 2006, 2005 and 2004, we received dividends of

$41, $38 and $50, respectively, which were reflected as a
reduction in our investment. Additionally, we have a
technology agreement with Fuji Xerox whereby we
receive royalty payments for their use of our Xerox brand
trademark, as well as, rights to access their patent
portfolio in exchange for access to our patent portfolio.
Effective April 2006, we renewed our technology
agreement with Fuji Xerox (the “2006 Technology
Agreement”). The 2006 Technology Agreement provides
that Fuji Xerox will pay us a royalty that is based on Fuji
Xerox’s revenue. The 2006 Technology Agreement will
not result in a material change to the royalty revenues we
receive from Fuji Xerox. In general, all other existing
agreements with respect to intellectual property between
the parties will remain in full force and effect. Therefore,
all technology licenses previously granted between the
parties will not be subject to the 2006 Technology
Agreement but will generally remain subject to the terms
of any such prior arrangements. The only exception is that
the licenses previously granted under the 1999

Technology Agreement will be converted into fully
paid-up and royalty free licenses.

In 2006, 2005 and 2004, we earned royalty revenues

under this agreement of $117, $123 and $119,
respectively, which are included in Service, outsourcing
and rental revenues in the Consolidated Statements of
Income. 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 commitments 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, 2006 were as follows (in millions):

Sales . . . . . . . . . . . . . . . . . . . .
Purchases . . . . . . . . . . . . . . . .

$ 168
$1,677

$ 163
$1,517

$ 166
$1,135

2006

2005

2004

71

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

(Dollars in millions, except per-share data and unless otherwise indicated)

In addition to the amounts described above, in 2006,

2005 and 2004, we paid Fuji Xerox $28, $28 and $27,
respectively, and Fuji Xerox paid us $3 in 2006 and $9
for 2005 and 2004, respectively, for unique research and

development. As of December 31, 2006 and 2005,
amounts due to Fuji Xerox were $169 and $157,
respectively.

Note 8 – Goodwill and Intangible Assets, Net

Goodwill:

The following table presents the changes in the carrying amount of goodwill, by operating segment, for the three

years ended December 31, 2006 (in millions):

Production Office DMO Other

Total

Balance at January 1, 2004 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Foreign currency translation adjustment
. . . . . . . . . . . . . . . . . . . . . . . .
Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Balance at December 31, 2004 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
. . . . . . . . . . . . . . . . . . . . . . . .

Foreign currency translation adjustment

Balance at December 31, 2005 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
. . . . . . . . . . . . . . . . . . . . . . . .
Foreign currency translation adjustment
Acquisition of Amici LLC . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Acquisition of XMPie, Inc.

$ 771
77
—

848
(103)

745
99
—
48

$827

$— $124
1
(6)

54 —
—
—

881 —
(74) —

807 —
69 —
—
—
—
—

119
—

119
1
136
—

$1,722
132
(6)

1,848
(177)

1,671
169
136
48

Balance at December 31, 2006 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$ 892

$876

$— $256

$2,024

Intangible Assets, Net:

Intangible assets primarily relate to the Office operating segment. Intangible assets were comprised of the

following as of December 31, 2006 and 2005 (in millions):

Weighted
Average
Amortization
Period

Installed customer base . . . . . . . . .
Distribution network . . . . . . . . . . .
Technology and trademarks . . . . .

16 years
25 years
7 years

As of December 31, 2006:

As of December 31, 2005:

Gross
Carrying
Amount

$258
123
165

$546

Accumulated
Amortization

Net
Amount

$ 89
35
136

$260

$169
88
29

$286

Gross
Carrying
Amount

$226
123
156

$505

Accumulated
Amortization

Net
Amount

$ 72
30
114

$216

$154
93
42

$289

Amortization expense related to intangible assets
was $45, $42, and $38 for the years ended December 31,
2006, 2005 and 2004, respectively, and is expected to
approximate $27 in 2007 and approximate $25 annually
from 2008 through 2011. 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.

72

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

(Dollars in millions, except per-share data and unless otherwise indicated)

Note 9 – Restructuring and Asset
Impairment Charges

We have engaged in a series of restructuring

programs related to downsizing our employee base,
exiting certain activities, outsourcing certain internal
functions and engaging in other actions designed to
reduce our cost structure and improve productivity.
Management continues to evaluate our 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 as a result of these programs.

The net restructuring and asset impairment charges
in the Consolidated Statements of Income totaled $385,
$366 and $86 in 2006, 2005 and 2004, respectively.
Detailed information related to restructuring program
activity during the three years ended December 31, 2006
is outlined below (in millions):

Severance and
Related Costs

Lease
Cancellation and
Other Costs

Asset
Impairments(1)

Legacy
Programs(2)

Restructuring Activity

Ending Balance December 31, 2003
Restructuring Provision . . . . . . . . . . . . . . . . . . . . . .
Reversals of prior accruals . . . . . . . . . . . . . . . . . . . .

Net current year charges(3)

. . . . . . . . . . . . . . . .
Charges against reserve and currency . . . . . . . . . . .

Ending Balance December 31, 2004 . . . . . . . . . . .
Restructuring Provision . . . . . . . . . . . . . . . . . . . . . .
Reversals of prior accruals . . . . . . . . . . . . . . . . . . . .

Net current year charges(3)

. . . . . . . . . . . . . . . .
Charges against reserve and currency . . . . . . . . . . .

Ending Balance December 31, 2005 . . . . . . . . . . .
Restructuring Provision . . . . . . . . . . . . . . . . . . . . . .
Reversals of prior accruals . . . . . . . . . . . . . . . . . . . .

Net current year charges(3)

. . . . . . . . . . . . . . . .
Charges against reserve and currency . . . . . . . . . . .

$ 143
95
(11)

84
(157)

$ 70
371
(21)

350
(203)

$ 217
351
(33)

318
(242)

Ending Balance December 31, 2006 . . . . . . . . . . .

$ 293

$ 36
8

—

8
(21)

$ 23
12
(6)

6
(10)

$ 19
39
(2)

37
(12)

$ 44

$—
1

—

1
(1)

$—

15
—

15
(15)

$—

30
—

30
(30)

$—

$ 42
2
(9)

(7)
(11)

$ 24
1
(6)

(5)
(19)

$—
—
—

—
—

$—

Total

$ 221
106
(20)

86
(190)

$ 117
399
(33)

366
(247)

$ 236
420
(35)

385
(284)

$ 337

(1) Charges associated with asset impairments represent the write-down of the related assets to their new cost basis

and are recorded concurrently with the recognition of the provision.

(2) Legacy Programs, includes the runoff activity of several predecessor restructuring programs which were initiated

between 2000 and 2001.

(3) Represents amount recognized within the Consolidated Statements of Income for the years shown.

73

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

(Dollars in millions, except per-share data and unless otherwise indicated)

Additional details about our restructuring programs

are as follows:

Reconciliation to Consolidated Statements of Cash
Flows

Years ended
December 31,

2006

2005

2004

Charges to reserve . . . . . . . . . . .
Pension curtailment, special
termination benefits and
settlements . . . . . . . . . . . . . . . —
30

Asset impairments . . . . . . . . . . .
Effects of foreign currency and

$(284) $(247) $(190)

—
15

8
1

other non-cash . . . . . . . . . . . .

(11)

18

(6)

Cash payments for

operations as well as an exit from certain leased and
owned facilities. These charges were offset by
reversals of $35 primarily related to changes in
estimates in severance costs from previously
recorded actions.

• During 2005, we provided $398 for ongoing

restructuring programs, which consisted of a charge
of $371 for severance costs, primarily related to the
elimination of approximately 3,900 positions
worldwide, a charge of $12 for lease terminations
and $15 for asset impairments. The initiatives in
2005 were focused on cost reductions in service,
manufacturing and back office support operations
primarily within the Office and Production
segments. These charges were offset by reversals of
$27 primarily related to changes in estimates in
severance costs from previously recorded actions.

restructurings . . . . . . . . . . . .

$(265) $(214) $(187)

• During 2004, we provided $104 for ongoing

Restructuring: In recent years we have initiated a

series of ongoing restructuring initiatives designed to
leverage cost savings resulting from realized productivity
improvements, realign and lower our overall cost
structure and outsource certain internal functions. These
initiatives primarily include severance actions and impact
all major geographies and segments. Recent initiatives
include:

• During 2006, we provided $420 for ongoing

restructuring programs which consisted of $351 for
severance and related costs, $39 for lease and
contract terminations and $30 for asset
impairments. The charges primarily relate to the
elimination of approximately 3,400 positions
primarily in North America and Europe. The 2006
actions associated with these charges primarily
include the following: technical and professional
services infrastructure and global back-office
optimization; continued R&D efficiencies and
productivity improvements; supply chain
optimization to ensure, for example, alignment to
our global two-tier model implementation; and
selected off-shoring opportunities. The lease
termination and asset impairment charges primarily
related to the relocation of certain manufacturing

restructuring programs, which consisted of a charge
of $87 related to the elimination of approximately
1,900 positions primarily in North America and
Latin America, $8 for pension settlements, $8 for
lease terminations and $1 for asset impairments.
These charges were offset by reversals of $11
related to changes in estimates for severance costs
from previously recorded actions.
We expect to utilize the majority of the
December 31, 2006 restructuring balance in 2007.

The following table summarizes the total amount of

costs incurred in connection with these restructuring
programs by segment for the three years ended
December 31, 2006 (in millions):

Years Ended December 31,

2006

2005

2004

Production . . . . . . . . . . . . . . . . . . . .
Office . . . . . . . . . . . . . . . . . . . . . . .
DMO . . . . . . . . . . . . . . . . . . . . . . . .
Other . . . . . . . . . . . . . . . . . . . . . . . .

$142
127
21
95

$ 27
$150
29
175
22
30
19 —

Total Provisions . . . . . . . . . . . . . .

$385

$366

$ 86

We expect to incur additional restructuring charges

in 2007 of approximately $11 related to initiatives
identified to date that have not yet been recognized in the
Consolidated Financial Statements as well as expected
interest accretion on the reserve.

74

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

(Dollars in millions, except per-share data and unless otherwise indicated)

Note 10 – Supplementary Financial Information

The components of other current assets and other
current liabilities at December 31, 2006 and 2005 were as
follows (in millions):

The components of other long-term assets and other
long-term liabilities at December 31, 2006 and 2005 were
as follows (in millions):

Other current assets
Deferred taxes . . . . . . . . . . . . . . . . . . . .
Restricted cash . . . . . . . . . . . . . . . . . . .
Prepaid expenses . . . . . . . . . . . . . . . . .
Financial derivative instruments . . . . .
Other . . . . . . . . . . . . . . . . . . . . . . . . . . .

2006

2005

$ 271
236
119
9
299

$ 290
270
133
28
311

Total Other current assets . . . . .

$ 934

$1,032

Other long-term assets
Prepaid pension costs . . . . . . . . . . . . . .
Net investment in discontinued

operations . . . . . . . . . . . . . . . . . . . . .
Internal use software, net . . . . . . . . . . .
Restricted cash . . . . . . . . . . . . . . . . . . .
Debt issuance costs, net
. . . . . . . . . . . .
Other . . . . . . . . . . . . . . . . . . . . . . . . . . .

2006

2005

$

19

$ 829

295
217
190
48
282

420
198
176
52
246

Other current liabilities
Income taxes payable . . . . . . . . . . . . . .
Other taxes payable . . . . . . . . . . . . . . .
Interest payable . . . . . . . . . . . . . . . . . . .
Restructuring reserves . . . . . . . . . . . . .
Unearned income . . . . . . . . . . . . . . . . .
Financial derivative instruments . . . . .
Product warranties . . . . . . . . . . . . . . . .
Liability to Xerox Capital LLC . . . . . .
Other . . . . . . . . . . . . . . . . . . . . . . . . . . .

Total Other current

$

63
157
128
291
194
17
21
—
546

$

84
199
102
212
191
12
20
98
625

Total Other long-term assets . . .

$1,051

$1,921

Other long-term liabilities
Deferred and other tax liabilities . . . . .
Minorities’ interests in equity of

subsidiaries . . . . . . . . . . . . . . . . . . . .
Financial derivative instruments . . . . .
Product warranties . . . . . . . . . . . . . . . .
Other . . . . . . . . . . . . . . . . . . . . . . . . . . .

Total Other long-term

$ 223

$ 771

108
42
1
447

90
45
1
388

liabilities . . . . . . . . . . . . . . . . .

$ 821

$1,295

liabilities . . . . . . . . . . . . . . . . .

$1,417

$1,543

Net investment in discontinued operations: Our

net investment in discontinued operations primarily
consists of a performance-based instrument relating to the
1997 sale of The Resolution Group (“TRG”) of $325, as
well as remaining liabilities associated with our
discontinued operations of $32.

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% of TRG’s available cash flow
as defined in the sale agreement. We received cash
distributions of $20 for each of the years ended
December 31, 2006 and 2005, 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 established number of shares of this
instrument each year through 2017. Based on current cash
flow projections, we expect to fully recover the $325
remaining balance of this instrument.

In 2005, our net investment in discontinued
operations also included our net investment in Ridge
Reinsurance Limited which was liquidated in 2006 as part
of an agreement to transfer its remaining reinsurance
obligation together with related investments to another
insurance company. Refer to Note 21 – Divestitures and
Other Sales for further information.

Liability to Xerox Capital LLC: Liability was
settled in February 2006 as part of mandatory redemption
of preferred securities issued by Xerox Capital LLC. This
liability was settled for Cdn. $114 million ($100) and
Cdn. $24 million ($21) was remitted back to us upon
liquidation of Xerox Capital LLC.

75

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

(Dollars in millions, except per-share data and unless otherwise indicated)

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 $73, $92, and $107 for the years
ended December 31, 2006, 2005 and 2004, respectively.

Note 11 – Debt

Short-term borrowings at December 31, 2006 and

2005 were as follows (in millions):

2006

2005

Current maturities of long-term

debt

. . . . . . . . . . . . . . . . . . . . . . .
Notes payable . . . . . . . . . . . . . . . . . .

$1,465
20

$1,099
40

Total

. . . . . . . . . . . . . . . . . . . . . . . .

$1,485

$1,139

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
Statements of Income.

76

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

(Dollars in millions, except per-share data and unless otherwise indicated)

Long-term debt, including debt secured by finance receivables at December 31, 2006 and 2005 was as follows (in

millions):

U.S. Operations
Xerox Corporation

Weighted Average
Interest Rates at
December 31, 2006

2006

2005

Notes due 2008 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Senior Notes due 2009(1)
Euro Senior Notes due 2009(1)
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Senior Notes due 2010(1)
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Notes due 2011 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Senior Notes due 2011(1)
Senior Notes due 2013(1)
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Convertible Notes due 2014 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Notes due 2016(1)
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
2003 Credit Facility due 2008 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Floating Senior Notes due 2009 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Senior Notes due 2016(1)
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Senior Notes due 2017(1)

5.89%
10.75
10.60
7.62
7.01
7.13
7.63
9.00
7.62
—
6.16
6.48
6.83

$

$

3
613
290
687
50
750
541
19
248
—
150
696
497

27
620
260
688
50
752
542
19
251
300
—
—
—

Subtotal . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$ 4,544

$ 3,509

Xerox Credit Corporation

Yen notes due 2007 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Notes due 2012 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Notes due 2013 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Notes due 2014 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Notes due 2018 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Subtotal . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Other U.S. Operations
Borrowings secured by finance receivables(2)
. . . . . . . . . . . . . . . . . . . . . . . . . . . .
Borrowings secured by other assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Subtotal . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

5.44
7.07
6.49
6.06
7.00

4.95
9.61

252
75
60
50
25

462

782
10

792

255
75
60
50
25

465

$

1,701
220

$ 1,921

$

$

Total U.S. Operations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$ 5,798

$ 5,895

International Operations

Pound Sterling secured borrowings due 2008(2) . . . . . . . . . . . . . . . . . . . . . . .
. . . . . . . . . . . . . . . . . . . . . . . . . .
Euro secured borrowings due 2006-2015(2)
Canadian dollars secured borrowings due 2006-2008(2)
. . . . . . . . . . . . . . . .
Other debt due 2006-2010 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

6.04
4.62
5.49
6.32

Total International Operations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Subtotal . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Less current maturities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Total Long-term debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

609
580
88
50

1,327

7,125

581
526
174
62

1,343

7,238

(1,465)

(1,099)

$ 5,660

$ 6,139

(1) The principal amounts of these debt instruments have been adjusted for the effects of fair value hedge accounting,

as described in Note 13 – Financial Instruments, premiums and discounts.

77

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

(Dollars in millions, except per-share data and unless otherwise indicated)

The following summarizes the principal amounts of those instruments as of December 31, 2006:

Senior Notes due 2009 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Euro Senior Notes due 2009 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Senior Notes due 2010 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Senior Notes due 2011 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Senior Notes due 2013 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Notes due 2016 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Senior Notes due 2016 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Senior Notes due 2017 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
(2) Refer to Note 4 – Receivables, Net, for further discussion of borrowings secured by finance receivables, net.

$600
296
700
750
550
250
700
500

Scheduled payments due on long-term debt for the next five years and thereafter are as follows (in millions):
Total
2010
2007

Thereafter

2008

2009

2011

$1,465

$736

$1,169

$733

$806

$2,216

$7,125

2006 Credit Facility

In April 2006, we entered into a $1.25 billion
unsecured revolving credit facility including a $200 letter
of credit subfacility (the “2006 Credit Facility” or
“facility”). The facility allows us to increase from time to
time, with willing lenders, its overall size to $2 billion.
The facility is available, without sublimit, to certain of
our qualifying subsidiaries. The facility replaced our 2003
Credit Facility that was terminated upon effectiveness of
the 2006 Credit Facility. As of December 31, 2006, we
had outstanding letters of credit of $15 and no borrowings
under the 2006 Credit Facility. In conjunction with the
2006 Credit Facility, debt issuance costs of $5 were
deferred.

Our obligations under the facility are unsecured and
are not guaranteed by any of our subsidiaries. However, if
in the future any of our domestic subsidiaries guarantees
any debt for money borrowed by us of more than $100,
that subsidiary is required to guaranty our obligations
under the facility as well. In the event that any of our
subsidiaries borrows under the facility, its borrowings
thereunder would be guaranteed by us.

The 2006 Credit Facility matures in April 2011,
subject to our right to request a one-year extension on
each of the first and second anniversaries of the facility.
The facility contains various conditions to borrowing, and
affirmative, negative and financial maintenance
covenants. Certain of the more significant covenants are
summarized below:

(a) Maximum leverage ratio (a quarterly test that is
calculated as debt for borrowed money divided
by consolidated EBITDA) ranging from 4.25 to
3.25 over the life of the facility.

(b) Minimum interest coverage ratio (a quarterly

test that is calculated as consolidated EBITDA
divided by consolidated interest expense) may
not be less than 3.00:1.

(c) Limitations on (i) liens of Xerox and certain of
our subsidiaries securing debt, (ii) certain
fundamental changes to corporate structure,
(iii) changes in nature of business and
(iv) limitations on debt incurred by certain
subsidiaries.

Borrowings under the 2006 Credit Facility bear

The 2006 Credit Facility also contains various events

interest at LIBOR plus a spread that will vary between
0.32% and 1.20% depending on our current credit ratings.
The spread as of December 31, 2006 was 0.60%. In
addition, we are required to pay a facility fee on the
aggregate amount of the revolving credit facility. As of
December 31, 2006, there were no outstanding
borrowings under the 2006 Credit Facility and the facility
fee rate was 0.15%.

of default, the occurrence of which could result in a
termination by the lenders and the acceleration of all our
obligations under the facility. These events of default
include, without limitation: (i) payment defaults,
(ii) breaches of covenants under the facility (certain of
which breaches do not have any grace period), (iii) cross-
defaults and acceleration to certain of our other
obligations and (iv) a change of control of Xerox.

78

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

(Dollars in millions, except per-share data and unless otherwise indicated)

Termination of 2003 Credit Facility

In connection with the effectiveness of the 2006
Credit Facility, we terminated the 2003 Credit Facility in
April 2006 and repaid all advances and loans outstanding
thereunder. The termination of the 2003 Credit Facility
resulted in the write-off of unamortized deferred debt

Senior Notes Offerings

In March 2006, we issued $700 aggregate principal
amount of Senior Notes due 2016 (“2016 Senior Notes”)
at 99.413% of par, resulting in net proceeds of $689. The
2016 Senior Notes accrue interest at the rate of 6.40% per
annum, payable semiannually, and as a result of the
discount, have a weighted average effective interest rate
of 6.481%. In conjunction with the issuance of the 2016
Senior Notes, debt issuance costs of $7 were deferred.

In August 2006, we issued $500 aggregate principal
amount of Senior Notes due 2017 (“2017 Senior Notes”)
and $150 aggregate principal amount of floating rate
Senior Notes due 2009 (“Floating 2009 Senior Notes”).
The 2017 Senior Notes aggregate principal amount was
issued at 99.392% of par, resulting in net proceeds of
$492. Interest on the 2017 Senior Notes accrues at the rate
of 6.75% per annum and is payable semiannually and, as
a result of the discount, has a weighted average effective
interest rate of 6.833%. The Floating 2009 Senior Notes
aggregate principal amount was issued at 100% of par,
resulting in net proceeds of $149. Interest on the Floating
2009 Senior Notes accrues at a rate per annum, reset
quarterly, equal to three-month LIBOR plus 0.75% and is
payable quarterly. In conjunction with the issuance of the
2017 Senior Notes and the Floating 2009 Senior Notes,
debt issuance costs of $6 were deferred.

Debt repayments and maturities: During 2006, we

repaid $24 of public unsecured debt prior to its scheduled
maturity. There were no other scheduled public debt
maturities in 2006.

Guarantees: At December 31, 2006, we have

guaranteed $31 of indebtedness of our foreign
subsidiaries. This debt is included in our Consolidated
Balance Sheet as of such date. In addition, as of
December 31, 2006, $40 of letters of credit have been
issued in connection with insurance guarantees.

Interest: Interest paid on our short-term debt, long-

term debt and liabilities to subsidiary trusts issuing
preferred securities amounted to $512, $555 and $710 for

79

issuance costs of $13, as well as termination of the
guaranty by Xerox International Joint Marketing Inc. of
our outstanding Senior Notes due 2009, 2010, 2011, 2013
and 2016.

the years ended December 31, 2006, 2005 and 2004,
respectively.

Interest expense and interest income for the three

years ended December 31, 2006 was as follows (in
millions):

Year Ended December 31,

2006

2005

2004

Interest expense(1) . . . . . . . . .
. . . . . . . . .
Interest income(2)

$ 544
(909)

$

557
(1,013)

$

708
(1,009)

(1)

(2)

Includes Equipment financing interest expense, as
well as, non-financing interest expense included in
Other expenses, net in the Consolidated Statements
of Income.
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

an estimated cost of funds, applied against the estimated
level of debt required to support our net finance
receivables. Prior to 2006, the estimated cost of funds was
primarily based on our secured borrowing rates. As a
result of the recent reduction in our level of secured
borrowings, effective January 1, 2006 the estimated cost
of funds is based on a blended rate for term and duration
comparable to available borrowing rates for a BBB rated
company, which were reviewed at the end of each period.
This change in basis did not materially impact the
calculated amount of Equipment finance interest expense
and accordingly did not impact comparability between the
periods. The estimated level of debt is based on an
assumed 7 to 1 leverage ratio of debt/equity as compared
to our average finance receivable balance during the
applicable period.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

(Dollars in millions, except per-share data and unless otherwise indicated)

Net cash payments on other debt as shown on the Consolidated Statements of Cash Flows for the three years

ended December 31, 2006 was as follows (in millions):

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Cash (payments) proceeds on notes payable, net
Net cash proceeds from issuance of long-term debt(1)
. . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Cash payments on long-term debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$ (19) $

1,502
(207)

4
50
(1,241)

$

(6)
974
(2,390)

Net cash proceeds (payments) on other debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$1,276

$(1,187) $(1,422)

2006

2005

2004

(1)

Includes payment of debt issuance costs.

Note 12 – 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, 2006 and 2005, the components of our
liabilities to the trusts were as follows (in millions):

Trust I . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Xerox Capital LLC(1)
Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$624
. . . . . . . . . . . . . . . . . —
$624

$626
98
$724

2006

2005

(1) Classified in Other current liabilities in the

December 31, 2005 Consolidated Balance Sheet.
This liability was settled, with no gains or losses, in
February 2006 as part of the mandatory redemption
of preferred securities issued by Xerox Capital LLC.

Trust I: In 1997, Xerox Capital Trust I (“Trust I”)

issued 650 thousand of 8.0% preferred securities (the
“Preferred Securities”) to investors for $644 ($650
liquidation value) and 20,103 shares of common
securities to us for $20. With the proceeds from these

Note 13 – Financial Instruments

securities, Trust I purchased $670 principal amount of
8.0% Junior Subordinated Debentures due 2027 of the
Company (“the Debentures”). The Debentures represent
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, was
$54 in 2006, 2005 and 2004. 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% per year of the stated liquidation amount
of one thousand dollars per Preferred Security. The
Preferred Securities are mandatorily redeemable upon the
maturity 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.

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 instruments are
utilized to hedge economic exposures as well as to 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. Certain of our derivatives

80

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

(Dollars in millions, except per-share data and unless otherwise indicated)

do not qualify for hedge accounting but are effective as
economic hedges of our inventory purchases and currency
exposure. These derivative contracts are accounted for
using the mark-to-market accounting method and
accordingly are exposed to some level of volatility. Under
this method, the contracts are carried at their fair value on
our consolidated balance sheet within Other assets and
Other liabilities. 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. The related cash flow impacts of all of
our derivative activities are reflected as cash flows from
operating activities.

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 and net purchased foreign currency
options to manage interest rate and foreign currency
exposures. Our primary foreign currency market
exposures include the Japanese Yen, Euro, British pound
sterling, Canadian dollar and Brazilian real. 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
management 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 counterparties having a
minimum investment-grade or better credit rating. Credit
risk is managed through the continuous monitoring of
exposures to such counterparties.

Some of our derivative and other material contracts

at December 31, 2006 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-Summary of Significant
Accounting Policies 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 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, 2006 and 2005, we had outstanding

single currency interest rate swap agreements with
aggregate notional amounts of $1.7 billion and $2.1
billion, respectively. The net liability fair values at
December 31, 2006 and 2005 were $41 and $40,
respectively.

81

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

(Dollars in millions, except per-share data and unless otherwise indicated)

Fair Value Hedges: As of December 31, 2006 and 2005, pay variable/receive fixed interest rate swaps with
notional amounts of $1.4 billion and $1.8 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 ineffective portion was recorded to earnings during 2006, 2005, or 2004. The following is a summary
of our fair value hedges at December 31, 2006:

Debt Instrument

Year First
Designated

Notional
Amount

Net
Liability
Fair
Value

Weighted-
average
Interest
Rate Paid

Interest
Rate Received

Basis Maturity

Senior Notes due 2010 . . . . . . . . . . . . . . .
Notes due 2016 . . . . . . . . . . . . . . . . . . . . .
Senior Notes due 2011 . . . . . . . . . . . . . . .
Liability to Capital Trust I . . . . . . . . . . . . .

2003/2005
2004
2004
2005

Total

. . . . . . . . . . . . . . . . . . . . . . . . .

$ 400
250
250
450

$1,350

$ 8.3
5.7
6.9
21.4

$42.3

7.83%
7.62%
7.84%
7.46%

7.13%
7.20%
6.88%
8.00%

Libor
Libor
Libor
Libor

2010
2016
2011
2027

Cash Flow Hedges: During 2006, pay fixed/receive

Issuance of foreign currency denominated debt

variable interest rate swaps with notional amounts of
£200 million ($392) and a net asset fair value of $1,
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 2006
and 2005.

Terminated Swaps: During 2006, we terminated
interest rate swaps with a notional value of $400 and a net
liability fair value of $8 which had previously been
designated fair value hedges of certain indebtedness. The
fair value adjustments to these debt instruments are
amortized to interest expense over the remaining term of
the notes. During 2005, we terminated interest rate swaps
with a notional value of $1.3 billion and a net fair liability
value of $29 which had previously been designated as fair
value hedges of certain indebtedness. The fair value
adjustment to these debt instruments are being amortized
to interest expense over the remaining term of the notes.
In 2006, 2005 and 2004, the amortization of these fair
value adjustments reduced interest expense by $9, $11
and $9, respectively.

Foreign Exchange Risk Management: We may use

certain derivative instruments to manage the exposures
associated with the foreign currency exchange risks
discussed below.

• We enter into cross-currency interest rate swap
agreements to swap the proceeds and related
interest payments with a counterparty. In return, we
receive and effectively denominate the debt in local
functional currencies.

• We 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.

Foreign currency denominated assets and liabilities
• We generally utilize forward foreign exchange

contracts and purchased option contracts to hedge
these exposures.

• 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.

Purchases of foreign-sourced inventory

• We generally utilize forward foreign exchange

contracts and purchased option contracts to hedge
these anticipated transactions. These contracts
generally mature in six months or less.
• Although these contracts are intended to

economically hedge foreign currency risks to the
extent possible, the differences between the
contract terms of our derivatives and the underlying

82

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

(Dollars in millions, except per-share data and unless otherwise indicated)

forecasted exposures reduce our ability to obtain
hedge accounting. Accordingly, changes in value
for these derivatives are recorded directly through
earnings.

During 2006, 2005, and 2004, we recorded net

currency losses of $39, $5 and $73, respectively. Net
currency losses primarily result from the mark-to-market
of foreign exchange contracts utilized to hedge foreign
currency denominated assets and liabilities, the cost of
hedging foreign currency-denominated assets and
liabilities, the re-measurement of foreign currency-
denominated assets and liabilities and the mark-to-market
impact of economic hedges of anticipated transactions for
which we do not apply cash flow hedge accounting
treatment.

At December 31, 2006, we had outstanding forward

exchange and purchased option contracts with gross
notional values of $1,733. The following is a summary of
the primary hedging positions and corresponding fair
values held as of December 31, 2006:

Currency Hedged (Buy/Sell) (in millions)

U.S. Dollar/Euro . . . . . . . . . . . . . . .
Japanese Yen/U.S. Dollar . . . . . . . .
Euro/U.S. Dollar . . . . . . . . . . . . . . .
Canadian Dollar/Euro . . . . . . . . . . .
Euro/U.K. Pound Sterling . . . . . . . .
Canadian Dollar/U.S. Dollar . . . . . .
Swedish Kronor/Euro . . . . . . . . . . .
Japanese Yen/Euro . . . . . . . . . . . . .
Euro/Canadian Dollar . . . . . . . . . . .
U.K. Pound Sterling/Euro . . . . . . . .
Swiss Franc/Euro . . . . . . . . . . . . . . .
All Other . . . . . . . . . . . . . . . . . . . . .

Gross
Notional
Value

Fair Value
Asset
(Liability)

$ 119
228
23
173
101
151
152
86
85
334
124
157

$

2
(5)

—
—
—

(1)
4
(1)

—

1
(2)
1

Total

. . . . . . . . . . . . . . . . . . . . . . . .

$1,733

$ (1)

At December 31, 2006 and 2005, we had

outstanding cross-currency interest rate swap agreements
with aggregate notional amounts of $126 and $127,
respectively. The net liability fair values at December 31,

2006 and 2005 were $9 and $5, respectively. There was
only one contract outstanding at December 31, 2006 and
Japanese Yen was the currency hedged.

Cash Flow Hedges: As of December 31, 2006,
cross currency swaps with a notional amount of $126
were used to hedge the currency exposure for interest
payments and principal on half of our Japanese Yen
denominated debt of ¥30 billion $(252). 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.

No amount of ineffectiveness was recorded in the
Consolidated Statements of Income during 2006, 2005 or
2004 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 2006, a $1 after-tax decrease in the
fair value of cash flow hedges was recorded in AOCL
while an after-tax amount of $1 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, 2006.

During 2005, a $32 after-tax decrease in the fair
value of cash flow hedges was recorded in AOCL while
an after-tax amount of $30 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, 2005.

Net Investment Hedges: We also utilize non–

derivative financial instruments to hedge against the
potentially adverse impacts of foreign currency
fluctuations on certain of our investments in foreign
entities. During 2006, $1 of net gains related to hedges of
our net investments were recorded in the cumulative
translation adjustment account as a component of
Accumulated other comprehensive loss. We did not have
any net investment hedges in 2005.

83

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

(Dollars in millions, except per-share data and unless otherwise indicated)

Fair Value of Financial Instruments: The estimated fair values of our financial instruments at December 31,

2006 and 2005 were as follows:

(in millions)

2006

2005

Carrying
Amount

Fair
Value

Carrying
Amount

Fair
Value

Cash and cash equivalents . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Short-term investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Accounts receivable, net
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Short-term debt
Long-term debt
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Short-term liabilities to trusts issuing preferred securities(1) . . . . . . . . . . . . . . . . .
Long-term liabilities to trusts issuing preferred securities . . . . . . . . . . . . . . . . . .

$1,399
137
2,199
1,485
5,660
—
624

$1,399
137
2,199
1,487
5,917
—
640

$1,322
244
2,037
1,139
6,139
98
626

$1,322
244
2,037
1,134
6,312
96
642

(1) Recognized as a component of Other current liabilities within the Consolidated Balance Sheet.

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 maturities. 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.

84

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

(Dollars in millions, except per-share data and unless otherwise indicated)

Note 14 – Employee Benefit Plans

We sponsor numerous pension and other post-retirement 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. Refer to
Note 1 – “New Accounting Standards and Accounting Changes” for further information regarding adoption of SFAS
No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans, an amendment of
FASB Statements No. 87, 88, 106 and 132(R).” Information regarding our benefit plans is presented below (in
millions):

Pension Benefits

Retiree Health

2006

2005

2006

2005

Change in Benefit Obligation
Benefit obligation, January 1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Service cost
Interest cost
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Plan participants’ contributions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Plan amendments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Actuarial (gain) loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Currency exchange rate changes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Curtailments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Benefits paid/settlements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$10,302
244
732
13
(234)
(85)
564
(2)
(1,067)

$10,028
234
581
11
30
527
(486)
(5)
(618)

$ 1,653
19
92
19
31
(105)
—
—
(117)

$ 1,662
19
90
15
44
(54)
4

—
(127)

Benefit obligation, December 31 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$10,467

$10,302

$ 1,592

$ 1,653

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 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Transfers/divestitures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Benefits paid/settlements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$ 8,444
959
355
13
513
—
(1,067)

$ 8,110
933
388
11
(418)
38
(618)

$ — $ —
—
112
15
—
—
(127)

—
98
19
—
—
(117)

Fair value of plan assets, December 31 . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$ 9,217

$ 8,444

$ — $ —

Funded status (including under-funded and non-funded plans) at the end
of year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$ (1,250) $ (1,858) $(1,592) $(1,653)

Unamortized transition obligations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Unrecognized prior service credit
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Unrecognized net actuarial loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Net amounts recognized . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Amounts recognized in the Consolidated Balance Sheets:
Other long-term assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Intangible asset . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Accrued compensation and benefit costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Pension and other benefit liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Post-retirement medical benefits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Minimum pension liability included in AOCL . . . . . . . . . . . . . . . . . . . . . . . . .

$

19
—
(79)
(1,190)
—
—

$

$

3
(28)
1,918

35

—
(45)
410

$(1,288)

833
9

—
(1,081)
—
274

$ — $ —
—
(100)
—
(1,188)
—

—
(102)
—
(1,490)
—

Net amounts recognized . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$ (1,250) $

35

$(1,592) $(1,288)

85

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

(Dollars in millions, except per-share data and unless otherwise indicated)

Amounts recognized in accumulated other comprehensive loss consist of:

Net actuarial loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Prior service credit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Transition obligation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Pension Benefits
2006

Retiree Health
2006

$1,595
(246)
1

$1,350

$286
(1)

—

$285

The accumulated benefit obligation for all defined benefit pension plans was $9,589 and $9,248 at December 31,

2006 and 2005, respectively.

Information for pension plans with an accumulated benefit obligation in excess of plan assets is presented below

(in millions):

2006

2005

Aggregate projected benefit obligation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Aggregate accumulated benefit obligation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Aggregate fair value of plan assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$5,316
4,856
4,133

$6,601
5,826
4,845

Our domestic retirement defined benefit plans provide employees a benefit, depending on eligibility, at the greater
of (i) the benefit calculated under a highest 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).

(in millions)

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 credit . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Recognized net transition obligation (asset) . . . . . . . . . . . . . . . . . . . . . . .
Recognized curtailment/settlement loss . . . . . . . . . . . . . . . . . . . . . . . . . .

Pension Benefits

Retiree Health

2006

2005

2004

2006

2005

2004

$ 244
732
(802)
104
(18)
2
93

$ 234
581
(622)
98
(3)
1
54

$ 19
$ 222
660
92
(678) —
19
104
(13)
(1)
(1) —
44 —

$ 20
90
—
31
(24)
—
—

117
—
—

$ 22
89
—
24
(24)
—
—

111
—
—

Net periodic benefit cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
355
Special termination benefits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . —
70
Defined contribution plans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

343
—
71

350

117
2 —
69 —

Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$ 425

$ 414

$ 421

$117

$117

$111

(1)

Interest cost includes interest expense on non-TRA obligations of $340, $328, and $312 and interest expense
directly allocated to TRA participant accounts of $392, $253, and $348 for the years ended December 31, 2006,
2005 and 2004, respectively.

(2) Expected return on plan assets includes expected investment income on non-TRA assets of $410, $369, and $330
and actual investment income on TRA assets of $392, $253, and $348 for the years ended December 31, 2006,
2005 and 2004, respectively.

86

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

(Dollars in millions, except per-share data and unless otherwise indicated)

The estimated net loss and prior service credit for
the defined benefit pension plans that will be amortized
from accumulated other comprehensive loss into net
periodic benefit cost over the next fiscal year are $133
and $(21), respectively. The estimated net loss and prior
service credit for the other defined benefit postretirement
plans that will be amortized from accumulated other
comprehensive loss into net periodic benefit cost over the
next fiscal year are $11 and $(12) respectively.

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 Amendment

During 2006 we amended one of our domestic
defined benefit pension plans. The amendment changed
the process of calculating benefits for certain employees
who retire from or leave the Company after 2012. The
new process ensures that certain benefit enhancements
are only provided to plan participants who qualify to
receive them based on age and years of service at
termination. The prior process for years after 2012
provided some plan participants with these benefit
enhancements regardless of qualification. The
amendment resulted in a net decrease of $173 in the PBO
and a net decrease of $20 in the ABO. The amendment
also decreased net periodic pension benefit cost by $31
for the full year 2006.

Plan Assets

Current Allocation and Investment Targets: As

of the 2006 and 2005 measurement dates, the global
pension plan assets were $9.2 billion and $8.4 billion,
respectively. These assets were invested among several
asset classes. The amount and percentage of assets
invested in each asset class as of each of these dates is
shown below:

Asset Value

Percentage of
Total Assets

(in millions)

2006

2005

2006

2005

Asset Category
Equity securities(1) . . . .
Debt securities(1)
. . . . .
Real estate . . . . . . . . . .
Other . . . . . . . . . . . . . .
Total . . . . . . . . . . . . . .

$4,971
3,319
728
199
$9,217

$4,830
2,723
504
387
$8,444

54% 57%
36
8
2

32
6
5

100% 100%

(1) None of the investments include debt or equity

securities of Xerox Corporation.

Investment Strategy: The target asset allocations
for our worldwide plans for 2006 were 53% invested in
equities, 39% invested in fixed income, 7% invested in
real estate and 1% invested in Other. The target asset
allocations for our worldwide plans for 2005 were 54%
invested in equities, 39% invested in fixed income, 6%
invested in real estate and 1% invested in Other. The
pension assets outside of the U.S. as of the 2006 and
2005 measurement dates were $5.1 billion and $4.3
billion, respectively.

The target asset allocations for the U.S. pension plan

include 64% invested in equities, 30% in fixed income,
5% in real estate and 1% 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%.

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 liabilities. 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

87

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

(Dollars in millions, except per-share data and unless otherwise indicated)

measures that address both return and risk. The
investment portfolio contains a diversified blend of equity
and fixed income investments. 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

approximately $130 to our worldwide defined benefit
pension plans and approximately $100 to our other post
retirement benefit plans in 2007. The 2007 expected
pension plan contributions do not include any planned
contribution for our domestic tax-qualified plans because
there are no required contributions to these plans for the
2007 fiscal year. However, once the January 1, 2007
actuarial valuations and projected results as of the end of
the 2007 measurement year are available, the desirability

Assumptions

of additional contributions will be reassessed. Based on
these results, we may voluntarily decide to contribute to
these plans, even though no contribution is required. In
2006 and 2005, after making this assessment, we decided
to contribute $228 and $230, respectively, to our
domestic tax qualified plans in order to make them 100%
funded on a current liability basis under the ERISA
funding rules. In addition, our debt ratings, which are
periodically reviewed by major rating agencies, have
steadily improved over the past three years. Since the
rating on the Company’s senior unsecured debt has now
reached investment grade, the Company will have
increased flexibility when considering these funding
decisions.

In 2006, the Pension Protection Act of 2006 (the
“Act”) was enacted into law. The Act alters the manner in
which liabilities and asset values are determined for the
purpose of calculating required pension contributions and
the timing and manner in which required contributions to
under-funded pension plans would be made. While we
are still evaluating the Act, at this time we do not expect
it to have any significant effect on our current funding
strategy for our U.S. pension plans. In the past, our
strategy has been to be fully funded on a current liability
basis.

Estimated Future Benefit Payments: The

following benefit payments, which reflect expected future
service, as appropriate, are expected to be paid (in
millions):

2007 . . . . . . . . . . . . . . . . . . . . . . . . . . .
2008 . . . . . . . . . . . . . . . . . . . . . . . . . . .
2009 . . . . . . . . . . . . . . . . . . . . . . . . . . .
2010 . . . . . . . . . . . . . . . . . . . . . . . . . . .
2011 . . . . . . . . . . . . . . . . . . . . . . . . . . .
Years 2012-2016 . . . . . . . . . . . . . . . . .

Pension
Benefits

$ 688
561
617
687
674
3,586

Retiree
Health

$

102
115
123
127
128
665

Pension Benefits
2005

2006

2004

Retiree Health
2005

2004

2006

Weighted-average assumptions used to determine benefit obligations

at the plan measurement dates

Discount rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Rate of compensation increase . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

5.3% 5.2% 5.6% 5.8% 5.6% 5.8%
4.0 — (1) — (1) — (1)
4.1

3.9

(1) Rate of compensation increase is not applicable to our other benefits as compensation levels do not impact earned

benefits.

88

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

(Dollars in millions, except per-share data and unless otherwise indicated)

Pension Benefits

Retiree Health

2007

2006

2005

2004

2007

2006

2005

2004

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 . . . . . . . . . . . . . . . . . . . . . . . . . .

5.3% 5.2% 5.6% 5.8% 5.8% 5.6% 5.8% 6.0%
8.1 — (1) — (1) — (1) — (1)
7.6
3.9 — (2) — (2) — (2) — (2)
4.1

7.8
3.9

8.0
4.0

(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 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

9.9% 10.9%
5.2% 5.2%

2011

2011

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 (in millions):

2006

2005

Effect on total service and interest cost components . . . . . . . . . . . . . . . . . . . .
Effect on post-retirement benefit obligation . . . . . . . . . . . . . . . . . . . . . . . . . . .

$ 5
77

$ (4)
(68)

One-percentage-point
increase

One-percentage-point
decrease

Note 15 – Income and Other Taxes

Income before income taxes for the three years ended December 31, 2006 were as follows (in millions):

Domestic income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Foreign income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$429
379

Income before income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$808

$386
444

$830

$426
539

$965

2006

2005

2004

(Benefits) provisions for income taxes for the three years ended December 31, 2006 were as follows (in millions):

2006

2005

2004

Federal income taxes

Current . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Deferred . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$(448)
94

$(94)
(59)

$ 26
114

Foreign income taxes

Current . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Deferred . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

State income taxes

Current . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Deferred . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

50
(9)

11
14

95
37

9
7

178
21

(19)
20

Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$(288)

$ (5)

$340

89

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

(Dollars in millions, except per-share data and unless otherwise indicated)

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, 2006 was as follows:

2006

2005

2004

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 convertible preferred stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . —
Other foreign, including earnings taxed at different rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

35.0% 35.0% 35.0%
3.4
0.3
(4.6)
1.6
(25.5)
(0.7)
—
(10.3)
0.2

3.4
(1.5)
1.3
1.3
0.7
(0.7)
(0.6)
(2.4)
(1.3)

1.4
(1.8)
1.4
1.8
(62.5)
(0.9)

(10.5)
0.5

Effective income tax rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

(35.6)% (0.6)% 35.2%

On a consolidated basis, we paid a total of $76,

$186, and $253 in income taxes to federal, foreign and
state jurisdictions in 2006, 2005 and 2004, respectively.
Total income tax (benefit) expense for the three
years ended December 31, 2006 was allocated as follows
(in millions):

Income taxes on income . . . . . .
Common shareholders’

2006

2005

2004

$(288)

$ (5)

$340

equity(1)

. . . . . . . . . . . . . . . . .

(466)

(43)

(20)

Total

. . . . . . . . . . . . . . . . . . . . .

$(754)

$(48)

$320

(1) This consists of the tax effects of items in

accumulated other comprehensive loss and tax
benefits related to stock option and incentive plans.
2006 includes the effects of the adoption of FAS
158-See Note 1 for further information.

General Tax Contingencies and Audit Resolutions:

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 examinations and related
tax positions require judgment and can materially
increase or decrease our effective tax rate, as well as
impact our operating results.

2006: In the first quarter 2006, we recognized an
income tax benefit of $24 from the favorable resolution of
certain tax issues associated with our 1999–2003 Internal
Revenue Service (“IRS”) audit which at the time had not
yet been finalized. In the second quarter 2006, we
recognized an income tax benefit of $46 related to the
favorable resolution of certain tax matters associated with
the finalization of foreign tax audits. In the third quarter
2006, we received notice that the U.S. Joint Committee
on Taxation had completed its review of our 1999–2003
IRS audit and as a result of that review our audit for those
years had been finalized. Accordingly, we recorded an
aggregate income tax benefit of $448 associated with the
favorable resolution of certain tax matters from this audit.
The recorded benefit will not result in a significant cash
refund, but we expect it to increase tax credit
carryforwards and reduce taxes otherwise potentially due.

2005: In June 2005, the 1996-1998 IRS audit was
finalized. As a result, we recorded an aggregate second
quarter 2005 net income benefit of $343. $260 of this
benefit, which includes an after-tax benefit of $33 for
interest ($54 pre-tax benefit), is the result of a change in
tax law that allowed us to recognize a benefit for $1.2
billion of capital losses associated with the disposition of
our insurance group operations in those years. The claim
of additional losses and related tax benefits required
review by the U.S. Joint Committee on Taxation, which
was completed in June 2005. The benefit did not result in
a significant cash refund, but increased tax credit
carryforwards and reduced taxes otherwise potentially
due.

90

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

(Dollars in millions, except per-share data and unless otherwise indicated)

The $343 benefit also includes after-tax benefits of

$83 related to the favorable resolution of certain other tax
matters. Of this amount, $53 was related to previously

discontinued operations and is reported within Income
from discontinued operations in the Consolidated
Statements of Income.

Deferred Income Taxes

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, 2006 was
approximately $7 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 thereon. It is not practicable to estimate the
amount of additional tax that might be payable on the
foreign earnings. Our 2001 sale of half of our ownership
interest in Fuji Xerox, resulted in our investment no
longer qualifying 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 tax effects of temporary differences that give rise

to significant portions of the deferred taxes at
December 31, 2006 and 2005 were as follows (in millions):

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 . . . . . . . . .
Pension . . . . . . . . . . . . . . . . . . . . .
Other . . . . . . . . . . . . . . . . . . . . . . .

2006

2005

$1,133

$1,173

576
261
553
197
354
232

108
70
300
129

478
271
480
307
346
185

118
69
32
134

Valuation allowance . . . . . . . . . . . . . . .

3,913
(647)

3,593
(590)

Total deferred tax assets . . . . . . . . . .

$3,266

$3,003

91

2006

2005

Tax effect of future taxable income

Unearned income and

installment sales . . . . . . . . . . .
. . . . . . . . . . . . . . . . . . . . .

Other

$(1,277) $(1,303)
(42)

(31)

Total deferred tax liabilities . . . . . . . .

(1,308)

(1,345)

Total deferred taxes, net . . . . . . . . .

$ 1,958

$ 1,658

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, 2006 and
2005 amounted to $271 and $290, respectively.

The deferred tax assets for the respective periods
were assessed for recoverability and, where applicable, 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, 2005 was $567. The
net change in the total valuation allowance for the years
ended December 31, 2006 and 2005 was an increase of
$57 and an increase of $23, 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
concluded that it is more likely than not that the deferred
tax assets for which a valuation allowance was
determined 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
operating 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.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

(Dollars in millions, except per-share data and unless otherwise indicated)

At December 31, 2006, we had tax credit

carryforwards of $354 available to offset future income
taxes, of which $221 are available to carryforward
indefinitely while the remaining $133 will begin to
expire, if not utilized, in 2007. We also had net operating

Note 16 – Contingencies

Guarantees, Indemnifications and Warranty Liabilities:
Guarantees and claims arise during the ordinary
course of business from relationships with suppliers,
customers and nonconsolidated affiliates when the
Company undertakes an obligation to guarantee the
performance of others if specified triggering events occur.
Nonperformance under a contract could trigger an
obligation of the Company. These potential claims include
actions based upon alleged exposures to products, real
estate, intellectual property such as patents, environmental
matters, and other indemnifications. The ultimate effect on
future financial results is not subject to reasonable
estimation because considerable uncertainty exists as to the
final outcome of these claims. However, while the ultimate
liabilities resulting from such claims may be significant to
results of operations in the period recognized, management
does not anticipate they will have a material adverse effect
on the Company’s consolidated financial position or
liquidity. As of December 31, 2006, we have accrued our
estimate of liability incurred under our indemnification
arrangements and guarantees.

Indemnifications provided as part of contracts and

agreements: We are a party to the following types of
agreements pursuant to which we may be obligated to
indemnify the other party with respect to certain matters:

• Contracts 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 arising prior to the
date of acquisition.

• Guarantees on behalf of our subsidiaries with

respect to real estate leases. These lease guarantees
may remain in effect subsequent to the sale of the
subsidiary.

loss carryforwards for income tax purposes of $238 that
will expire in 2007 through 2024, if not utilized, and $2.8
billion available to offset future taxable income
indefinitely.

• Agreements to indemnify various service providers,

trustees and bank agents from any third party
claims related to their performance on our behalf,
with the exception of claims that result from third-
party’s own willful misconduct or gross negligence.
• Guarantees of our performance in certain sales and
services contracts to our customers and indirectly
the performance of third parties with whom we
have subcontracted for their services. This includes
indemnifications to customers for losses that may
be sustained as a result of the use of our equipment
at a customer’s location.

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
possible 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.

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

92

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

(Dollars in millions, except per-share data and unless otherwise indicated)

indemnification, we may have recourse against our
insurance carriers for certain payments made by us.
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.

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

Other contingencies

in return for our performance 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.
Aggregate product warranty liability expenses for the
three years ended as of December 31, 2006 were $43, $45
and $45, respectively. Total product warranty liabilities as
of December 31, 2006 and 2005 were $22 and $21,
respectively.

Brazil Tax and Labor Contingencies: Our Brazilian
operations were involved in various litigation matters and
have received or been the subject of numerous
governmental assessments related to indirect and other
taxes as well as disputes associated with former
employees and contract labor. The tax matters, which
comprise a significant portion of the total contingencies,
principally relate to claims for taxes on the internal
transfer of inventory, municipal service taxes on rentals
and gross revenue taxes. We are disputing these tax
matters and intend to vigorously defend our position.
Based on the opinion of legal counsel, we do not believe
that the ultimate resolution of these matters will
materially impact our results of operations, financial
position or cash flows. The labor matters principally
relate to claims made by former employees and contract
labor for the equivalent payment of all social security and
other related labor benefits, as well as consequential tax
claims, as if they were regular employees. Following our
assessment of a negative trend in recent settlements and a
decision to change our legal strategy, we reassessed the
probable estimated loss on these matters and, as a result,

recorded an additional provision of $68 in 2006. As of
December 31, 2006, the total amounts related to the
unreserved portion of the tax and labor contingencies,
inclusive of any related interest, amounted to
approximately $960, with the increase from December 31,
2005 balance of $900 primarily related to indexation,
interest and currency partially offset by the additional
provision. In connection with the above proceedings,
customary local regulations may require us to make
escrow cash deposits or post other security of up to half of
the total amount in dispute. As of December 31, 2006 we
had $154 of escrow cash deposits for matters we are
disputing and there are liens on certain Brazilian assets
with a net book value of $18 and additional letters of
credit of approximately $60. Generally, any escrowed
amounts would be refundable and any liens would be
removed to the extent the matters are resolved in our
favor. We routinely assess all these matters as to
probability of ultimately incurring a liability against our
Brazilian operations and record our best estimate of the
ultimate loss in situations where we assess the likelihood
of an ultimate loss as probable of occurring.

93

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

(Dollars in millions, except per-share data and unless otherwise indicated)

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.

Litigation Against the Company:

In re Xerox Corporation Securities Litigation: A
consolidated 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 disclose
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 proficiencies,
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. Xerox and
the individual defendants filed their opposition to that
motion on June 28, 2005. On or about November 8, 2004,
the International Brotherhood of Electrical Workers
Welfare Fund of Local Union No. 164 (“IBEW”) filed a
motion to intervene as a named plaintiff and class
representative. Separately, on June 8, 2005, IBEW and
Robert W. Roten (“Roten”) moved to substitute as lead
plaintiffs and proposed class representatives. On May 12,
2006, the court denied, without prejudice to refiling,
plaintiffs’ motion for class certification, IBEW’s motion
to intervene and serve as named plaintiff and class
representative, and IBEW and Roten’s joint motion to
substitute as lead plaintiffs and proposed class
representatives. The court also ordered the parties to
submit to it a notice to certain putative class members to
inform them of the circumstances surrounding the
withdrawal of several lead plaintiffs, and to advise them
of the opportunity to express their desire to serve as a
representative of the putative class. On July 25, 2006, the
court so-ordered a form of notice, and plaintiffs thereafter
distributed the notice. Thereafter, Roten, Robert Agius

94

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

(Dollars in millions, except per-share data and unless otherwise indicated)

(“Agius”) and Georgia Stanley (“Stanley”) filed
applications to be considered lead plaintiff. On
November 13, 2006, IBEW, Roten, Agius and Stanley
filed a motion for appointment as additional lead
plaintiffs. Defendants filed their response on
November 28, 2006. On February 2, 2007, the Court
granted the motion of IBEW, Roten, Agius and Stanley
and appointed them as additional lead plaintiffs. The
parties 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.

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
consolidated amended complaint. The defendants’
motion to dismiss the second consolidated amended
complaint was denied, as moot. According to the third
consolidated 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
purchased 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 violated 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 participated in a fraudulent scheme that
operated as a fraud and deceit on purchasers of the
Company’s common 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 settlement
which, among other things, required the Company to pay
a $10 penalty and restate its financials for the years 1997-
2000 (including restatement 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. On
July 13, 2005, the court denied the motion. On
October 31, 2005, the defendants answered the
complaint. On January 19, 2006, plaintiffs filed a motion
for class certification. That motion has not been fully
briefed or argued before the court. The parties are
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.

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 individually on their own behalves. In
an amended complaint filed on October 3, 2002, one or
more of the plaintiffs allege that each of the Company,
the individual 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
individual defendants are each liable as “controlling
persons” of the Company pursuant to Section 20 of the

95

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

(Dollars in millions, except per-share data and unless otherwise indicated)

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 materially
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 restatement 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. On July 13, 2005,
the court denied the motion. On December 9, 2005, the
defendants moved to dismiss claims based on issues
uniquely related to plaintiffs. That motion has been fully
briefed, but has not been argued before the court. The
court has not issued a ruling. The parties are 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.

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
proposed class period, May 12, 1997 through
November 15, 2002, and allegedly exceeds 50,000
persons. The defendants include Xerox Corporation and
the following 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 information to participants concerning Xerox
stock, including accounting practices which allegedly
artificially inflated 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

96

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

(Dollars in millions, except per-share data and unless otherwise indicated)

briefs were filed in December of that year. On March 31,
2006, the Court granted our motion to postpone
consideration of class certification pending disposition of
our motion to dismiss, and granted plaintiffs motion to
commence formal discovery. 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 corporate
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
international 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 billion. The foregoing damages are being sought
from all defendants, jointly and severally. Xerox filed a
motion to dismiss the Second Amended Complaint. Oral
argument 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. On March 28, 2005, Plaintiffs submitted a
letter requesting permission to file a motion for leave to
file an amended and consolidated complaint. By
Summary Order filed April 6, 2005, the Court denied the

request. In a second Summary Order filed the same day,
the Court amended its November 29, 2004, Opinion and
Order, which dismissed the action, so as to render the
Opinion and Order appealable and plaintiffs filed a new
appeal on May 3, 2005. On August 19, 2005, plaintiffs-
appellants filed their brief in the Second Circuit Court of
Appeals. On October 4, 2005, defendants-appellees filed
their brief in the Second Circuit Court of Appeals. Oral
argument in the Second Circuit Court of Appeals was
held on January 24, 2006. Xerox denies any wrongdoing
and is vigorously defending 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.

Arbitration between MPI Technologies, Inc. and

Xerox Canada Ltd. and Xerox Corporation: In an
arbitration proceeding the hearing of which commenced
on January 18, 2005, MPI Technologies, Inc. and MPI
Tech S.A. (collectively “MPI”) sought damages from
Xerox Corporation and Xerox Canada Ltd. (“XCL”) for
royalties owed under a license agreement made as of
March 15, 1994 between MPI and XCL (the
“Agreement”) and breach of fiduciary duty, breach of
confidence, equitable royalties and punitive damages and
disgorgement of profits and injunctive relief with respect
to a claim of copyright infringement. On September 9,
2005, the arbitration panel rendered its decision, holding
in part that the Agreement had been assigned to Xerox
and that no punitive damages should be granted, and
awarded MPI approximately $89, plus interest thereon.
On December 12, 2005, the arbitration panel rendered its
decision on the applicable rate of pre-judgment interest
resulting in an award of $13 for pre- and post-judgment
interest. In June 2006, Xerox’s application for judicial
review of the award, seeking to have the award set aside
in its entirety, was heard by the Ontario Superior Court in
Toronto. The Ontario Superior Court issued a decision on
November 30, 2006 dismissing Xerox’s appeal. In
December 2006, Xerox released all monies and software
it had placed in escrow prior to its application for review
in satisfaction of the arbitration panel’s final award. On
January 30, 2007, Xerox and XCL served an arbitration
claim against MPI seeking a declaratory award
concerning the preclusive effect of the remedy awarded
by the prior arbitration panel. MPI has notified Xerox
that it intends to respond to the arbitration demand with
its own claims and/or counterclaims.

97

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

(Dollars in millions, except per-share data and unless otherwise indicated)

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 that seek to limit
coverage based on particular provisions in the policy and
that at least in part related to settlement with the SEC.
Plaintiff filed notices of appeal on January 10, 2005 and
February 11, 2005. By order entered on January 3, 2006,
the Appellate Division affirmed the portions of the
Court’s November 10, 2004 decision which dismissed
several of plaintiff’s claims and denied leave to replead.
On February 2, 2006, plaintiff moved for reargument or
for leave to appeal to the Court of Appeals. On May 30,
2006, the Appellate Division denied plaintiff’s motion.
Separately, on February 22, 2005, the defendants filed a
motion seeking dismissal of any remaining claims in
light of Xerox’s representation that it will not seek

coverage from plaintiff for settlement payments to the
SEC. By order dated July 12, 2005, the Court denied the
motion. On August 23, 2005, defendants moved for leave
to reargue the February 22 motion and separately moved
for leave to renew the December 19, 2003 motions. On
April 10, 2006, the court issued an order granting those
motions, dismissing one cause of action and partially
dismissing the two other causes of action that were the
subject of those motions. Subsequently, at a status
conference on May 4, 2006, the parties appeared before
the Court and discussed inconsistencies between the
Court’s April 10, 2006 order and its November 10, 2004
decision. As a result, on May 5, 2006 the court executed
an order, which was later rendered on July 27, 2006,
withdrawing the April 10, 2006 order and substituting a
new order which clarified and confirmed the dismissal of
all claims asserted in the original complaint. On
August 31, 2006, plaintiff filed a notice of appeal (to the
Appellate Division) of the May 5, 2006 order. In
addition, on September 5, 2006, plaintiff served a motion
to the Court of Appeals seeking leave to appeal directly
to that court from the May 5, 2006 order, and seeking
review of the Appellate Division’s January 3, 2006 order.
On November 20, 2006, the Court of Appeals denied
plaintiff’s motion. Plaintiff had earlier filed an amended
complaint on February 27, 2006, naming all defendants
named in the original complaint and adding four causes
of action against Xerox only, as well as a demand for
unspecified monetary relief. On May 11, 2006, Xerox
served its motion to dismiss the amended complaint and
for sanctions. On August 2, 2006, the Court granted
Xerox’s motion to dismiss and for sanctions. All claims
asserted by National Union now have been dismissed. In
accordance with the Court’s instructions during the
August 2, 2006 oral argument, Xerox submitted an
affidavit, sworn to on August 16, 2006, specifying the
precise amount of fees and sanctions requested by Xerox.
On September 11, 2006, National Union submitted an
opposition to Xerox’s specific request for fees and
sanctions and requested a hearing before the Court. The
Court has not scheduled a hearing on the fees issues, nor
has it issued a decision.

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

98

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

(Dollars in millions, except per-share data and unless otherwise indicated)

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 representatives. The
plaintiffs allege that Xerox has engaged in a pattern or
practice of race discrimination against them and other
black sales representatives by assigning them to less
desirable sales territories, denying them promotional
opportunities, and paying them less than their white
counterparts. Although the complaint 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.
Fact discovery has concluded and expert reports have
been exchanged. Following three days of mediation with
a private mediator, a tentative agreement was reached,
the terms of which are not material to Xerox. Counsel for
the parties are working on drafting mutually-acceptable
language for a settlement agreement and release. The
agreement will be subject to a fairness hearing and court
approval.

Derivative Litigation Brought on Behalf of the Company:

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 jurisdiction. 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
defendants. The plaintiff asserts claims for contribution
under the securities laws, negligence, negligent
misrepresentation, 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. On September 29, 2006,
the Court issued an order granting the motions and
dismissing all claims. The court entered judgment in
favor of the defendants on October 10, 2006. Plaintiff has
not filed an appeal and the time to appeal has expired.

Other Matters:

It is our policy to promptly and carefully investigate,

often with the assistance of outside advisers, allegations
of impropriety that may come to our attention. If the
allegations are substantiated, appropriate prompt
remedial action is taken. When and where appropriate,
we report such matters to the U.S. Department of Justice
and to the SEC, and/or make public disclosure.

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 authorities, 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. In February 2005, the Indian Ministry of
Company Affairs provided our Indian subsidiary with the
investigator’s report which addresses the previously
disclosed misappropriation of funds and improper
payments and requested comments. The report included
allegations that Xerox Modicorp Ltd.’s senior officials
and the Company were aware of such activities. The
report also asserted 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
reported these developments and made a copy of the
report received by Xerox Modicorp Ltd. available to the
U.S. Department of Justice and the SEC.

99

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

(Dollars in millions, except per-share data and unless otherwise indicated)

On November 17, 2005, Xerox filed its 40-page
Reply (plus attachments) with the DCA. Xerox has sent
copies of the Xerox Reply to the SEC and DOJ in the
United States. In our Reply, we argue that the alleged
violations of Indian Company Law by means of alleged
improper payments and alleged defaults/failures of the
Xerox Modicorp Ltd. board of directors were
generally unsubstantiated and without any basis in law.
Further, we stated that the Report’s findings of other
alleged violations were unsubstantiated and unproven.
The DCA (now called the “Ministry of Company Affairs”
or “MCA”) will consider our Reply and will let us know
their conclusions in the coming months. There is the
possibility of fines or criminal penalties if conclusive
proof of wrongdoing is found. We have told the DCA that
Xerox’s conduct in voluntarily disclosing the initial
information and readily and willingly submitting to
investigation, coupled with the non-availability of earlier
records, warrants complete closure and early settlement.
In January 2006, we learned that the DCA has issued a
“Show Cause Notice” to certain former executives of
Xerox Modicorp Ltd. seeking a response to allegations of
potential violations of the Indian Companies Act. We
have also learned that Xerox Modicorp Ltd. has received
a formal Notice of Enquiry from the Indian
Monopolies & Restrictive Trade Practices Commission
(“MRTP Commission”) alleging that Xerox Modicorp
Ltd. committed unfair trading practices arising from the
events described in the DCA investigator’s Report.
Following a hearing on August 29, 2006, the MRTP
Commission ordered a process with deadlines between
Xerox Modicorp Ltd. and the investigating officer for
provision of relevant documents to Xerox Modicorp Ltd.,

Note 17 – Preferred Stock

after which Xerox Modicorp Ltd. will have four weeks to
file its reply. The MRTP Commission had scheduled a
hearing for framing of the issues on January 9, 2007, but
this hearing has been delayed. A new hearing was
scheduled for January 29, 2007 for consideration of
Xerox Modicorp Ltd.’s motion for the MRTP
Commission to direct the investigating officer to supply
us the relevant documents. At the hearing on January
29th, no additional documents were supplied to us. The
MRTP Commission directed us to file our reply to the
original Notice of Enquiry within four weeks. Our Indian
subsidiary plans to contest the Notice of Enquiry and has
been fully cooperating with the authorities.

In March 2005, following the completion of a share

buy-back program that increased our controlling
ownership interest in our Indian subsidiary to
approximately 89% from approximately 86% at year-end
2004, we changed the name of our Indian subsidiary to
Xerox India Ltd.

New York State School District Contracts: A local

New York State school district has raised questions
regarding the enforceability of their contracts, which may
have implications for contracts with similar customers.
We have reviewed this matter internally and have worked
with the appropriate state agencies in an effort to bring it
to a satisfactory resolution. We have received state
agency approval for a proposed resolution and are in the
process of implementing that resolution with the school
district that raised these questions as well as other
affected customers. Until this resolution is fully
implemented, it is not possible to estimate the amount of
loss, if any, or range of possible loss that might result
from this matter.

As of December 31, 2006, we had no preferred stock

shares outstanding and one class of preferred stock
purchase rights. We are authorized to issue approximately
22 million shares of cumulative preferred stock, $1.00 par
value.

Series C Mandatory Convertible Preferred Stock
Automatic Conversion: In July 2006, 9.2 million shares
of 6.25% Series C Mandatory Convertible Preferred
Stock were converted at a rate of 8.1301 shares of our
common stock, or 74.8 million common stock shares. The

recorded value of outstanding shares at the time of
conversion was $889. The conversion occurred pursuant
to the mandatory automatic conversion provisions set at
original issuance of the Series C Preferred Stock. As a
result of the automatic conversion, there are no remaining
outstanding shares of our Series C Mandatory
Convertible Preferred Stock.

Series B Convertible Preferred Stock Conversion:
In May 2004, all 6.2 million of our Convertible Preferred
shares were redeemed for 37 million common shares in
accordance with the original conversion provisions of the

100

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

(Dollars in millions, except per-share data and unless otherwise indicated)

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.

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 18 – Common Stock

We have 1.75 billion authorized shares of common
stock, $1 par value. At December 31, 2006, 106 million
shares were reserved for issuance under our incentive
compensation plans, 48 million shares were reserved for
debt to equity exchanges, 15 million shares were reserved
for the conversion of the Series C Mandatory Convertible
Preferred Stock and 2 million shares were reserved for
the conversion of convertible debt. The 15 million shares
reserved for the conversion of the Series C Mandatory
Convertible Preferred Stock are expected to be released
in 2007, since conversion was completed in 2006.

Stock-Based Compensation: We have a long-term

incentive plan whereby eligible employees may be
granted restricted stock units (“RSUs”), performance
shares (“PSs”) and non-qualified stock options.

In January 2005, we implemented changes in our

stock-based compensation programs designed to help us
continue to attract and retain employees and to better
align employee interests with those of our shareholders.
With these changes, in lieu of stock options we began
granting PSs and expanded the use of RSUs. Each of
these awards is subject to settlement with newly issued
shares of our common stock. At December 31, 2006 and
2005, 25.0 million and 38.9 million shares, respectively,
were available for grant of awards.

Total compensation related to these programs was
$64, $40 and $22 for the years ended December 31, 2006,
2005 and 2004, respectively. The related income tax
benefit recognized was $25, $16 and $8 for 2006, 2005
and 2004, respectively. A description of each of our
stock-based compensation programs follows:

Restricted Stock Units: Prior to 2005, the RSUs were generally subject to a three-year ratable vesting period
from the date of grant and entitled the holder to one share of common stock. In 2005, the terms of newly-issued RSU’s
were changed such that the entire award vests three years from the date of grant. Compensation expense is based upon
the grant date market price and is recorded over the vesting period. A summary of the activity for RSUs as of
December 31, 2006, 2005 and 2004, and changes during the years then ended, is presented below (shares in thousands):

Nonvested Restricted Stock Units

Outstanding at January 1 . . . . . . . . . . . . . . . .
Granted . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Vested . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Cancelled . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Shares

5,491
4,256
(686)
(426)

Outstanding at December 31 . . . . . . . . . . . .

8,635

2005

Weighted
Average Grant
Date Fair Value

$13.86
16.89
15.01
16.21

15.69

Shares

2,804
3,750
(977)
(86)

5,491

Shares

2,180
2,539
(1,905)
(10)

2,804

2004

Weighted
Average Grant
Date Fair Value

$10.46
13.70
9.72
19.14

13.86

2006

Weighted
Average Grant
Date Fair Value

$15.69
15.18
13.70
13.45

15.71

101

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

(Dollars in millions, except per-share data and unless otherwise indicated)

At December 31, 2006, the aggregate intrinsic value
of RSUs outstanding was $147. The total intrinsic value
of RSUs vested during 2006, 2005 and 2004 was $10, $13
and $26, respectively. The actual tax benefit realized for
the tax deductions for vested RSUs totaled $3, $4 and $9
for the years ended December 31, 2006, 2005 and 2004,
respectively.

At December 31, 2006, there was $65 of total
unrecognized compensation cost related to nonvested
RSUs, which is expected to be recognized ratably over a
remaining weighted-average contractual term of 1.7
years.

Performance Shares: We grant officers and

selected executives PSs whose vesting is contingent upon
meeting pre-determined Diluted Earnings per Share
(“EPS”) and Cash Flow from Operations targets. These
shares entitle the holder to one share of common stock,
payable after a three-year period and the attainment of the
stated goals. If the cumulative three-year actual results for
EPS and Cash Flow from Operations exceed the stated
targets, then the plan participants have the potential to
earn additional shares of common stock. This
overachievement can not exceed 50% for officers and
25% for non-officers of the original grant.

A summary of the activity for PSs as of December 31, 2006 and 2005, and changes during the years then ended, is

presented below (shares in thousands):

Nonvested Performance Shares

2006

Weighted
Average Grant
Date Fair Value

Shares

2,052
Outstanding at January 1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
2,588
Granted . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Vested . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . —
Cancelled . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

(69)

Outstanding at December 31 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

4,571

$14.87
15.17
—
14.95

15.04

2005

Weighted
Average Grant
Date Fair Value

$ —
14.87
—
14.87

14.87

Shares

—
2,070
—
(18)

2,052

At December 31, 2006, the aggregate intrinsic value

of PSs outstanding was $78.

For 2005, the PSs were accounted for as variable
awards requiring that the shares be adjusted to market
value at each reporting period. Effective January 1, 2006,
upon the adoption of FAS 123(R), PSs were recorded
prospectively using fair value determined as of the grant

date. If the stated targets are not met, any recognized
compensation cost would be reversed. As of
December 31, 2006, there was $47 of total unrecognized
compensation cost related to nonvested PSs; this cost is
expected to be recognized ratably over a remaining
weighted-average contractual term of 1.7 years.

Stock Options: Stock options generally vest over a period of three years and expire between eight and ten years

from the date of grant. 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, 2006 (stock options in thousands):

2006

2005

2004

Employee Stock Options

Outstanding at January 1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Granted . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Cancelled/Expired . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Exercised . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Stock
Options

76,307
—
(5,478)
(10,349)

Average
Option
Price

$19.40
—
49.44
8.46

Stock
Options

91,833
—
(10,291)
(5,235)

Average
Option
Price

Stock
Options

$20.98

97,839
— 11,216
(8,071)
(9,151)

39.41
7.74

Average
Option
Price

$21.46
13.71
32.24
7.28

Outstanding at December 31 . . . . . . . . . . . . . . . . . . . . . . . .

60,480

18.56

76,307

19.40

91,833

20.98

Exercisable at December 31 . . . . . . . . . . . . . . . . . . . . . . . . . .

60,180

66,928

65,199

102

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

(Dollars in millions, except per-share data and unless otherwise indicated)

Options outstanding and exercisable at December 31, 2006 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 32.16
42.83 to 60.95

Options Outstanding

Number
Outstanding

Weighted
Average
Remaining
Contractual Life

Weighted Average
Exercise Price

Number
Exercisable

Options Exercisable

Weighted
Average
Remaining
Contractual Life

Weighted
Average
Exercise Price

3,965
23,864
9,760
11,835
3,735
7,321

60,480

3.98
5.37
4.98
3.00
2.90
2.21

$ 4.91
9.20
13.66
21.77
26.36
53.78

3,665
23,864
9,760
11,835
3,735
7,321

60,180

3.89
5.37
4.98
3.00
2.90
2.21

$ 4.90
9.20
13.66
21.77
26.36
53.78

At December 31, 2006, the aggregate intrinsic value of stock options outstanding and stock options exercisable

was $267 and $263, respectively.

The following table provides information relating to stock option exercises for the three years ended

December 31, 2006:

(in millions)

2006

2005

2004

Total Intrinsic Value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Cash Received . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Tax Benefit Realized for Tax Deductions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$72
82
25

$36
41
12

$67
67
23

Treasury Stock: The Board of Directors has authorized programs for the repurchase of the Company’s common

stock totaling $2.0 billion as of December 31, 2006. The following is a summary of the purchases of common stock
made under our stock repurchase programs (shares in thousands):

Authorized Repurchase Programs

Total
$2,000 Authorized Programs

Shares

Amount

As of January 1, 2005 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Purchases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Less cancellations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

—
30,502
(16,585)

As of December 31, 2005 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

13,917

Purchases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Less cancellations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

70,111
(75,665)

$ —

433*
(230)

203

1,069*
(1,131)

Treasury stock as of December 31, 2006 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

8,363

$

141

* Includes total associated fees of $3.

Subsequent to December 31, 2006 and through February 12, 2007, 7,399,400 shares were repurchased at an

aggregate cost of $127, (including associated fees of less than $1). Additionally, in February 2007, 8,813,000
repurchased shares were cancelled upon the approval of the Board of Directors and were recorded as a reduction to
both Common stock of $9 and Additional paid-in-capital of $139.

103

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

(Dollars in millions, except per-share data and unless otherwise indicated)

Note 19 – Earnings Per Share

The following table sets forth the computation of basic and diluted earnings per share of common stock (in

millions, except shares in thousands):

2006

2005

2004

Basic Earnings per Share:
Income from continuing operations before discontinued operations and

cumulative effect of change in accounting principle . . . . . . . . . . . . . . . . . . . . .

$

1,210

$

933

$

Accrued dividends on:

Series B Convertible Preferred Stock, net . . . . . . . . . . . . . . . . . . . . . . . . . . .
Series C Mandatory Convertible Preferred Stock . . . . . . . . . . . . . . . . . . . . .

—
(29)

Adjusted income from continuing operations before discontinued operations

and cumulative effect of change in accounting principle . . . . . . . . . . . . . . . . .
Income from discontinued operations, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Cumulative effect of change in accounting principle, net . . . . . . . . . . . . . . . . . . .
Adjusted net income available to common shareholders . . . . . . . . . . . . . . . . . . .

1,181
—
—
1,181

$

Weighted Average Common Shares Outstanding . . . . . . . . . . . . . . . . . . . . . . . . .

943,852

—
(58)

875
53
(8)
920

957,149

0.91
0.06
(0.01)
0.96

933
—

1

934
53
(8)
979

$

$

$

$

$

$

$

$

$

$

776

(16)
(57)

703
83
—
786

834,321

0.84
0.10
—
0.94

776
(6)
51

821
83
—
904

1.25
—
—
1.25

1,210
—

1

1,211
—
—
1,211

943,852

957,149

834,321

9,300
3,980
—
37,398
1,992
996,522

10,470
945
—
74,797
1,992
1,045,353

14,198
—
17,359
74,797
106,272
1,046,947

1.22
—
—
1.22

$

$

0.90
0.05
(0.01)
0.94

$

$

0.78
0.08
—
0.86

Basic Earnings per Share:
Earnings from continuing operations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Earnings from discontinued operations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Loss from cumulative effect of change in accounting principle . . . . . . . . . . . . . .
Basic Earnings per Share . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Diluted Earnings per Share:
Income from continuing operations before discontinued operations and

cumulative effect of change in accounting principle . . . . . . . . . . . . . . . . . . . . .
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
ESOP expense adjustment, net
Interest on Convertible securities, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Adjusted income from continuing operations before discontinued operations

and cumulative effect of change in accounting principle . . . . . . . . . . . . . . . . .
Income from discontinued operations, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Cumulative effect of change in accounting principle, net . . . . . . . . . . . . . . . . . . .
Adjusted net income available to common shareholders . . . . . . . . . . . . . . . . . . .

Weighted Average Common Shares Outstanding . . . . . . . . . . . . . . . . . . . . . . . . .
Common shares issuable with respect to:

Stock options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Restricted stock and performance shares . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Series B Convertible Preferred Stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Series C Mandatory Convertible Preferred Stock . . . . . . . . . . . . . . . . . . . . .
Convertible securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Adjusted Weighted Average Shares Outstanding . . . . . . . . . . . . . . . . . . . . . . . . .

Diluted Earnings per Share:
Earnings from continuing operations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Earnings from discontinued operations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Loss from cumulative effect of change in accounting principle . . . . . . . . . . . . . .
Diluted Earnings per Share . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$

$

$

$

$

$

The 2006, 2005 and 2004 computation of diluted earnings per share did not include the effects of 27 million,

36 million and 38 million stock options, respectively, because their respective exercise prices were greater than the
corresponding market value per share of our common stock.

104

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

(Dollars in millions, except per-share data and unless otherwise indicated)

Note 20 – Acquisitions

Amici LLC: In July 2006, we acquired substantially
all of the net assets of Amici LLC (“Amici”), a provider
of electronic-discovery (e-discovery), services for $175 in
cash, including transaction costs. Amici provides
comprehensive litigation discovery management services,
including the conversion, hosting and production of
electronic and hardcopy documents. Amici also provides
consulting and professional services to assist attorneys in

the discovery process. The purchase agreement requires
us to pay the sellers an additional $20 if certain
performance targets are achieved in 2008, which would
be an addition to the acquired cost of the entity. The
operating results of Amici were not material to our
financial statements and are included within our Other
segment from the date of acquisition.

The table below presents the estimated purchase price allocation based upon third-party valuations and
management estimates. The Goodwill was assigned to our Other segment. The primary elements that generated the
Goodwill are the value of synergies and the acquired assembled workforce, neither of which qualify as an amortizable
intangible asset.

(in millions)

Amortization
Period in Years

Purchase Price
Allocation

Net assets, less cash acquired . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Goodwill . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Intangible assets:

Customer relationships . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Software . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

N/A

13
5

Total Purchase price . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

2
$
136

29
8

$175

XMPie, Inc: In November 2006, we acquired the

stock of XMPie, Inc. (“XMPie”), a provider of variable
information software, for $54 in cash, including
transaction costs. XMPie’s software enables printers and
marketers to create and print personalized and customized
marketing materials to help improve response rates. We
had an existing relationship with XMPie, as its largest
reseller, and its software is primarily sold together with
our Production systems including the iGen3. The
operating results of XMPie are not material to our
financial statements, and are included within our

Production segment from the date of acquisition. The
purchase price was primarily allocated to Goodwill $48,
Intangible assets, net $9 and deferred tax liabilities $(3).
The primary element that generated the Goodwill is the
value of synergies between the entities, which do not
qualify as an amortizable intangible asset. The allocations
were based on third-party valuations and management
estimates which have not yet been finalized. Accordingly,
the allocation of purchase price is preliminary and
revisions may be necessary, although not expected to be
material.

Note 21 – Divestitures and Other Sales

During the three years ended December 31, 2006,

the following significant divestitures occurred:

Ridge Re: In March 2006, Ridge Re, a wholly owned
subsidiary included in our net investment in discontinued
operations (within Other long-term assets), completed an
agreement to transfer its obligations under its remaining
reinsurance agreement, together with related investments
held in trust, to another insurance company as part of a
complete exit from this business. As a result of this
transaction, the remaining investments held by Ridge Re

were sold and the excess cash held by Ridge Re of $119,
after the payment of its remaining liabilities, was
distributed back to the Company as part of a plan of
liquidation. This amount is presented within investing
activities in the Consolidated Statements of Cash Flows.

Integic: In March 2005, we completed the sale of our

entire equity interest in Integic Corporation (“Integic”)
for $96 in cash, net of transaction costs. The sale resulted
in a pre-tax gain of $93. Prior to this transaction, our
investment in Integic was accounted for using the equity

105

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

(Dollars in millions, except per-share data and unless otherwise indicated)

method and was included in Investments in affiliates, at
equity within our Consolidated Balance Sheets. The
pre-tax gain is classified within Other (income) expenses,
net in the accompanying Consolidated Statements of
Income. In May 2006, we recognized an additional
pre-tax gain of $10 on this sale from the receipt of
additional proceeds from escrow. The proceeds were
placed in escrow upon the sale of Integic pending
completion of an indemnification period.

ScanSoft: In April 2004, we completed the sale of

our ownership interest in ScanSoft, Inc. (“ScanSoft”) 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. The gain is classified within
Other (income) expenses, net in the accompanying
Consolidated Statements of Income.

ContentGuard: In March 2004, we sold all but 2% of

our 75% ownership interest in ContentGuard Inc,
(“ContentGuard”) for $66 in cash. The sale resulted in a
pre-tax gain of $109 (after-tax $83) as our investment
reflected the recognition of cumulative operating losses
and was classified as a gain in Income from discounted
operations, net of tax. 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 created out of
research developed at the Xerox Palo Alto Research
Center (“PARC”), licenses intellectual property and
technologies related to digital rights management. During
2005, we sold our remaining interest in ContentGuard.

Note 22 – Subsequent Event

In February 2007, the Board of Directors authorized
an additional repurchase of up to $500 of the Company’s
common stock over the next 12 months. The repurchases
may be made on the open market, or through derivative or
negotiated transactions. The Company expects the stock
to be repurchased primarily through open-market

purchases. Open-market repurchases will be made in
compliance with the Securities and Exchange
Commission’s Rule 10b-18, and are subject to market
conditions as well as applicable legal and other
considerations.

106

REPORTS OF MANAGEMENT

Management’s Responsibility for Financial Statements
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.

Management’s Report on Internal Control Over Financial Reporting
Our management is responsible for establishing and
maintaining adequate internal control over financial
reporting, as such term is defined in the rules promulgated
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 control 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, management has

concluded that our internal control over financial
reporting was effective as of December 31, 2006. Our
management’s assessment of the effectiveness of our
internal control over financial reporting as of
December 31, 2006 has been audited by
PricewaterhouseCoopers LLP, an independent registered
public accounting firm, 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

107

REPORT OF INDEPENDENT
REGISTERED PUBLIC ACCOUNTING
FIRM

To the Board of Directors and Shareholders of Xerox
Corporation:

We have completed integrated audits of Xerox
Corporation’s consolidated financial statements and of its
internal control over financial reporting as of
December 31, 2006 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,
2006 and 2005, and the results of their operations and
their cash flows for each of the three years in the period
ended December 31, 2006 in conformity 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

recognition and disclosure provisions of Statement of
Financial Accounting Standards No. 158, “Employers’
Accounting for Defined Benefit Pension and Other
Postretirement Plans, an amendment of FASB Statements
No. 87, 88, 106 and 132(R)” as of December 31, 2006.

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, 2006, 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, 2006, based on criteria
established in Internal Control – Integrated Framework
issued by the COSO. The Company’s management is
responsible for maintaining 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 conducted 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 control 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 reporting
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

108

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
evaluation 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 16, 2007

109

QUARTERLY RESULTS OF OPERATIONS (Unaudited) (in millions, except per-share data)

2006
Revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Costs and Expenses(1)

Income from Continuing Operations before Income Taxes, Equity

Income, Discontinued Operations and Cumulative Effect of Change
in Accounting Principle . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Income tax expenses (benefits)(2)
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Equity in net income of unconsolidated affiliates . . . . . . . . . . . . . . . . . .

First
Quarter

Second
Quarter

Third
Quarter

Fourth
Quarter

Full
Year

$3,695
3,487

$3,977
3,712

$3,844
3,753

$4,379
4,135

$15,895
15,087

208
47
39

265
22
17

91
(416)
29

244
59
29

808
(288)
114

Net Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$ 200

$ 260

$ 536

$ 214

$ 1,210

Basic Earnings per Share(3) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$ 0.20

$ 0.27

$ 0.55

$ 0.22

Diluted Earnings per Share(3)

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$ 0.20

$ 0.26

$ 0.54

$ 0.22

$

$

1.25

1.22

2005
Revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Costs and Expenses(1)

Income from Continuing Operations before Income Taxes, Equity

Income, Discontinued Operations and Cumulative Effect of Change
in Accounting Principle . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Income tax expenses (benefits)(2)
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Equity in net income of unconsolidated affiliates . . . . . . . . . . . . . . . . . .
. . . . . . . . . . . . . . . . . . . . . . .
Income from discontinued operations, net
. . . . . . . . . . .
Cumulative effect of change in accounting principle, net

$3,771
3,482

$3,921
3,804

$3,759
3,682

$4,250
3,903

$15,701
14,871

289
116
37
—
—

117
(233)
20
53
—

77
29
23
—

347
83
18
—
(8) —

830
(5)
98
53
(8)

978

0.96

0.94

$

$

$

Net Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$ 210

$ 423

$

63

$ 282

Basic Earnings per Share(3) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$ 0.20

$ 0.43

$ 0.05

$ 0.28

Diluted Earnings per Share(3)

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$ 0.20

$ 0.40

$ 0.05

$ 0.27

(1) Costs and expenses include restructuring and asset impairment charges of $36, $110 and $239 for the second,

third and fourth quarters of 2006, respectively, and $85, $194, $17 and $70 for the first, second, third and fourth
quarters of 2005, respectively. In addition, the third quarter 2006 includes $68 for litigation matters related to
probable losses on Brazilian labor-related contingencies (See Note 16). The 2005 first quarter includes a $93 gain
from the sale of our equity interest in Integic (See Note 21) and the third quarter 2005 includes $115 of expense
from the MPI arbitration panel ruling and probable losses for other legal matters (See Note 16).

(2) The first and third quarters of 2006 include $24 and $448 of income tax benefits, respectively, related to the

favorable resolution of certain tax matters from the 1999-2003 IRS audit. The second quarter of 2006 included
$46 of income tax benefits from the resolution of certain tax issues associated with foreign tax audits. The 2005
second quarter included $343 of net income benefits related to the finalization of the 1996-1998 IRS audit, of
which $233 was included in income taxes, $57 was included in other expenses, net and $53 was included in
discontinued operations (See Note 15).

(3) The sum of quarterly 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.

110

FIVE YEARS IN REVIEW

(in millions, except per-share data)

2006

2005

2004

2003

2002

Per-Share Data
Income from continuing operations before discontinued operations and

cumulative effect of change in accounting principle

Basic . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Diluted . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Earnings

Basic . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Diluted . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Operations
Revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Service, outsourcing and rentals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Finance income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Research, development and engineering expenses . . . . . . . . . . . . . . . . . . . . . . .
Selling, administrative and general expenses . . . . . . . . . . . . . . . . . . . . . . . . . . .
Income from continuing operations before discontinued operations and

cumulative effect of change in accounting principle . . . . . . . . . . . . . . . . . . .
Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Financial Position
Cash, cash equivalents and Short-term investments . . . . . . . . . . . . . . . . . . . . . .
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Accounts and finance receivables, net
Inventories . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Equipment on operating leases, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Land, buildings and equipment, net
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Investment in discontinued operations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Total Assets(1)

Consolidated Capitalization
Short-term debt and current portion of long-term debt . . . . . . . . . . . . . . . . . . . .
Long-term debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Total Debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Minorities’ interests in equity of subsidiaries . . . . . . . . . . . . . . . . . . . . . . . . . . .
. . . . . . . . . . . . . . .
Liabilities to subsidiary trusts issuing preferred securities(2)
Series B convertible preferred stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Series C mandatory convertible preferred stock . . . . . . . . . . . . . . . . . . . . . . . . .
Common shareholders’ equity(1) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$

$

1.25
1.22

1.25
1.22

$15,895
7,464
7,591
840
922
4,008

$

$

0.91
0.90

0.96
0.94

$15,701
7,400
7,426
875
943
4,110

$

$

0.84
0.78

0.94
0.86

$15,722
7,259
7,529
934
914
4,203

$

$

0.38
0.36

0.38
0.36

$15,701
6,970
7,734
997
962
4,249

$

$

0.11
0.10

0.02
0.02

$15,849
6,752
8,097
1,000
980
4,437

1,210
1,210

933
978

776
859

360
360

154
91

$ 1,536
10,043
1,163
481
1,527
295
21,709

$ 1,566
9,886
1,201
431
1,627
420
21,953

$ 3,218
10,573
1,143
398
1,759
440
24,884

$ 2,477
10,972
1,152
364
1,827
449
24,591

$ 2,887
11,077
1,231
450
1,757
728
25,550

1,485
5,660

7,145
108
624
—
—
7,080

1,139
6,139

7,278
90
724
—
889
6,319

3,074
7,050

10,124
80
717
—
889
6,244

4,236
6,930

11,166
102
1,809
499
889
3,291

4,377
9,794

14,171
73
1,793
508
—
1,893

Total Consolidated Capitalization . . . . . . . . . . . . . . . . . . . . . . . . . .

$14,957

$15,300

$18,054

$17,756

$18,438

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

40,372
$
7.48
$ 16.95
53,700

53,017
$
6.79
$ 14.65
55,220

55,152
$
6.53
$ 17.01
58,100

56,326
$
4.15
$ 13.80
61,100

$
$

57,300
2.56
8.05
67,800

40.6%
35.7%
43.0%
63.7%

41.2%
36.6%
43.3%
62.7%

41.6%
37.4%
43.0%
63.1%

42.6%
37.6%
44.3%
63.7%

42.8%
38.2%
44.5%
59.9%

$ 4,056
1.9
215
277

$
$

$ 4,390
2.0
181
280

$
$

$ 4,628
1.7
204
305

$
$

$ 2,666
1.4
197
299

$
$

$ 3,242
1.4
146
341

$
$

(1) Refer to Note 1 – “New Accounting Standards and Accounting Changes” for further information representing the effect of

adopting FAS 158.
In 2005, includes $98 reported in other current liabilities.

(2)

111

CORPORATE INFORMATION

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 and Switzerland exchanges.

Xerox Common Stock Prices and Dividends:

New York Stock Exchange composite prices*

First
Quarter

Second
Quarter

Third
Quarter

Fourth
Quarter

2006

2005

High . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Low . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$15.34
13.98

$15.10
13.28

$15.71
13.31

$17.22
15.37

High . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Low . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

16.97
$14.44

15.25
$13.09

14.12
$13.11

15.03
$12.41

* Prices as of close of business

At its July 9, 2001 meeting, the company’s Board of Directors eliminated the dividend on the common stock.

Certifications

We have filed with the SEC the certification required by
Section 302 of the Sarbanes-Oxley Act as an exhibit to
our 2006 Annual Report on Form 10-K, and have
submitted to the NYSE in 2006 the CEO certification
required by the NYSE corporate governance rules.

112

C O R P O R A T E I N F O R M A T I O N

Shareholder Information

Electronic Delivery Enrollment

For investor information, including comprehensive earnings
releases: www.xerox.com/investor

Xerox offers shareholders the convenience of electronic 
delivery including:

Earnings releases are also available by mail by calling: 
800 828-6396.

For shareholder services, call 800 828-6396 
(TDD: 800 368-0328) or 781 575-3222, or write to 
Computershare Trust Company, N.A., PO Box 43010, 
Providence, RI 02940-3010 or use e-mail available 
at www.computershare.com

Annual Meeting

Thursday, May 24, 2007, 10:00 a.m. EDT
Xerox Corporation Corporate Headquarters
800 Long Ridge Road
Stamford, Connecticut

Proxy material mailed by April 10, 2007, 
to shareholders of record March 26, 2007. 

Investor Contacts

James Lesko, Vice President, Investor Relations
james.lesko@xerox.com
Chris Acocella, Manager, Investor Relations
chris.acocella@xerox.com

This annual report is also available online 
at www.xerox.com/investor

Armando Zagalo de Lima
Senior Vice President
President, Xerox Europe

Quincy L. Allen
Vice President
President, Production 
Systems Group

Wim T. Appelo
Vice President 
Xerox Strategic Services

Michael D. Brannigan 
Vice President
President, United States 
Solutions Group

Richard F. Cerrone
Vice President
Strategic Initiatives

M. Stephen Cronin
Vice President
President,
Xerox Global Services

Kathleen S. Fanning
Vice President
Worldwide Tax

Anthony M. Federico
Vice President
Chief Engineer

O F F I C E R S

Anne M. Mulcahy
Chairman and 
Chief Executive Officer

Ursula M. Burns
President

James A. Firestone
Executive Vice President
President, Xerox North America

Lawrence A. Zimmerman
Executive Vice President and 
Chief Financial Officer

Thomas J. Dolan
Senior Vice President
President, Global Accounts

Michael C. Mac Donald
Senior Vice President
President, Marketing Operations

Jean-Noel Machon
Senior Vice President
President, Developing Markets
Operations

Hector J. Motroni
Senior Vice President
Chief Staff Officer

Brian E. Stern
Senior Vice President
Fuji Xerox Operations

• Immediate receipt of the Proxy Statement and Annual Report
• Online proxy voting

Registered Shareholders, visit
www.eTree.com/Xerox

You are a registered shareholder if you have your stock 
certificate in your possession or if the shares are being held 
by our transfer agent, Computershare.

Beneficial Shareholder, visit
http://enroll.icsdelivery.com/xrx

You are a beneficial shareholder if you maintain your 
position in the Company within a brokerage account.

Thank you to our customers who participated in this report:
Fujitsu Siemens Computers, Shutterfly and Xavier University. 
All of us at Xerox deeply appreciate our relationships and look
forward to making them even stronger.

© 2007 Xerox Corporation. All rights reserved. XEROX,®
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Phaser,® Smarter Document Management,™ WorkCentre,®
iGen3,® Xerox Nuvera® and 2101® are trademarks of Xerox
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Emerson U. Fullwood
Vice President
Chief of Staff and Marketing
Xerox North America

Patricia M. Nazemetz
Vice President
Chief Human Resources 
and Ethics Officer

Rhonda L. Seegal
Vice President and Treasurer 

Sophie V. Vandebroek
Vice President 
Chief Technology Officer and
President, 
Xerox Innovation Group

Leslie F. Varon
Vice President and
Controller

Samuel K. Lee
Assistant Secretary and 
Associate General Counsel

Carol Ann McFate
Assistant Treasurer and 
Chief Investment Officer

D. Cameron Hyde
President,
North American Partners Group

Gary R. Kabureck
Vice President and 
Chief Accounting Officer

John M. Kelly
Vice President
President,
Xerox Global Services 
North America

James H. Lesko
Vice President
Investor Relations

Timothy J. MacCarrick
Vice President, Finance
Xerox North America

John E. McDermott
Vice President 
Corporate Strategy and 
Alliances and 
Chief Information Officer 

Ivy Thomas McKinney
Vice President and Deputy 
General Counsel

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How to Reach Us

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Products and Service

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Additional Information

The Xerox Foundation
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Diversity Programs and EEO-1 Reports 
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Minority and Women Owned Business Suppliers 
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Ethics Helpline 
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Environment, Health and Safety Progress Report 
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Questions from Students and Educators
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Independent Auditors
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203 539-3000

© 2007 Xerox Corporation. All rights reserved. A portion of this report is printed on paper made
using wind-generated electricity and 15% post-consumer waste.

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