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    Annual Report 2005 True Colors

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    Quality measured in tolerances that approach perfection. Adaptability that consistently beats our competitors to the marketplace with new offerings. A passion for innovation and creativity that allows our customers to be even better than they thought they could be. A steadfast and demonstrable commitment to diversity and social responsibility. These are the True Colors of Xerox. In everything that we do, our True Colors inspire us to succeed and allow our customers to reveal theirs. They keep us at the forefront of technological innovation, timely product delivery and end-to-end services that spur profitable growth. They keep us financially strong and intently focused on increasing value to our shareholders. The True Colors of Xerox guide us every day and will continue to propel us in the future.

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    01 Financial Overview 02 Chairman’s Letter 09 True Colors of Our Customers 14 Social Responsibility 16 Description of Business 26 Management’s Discussion and Analysis of Results of Operations and Financial Condition 104 Corporate Information Financial Overview ($ millions, except EPS) 2005 2004 Total Revenue $ 15,701 $ 15,722 Equipment Sales 4,519 4,480 Post Sale, Finance Income and Other Revenue 11,182 11,242 Net Income 978 859 Diluted Earnings Per Share 0.94 0.86 1

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    Anne M. Mulcahy Chairman and Chief Executive Officer Fellow shareholders: I am pleased to report another solid year of progress for Xerox. Our company is in excellent financial health. Our balance sheet is strong and getting stronger. Our new business model is doing what we intended: whatever the challenges of our business, we are able to adjust quickly and produce earnings growth. In fact, we have met or exceeded our earnings expectations in 13 of the last 14 quarters. Our global operations are producing significant cash flow. At the same time, we have virtually eliminated debt except for the debt that supports our customer financing activities. As a result of our performance as well as confidence that it will continue, the Xerox Board of Directors has authorized the company to repurchase $1 billion in Xerox common shares. It’s a tangible way to deliver shareholder value and to assure you that we take very seriously the trust you have placed in us. 2

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    C h a i r m a n ’s L e t t e r Our progress in 2005 provided more evidence that We do business in a very attractive – and therefore very we are on track and continuing to build momentum: competitive – market that currently affords us a $112 billion opportunity. Parts of that market are stable, parts • Net income of $978 million or 94 cents per share, an are growing rapidly, and parts are being created. In each, increase of 9 percent from full-year 2004. we have a clear, consistent and credible strategy. Simply • Gross margins of 41.2 percent – in line with our expectations. put, it’s this: • Selling, general and administrative (SAG) expenses of 26.2 percent of revenue – down one-half point from • Compete aggressively and effectively in the relatively the previous year. stable $58 billion digital black-and-white printing market. • Debt balance of $7.3 billion, a reduction of $2.8 billion • Drive the rapidly growing $17 billion digital color printing from year-end 2004 – and virtually all of what remains market, where the breadth and depth of our technology is in support of our customer financing activities. gives us a commanding competitive advantage. • Operating cash flow of $1.4 billion. • Create a new $17 billion market by harnessing digital • Year-end cash and short-term investments balance of technology to the world of offset printing with applications $1.6 billion. such as print-on-demand, personalized communications and one-to-one marketing. We call it the New Business Xerox is at a pivotal point. We get a lot of credit these days of Printing®. for turning Xerox around. We’re pleased by that, but hardly • Lead the burgeoning document services market by working satisfied. All of our hard work these past five years has with our customers to reduce document costs, streamline been done with a single-minded purpose – to return Xerox processes and enable the free flow of documents down the to growth, thereby providing value to our shareholders. hall, cross-town and around the world. We made progress in 2005, but not enough. We accelerated That’s the opportunity we’re attacking. It’s a blend of the pace of install activity for Xerox digital systems such markets where we have traditionally competed and as color printers, digital presses and multifunction devices natural extensions of those markets – extensions that that print, copy, fax and scan. In fact, activity increased are enabled by new technology and inspired by the by double-digit rates in our key markets. At the same time, evolving needs of our customers. A question I’m often we aggressively ramped our services business, winning asked by investors is how Xerox believes it will win in more global consulting contracts for Xerox’s document this $112 billion market. It’s a fair question. When I management expertise. reflect on it, I believe there are six tangible – and one intangible – reasons why Xerox will succeed. All of this bodes well for our long-term success: increased equipment installs drives more pages printed on Xerox First, our technology – a past, present and future systems. More pages fuel growth for Xerox supplies and strong suit for Xerox. We routinely invest 6 percent of service. This translates into “post-sale” revenue, which our revenues in research, development and engineering. represents about 70 percent of Xerox’s total revenue. More Our research investments are closely aligned with our multi-year contracts for Xerox’s document management growth strategy; this way we’re always outrunning services also flows through to support our annuity stream. our competitors. For example, Xerox and our partner Fuji Xerox are jointly investing about two-thirds of our Our post-sale revenue turned positive in the second half combined research and development budget on color. of 2005 – an important sign that our annuity-based Over the last decade, this investment has resulted in business model is working. However, total revenue was more than 2,700 color-related patents. flat, slightly below our expectations. We know we can do better and are confident we will. And that’s what I’d During 2005, we brought 49 new products to market – like to take this opportunity to discuss with you – how products that won more than 260 industry awards. we will grow Xerox over the next few years. In fact, fully two-thirds of our equipment sales last year came from products introduced in the past two years. 3

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    It’s fair to say that no other company has a broader Third, our superior knowledge of documents and or better set of offerings than Xerox. Perhaps more the way people work with them. Ever since creating the importantly, we remain committed to our ongoing plain-paper copier industry 50 years ago, documents investment in research and technology – investment have been part of the DNA of Xerox. We have research that is yielding great returns. teams around the world that study the flow of documents in a workplace and develop smarter software and During 2005, the Xerox scientific community was services that simplify this workflow. Our customers in awarded 643 patents, placing the patent portfolio in industries such as health care, legal and manufacturing the top 25 of American companies. And, in 2005, rely solely on Xerox to manage the huge volume of paper we filed 60 percent more patent applications than and digital documents that keep their businesses running. in the previous year. This relentless focus on innovation As we like to say, we know more about the document, assures us that we will be able to bring added value care more about the document and can do more with to our customers far into the future. the document than anyone in our industry. Period. Second, color. The demand for color in today’s world That’s an enormous advantage as the document is great. Our response is straightforward – make it becomes more digital, more dynamic and more critical affordable and make it easy to use. That strategy has to the conduct of business. Heretofore, the substantial made us the revenue leader in a market that is expected cost of documents flew under the radar screen of most to double by 2009. Chief Information Officers and Chief Financial Officers. Everyone used documents, but no one was accountable Color has rapidly become a business-critical tool for their management. That is rapidly changing and it for our customers. More and more businesses are plays to our expertise. We can save our customers up shifting to digital color systems to produce personalized, to 30 percent of their document costs. And we are. colorful materials such as marketing collaterals, financial statements, catalogs and user guides on An increasing number of customers are turning to us Xerox digital devices. The number of pages printed to simplify their document-intensive work processes; on Xerox color devices has doubled in the past manage their document-related assets; develop systems two years. In fact, color now represents approximately to easily store, search and retrieve digital files; and 30 percent of our total revenue. provide other services that add value. The potential for color technology is as enormous as Fourth, our broadening portfolio of distribution channels. it is profitable. Two facts stand out: around 7 percent It includes 8,000 sales professionals, 7,000 agents of the pages printed or copied on Xerox devices today and concessionaires, 10,000 resellers, a world-class are color, and color pages are five times more profitable teleweb operation, strong OEM relationships, IT and than black-and-white. The combination presents us with consulting partners – all backed up by industry experts a world of opportunity. We intend to capture it. and business analysts. It’s a critical mass of people and expertise that no one else can match. “ The potential for Those distribution and consulting resources span the world and give us a presence that global customers color technology covet. Digital documents and business enterprises don’t stop at geographic boundaries. Neither does is as enormous as our ability to help our customers. it is profitable.” 4

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    Increased Net Income C h a i r m a n ’s L e t t e r Net Income (Loss) 978 859 ($ millions) 360 A growing list of global companies are turning to Xerox (94) 91 for help in managing their worldwide document needs. ’02 ’03 ’04 ’05 The Dow Chemical Company is a good example. ’01 They’ve signed a $66 million deal with us to consolidate Steady all of their document assets – printers, copiers, fax Equipment Sales 4,403 4,250 4,480 4,519 machines and scanners – in 54 countries. Dow will get 3,970 ($ millions) more technology at less cost, seamless integration around the world and the value of working with a global partner. We believe arrangements such as this are the wave of the future. You can read more about our relationship with Dow on page 10 in this report. ’01 ’02 ’03 ’04 ’05 Fifth, the customer-centric culture we have built and Accelerated continue to strengthen. Our people recognize that the Color Revenue 4,634 customer is our priority among priorities – the reason (Included in Total 3,903 we exist. Some 12,000 of our people – that’s one in Revenue – $ millions) 3,267 2,759 2,781 five – literally work every day on customer sites. We work with our customers, offering not just our products, but also providing solutions to the most pressing problems of our customers. ’01 ’02 ’03 ’04 ’05 The vast majority of our leadership team – including Decreased Debt people such as our Chief Accounting Officer and General as of December 31 16.7 ($ billions) 14.2 Counsel – have personal responsibility for the relationship 11.2 with one of our major customers. Whenever I call on a 10.1 customer – and that’s every chance I get – they tell me 7.3 that the most important reason they do business with us is the caliber and commitment of our people. It’s a priceless asset. ’01 ’02 ’03 ’04 ’05 Sixth, the strength of our brand. We nurture it. Stabilized Gross Margins We invest in it. And we know that it opens doors, gives 42.8 42.6 41.6 41.2 (Percent) 38.6 us permission to compete for business and positions us as an attractive and trusted partner. One recent brand-building achievement is worthy of special mention. J.D. Power and Associates named Xerox the first document management company to receive ’01 ’02 ’03 ’04 ’05 its certification for excellence in customer service Reduced Selling, and support. J.D. Power evaluated the breadth of our Administrative and 4,728 on-site, phone and online customer service. In addition, 4,437 4,249 4,203 General Expenses 4,110 auditors conducted several comprehensive visits to ($ millions) our call centers and surveyed hundreds of our customers. It’s quite an honor and one that will motivate us to strive for even higher levels of performance. ’01 ’02 ’03 ’04 ’05 5

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    C h a i r m a n ’s L e t t e r So there you have it – a half-dozen reasons that We’re proud of our accomplishments, but not satisfied. give us a competitive advantage in the marketplace We’re confident in our strategy, but not complacent. and should serve to give you confidence that you We’re bullish on our future, but take nothing for granted. have invested your money wisely. Because our opportunities are large, our competition is formidable. As we get better, so do they. As we deliver As I write this letter, I am gathered with the senior value to our customers, they expect more. As you invest leadership team of Xerox – some 300 individuals whom in us, you anticipate greater returns. I am proud to call my colleagues. They and the people they lead are the intangible reason I am confident we We do not shrink from those expectations; we embrace will continue to be successful. them. They are an opportunity to continue to show our True Colors. This is a management team that has been Most of the leadership team has been with the tested by adversity and sharpened by challenge. company through our most challenging times. Others were recruited to Xerox to fill gaps in our capabilities We’re going after a $112 billion opportunity. We’re and provide leadership in key areas. All chose to be competitively advantaged to attack it aggressively. Our part of our turnaround, to be with us during the most financial health enables continued investments to keep difficult, yet most rewarding period in our history. us on the leading edge of our markets. Our business “ We’re going after a $112 billion opportunity. We’re competitively advantaged to attack it aggressively.” They inherited a company that lost $273 million dollars model is tested and flexible. We adapt to changes in the in 2000, but had a noble history. And they brought marketplace, holding steady on our gross margins and it back to a company that made $978 million last increasing earnings for our shareholders. Our leadership year, adding another inspiring chapter to a storied team and our people are aligned around a common past. They refused to let Xerox fail, exhibiting what I’ve set of objectives aimed at delivering shareholder value. come to call steely optimism in the face of enormous You should expect no less. We aim to deliver no less. adversity. While others predicted failure, they said Because of our people, I believe our best days are not on our watch. Xerox cannot and will not fail. ahead of us – just ahead. They showed their True Colors. Now they are focused with an intensity that’s hard to describe, but easy to feel. They are writing another chapter in our history – the story of our return to growth. As I met and talked with the leadership team Anne M. Mulcahy this week, I was galvanized by their dissatisfaction Chairman and CEO with the status quo. To them, good is not good enough. They are on a mission to put Xerox back on a growth trajectory and give you a solid return on the trust you place in us. As one of them put it: “We’ve been playing defense. Now it’s time to play offense.” 6

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    8 6 7 10 9 5 3 4 2 1 11 Board of Directors 1. Anne M. Mulcahy 8. Vernon E. Jordan, Jr. B, C Chairman and Chief Executive Officer Senior Managing Director Xerox Corporation Stamford, CT Lazard Fréres & Co., LLC New York, NY Of Counsel, Akin, Gump, Strauss, 2. Glenn A. Britt A, C Hauer & Feld, LLP Attorneys-at-Law President and Chief Executive Officer Washington, DC Time Warner Cable Stamford, CT 9. Hilmar Kopper B, D 3. Ann N. Reese C, D Former Chairman and Chief Executive A: Member of the Audit Committee Executive Director Officer Deutsche Bank AG B: Member of the Compensation Committee Center for Adoption Policy Rye, NY C: Member of the Corporate Governance Committee Frankfurt, Germany D: Member of the Finance Committee 4. William Curt Hunter A, C 10. Ralph S. Larsen B, C Dean and Distinguished Professor * Will not stand for reelection at the 2006 annual Former Chairman and Chief of Finance meeting of shareholders Executive Officer Johnson & Johnson University of Connecticut School ** Elected to the Board March 1, 2006 New Brunswick, NJ of Business Storrs, CT 11. N. J. Nicholas, Jr. B, D 5. Stephen Robert D* Investor New York, NY Chancellor Brown University Chairman and Chief Executive Mary Agnes Wilderotter** (not pictured) Officer Renaissance Institutional Chairman and Chief Executive Officer Management LLC New York, NY Citizens Communications Stamford, CT 6. Richard J. Harrington A President and Chief Executive Officer The Thomson Corporation Stamford, CT 7. Robert A. McDonald A Vice Chairman – Global Operations The Procter & Gamble Company Cincinnati, OH 7

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    “Our True Colors come through in our people. That’s more than 14,000 variations.” “ I love this business. Whether it’s wedding invitations, greeting cards, customized newsletters or targeted mailings, what’s more important to bringing people together than the right communication, at the right time? Even in the most ‘paperless’ society, there will always be the printed word. “ At the same time, the True Colors of the success we’ve enjoyed at Taylor Corporation could apply to any business, in any industry. Passion and enthusiasm, hard work, intelligence, common sense and, above all, people. “ The right people don’t just happen. They get that way by being nurtured, challenged, empowered and given the space to succeed. “ We encourage our people through ‘opportunity and security.’ Some might look at these as distinct concepts. To the Taylor team, they’re one and the same. Seizing opportunity is security. In fact, it’s the only security this world has to offer.

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    “ That philosophy is embedded in our culture. Which is why we’ve grown to 85 Taylor companies. I like to think of them as entrepreneurial ventures that are continually evolving. “ When we touch customers, what are they really getting? People. Human interaction. The desire, responsiveness and expertise that they know can improve their business, and their lives. “ I know it sounds corny, but I really like people. I am continually refreshed by the human spirit. Any success we have at Taylor is that spirit multiplied by 14,000.”

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    “Taylor’s people exemplify the New Business of Printing.” All 85 Taylor companies are driven by a passion to improve the entire range of printed communication. So are we. That makes Taylor and Xerox natural partners. Together, we understand that the “New Business of Printing” is not really just about printing. It’s about increasing value to client companies. That means, for example, communicating with prospective customers one-to-one while retaining the impact of full color. Which can lower the overall cost of acquiring those customers. Or presenting existing customers with personalized offers based on past buying behavior. Which boosts per-customer revenue and builds loyalty. Xerox team from left to right: TC Campbell Denise De’te Steve Cullers Kim Armstrong

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    That’s where the Xerox iGen3® Digital Production Press is changing the landscape. It allows Taylor to provide variable and on-demand color printing solutions that are economically feasible, at quantities from one to tens of thousands. And we don’t mean just changing names and addresses. We mean changing 100% of the content and four-color photographs. So there’s more variation, shorter runs, less waste and less warehousing. In short, Taylor’s iGen3 presses produce much more than striking, made-to-order printed materials. They produce cost-effective results – and satisfied customers. That’s important work. And we’re privileged to be a part of it. TC, Denise, Steve, Kim Brad Schreier CEO Taylor Corporation 9

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    “We strive, every day, to improve what is essential to human progress.” “ We enable collaboration and consistency around the world by engaging best-in-class technology and work-process systems. The result is that we’re truly global. Walk into an operation in Argentina and you’ll see the same approach to our business as in Osaka. Which means our quality remains uniformly excellent and our productivity is always improving. “ Making continuous improvements to our operations energizes me. As our founder, Herbert Dow, observed, ‘If you can’t do it better, why do it?’ It’s gratifying to know that the Dow culture can seize on a better idea and implement it across the globe. Not for the sake of change itself, but because what we’re doing is so important. Our mission is to improve what is essential to human progress – including crops, drinking water, pharmaceuticals, building materials and consumer goods.

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    “ We make those improvements through science and technology, but at the core of our 110 years of success is integrity. That’s what you might expect to hear from any well-meaning executive, but at Dow, it’s part of the DNA. It means living by our word. It means doing the right thing without being asked. It means leaving things better than we found them. We take integrity very seriously. “ Combine integrity with the ability to implement globally and you have an organization that is capable of making the world a better place, every day. By creating solutions for society. By protecting the health and safety of our people and our communities around the world. By viewing every customer relationship as a partnership in which we create value for one another. These really are the True Colors of Dow. And the reasons I’ve invested my entire career here.”

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    “350 locations, 54 countries, one solution.” Think global, execute local. That became our charge when Dow tapped Xerox to streamline its copy, print, scan and fax capabilities at all of its locations worldwide. We learned pretty quickly that Dow does nothing by halves. When it makes improvements, it does so globally. The direction seemed straightforward enough: Make sure that uniform, cost-effective document-management functionality is a defined distance from the users who need it. And make sure they’re fully satisfied! Thank goodness Xerox, like Dow, lives by Lean Six Sigma, a data-driven method for removing costs and improving processes. It resulted in the exact number of correct assets in every location at the lowest possible cost. Xerox team from left to right: Kent Purvis Katherine Agbe Tom Marler Susan Loberg

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    Now documents of any length, size, color or complexity can be sent halfway around the world as easily as to the building next door. That means huge savings in time and cost, as Dow’s documents will no longer have to be shipped and caught up in transportation delays before they’re delivered. It might sound easy, but the implementation has been, well, significantly more complicated than a domestic initiative. There are 54 countries we’re working with and that’s where Xerox’s global leadership shines through. We’ve devised processes that work in any culture, and we’ve trained and set up help desks in over ten languages. Even though the solution is global, Dow is measuring success one local user at a time. Mack Murrell Senior Director Kent, Katherine, Tom, Susan Enterprise IT Operations & Office Facilities The Dow Chemical Company 11

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    “Our True Colors are helping people discover theirs.” “ We founded The ConferenceWorks! as a company dedicated to the evolution of personal consciousness. Through natural self-healing, alternative medicine, essential life wisdom and other enriching topics, our seminars showcase today’s most relevant presenters, who seek to bring to our attendees learning, wisdom and new perspectives. “ There’s an accumulating body of evidence that raising consciousness one person at a time has a beneficial effect on other people who may not seem to be otherwise connected. Thoughts truly do make a difference in creating what we call Aha! opportunities. “ So I guess you could say that the True Colors of The ConferenceWorks! are to promote deeper learning, new ideas and real tools our clients can use to support conscious evolution in their lives, their works and their relationship with the world in which they live.

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    “ I’m continually encouraged and gratified at the number of insights and positive experiences that our clients have many weeks, even months, after attending our seminars. “ My job is particularly enriching since more than anyone, I’m responsible for getting people to our seminars in the first place. We need to convince them that spending a weekend with us for something that, at first, they only vaguely understand is worth their effort, time and money. “ Challenging to be sure, but gratifying. As close to 100% customer satisfaction as I’ve ever seen. It’s a great feeling to promote a product that I believe in so strongly and that actually changes the world for the better.”

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    “Our routine inquiry became a transformational experience.” Our work started when we were following up on an historical agreement report. These tell us when a client is coming off lease and may be interested in renewal or an upgrade. Enter Indiana Business Equipment, one of Xerox’s 1,100 authorized sales agencies that sell the complete line of Xerox office systems to small and medium-sized businesses. What our sales agents found went way beyond the analog copiers and printers that they were using for everyday office management. It turns out The ConferenceWorks! was outsourcing the printing of almost all of its marketing material. That meant long lead times, excessively large print runs and, ultimately, more time and money than were necessary. Xerox team from left to right: Kyle Smelser Andrea Hall Ryan Gerber

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    Our solution started with listening and exploring the possibilities, which, as you might expect, is something The ConferenceWorks! encourages. They let us examine their entire marketing approach from the time they solicit a potential client to when that prospect becomes a bona fide customer. What we discovered led us to the Xerox WorkCentre® Pro C3545 and its ability to bring high-quality, affordable color to an office environment. Talk about an Aha! opportunity. As the result of our analysis and solution, The ConferenceWorks! now produces color documents every bit as vibrant as those from an offset press. And no matter what the quantity, they can customize the message. All for about a third less than they were spending on outsourcing. And in a fraction of the time. Any time we can make a client better at what they do, it’s a great feeling. When we can do it for a client that’s transforming lives, that’s even better. Sharon Krieg Operations Manager The ConferenceWorks! Kyle, Andrea, Ryan 13

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    Social Responsibility Our Commitment to Good support sustainable growth. Among Xerox’s efforts: the Palo Alto Research Center’s work on “clean technologies” Citizenship is Unwavering and renewable energy. • Xerox solid ink color printers – based on the company’s Of the True Colors of Xerox, none is brighter and more proprietary technology – generate about 95% less waste enduring than our commitment to corporate citizenship, than laser printers. Xerox is extending this technology to a core value since the company’s founding. Here are more products, like the WorkCentre C2424, launched in some examples: 2005 as the industry’s first solid ink multifunction system. • The Xerox Foundation invested $13.2 million in 2005, • Xerox paper comes from suppliers that meet the which included 42 grants to university science programs, company’s stringent environmental requirements, which more than 190 grants for college scholarships and are designed to ensure that all Xerox paper is sourced support, and 550 grants to nonprofits. from sustainably managed forests. • Xerox provided $2 million for Southeast Asia earthquake and tsunami relief and $2 million in financial and technical assistance for victims of Hurricane Katrina. “ Xerox is one of our • Through its supplier diversity program, Xerox placed nation’s pillars, advancing $400 million worth of orders with minority-, women- and veteran-owned businesses in 2005. important social and • Black Enterprise, DiversityInc, the Human Rights economic goals for Campaign, Computerworld, Hispanic Business and several other entities recognize Xerox’s workplace as communities across being among the best. the country.” • Following Xerox’s mission to make “waste-free products – U.S. Chamber of Commerce upon awarding Xerox a 2005 Corporate in waste-free factories to help customers attain waste-free Citizenship Award. workplaces,” the company diverts more than 140 million pounds of waste from landfills. Nearly all eligible new products launched in 2005 met the international ENERGY • Xerox encourages employees to volunteer in their STAR® and Canada’s Environmental Choice standards. communities through programs like Social Service Leave, which offers paid sabbaticals for community • Xerox pledged to drive its worldwide greenhouse gas service; the Community Involvement Program, emissions 10% lower than 2002 levels, by 2012. which provides seed money for Xerox teams to fund • Xerox became a charter partner in the Business volunteers projects; and the Science Consultant Roundtable’s new “S.E.E. Change” initiative, which calls Program, through which employees bring real-life for corporations to strengthen business strategies that science experiments into the classroom. • Xerox’s Board of Directors is more than 90 percent independent with Xerox Chairman and CEO Anne Mulcahy serving as the only employee director. • Fortune Magazine’s 2006 “U.S. Most Admired Companies” survey ranked Xerox No. 1 in its industry for “social responsibility.” For more information, visit www.xerox.com/csr. 14

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    TA B L E O F C O N T E N T S 16 Description of Business 26 Management’s Discussion and Analysis of Results of Operations and Financial Condition 46 Consolidated Statements of Income 47 Consolidated Balance Sheets 48 Consolidated Statements of Cash Flows 49 Consolidated Statements of Common Shareholders’ Equity 50 Notes to the Consolidated Financial Statements 99 Reports of Management 100 Report of Independent Registered Public Accounting Firm 101 Quarterly Results of Operations (Unaudited) 102 Five Years in Review 103 Officers 104 Corporate Information Xerox Annual Repor t 2005 15

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    DESCRIPTION OF BUSINESS Global Overview Xerox is a Revenues by $15.7 billion technology and services Geography enterprise and a leader in ($ millions) U.S.: $8,388 the global document market. Europe: $5,226 Other Areas: $2,087 We develop, manufacture, market, service and finance a complete range of document equipment, software, solutions and services. We operate in over 55,200 160 Globally we have direct employees. We have over 8,000 Sales Professionals, over 12,000 Managed Service Employees at customer sites and 13,000 Technical Service Employees. In addition, we have over 7,000 Agents and Concessionaires and over countries worldwide. 10,000 Resellers. Overview The document industry is transitioning from older technology light-lens devices to digital systems, from black and white to color References herein to “we,” “us,” “our,” the “Company” and “Xerox” and from paper documents to an increased reliance on electronic refer to Xerox Corporation and its subsidiaries unless the context documents. More and more people are creating and storing specifically states or implies otherwise. documents digitally and using the Internet to easily exchange Xerox is a $15.7 billion technology and services enterprise and a electronic documents. We believe these trends play to the leader in the global document market. We develop, manufacture, strengths of our product and service offerings and represent market, service and finance a complete range of document opportunities for future growth within the $112 billion market we equipment, software, solutions and services. Our international serve. In our core markets of Production and Office, we believe operations represented approximately one-half of our total revenues we are well placed to capture core growth opportunities by in 2005. Our largest subsidiary outside the United States is Xerox leading the transition to color and by reaching new customers Limited, which operates predominantly in Europe. We conduct our with our broadened offerings and expanded distribution channels. Latin American operations through subsidiaries or distributors in We are expanding our core markets with Document Services and over 38 countries. Fuji Xerox, an unconsolidated entity of which we are creating new market opportunities with digital printing we own 25%, develops, manufactures and distributes document as a complement to traditional offset printing, which we refer processing products in Japan, China, Hong Kong and other areas to as the “Eligible Offset” market. Our Document Services are of the Pacific Rim, Australia and New Zealand. organized around three offerings: Xerox Office Services, where we help our customers reduce costs and maximize productivity by optimizing their print infrastructure; Document Outsourcing and Communication Services, which focuses on optimizing the production environment; and Business Process Services, where 16 Xerox Annual Repor t 2005

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    Xerox Corporation Markets $112* *The document industry is transitioning from the older technology of light-lens devices to the new digital systems, from black and white to color, and from paper documents to electronic documents. More and more people are creating We serve a and storing documents digitally, and using the Internet allows the easy exchange of electronic documents. We believe these billion market. trends play to the strengths of our product and service offerings and represent opportunities for future growth within the This estimate, and the market estimates which follow, is $112 billion market we serve. calculated by leveraging third-party forecasts from firms such as International Data Corporation and InfoSource in conjunction with our assumptions about our markets. $20 Services: Our value-added services deliver solutions, which not only optimize enterprise output spend and infrastructure, but also streamline, simplify and digitize ($ billions) $120 our customers’ document-intensive business processes. $17 100 Eligible Offset: We are creating new market opportunities with digital printing as 80 a complement to traditional offset printing. (This is an estimate for this “Eligible Offset” market.) 60 $ 8 Production: We are the only manufacturer in the market that offers a complete 40 family of monochrome production systems from 65 to 180 impressions per minute 20 and color production systems from 40 to 110 pages per minute (“ppm”). $67 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. we show our customers how to improve their processes by using Our business model is an annuity model, based on increasing digital workflow. Within the Eligible Offset market we offer leading equipment sales and installations in order to increase the number digital technology, led by our market-making Xerox iGen3® tech- of machines in the field (“MIF”) that will produce pages and gener- nology and accompanied by the industry’s broadest migration ate post sale and financing revenue streams. We sell the majority path to digital, which meets the increasing demand for short-run, of our equipment through sales-type leases that are recorded as customized and quick-turnaround offset quality printing. equipment sale revenue. Equipment sales represented 29% of our 2005 total revenue. Post sale and financing revenue includes Our products include high-end printing and publishing systems, equipment maintenance and consumable supplies, among other digital multifunctional devices (“MFDs”) (which can print, copy, elements. We expect this large, recurring revenue stream to scan and fax), digital copiers, laser and solid ink printers, fax approximate three times the equipment sale revenue over the machines, document-management software, and supplies such life of a lease. Thus, the number of equipment installations is as toner, paper and ink. We provide software and workflow a key indicator of post sale and financing revenue trends. The solutions that can help businesses easily and affordably print mix of color pages is another significant indicator of post sale books, create personalized documents for their customers revenue trends because color pages use more consumables and scan and route digital information. In addition, we provide per page than black and white. Thus, color pages generate a range of comprehensive document management services, approximately five times the revenue and profit per page as such as operating in-house production centers, developing online compared to black and white. In addition, market development, document repositories and analyzing how customers can most particularly within the Eligible Offset market, is key to increasing efficiently create and share documents in the office. pages and we have leading tools and resources to develop this large market opportunity. Xerox Annual Repor t 2005 17

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    DESCRIPTION OF BUSINESS Segment Information geographically and demographically, ranging from small and medium businesses to graphic communications companies, Our reportable segments are Production, Office, Developing governmental entities, educational institutions and large (Fortune Markets Operations (“DMO”) and Other. Operating segment 1000) corporate accounts. None of our business segments financial information is presented in Note 2 to the Consolidated depends upon a single customer, or a few customers, the loss Financial Statements, which is incorporated by reference. of which would have a material adverse effect on our business. We have a very broad and diverse base of customers, both Reviews by Business Segment Production Office DMO Other 28.92% 48.52% 11.54% 11.02% Production Office DMO Other $4,540 $7,618 $1,812 $1,731 million million million million We provide high-end digital Our Office segment serves DMO includes marketing, The Other segment monochrome and color global, national and direct sales, distributors primarily includes revenue systems designed for small to medium-size and service operations from paper sales, wide- customers in the graphic commercial customers for Xerox products, format systems and communications industry as well as government, supplies and services value-added services. and for large enterprises. education and other in Latin America, the public sector customers. Middle East, India, Eurasia, Central-Eastern Europe and Africa. 18 Xerox Annual Repor t 2005

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    Xerox Corporation Production • Expanded our leading product line of color systems and increased We provide high-end digital monochrome and color systems our presence in the graphic communications environment. designed for customers in the graphic communications industry – Xerox iGen3: During 2005, we continued to increase installations and for large enterprises. These high-end devices enable digital of our flagship Xerox iGen3 Digital Production Press (“Xerox on-demand printing, digital full-color printing and enterprise iGen3”). In March 2005, we announced the Xerox iGen3 110, printing. We are the only manufacturer in the market that offers a 110 ppm full-color production system, which represents a complete family of monochrome production systems from 65 a 10% increase in speed from the previous system. At an to 180 impressions per minute and color production systems operating cost of approximately 5 cents per image, the from 40 to 110 pages per minute (“ppm”). In addition, we offer Xerox iGen3 uses next-generation color technology which a variety of pre-press and post-press options and the industry’s we expect will expand the digital color print on-demand broadest set of workflow software. market as its speed, image quality, personalization and cost The Xerox Freeflow™ digital workflow collection improves our advantages enable the device to capture valuable pages in customers’ work processes from content creation and management the color offset printing market. to production and fulfillment. Our digital technology, combined – DocuColor™ 7000: In May 2005, we launched the DocuColor with total document solutions and services that enable personali- 7000 Digital Press, a 70 ppm production system, which zation and printing on demand, delivers value that improves our provides a new digital full-color entry point for our graphic customers’ business results. communications and central reproduction center customers. Our 2005 Goals – DocuColor 240 and 250: In September 2005, we announced Our goals in the Production segment in 2005 were to strengthen the production version of the DocuColor 240/250, a 40 and our leadership position in monochrome and color and leverage 50 ppm digital color MFD with three external controllers the power of digital printing in the Eligible Offset market. Our designed for the production environment. We now offer our “New Business of Printing” strategy complements the traditional customers the broadest migration path to digital with digital offset press market with digital printing capabilities, which color devices offered at 40, 50, 52, 60, 70, 80 and 110 ppm. includes introducing innovative production systems and solutions • Leveraged the power of digital printing in the offset to expand our leadership position and focus on the higher-growth digital color opportunities. To reach our 2005 goals, we: printing market. – Workflow and Market Development: We continue to expand Our 2005 Accomplishments and improve our leading workflow collection. In September • Increased our presence in the monochrome digital light 2005, we introduced several enhancements to the FreeFlow production market and scaled the new monochrome publishing Digital Workflow collection, expanded the remote services platform (Xerox Nuvera™). offering, PrinterAct, to include the DocuColor 7000 and – Xerox 4110: In February 2005, we launched the Xerox 4110, 8000 (previously available for Xerox iGen3 and Xerox a 110 ppm copier/printer. We first entered the light production Nuvera systems), and ramped up our ProfitAccelerator™ space in 2003 with the introduction of the Xerox 2101. We program, which helps customers maximize digital technology took market share in 2004 and continued to maintain a strong investments. All products are interoperable, consisting of position in 2005 with the success of the 4110. open architecture that links and controls print shop activities – Xerox Nuvera 100/120: We launched the Xerox Nuvera with digital and offset printing equipment. They help print 100/120 full-production systems in Europe in the fourth providers streamline job ordering and management, reduce quarter of 2004 and in North America in the first quarter manual steps and automate error-prone parts of the printing of 2005. process. These new workflow products make it easy to – Xerox Nuvera 144: In September 2005, we announced the integrate digital printing into JDF (job definition format)- Xerox Nuvera 144 Digital Production System, which prints at based workflows, enabling a common set of software 144 ppm (a 20% increase over the previous Nuvera production instructions to direct a print job from creation to completion, system) and features a more powerful print controller and in a consistent, uniform manner. finishing options. We will continue to add features and func- tionality to Nuvera platform products into 2006. Xerox Annual Repor t 2005 19

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    DESCRIPTION OF BUSINESS Office – The Phaser 6300 and 6350: The Phaser 6300 and 6350 Our Office segment serves global, national and small to medium- laser printers at speeds of 26 ppm color and 36 ppm size commercial customers as well as government, education black and white. These new laser printers have the fastest and other public sector customers. Office systems and services, print speeds and fastest first-page-out speeds in their class. which include monochrome devices at speeds up to 90 ppm and – The DocuColor 240 and 250: The DocuColor 240 and color devices up to 40 ppm, as well as 50 ppm color devices 250 “light production” color MFDs with speeds of 40 ppm with an embedded controller, include our family of CopyCentre®, and 50 ppm color, respectively. These devices include an WorkCentre® and WorkCentre® Pro digital multifunction systems; embedded controller and smaller footprint, which are geared DocuColor printer/copiers; color laser, LED (light emitting toward the larger office. Further, these devices provided diode), solid ink and monochrome laser desktop printers; digital significant growth opportunity in the Office and Production copiers; light-lens copiers and facsimile products. We are leading segments (see “Production”), depending upon configuration. the transition to digital by mapping our feature-rich, innovative – Desktop management software: An expanded line of desktop laser and solid ink MFDs to powerful scanning technology in management software and solutions including security the enterprise environment, which enables our customers to features and remote services. maximize their document workflow. We provide further value to our customers by offering a range of solutions including the – The Phaser 7400 and 6120 and the WorkCentre Pro 133 Office Document Assessment (“ODA”), in which we analyze a and WorkCentre PE 220: The October 2005 launch of two business’ workflow and document needs, and then we identify new laser printers including the Phaser 7400 and Phaser the most efficient, productive mix of office equipment and 6120, as well as the WorkCentre Pro 133 advanced MFD software for that business, thereby helping to reduce the (also available in WorkCentre and CopyCentre) and the customer’s document-related costs. WorkCentre PE 220. Our 2005 Goals • Continued to drive the transition to color by making color more Our goals in the Office segment in 2005 were to digitize the affordable, easier to use, faster and more reliable. office by leading in MFDs, drive the transition to color and reach – Our color-capable devices provide an attractive entry point more customers with a broadened product line and expanded into color by offering black and white pages at the same distribution channels. To reach our 2005 goals, we announced cost as black and white systems. Our patented solid ink a significant refresh of our Office systems, including most of technology offers unmatched ease of use, vibrant color our black and white MFDs, and introduced new solid ink and image quality, and economic color run cost that support laser color printers and MFDs. To reach our 2005 goals, we: color transition leadership. Our 2005 Accomplishments • Announced new products, including: • Expanded distribution channels. – The first solid ink MFD, the C2424: The March 2005 – Expanded distribution channels through increased use of introduction of three new solid ink devices including the first our indirect distribution model in Europe and greater use solid ink MFD, the C2424, which runs at 24 ppm – in color of Teleweb (a combination of telephone and Internet selling) or black and white, and offers copy, print and scan functions. and OEM partnerships in the U.S. – The Phaser 8500 and 8550: The June 2005 introduction of two new solid ink office printers including the DMO Phaser 8500 and Phaser 8550, with speeds of 24 ppm DMO includes marketing, direct sales, distributors and 30 ppm, respectively. and service operations for Xerox products, supplies and services in Latin America, the Middle East, India, Eurasia – WorkCentre Pro 232, 238, 245, 255, 265 and 275: and Central-Eastern Europe and Africa. Brazil, Eurasia and The WorkCentre Pro 232, 238, 245, 255, 265 and 275 – Central-Eastern Europe represented approximately 12% advanced black and white digital MFDs that combine of total revenues in 2005. In countries with developing high-performance printing, copying, scanning and faxing economies, DMO manages the Xerox business through in one easy-to-use office system. These products are also operating companies, subsidiaries, joint ventures, product available as WorkCentre, offering copy/print capabilities distributors, affiliates, concessionaires, resellers and and optional fax and CopyCentre standalone digital copiers. dealers. Two-tiered distribution has proven very successful in the high-growth geographies of Russia and Central-Eastern Europe and we are currently implementing it throughout Latin America. We manage our DMO operations separately as a segment because of the political and economic volatility and unique nature of its markets. Our 2005 DMO goals included revenue stabilization and improvement, a continued focus on cost structure to improve margins, and increased 20 Xerox Annual Repor t 2005 profitability for growth.

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    Xerox Corporation Other Twenty-nine percent of our revenue comes from Equipment sales, The Other segment primarily includes revenue from paper primarily from either lease arrangements that qualify as sales for sales, wide-format systems and value-added services. accounting purposes or outright cash sales. The remaining 71% of our revenue, “Post sale and finance income,” includes annuity- We sell cut-sheet paper to our customers for use in their based revenue from maintenance, service, supplies and financing document processing products. The market for cut-sheet as well as revenue from rentals or operating lease arrangements. paper is highly competitive and revenues are significantly We sell most of our products and services under bundled lease affected by pricing. Our strategy is to charge a premium over arrangements, in which our customers pay a monthly amount mill wholesale prices, which is adequate to cover our costs for the related equipment, maintenance, services, supplies and and the value we add as a distributor. financing elements over the course of the lease agreement. We offer document processing products and devices in These arrangements are beneficial to our customers and us our wide-format systems business designed to reproduce since, in addition to customers receiving a bundled offering, large engineering and architectural drawings up to three the arrangement allows us to maintain the customer relationship feet by four feet in size. for subsequent sales of equipment and services. An increasingly important part of our offering is value-added We are required for accounting purposes to analyze these services, which leverage our document industry knowledge arrangements to determine whether the equipment component and experience. Xerox value-added services deliver solutions, meets certain accounting requirements such that the equipment which not only optimize enterprise output spend and infra- should be recorded as a sale at lease inception (i.e., sales-type structure, but also streamline, simplify and digitize our customers’ lease). Sales-type leases require allocation of a portion of the document-intensive business processes. Often the value-added monthly payment attributable to the fair value of the equipment services solutions lead to larger Xerox managed services which we report as “equipment sales.” The remaining portion contracts, which include Xerox equipment, supplies, service of the monthly payment is allocated to the various remaining and labor. The revenue from these contracts is reported within elements based on fair value – service, maintenance, supplies the Production, Office or DMO segments. In 2005, value-added and financing – which are generally recognized over the term services and managed services revenue, including equipment, of the lease agreement and reported as “post sale and other totaled $3.3 billion. revenue” and “finance income” revenue. In those arrangements that do not qualify as sales-type leases, which has been starting to occur more frequently as a result of our services-led strategy, the entire monthly payment will be recognized over the term of the lease agreement (i.e., rental or operating lease) and is reported in “post sale and other revenue.” Our accounting Revenue policies related to revenue recognition for leases and bundled arrangements are included in Note 1 to the Consolidated Financial Statements in our 2005 Annual Report. Revenue Stream 29% $100 Approximately 29% of our revenue 80 comes from Equipment sales, from either lease arrangements that 60 qualify as sales for accounting purposes or outright cash sales. 40 71% 20 The remaining 71% of our revenue, “Post sale and financing,” includes annuity-based revenue from maintenance, service, supplies and financing, as well as revenue from rentals or operating lease arrangements. Xerox Annual Repor t 2005 21

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    DESCRIPTION OF BUSINESS Research and Development Patents, Trademarks and Licenses Investment in R&D is critical to drive future growth and we We are a technology company. With our PARC subsidiary, we have aligned our investments with our strategic planks: Office, were awarded nearly 450 U.S. utility patents in 2005, ranking Production and Services. Our goal is to continue to create us 35th on the list of companies that had been awarded the innovative technologies that will expand current and future most U.S. patents during the year. With our research partner, markets. Our R&D investments employ three key themes: Fuji Xerox, we were awarded nearly 650 U.S. utility patents in 1) continue to reinvent our machines to deliver better quality, 2005. Our patent portfolio evolves as new patents are awarded more functionality and improved productivity, 2) rethink how to us and as older patents expire. As of December 31, 2005, people work, including the use of variable information printing we held approximately 8,100 design and utility U.S. patents. to customize documents and 3) redefine the document through These patents expire at various dates up to 20 years or more new inventions. Our research scientists regularly meet with from their original filing dates. While we believe that our portfolio customers and have dialogues with our business groups to of patents and applications has value, in general no single ensure they understand customer requirements and develop patent is essential to our business or any individual segment. products and solutions that can be commercialized. In addition, any of our proprietary rights could be challenged, invalidated or circumvented, or may not provide significant In 2005, R&D expense was $755 million, compared with competitive advantages. $760 million in 2004. 2005 R&D spending focused primarily on the development of high-end business applications to drive the In the U.S., we are party to numerous patent licensing agreements, “New Business of Printing,” on extending our color capabilities, and in a majority of them, we are a licensee. Most of the patent and on lower-cost platforms and customer productivity enablers licenses expire concurrently with the expiration of the last patent to drive digitization of the office. The Xerox iGen3, an advanced identified in the license. In 2005, with our PARC subsidiary, we next-generation digital printing press launched in October added approximately 15 agreements to our portfolio of patent 2002 that uses our patented imaging technology to produce licensing agreements, and either we or our PARC subsidiary photographic-quality prints indistinguishable from offset, was a licensor in 13 of the agreements. Xerox’s licensing efforts is an example of the type of breakthrough technology we include a number of cross-licensing agreements with companies developed and that we expect will drive future growth. with substantial patent portfolios. Those agreements vary in In addition, sustaining engineering expenses reported within subject matter, scope, compensation, significance and time. R,D&E, were $188 million in 2005 and $154 million in 2004. Among the more recent licenses are agreements with Canon, Microsoft, IBM and Hewlett-Packard. In the U.S., we own approximately 560 trademarks (either registered or applied for). These trademarks have a perpetual Xerox Research, Development and Engineering Expenses life, subject to renewal every ten years. We vigorously enforce and protect our trademarks. We hold a perpetual trademark ($ millions) $943 $1000 license for “DocuColor.” 800 600 $914 400 200 05 04 Our R&D is strategically coordinated with that of Fuji Xerox, which invested $720 million in R&D in 2005 and $704 million in 2004. 22 Xerox Annual Repor t 2005

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    Xerox Corporation Competition Marketing and Distribution Although we encounter aggressive competition in all areas of We manage our business based on the principal business segments our business, we are the leader, or among the leaders, in each described above. The marketing and selling of our products and of our principal business segments. Our competitors range solutions, however, are organized according to geography and from large international companies to relatively small firms. channel types. Our products and solutions are sold directly to We compete primarily on the basis of technology, performance, customers by our worldwide sales force of approximately 8,000 price, quality, reliability, brand, distribution, and customer service employees and through a network of independent agents, dealers, and support. To remain competitive, we invest in and develop value-added resellers and systems integrators. Increasingly, we new products and services and continually enhance our existing are utilizing our direct sales force to address our customers' offerings. Our key competitors include Canon, Ricoh, IKON, more advanced technology, solutions and services requirements, Hewlett-Packard and, in certain areas of the business, Pitney while expanding our use of cost-effective indirect distribution Bowes, Kodak, Oce, Konica-Minolta and Lexmark. channels, such as Teleweb, for basic product offerings. We believe that our brand recognition, reputation for document We market our Phaser line of color and monochrome laser-class knowledge and expertise, innovative technology, breadth of and solid ink printers through office information technology product offerings, global distribution channels and our customer industry resellers, who typically access our products through relationships and large customer base are important competitive distributors. In 2005, we increased the product offerings advantages. We and our competitors continue to develop and available through a two-tiered distribution model in Europe market new and innovative products at competitive prices and, and DMO. Through a multi-phased roll-out, we will continue to at any given time, we may set new market standards for quality, increase offerings through this lower-cost distribution channel speed and function. for our Office portfolio. Additionally, we expanded our distribution channels in North America in 2005. 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 (collectively "Xerox Limited"). Xerox Limited enters into distribution agreements with unaffiliated third parties covering distribution of our products in certain countries located in these regions, including Iran, Sudan and Syria. Iran, Sudan and Syria, among others, have been designated as state sponsors of terrorism by the U.S. 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 applicable U.S. laws and government regulations related to these countries. In addition, we had no assets, liabilities or operations in these countries other than liabilities under the distribution agreements. As a result of the termination of these agreements, we anticipate that our revenues attributable to these countries will decline over time. Xerox Limited is terminating its distribution agreements related to these countries and expects that, by the end of 2006, it will have only legacy obligations such as providing spare parts and supplies to these third parties. In 2005, we had total revenues of $15.7 billion, of which less than $10 million was attributable to Iran, Sudan and Syria. Xerox Annual Repor t 2005 23

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    DESCRIPTION OF BUSINESS In January 2006, Xerox Limited entered into a five-year Manufacturing Outsourcing distribution agreement with an unaffiliated third party covering distribution of our products in Libya. Libya is also designated In the fourth quarter of 2001, we outsourced certain manufac- as a state sponsor of terrorism by the U.S. Department of State. turing activities for the Office segment to Flextronics, a global The decision to enter into this distribution agreement was made electronics manufacturing services company. Our inventory in light of recent U.S. federal government actions that have purchases from Flextronics currently represent approximately lifted the country-wide embargo previously imposed on Libya. 25% of our overall worldwide inventory procurement. The initial Our sales in Libya through this distribution agreement will be term of the Flextronics supply agreement is five years through subject to our export and sanctions compliance program and November 2006, and is subject to our right to extend for two will be in accordance with applicable U.S. laws and government years. Thereafter, it will automatically be renewed for one-year regulations as they relate to Libya. periods, unless either party elects to terminate the agreement. We have agreed to purchase from Flextronics most of our We are increasing our use of partners to improve our market requirements for certain products in specified product families. coverage. Through alliances with Premier Partners and Fuji Flextronics must acquire inventory in anticipation of meeting our Ennovation, we expanded coverage to market our DocuColor forecasted requirements and must maintain sufficient manufac- series to commercial printers. Our alliance with Electronic turing capacity to satisfy such forecasted requirements. Under Data Systems ("EDS") is designed to integrate EDS' information certain circumstances, we may become obligated to repurchase technology ("IT") services with our document management inventory that remains unused for more than 180 days, becomes systems and services to provide customers with full IT obsolete or upon termination of the supply agreement. infrastructure support. In addition, Xerox sources certain other Office products from Our brand is a valuable resource and continues to be recognized various third parties, to maximize breadth of its product portfolio in the top ten percent of all U.S. brands. and to meet channel requirements. Xerox also has arrangements with Fuji Xerox whereby it purchases products from and sells products to Fuji Xerox. Certain of these purchases and sales are Service the result of mutual research and development arrangements. As of December 31, 2005, we had a worldwide service force Our remaining manufacturing operations are primarily located of approximately 13,000 employees and an extensive network in Rochester, New York, and Dundalk, Ireland, for our high-end of independent service agents. We are expanding our use of production products and consumables and Wilsonville, Oregon, cost-effective remote service technology for basic product for solid ink products, consumable supplies and components offerings while utilizing our direct service force and a variable for our Office segment products. 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 is continually trained on our products and their diagnostic equipment is state-of-the-art. Twenty-four-hours-a-day, seven-days-a-week service is available in major metropolitan areas around the world. As a result, we are able to provide a consistent and superior level of service worldwide. 24 Xerox Annual Repor t 2005

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    Xerox Corporation Fuji Xerox Other Information Fuji Xerox Co., Limited is an unconsolidated entity in which Xerox is a New York corporation and our principal executive we currently own 25% and Fuji Photo Film Co., Ltd. (“FujiFilm”) offices are located at 800 Long Ridge Road, P. O. Box 1600, owns 75%. Fuji Xerox develops, manufactures and distributes Stamford, Connecticut 06904-1600. Our telephone number is document processing products in Japan, China, Hong Kong (203) 968-3000. and other areas of the Pacific Rim, Australia and New Zealand. Through the Investor Information section of our Internet website, We retain significant rights as a minority shareholder. Our our Annual Reports on Form 10-K, Quarterly Reports on Form technology licensing agreements with Fuji Xerox ensure that 10-Q, Current Reports on Form 8-K and all related amendments the two companies retain uninterrupted access to each other’s are available, free of charge, as soon as reasonably practicable portfolio of patents, technology and products. after such material is electronically filed with or furnished to the Securities and Exchange Commission. Our Internet address is http://www.xerox.com. International Operations Certain financial measures by geographical area for 2005, 2004 and 2003, included in Note 2 to the Consolidated Financial Statements in our 2005 Annual Report, are hereby incorporated by reference. Backlog We believe that backlog, or the value of unfilled orders, is not a meaningful indicator of future business prospects due to the significant proportion of our revenue that follows equipment installation, the large volume of products delivered 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. Xerox Annual Repor t 2005 25

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    M A N A G E M E N T ’ S D I S C U S S I O N A N D A N A LY S I S O F R E S U LT S O F O P E R A T I O N S A N D F I N A N C I A L C O N D I T I O N The following Management’s Discussion and Analysis (“MD&A”) is Financial Overview intended to help the reader understand the results of operations and financial condition of Xerox Corporation. MD&A is provided In 2005, we expanded earnings and made significant progress as a supplement to, and should be read in conjunction with, our in positioning ourselves for revenue growth while significantly consolidated financial statements and the accompanying notes. improving our overall financial condition and liquidity. Our continued focus on investment in the growing areas of digital Throughout this document, references to “we,” “our,” the “Company” production and office systems, particularly with respect to color and “Xerox” refer to Xerox Corporation and its subsidiaries. products, contributed to equipment sales growth, as the majority References to “Xerox Corporation” refer to the stand-alone parent of our equipment sales were generated from products launched company and do not include its subsidiaries. in the last two years. Total revenue was comparable to the prior year, as modest equipment sales growth was offset by declines in finance income. Post sale and other was comparable to Executive Overview the prior year. Color revenue was up 19% over the prior year, We are a technology and services enterprise and a leader in the reflecting our investments in this market. global document market, developing, manufacturing, marketing, We maintained our focus on cost management throughout 2005. servicing and financing the industry’s broadest portfolio of docu- While 2005 gross margins were slightly below 2004, we continued ment equipment, solutions and services. Our industry is undergoing to more than offset lower prices with productivity improvements. a series of transformations from older technology light-lens Gross margins were impacted by a change in overall product devices to digital systems, from black and white to color, and mix reflecting a higher proportion of sales of products with lower from paper documents to an increased reliance on electronic gross margins. We reduced selling, administrative and general documents. We believe we are well positioned as these trans- (“SAG”) expenses as administrative and general expense effi- formations play to our strengths and represent opportunities for ciencies, and reductions in bad debt expense more than offset future growth, since our research and development investments increased selling expenses. We continued to invest in research have been focused on digital and color offerings. and development, prioritizing our investments in the faster- We operate in competitive markets and our customers demand growing areas of the market. In addition, we reduced interest improved solutions, such as the ability to print offset-quality color expense by decreasing debt by over $2.8 billion during the year. documents on demand; improved product functionality, such To understand the trends in the business, we believe that it is as the ability to print, copy, fax and scan from a single device; helpful to analyze the impact of changes in the translation of and lower prices for the same functionality. Customers are also foreign currencies into U.S. dollars on revenue and expense growth. increasingly demanding document services such as consulting We refer to this analysis as “currency impact” or “the impact from and assessments, managed services, imaging and hosting, and currency.” Revenues and expenses from our Developing Markets document-intensive business process improvements. Operations are analyzed at actual exchange rates for all periods We deliver advanced technology through focused investment presented, since these countries generally have volatile currency in research and development and offset lower prices through and inflationary environments, and our operations in these countries continuous improvement of our cost base. The majority of have historically implemented pricing actions to recover the impact our revenue is recurring revenue (supplies, service, paper, out- of inflation and devaluation. We do not hedge the translation effect sourcing and rentals), which we collectively refer to as post sale of revenues or expenses denominated in currencies where the local revenue. Post sale revenue is heavily dependent on the amount currency is the functional currency. of equipment installed at customer locations and the utilization A substantial portion of our consolidated revenue is derived of those devices. As such, our critical success factors include from operations outside of the United States where the U.S. dollar hardware installations, which stabilize and grow our installed base is not the functional currency. When compared with the average of equipment at customer locations, page volume growth and of the major European currencies on a revenue-weighted basis, higher revenue per page. Connected multifunction devices, new the U.S. dollar was largely unchanged in 2005, 10% weaker in services and solutions are key drivers to increase equipment 2004 and 17% weaker in 2003. As a result, the foreign currency usage. The transition to color is the primary driver to improve translation impact on revenue was negligible in 2005. For 2004 revenue per page, as color documents typically require signifi- and 2003, foreign currency translation had a 3-percentage point cantly more toner coverage per page than traditional black and and 5-percentage point favorable impact, respectively. white printing. Revenue per color page is approximately five times higher than revenue per black and white page. 26 Xerox Annual Repor t 2005

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    Xerox Corporation Our 2005 balance sheet strategy focused on reducing our total our credit rating to investment grade; optimizing operating cash debt, optimizing operating cash flows and matching our remaining flows; achieving an optimal cost of capital; rebalancing secured debt portfolio to support our customer financing operations. The and unsecured debt; and effectively deploying cash to deliver and successful implementation of this strategy in 2005 enabled us to maximize long-term shareholder value. In addition, our strategy significantly improve our liquidity and finish the year with a cash, includes maintaining our current leverage of financing assets cash equivalents and short-term investments balance of $1.6 (finance receivables and equipment on operating leases) and billion. Our prospective balance sheet strategy includes: returning maintenance of a minimal level of non-financing debt. Revenues for the three years ended December 31, 2005 were as follows: Year Ended December 31, Percent Change (in millions) 2005 2004 2003 2005 2004 Equipment sales $ 4,519 $ 4,480 $ 4,250 1% 5% Post sale and other revenue 10,307 10,308 10,454 – (1)% Finance income 875 934 997 (6)% (6)% Total Revenues $15,701 $15,722 $15,701 – – Total Color revenue included in total revenues $ 4,634 $ 3,903 $ 3,267 19% 19% The following presentation reconciles the above information to the • Comparable Post sale and other revenues, including a negligible revenue classifications included in our Consolidated Statements impact from currency, primarily reflecting revenue growth from of Income: digital products and in DMO, which were partially offset by declines in light lens. (in millions) • 6% decline in Finance income including benefits from currency Year Ended December 31, 2005 2004 2003 of 1-percentage point, which reflects lower finance receivables. Sales $ 7,400 $ 7,259 $ 6,970 Less: Supplies, paper Total 2004 revenues of $15.7 billion increased modestly as and other sales (2,881) (2,779) (2,720) compared to 2003 including a 3-percentage point benefit from Equipment Sales $ 4,519 $ 4,480 $ 4,250 currency. Total 2004 revenues included the following: Service, outsourcing • 5% growth in Equipment sales, reflecting the success of our and rentals $ 7,426 $ 7,529 $ 7,734 color and digital light production products and a 3-percentage Add: Supplies, paper point benefit from currency. and other sales 2,881 2,779 2,720 • 1% decline in Post sale and other revenues due to declines in Post sale and other revenue $10,307 $10,308 $10,454 older light-lens technology products and Developing Market Operations (“DMO”), driven by Latin America, were partially Total 2005 revenues of $15.7 billion were comparable to offset by growth in digital office and production color, as well the prior-year period. Currency impacts on total revenues as a 3-percentage point benefit from currency. The light-lens were negligible for the year. Total 2005 revenues included and DMO declines reflect a reduction of equipment at customer the following: locations and related page volume declines. As our equipment • 1% growth in Equipment sales, including a negligible impact sales continue to increase, we expect the effects of post sale from currency, primarily reflecting revenue growth from color in declines will moderate and ultimately reverse over time. Office and Production, low-end black and white office products • 6% decline in Finance income, including a 4-percentage point as well as growth in DMO. These growth areas were partially benefit from currency, which reflects a decrease in equipment offset by revenue declines in higher-end office black and white lease originations over the past several years. products, and black and white production products. Xerox Annual Repor t 2005 27

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    M A N A G E M E N T ’ S D I S C U S S I O N A N D A N A LY S I S O F R E S U LT S O F O P E R A T I O N S A N D F I N A N C I A L C O N D I T I O N Net income and diluted earnings per share for the three years Application of Critical Accounting Policies ended December 31, 2005 were as follows: In preparing our Consolidated Financial Statements and accounting (in millions, except share amounts) for the underlying transactions and balances, we apply various Year Ended December 31, 2005 2004 2003 accounting policies. We consider the policies discussed below as critical to understanding our Consolidated Financial Statements, Net income $ 978 $ 859 $ 360 as their application places the most significant demands on Preferred stock dividends (58) (73) (71) management’s judgment, since financial reporting results rely on Income available to estimates of the effects of matters that are inherently uncertain. common shareholders $ 920 $ 786 $ 289 Specific risks associated with these critical accounting policies Diluted earnings per share $0.94 $0.86 $0.36 are discussed throughout this MD&A where such policies affect our reported and expected financial results. For a detailed dis- 2005 Net income of $978 million, or 94 cents per diluted share, cussion of the application of these and other accounting policies, included the following: refer to Note 1 to the Consolidated Financial Statements. • $343 million after-tax benefit related to the finalization of the Senior management has discussed the development and 1996-1998 IRS audit. selection of the critical accounting policies, estimates and related • $84 million after-tax ($115 million pre-tax) charge for litigation disclosures, included herein, with the Audit Committee of the Board matters relating to the MPI arbitration panel decision and of Directors. Preparation of this annual report requires us to make probable losses for other legal matters. estimates and assumptions that affect the reported amount of • $58 million after-tax ($93 million pre-tax) gain related to the sale assets and liabilities, as well as disclosure of contingent assets of our entire equity interest in Integic Corporation (“Integic”). and liabilities. These estimates and assumptions also impact • $247 million after-tax ($366 million pre-tax) restructuring charges. 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 2004 Net income of $859 million, or 86 cents per diluted share, different estimates could reasonably have been used in the included the following: current period, we have disclosed the impact on our operations • $83 million after-tax ($109 million pre-tax) gain related to the of these different estimates. In certain instances, such as with sale of substantially all of our investment in ContentGuard respect to revenue recognition for leases, because the accounting Holdings, Inc. (“ContentGuard”). rules are prescriptive, it would not have been possible to have • $38 million after-tax pension settlement benefit from Fuji Xerox. reasonably used different estimates in the current period. In these • $30 million after-tax ($38 million pre-tax) gain from the sale of instances, use of sensitivity information would not be appropriate. our investment in ScanSoft, Inc. (“ScanSoft”). Changes in assumptions and estimates are reflected in the • $57 million after-tax ($86 million pre-tax) restructuring charges. 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. 2003 Net income of $360 million, or 36 cents per diluted share, included the following: Revenue Recognition Under Bundled Arrangements: We sell most • $146 million after-tax ($239 million pre-tax) charge related to of our products and services under bundled lease arrangements, the court-approved settlement of the Berger v. RIGP litigation. which typically include equipment, service, supplies and financing • $111 million after-tax ($176 million pre-tax) restructuring components for which the customer pays a single negotiated monthly fixed price for all elements over the contractual lease charges. term. These arrangements typically also include an incremental, • $45 million after-tax ($73 million pre-tax) loss on early variable component for page volumes in excess of contractual extinguishment of debt and income tax benefits of $35 million page volume minimums, which are often expressed in terms of from the reversal of deferred tax asset valuation allowances. 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 deliver- ables 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. 28 Xerox Annual Repor t 2005

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    Xerox Corporation The remaining amounts are allocated to the equipment and Accounts and Finance Receivables Allowance for Doubtful Accounts financing elements. We perform extensive analyses of available and Credit Losses: We perform ongoing credit evaluations of our verifiable objective evidence of equipment fair value based on customers and adjust credit limits based upon customer payment cash selling prices during the applicable period. The cash selling history and current creditworthiness. We continuously monitor prices are compared to the range of values included in our lease collections and payments from our customers and maintain a accounting systems. The range of cash selling prices must be provision for estimated credit losses based upon our historical reasonably consistent with the lease selling prices, taking into experience and any specific customer collection issues that have account residual values that accrue to our benefit, in order for us been identified. While such credit losses have historically been to determine that such lease prices are indicative of fair value. within our expectations and the provisions established, we cannot Our pricing interest rates, which are used in determining customer guarantee that we will continue to experience credit loss rates payments, are developed based upon a variety of factors including similar to those we have experienced in the past. Measurement of local prevailing rates in the marketplace and the customer’s such losses requires consideration of historical loss experience, credit history, industry and credit class. Effective in 2004, our including the need to adjust for current conditions, and judgments pricing rates are reassessed quarterly based on changes in local about the probable effects of relevant observable data, including prevailing rates in the marketplace and are adjusted to the extent present economic conditions such as delinquency rates and such rates vary by twenty-five basis points or more, cumulatively, financial health of specific customers. We recorded bad debt from the last rate in effect. The pricing interest rates generally provisions of $72 million, $110 million and $224 million in equal the implicit rates within the leases, as corroborated by our selling, administrative and general expenses in our Consolidated comparisons of cash to lease selling prices. Statements of Income for the years ended December 31, 2005, 2004 and 2003, respectively. The declining trend in our provision Revenue Recognition for Leases: Our accounting for leases for doubtful accounts is primarily due to improvements in customer involves specific determinations under applicable lease accounting administration, receivables aging, write-off trends, collection standards, which often involve complex and prescriptive provi- practices and credit approval policies. sions. These provisions affect the timing of revenue recognition for our equipment. If the leases qualify as sales-type capital leases, As discussed above, in preparing our Consolidated Financial equipment revenue is recognized upon delivery or installation of Statements for the three years ended December 31, 2005, the equipment as sale revenue as opposed to ratably over the we estimated our provision for doubtful accounts based on lease term. The critical elements that we consider with respect historical experience and customer-specific collection issues. to our lease accounting are the determination of the economic life This methodology has been consistently applied for all periods and the fair value of equipment, including the residual value. For presented. During the five-year period ended December 31, purposes of determining the economic life, we consider the most 2005, our allowance for doubtful accounts ranged from 3.6% objective measure to be the original contract term, since most to 5.5% of gross receivables. Holding all other assumptions equipment is returned by lessees at or near the end of the con- constant, a 1-percentage point increase or decrease in the tracted term. The economic life of most of our products is five allowance from the December 31, 2005 rate of 3.6% would years, since this represents the most frequent contractual lease change the 2005 provision by approximately $100 million. term for our principal products and only a small percentage of our Historically, about half of the provision for doubtful accounts leases are for original terms longer than five years. There is no relates to our finance receivables portfolio. This provision is significant after-market for our used equipment. We believe five inherently more difficult to estimate than the provision for trade years is representative of the period during which the equipment accounts receivable because the underlying lease portfolio is expected to be economically usable, with normal service, for has an average maturity, at any time, of approximately two to the purpose for which it is intended. Residual values are estab- three years and contains past due billed amounts, as well as lished at lease inception using estimates of fair value at the unbilled amounts. The estimated credit quality of any given end of the lease term and are established with due consideration customer and class of customer or geographic location can to forecasted supply and demand for our various products, significantly change during the life of the portfolio. We consider product retirement and future product launch plans, end-of-lease all available information in our quarterly assessments of the customer behavior, remanufacturing strategies, competition adequacy of the provision for doubtful accounts. and technological changes. 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 Xerox Annual Repor t 2005 29

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    M A N A G E M E N T ’ S D I S C U S S I O N A N D A N A LY S I S O F R E S U LT S O F O P E R A T I O N S A N D F I N A N C I A L C O N D I T I O N the expense, liability and asset values related to our pension and outflows related to the bonds. In the U.S. and the U.K., which post-retirement benefit plans. These factors include assumptions comprise approximately 81% of our projected benefit obligations, we make about the discount rate, expected return on plan assets, we consider the Moody’s Aa Corporate Bond Index and the rate of increase in healthcare costs, the rate of future compen- International Index Company’s iBoxx Sterling Corporates AA Cash sation increases and mortality, among others. For purposes of Bond Index, respectively, in the determination of the appropriate determining the expected return on plan assets, we utilize a discount rate assumptions. The weighted average rate we will calculated value approach in determining the value of the pension utilize to measure our pension obligation as of December 31, 2005 plan assets, as opposed to a fair market value approach. The and calculate our 2006 expense will be 5.2%, which is a decrease primary difference between the two methods relates to a systematic from 5.6% used in determining 2005 expense. Primarily as a recognition of changes in fair value over time (generally two result of the reduction in the discount rate, our 2006 net periodic years) versus immediate recognition of changes in fair value. pension cost is expected to be $32 million higher than 2005. Our expected rate of return on plan assets is then applied to the On a consolidated basis, we recognized net periodic pension calculated asset value to determine the amount of the expected cost of $343 million, $350 million and $364 million for the return on plan assets to be used in the determination of the net years ended December 31, 2005, 2004 and 2003, respectively. periodic pension cost. The calculated value approach reduces Pension cost is included in several income statement components the volatility in net periodic pension cost that results from using based on the related underlying employee costs. Pension and the fair market value approach. The difference between the actual post-retirement benefit plan assumptions are included in Note return on plan assets and the expected return on plan assets is 14 to the Consolidated Financial Statements. Holding all other added to, or subtracted from, any cumulative differences that assumptions constant, a 0.25% increase or decrease in the arose in prior years. This amount is a component of the unrecog- discount rate would change the 2006 projected net periodic nized net actuarial (gain) loss and is subject to amortization to pension cost by approximately $35 million. Likewise, a 0.25% net periodic pension cost over the average remaining service increase or decrease in the expected return on plan assets lives of the employees participating in the pension plan. would change the 2006 projected net periodic pension cost As a result of cumulative historical asset returns being lower than by approximately $15 million. expected asset returns, as well as declining interest rates, 2006 Income Taxes and Tax Valuation Allowances: We record the net periodic pension cost will increase. The total unrecognized estimated future tax effects of temporary differences between actuarial loss as of December 31, 2005 was $1.9 billion, as the tax bases of assets and liabilities and amounts reported in compared to $2.0 billion at December 31, 2004. The change our Consolidated Balance Sheets, as well as operating loss and from December 31, 2004 relates to improved asset returns as tax credit carryforwards. We follow very specific and detailed compared to expected returns, partially offset by a decline in guidelines in each tax jurisdiction regarding the recoverability of the discount rate. The total unrecognized actuarial loss will be any tax assets recorded in our Consolidated Balance Sheets and amortized in the future, subject to offsetting gains or losses that provide necessary valuation allowances as required. We regularly will change the future amortization amount. We have recently review our deferred tax assets for recoverability considering utilized a weighted average expected rate of return on plan assets historical profitability, projected future taxable income, the of 8.0% for 2005 expense, 8.1% for 2004 expense and 8.3% for expected timing of the reversals of existing temporary differences 2003 expense, on a worldwide basis. In estimating this rate, we and tax planning strategies. If we continue to operate at a loss considered the historical returns earned by the plan assets, the in certain jurisdictions or are unable to generate sufficient future rates of return expected in the future and our investment strategy taxable income, or if there is a material change in the actual and asset mix with respect to the plans’ funds. The weighted effective tax rates or time period within which the underlying average expected rate of return on plan assets we will utilize to temporary differences become taxable or deductible, we could calculate our 2006 expense will be 7.8%. be required to increase the valuation allowance against all or Another significant assumption affecting our pension and post- a significant portion of our deferred tax assets, resulting in retirement benefit obligations and the net periodic pension and a substantial increase in our effective tax rate and a material other post-retirement benefit cost is the rate that we use to adverse impact on our operating results. Conversely, if and when discount our future anticipated benefit obligations. The discount our operations in some jurisdictions were to become sufficiently rate reflects the current rate at which the pension liabilities could profitable to recover previously reserved deferred tax assets, we be effectively settled considering the timing of expected payments would reduce all or a portion of the applicable valuation allowance for plan participants. In estimating this rate, we consider rates of in the period when such determination is made. This would result return on high-quality fixed-income investments included in various in an increase to reported earnings in such period. Adjustments to published bond indexes, adjusted to eliminate the effects of call our valuation allowance, through (credits) charges to income tax provisions and differences in the timing and amounts of cash expense, were $(38) million, $12 million, and $(16) million for the years ended December 31, 2005, 2004 and 2003, respectively. There were other increases/(decreases) to our valuation 30 Xerox Annual Repor t 2005

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    Xerox Corporation allowance, including the effects of currency, of $61 million, including activity-based cost analysis on shared services and $(21) million and $69 million for the years ended December 31, internal cost allocations. As a result of the implementation, we 2005, 2004 and 2003, respectively, that did not affect income made changes to the allocation of certain segment costs and tax expense in total, as there was a corresponding adjustment expenses. These changes included a reallocation of costs to deferred tax assets or other comprehensive income. Gross associated with corporate and certain shared service functions. deferred tax assets of $3.6 billion and $3.5 billion had valuation These changes did not involve a change in the composition of allowances of $590 million and $567 million at December 31, our reportable segments and did not impact segment revenue. 2005 and 2004, respectively. We have reclassified prior-period amounts to conform to the current period’s presentation. We are subject to ongoing tax examinations and assessments in various jurisdictions. Accordingly, we may incur additional tax Our reportable segments are consistent with how we manage the expense based upon our assessment of the probable outcomes business and view the markets we serve. Our reportable segments of such matters. In addition, when applicable, we adjust the are Production, Office, DMO and Other. Our offerings include previously recorded tax expense to reflect examination results. hardware, services, solutions and consumable supplies. The Our ongoing assessments of the probable outcomes of the Production segment includes black and white products, which examinations and related tax positions require judgment and operate at speeds over 90 pages per minute (“ppm”) and color can materially increase or decrease our effective tax rate as products which operate at speeds over 40 ppm, excluding 50 well as impact our operating results. ppm products with an embedded controller. Products include the Xerox iGen3® digital color production press, Xerox Nuvera™, Legal Contingencies: We are involved in a variety of claims, DocuTech®, DocuPrint®, Xerox 4110™ and DocuColor® families, lawsuits, investigations and proceedings concerning securities as well as older technology light-lens products. These products law, intellectual property law, environmental law, employment law are sold predominantly through direct sales channels in North and ERISA, as discussed in Note 16 to the Consolidated Financial America and Europe to Fortune 1000, graphic arts, government, Statements. We determine whether an estimated loss from a education and other public sector customers. The Office segment contingency should be accrued by assessing whether a loss is includes black and white products that operate at speeds up to deemed probable and can be reasonably estimated. We assess 90 ppm, and color devices up to 40 ppm, as well as 50 ppm our potential liability by analyzing our litigation and regulatory color devices with an embedded controller. Products include the matters using available information. We develop our views on suite of CopyCentre®, WorkCentre® and WorkCentre Pro digital estimated losses in consultation with outside counsel handling our multifunction systems, DocuColor color multifunction products, defense in these matters, which involves an analysis of potential color laser, solid ink and monochrome laser desktop printers, results, assuming a combination of litigation and settlement digital and light-lens copiers and facsimile products. These strategies. Should developments in any of these matters cause products are sold through direct and indirect sales channels a change in our determination as to an unfavorable outcome and in North America and Europe to global, national and mid-size result in the need to recognize a material accrual, or should any commercial customers as well as government, education and of these matters result in a final adverse judgment or be settled other public sector customers. The DMO segment includes our for significant amounts, they could have a material adverse effect operations in Latin America, Central and Eastern Europe, the on our results of operations, cash flows and financial position in Middle East, India, Eurasia, Russia and Africa. This segment the period or periods in which such change in determination, includes sales of products that are typical to the aforementioned judgment or settlement occurs. segments; however, management serves and evaluates these markets on an aggregate geographic basis, rather than on a product basis. The segment classified as Other includes several Summary of Results units, none of which met the thresholds for separate segment Segment Revenues reporting. This group primarily includes Xerox Supplies Business As discussed in Note 2 to the Consolidated Financial Statements, Group (predominantly paper), Small Office/Home Office (“SOHO”), operating segment financial information for 2004 and 2003 has Wide Format Systems, Xerox Technology Enterprises and value- been restated to reflect changes in operating segment structure added services, royalty and license revenues. Paper sales were made during 2005. In 2005, we implemented a new financial approximately 45% of Other segment revenues in 2005. Other reporting system, which has enabled greater efficiencies in segment profit (loss) includes the operating results from these financial reporting and provides enhanced analytical capabilities 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. Xerox Annual Repor t 2005 31

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    M A N A G E M E N T ’ S D I S C U S S I O N A N D A N A LY S I S O F R E S U LT S O F O P E R A T I O N S A N D F I N A N C I A L C O N D I T I O N Revenues by segment for the years ended 2005, 2004 and 2003 were as follows: (in millions) Production Office DMO Other Total 2005 Equipment sales $ 1,368 $ 2,436 $ 558 $ 157 $ 4,519 Post sale and other revenue 2,830 4,670 1,245 1,562 10,307 Finance income 342 512 9 12 875 Total Revenue $ 4,540 $ 7,618 $ 1,812 $ 1,731 $15,701 2004 Equipment sales $ 1,358 $ 2,431 $ 503 $ 188 $ 4,480 Post sale and other revenue 2,880 4,644 1,194 1,590 10,308 Finance income 352 552 10 20 934 Total Revenue $ 4,590 $ 7,627 $ 1,707 $ 1,798 $15,722 2003 Equipment sales $ 1,188 $ 2,426 $ 466 $ 170 $ 4,250 Post sale and other revenue 2,943 4,622 1,285 1,604 10,454 Finance income 376 594 12 15 997 Total Revenue $ 4,507 $ 7,642 $ 1,763 $ 1,789 $15,701 Equipment Sales Production Equipment sales reflect the results of our technology investments 2005 Equipment sales increased 1% from 2004, primarily reflecting and the associated product launches, as approximately two-thirds install growth with a negligible impact from currency, partially of 2005 equipment sales were generated from products launched offset by price declines of approximately 5% and product mix. over the past two years. During 2005, we launched 49 new Production system install activity for 2005 included the following: products including 6 products in the fourth quarter. • 30% growth in installs of production color products largely 2005 Equipment sales of $4.5 billion increased 1% from driven by strong iGen3 and DocuColor 240, 250, 7000 and 2004, reflecting: 8000 activity. • Negligible impact from currency. • 9% growth in installs of black and white production systems, reflecting the success of the 4110 light production system, • Growth in lower-end office black and white devices, color as well as growth in production publishing systems. printers, as well as office and production color systems, which more than offset declines in other monochrome office and 2004 Equipment sales increased 14% from 2003, as improved monochrome production products. product mix, installation growth and favorable currency of • Growth in color equipment sales of $306 million, or 22%, 4-percentage points more than offset price declines of approxi- from the prior comparable period. Color equipment sales mately 3%. Production system install activity for 2004 included represented 38% of total equipment sales versus 32% for the following: the prior-year comparable period. • Strong 2004 production color equipment install growth of 11% due to increased installations driven by the DocuColor 2004 Equipment sales of $4.5 billion increased 5% from 5252 and Xerox iGen3 digital color production press products. 2003, reflecting: • 2004 production monochrome equipment install growth of • 3-percentage point benefit from currency. 7% driven by the success of the Xerox 2101 copier/printer and • Market acceptance of our color and digital light production strong demand for the Xerox Nuvera 100 and 120 copier/printers, products. more than offset declines of 32% in production publishing, • Continued equipment sales growth, reflecting the success printing and older technology light lens products. of numerous products launched in the past two years, as the majority of 2004 equipment sales was generated from these products. • Continued color equipment sales growth in 2004 representing approximately one-third of total equipment sales. 32 Xerox Annual Repor t 2005

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    Xerox Corporation Office Post Sale and Other Revenue 2005 Equipment sales were comparable to 2004, including a Post sale revenue is largely a function of the equipment placed negligible impact from currency. Strong install growth was offset at customer locations, the volume of prints and copies that our by price declines of approximately 7% and product mix, which customers make on that equipment and the mix of color pages, reflected an increased proportion of lower-end equipment sales. as well as associated services. Office product install activity for 2005 included the following: 2005 Post sale and other revenues of $10.3 billion were • 22% install growth in black and white digital copiers and comparable to the prior year period, with our growth areas multifunction devices driven by strong sales of Segment 1 and (“digital office, digital production and value-added services”) 2 devices (11-30 ppm), which more than offset declines of collectively growing 5% and DMO growing 4%, more than Segment 3 to 5 devices (31-90 ppm). offsetting a 40% decline in analog light-lens products. Color • 51% install growth in office color multifunction systems driven post sale and other revenue grew 16% for 2005, and color in part by strong sales of the DocuColor 240/250, which was sales represented 26% of post sale and other revenue in 2005 announced during the second quarter of 2005. versus 22% in 2004. In 2005, approximately 7% of our pages • 111% improvement in install activity for color printers. were printed on color devices, which is up from 5% in 2004. Color pages generate around five times more revenue and 2004 Equipment sales were essentially unchanged from 2003, gross profit dollars than black and white pages. reflecting the following: 2004 Post sale and other revenues of $10.3 billion declined 1% • Installation growth of approximately 20% and favorable currency from 2003, including a 4-percentage point benefit from currency. of 3-percentage points were offset by moderating price declines These declines reflect lower equipment populations, as post sale of approximately 6% and the impact of product mix. Product mix revenue is largely a function of the equipment placed at customer reflected an increased proportion of low-end equipment due to locations, the volume of prints and copies that our customers very strong growth in office monochrome (“Segments 1 and 2”) make on that equipment and the mix of color pages, as well as of 30% as well as monochrome and color printers of 54%. associated services. 2004 supplies, paper and other sales of • Color printer growth of 74% primarily reflects the success of $2.8 billion (included within post sale and other revenue) the solid ink Phaser® 8400, the first product launched from our increased 2% from 2003, primarily reflecting currency benefits new solid ink platform in January 2004, as well as other color which offset declines in supplies. Supplies sales declined due printer introductions. to our exit from the SOHO business in 2001. 2004 service, outsourcing and rental revenue of $7.5 billion declined 3% from DMO 2003, as declines in rental and facilities management revenues Equipment sales in DMO consist primarily of Segment 1 and 2 more than offset benefits from currency. Declines in rental devices and office printers. Equipment sales in 2005 increased revenues primarily reflect reduced equipment populations within 11% from 2004, primarily reflecting strong growth in Eurasia and DMO and declines in facilities management revenues reflect Central and Eastern Europe. Equipment sales in 2004 increased consolidations by our customers as well as our prioritization 8% from 2003, primarily reflecting growth in Russia and Central of profitable contracts. and Eastern Europe offset by declines in Latin America, primarily Production: 2005 Post sale and other revenue declined 2% from driven by Brazil, and shift in product mix to lower segments. 2004, as declines in older light-lens technology were only partially Other offset by revenue growth from digital products. Currency impact 2005 Equipment sales declined 16% from 2004, driven by was negligible for 2005. 2004 Post sale and other revenue declined declines in value-added services. The decline in value-added 2% from 2003, as declines in monochrome products, driven services reflects the integration of a portion of our service primarily by lower page volumes, offset favorable mix from color contracts into our outsourcing business, the revenue from which page growth of approximately 40% as well as favorable currency. is included in the Office and Production segments. Other 2004 Office: 2005 Post sale and other revenue increased 1% from equipment sales grew 11% from 2003, primarily due to growth 2004, primarily reflecting a 1-percentage point benefit from in equipment sales associated with our value-added services currency and growth in digital black and white, color printing business and a 2-percentage point currency benefit. and color multifunctional products. These positive effects were partially offset by declines in older light-lens technology. 2004 post sale and other revenue improved modestly from 2003 as favorable mix to color pages, digital page growth and favorable currency were partially offset by declines in older technology light lens products. Xerox Annual Repor t 2005 33

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    M A N A G E M E N T ’ S D I S C U S S I O N A N D A N A LY S I S O F R E S U LT S O F O P E R A T I O N S A N D F I N A N C I A L C O N D I T I O N DMO: 2005 Post sale and other revenue grew 4% from 2004, 2006 Projected Revenues reflecting growth in Eurasia and Central and Eastern Europe, more than offsetting declines in Brazil. 2004 Post sale and other We expect 2006 Equipment sales will continue to grow, as we revenue declined 7% from 2003, primarily reflecting a decline in anticipate that new platforms and products launched during the Latin America’s rental equipment population. In response, we have past 2 years, and those planned in 2006, will enable us to further continued our transition to indirect distribution channels that is strengthen our market position. Excluding currency impacts, intended to increase, over time, the sales of office devices and compared to 2005, we expect 2006 Post sale and other revenue the associated supplies and service revenue. and financing income will grow following the transition to positive growth during the second half of 2005. Growth in post sale and Other: 2005 Post sale and other revenue declined 2% from 2004, other revenue and financing income will be driven by our success including a negligible impact from currency, as declines in SOHO at increasing the amount of our equipment at customer locations and other revenues were partially offset by growth in value-added and the volume of pages and mix of color pages generated on services. 2004 Post sale and other revenue declined 1% from that equipment. Excluding currency impacts, we expect 2006 2003, as declines in SOHO were essentially offset by currency total revenues to increase approximately 3% from 2005 levels. benefits and growth in value-added services as well as other activity. Segment Operating Profit Segment operating profit and operating margin for the three years ended December 31, 2005 were as follows: (in millions) Production Office DMO Other Total 2005 Operating Profit $427 $819 $ 64 $ 151 $1,461 Operating Margin 9.4% 10.8% 3.5% 8.7% 9.3% 2004 Operating Profit $511 $779 $ 35 $ (125) $1,200 Operating Margin 11.1% 10.2% 2.1% (7.0)% 7.6% 2003 Operating Profit $466 $790 $172 $ (440) $ 988 Operating Margin 10.3% 10.3% 9.8% (24.6)% 6.3% Production: 2005 Operating Profit declined $84 million and DMO: 2005 Operating Profit increased $29 million from 2004 operating margin declined 1.7-percentage points from 2004. and operating margin improved 1.4-percentage points from The declines primarily reflect reduced gross margins impacted 2004. These improvements primarily reflect increasing revenues by mix, and higher selling expenses, which were partially offset and operating margin contributions from Eurasia and Central and by improvements in G&A and R,D&E efficiencies. 2004 operating Eastern Europe. 2004 operating profit declined $137 million from profit increased $45 million and operating margin increased 2003, primarily reflecting results in Latin America, where the pace 0.8-percentage points from 2003. These increases primarily of revenue declines have exceeded cost and expense reductions. reflect R&D efficiencies and lower bad debt expenses, which Other: 2005 Operating Profit increased $276 million as were partially offset by lower gross margin. compared to 2004, principally due to: Office: 2005 Operating Profit increased $40 million and • Reduced interest expense of $157 million, primarily due to operating margin improved 0.6-percentage points from 2004. lower average debt balances. The improvements primarily reflect lower SAG, partially offset • Higher interest income of $63 million, which includes $57 million by lower gross margins impacted by mix and higher R,D&E. associated with the finalization of the 1996-1998 IRS audit. 2004 operating profit decreased $11 million and operating • An improvement in aggregate currency gains and losses of margin declined 0.1-percentage points from 2003. The declines primarily reflect lower gross margins, partially offset by lower $68 million. bad debt expense. • 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. 34 Xerox Annual Repor t 2005

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    Xerox Corporation 2004 operating loss improved by $315 million as compared 2005 Service, outsourcing and rentals gross margin of 43.3% to 2003, principally due to: increased 0.3-percentage points driven by cost improvements • Reduced interest expense of $127 million. of 2.6-percentage points, which more than offset price declines of 1.1-percentage points and product mix declines • An increase in equity income from Fuji Xerox of $93 million. of 0.9-percentage points. • Gain on sale of our interest in ScanSoft of $38 million. 2004 Service, outsourcing and rentals gross margin of 43.0% Gross Margins declined 1.3-percentage points from 2003. The majority of the Gross margins by revenue classification were as follows: decline is attributed to a change in product mix in the Office and Production segments as well as DMO results. Productivity Year Ended December 31, 2005 2004 2003 and cost improvements offset lower prices for the year. Total gross margin 41.2% 41.6% 42.6% 2005 Finance income gross margin of 62.7% declined 0.4-per- Sales 36.6% 37.4% 37.6% centage points due to interest costs specific to equipment Service, outsourcing and rentals 43.3% 43.0% 44.3% financing. Equipment financing interest is determined based on Finance income 62.7% 63.1% 63.7% an estimated cost of funds, applied against an estimated level of debt required to support our finance receivables. The esti- 2005 Gross margin of 41.2% decreased 0.4-percentage points mated cost of funds is primarily based on our secured borrowings from 2004, reflecting a decline in product mix of 1.3-percentage rates. The estimated level of debt is based on an assumed 7 to 1 points, reflecting a higher proportion of sales in office printer leverage ratio of debt/equity as compared to our average finance and light production systems. Price declines of 1.5-percentage receivables. This methodology has been consistently applied for points were more than offset by cost improvements of all periods presented. 2.3-percentage points. 2004 Finance income gross margin decreased 0.6-percentage 2004 Gross margin of 41.6% declined 1.0-percentage points points from 2003 due to interest costs specific to equipment from 2003. Approximately 0.8-percentage points of the decline financing. is due to product mix impacts from a greater proportion of lower gross margin products in the Office and Production segments. Research, development and engineering (“R,D&E”) of $943 million Approximately 0.6-percentage points of the decline reflects the in 2005 was $29 million higher than the prior year. We expect 2006 impact of DMO results. The decline in DMO results relates to R,D&E spending to approximate 6% of total revenue in 2006. Brazil’s revenue, which has declined faster than declines in its Research and development (“R&D”) of $755 million in 2005 cost levels and a shift in product mix to lower gross margin products decreased from the prior year by $5 million. This period-over- in various DMO geographies. Productivity improvements essentially period comparison reflects lower expenditures in the Production offset the impact of lower prices. segment, which were partially offset by increased spending in the 2005 Sales gross margin of 36.6% decreased 0.8-percentage Office segment. The lower spending in the Production segment points from 2004, driven by product mix declines of 1.5-percent- was a result of recent product launches, and cost efficiencies age points. Price declines of 2.2-percentage points were more that we captured from our platform development strategy. We than offset by cost improvements of 2.4-percentage points. invest in technological development, particularly in color, and Product mix reflects a higher proportion of sales of products with believe our R&D spending is sufficient to remain technologically lower gross margins, including office printers and light production competitive. Our R&D is strategically coordinated with that of systems, and a lower proportion of sales of products with higher Fuji Xerox, which invested $720 million and $704 million in R&D gross margins such as higher-end office black and white multi- in 2005 and 2004, respectively. 2004 R&D expense of $760 function devices and high-end production black and white systems. million was $108 million lower than the prior year, primarily due to improved efficiencies as we captured benefits from our 2004 Sales gross margin of 37.4% decreased 0.2-percentage platform development strategy as well as the commercial launch points from 2003. Approximately 0.4-percentage points of the of the Xerox iGen3. decline results from product mix and DMO results contributed 0.6-percentage points to the decline. Additionally, productivity Sustaining engineering costs of $188 million increased by improvements offset lower prices and other variances. $34 million from the prior year, based on increases in year-over- year product launches. Refer to Note 1 – “Basis of Presentation” and Note 19 – Research, Development and Engineering in the Consolidated Financial Statements for additional information. On average, the reclassification of sustaining engineering costs increased gross margins by approximately 1% for the year ended 2005. Xerox Annual Repor t 2005 35

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    M A N A G E M E N T ’ S D I S C U S S I O N A N D A N A LY S I S O F R E S U LT S O F O P E R A T I O N S A N D F I N A N C I A L C O N D I T I O N The following table illustrates the effects of our 2005 reclassification of our sustaining engineering costs from cost of sales to R,D&E: 2004 2005 (in millions) Q1 Q2 Q3 Q4 YTD Q1 Q2 Q3 Q4 YTD Total Sustaining Engineering (“SE”) $ 30 $ 41 $ 45 $ 38 $ 154 $ 42 $ 54 $ 46 $ 46 $ 188 Gross Margin %, with SE 39.8% 41.3% 41.3% 40.1% 40.6% 40.7% 39.0% 40.1% 40.3% 40.0% Gross Margin %, without SE 40.6% 42.4% 42.5% 41.0% 41.6% 41.8% 40.4% 41.3% 41.4% 41.2% R&D % revenue, without SE 5.0% 4.9% 5.1% 4.4% 4.8% 4.9% 4.8% 5.2% 4.4% 4.8% R,D&E % revenue, with SE 5.8% 5.9% 6.3% 5.3% 5.8% 6.0% 6.2% 6.4% 5.5% 6.0% Selling, Administrative and General Expenses (“SAG”): SAG expense information was as follows (in millions): Year Ended December 31, Amount Change 2005 2004 2003 2005 2004 Total SAG expenses $4,110 $4,203 $4,249 $ (93) $ (46) SAG as a percentage of revenue 26.2% 26.7% 27.1% (0.5)% (0.4)% In 2005, SAG expenses decreased primarily as a result of For the three years ended December 31, 2005, 2004 and 2003 the following: we recorded restructuring charges of $366 million, $86 million • An $86 million reduction in general and administrative (“G&A”) and $176 million, respectively, primarily related to the headcount expenses due to continued expense management initiatives. reductions of approximately 3,900, 1,900 and 2,000 employees, respectively, across all geographies and segments. The 2005 • A $38 million decrease in bad debt expense. restructuring initiatives are focused on implementing a flexible • A partially offsetting increase in selling expenses of $31 million workforce in our service operations, as well as creating cost from 2004 due to additional spending for advertising and efficiencies in our manufacturing and back-office support opera- marketing programs to support product launches and other tions. We expect prospective annual savings associated with the selling expenses, as well as special compensation payments 2005 actions to be approximately $290 million. The remaining related to the 2005 merit increase process. These increases restructuring reserve balance as of December 31, 2005 for all in selling expenses were partially offset by the absence of the programs was $236 million. In the next 12 months, we expect to $28 million Olympic marketing expense that occurred in 2004. spend approximately $212 million of this reserve. In 2004, SAG expenses decreased primarily as a result of Worldwide employment of 55,200 as of December 31, 2005 the following: declined approximately 2,900 from December 31, 2004, primarily reflecting reductions attributable to our restructuring • A $114 million decline in bad debt expense. programs and other attrition. Worldwide employment was • Reductions in G&A due to efficiencies from continued expense approximately 58,100 and 61,100 at December 31, 2004 management initiatives. and 2003, respectively. • An offsetting increase in selling expenses of $52 million Gain on Affiliate’s Sale of Stock: In 2003, we recorded cumulative from 2003, reflecting increased spending in selling and gains on an affiliate’s sale of stock of $13 million, reflecting our marketing initiatives, as well as unfavorable currency impacts proportionate share of the increase in equity of ScanSoft Inc., of $141 million. an equity investment. The gain resulted from ScanSoft’s issuance of stock in connection with its acquisition of Speechworks, Inc. Bad debt expense included in SAG was $72 million, $110 million ScanSoft is a developer of digital imaging software that enables and $224 million in 2005, 2004 and 2003, respectively. The users to leverage the power of their scanners, digital cameras 2005 reduction reflects improved collections performance, and other electronic devices. As discussed in Note 21 to the receivables aging and write-off trends. Bad debt expense as a Consolidated Financial Statements, in April 2004 we completed percent of total revenue was 0.5%, 0.7% and 1.4% for 2005, the sale of our ownership interest in ScanSoft. 2004 and 2003, respectively. 36 Xerox Annual Repor t 2005

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    Xerox Corporation Other Expenses, Net: Other expenses, net, for the three years ended December 31, 2005 consisted of the following: Year Ended December 31, Amount Change (in millions) 2005 2004 2003 2005 2004 Non-financing interest expense $ 231 $363 $522 $ (132) $ (159) Interest income (138) (75) (65) (63) (10) (Gain) loss on sales of businesses and assets (97) (61) 13 (36) (74) Currency losses, net 5 73 11 (68) 62 Amortization of intangible assets 38 37 36 1 1 Legal matters 115 9 242 106 (233) Minorities’ interests in earnings of subsidiaries 15 8 6 7 2 All other expenses, net 55 15 111 40 (96) $ 224 $369 $876 $(145) $(507) Non-financing Interest Expense: In 2005, non-financing interest Currency Gains and Losses: Currency gains and losses primarily expense decreased due to lower average debt balances as a result from the mark-to-market of foreign exchange contracts utilized result of scheduled term debt repayments and medium-term to hedge foreign currency-denominated assets and liabilities, the note redemptions, as well as the full-year effect of the December re-measurement of foreign currency-denominated assets and 2004 Capital Trust II liability conversion. 2004 non-financing liabilities and the mark-to-market impact of hedges of anticipated interest expense was $159 million lower than in 2003, primarily transactions, primarily future inventory purchases, for which we due to lower average debt balances as a result of the full-year do not generally apply cash flow hedge accounting treatment. effect of the June 2003 recapitalization and other scheduled In 2005, 2004 and 2003, currency losses totaled $5 million, term debt repayments. $73 million and $11 million, respectively. The decrease in 2005 Interest Income: Interest income is derived primarily from our from 2004 was primarily due to the strengthening of the U.S. invested cash and cash equivalent balances and interest resulting and Canadian Dollars against the Euro and the Yen in 2005, as from periodic tax settlements. In 2005, interest income increased compared to the weakening U.S. Dollar in 2004, and decreased primarily due to: costs of hedging foreign currency-denominated assets and • A $57 million increase associated with the previously liabilities due to lower spot/forward premiums in 2005. The disclosed settlement of the 1996-1998 IRS audit (refer increase in currency losses in 2004 from 2003 was primarily to Note 15 – Income and Other Taxes in the Consolidated due to the weakening U.S. Dollar in 2004 and increased costs Financial Statements). of hedging foreign currency-denominated assets and liabilities due to higher spot/forward premiums in 2004. • A $23 million increase primarily reflecting higher rates of return from our money market funds. Legal Matters: In 2005, legal matters costs consisted of • Partially offset by the absence of $26 million of interest the following: income related to a 2004 domestic tax refund. • $102 million, including $13 million for interest expense, related to the MPI arbitration panel ruling (refer to Note 16 – In 2004, interest income increased primarily as a result of $26 Contingencies in the Consolidated Financial Statements). million related to a domestic tax refund claim in 2004, partially • $13 million related to other legal matters, primarily reflecting offset by the absence of $13 million of interest income related charges for probable losses on cases that have not yet to Brazilian tax credits in 2003. been resolved. (Gain) Loss on Sales of Businesses and Assets: In 2005, gain on sales of businesses and assets primarily relate to the $93 million In 2004, legal matters costs consist of expenses associated gain in the first quarter on the sale of Integic. In 2004, gains on with the resolution of legal and regulatory matters, none the sale of businesses and assets primarily reflect the $38 million of which was individually material, partially offset by the pre-tax gain from the sale of our ownership interest in ScanSoft, adjustment of an estimate associated with a previously as well as gains totaling $14 million related to the sale of certain recorded litigation accrual. excess land and buildings in Europe and Mexico. The 2003 amount primarily included losses related to the sale of Xerox Engineering Systems subsidiaries in France and Germany, which were partially offset by a gain on the sale of our investment in Xerox South Africa. Xerox Annual Repor t 2005 37

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    M A N A G E M E N T ’ S D I S C U S S I O N A N D A N A LY S I S O F R E S U LT S O F O P E R A T I O N S A N D F I N A N C I A L C O N D I T I O N In 2003, legal matters costs primarily consisted of a $239 • These impacts were partially offset by losses in certain million provision for litigation relating to the court-approved jurisdictions where we are not providing tax benefits and settlement of the Berger v. Retirement Income Guarantee Plan continue to maintain deferred tax valuation allowances. (“RIGP”) litigation. RIGP represents the primary U.S. pension plan for salaried employees. The settlement was paid from The 2004 effective tax rate of 35.2% was comparable to the RIGP assets and was reflected in our 2004 actuarial valuation. U.S. statutory tax rate, primarily reflecting: The obligation related to this settlement was included in plan • The impact of nondeductible expenses and $20 million of amendments in the change in the benefit obligation. unrecognized tax benefits primarily related to recurring Refer to Note 16 – Contingencies in the Consolidated Financial losses in certain jurisdictions where we maintained deferred Statements for additional information regarding litigation against tax asset valuation allowances. the Company. • Partially offset by tax benefits from other foreign adjustments, including earnings taxed at different rates, tax law changes of All Other Expenses, Net: In 2005 all other expenses, net, included $14 million and other items that are individually insignificant. the following individually significant items: • $15 million for losses sustained from Hurricane Katrina The 2003 effective tax rate of 30.7% was lower than the U.S. related to property damage and impaired receivables. We statutory tax rate, primarily reflecting: continue to reassess the estimate of our losses from the • Tax benefits of $35 million resulting from the reversal of effects of Hurricane Katrina. Our current estimate as of valuation allowances on deferred tax assets following a December 31, 2005, of total assets at risk in the affected re-evaluation of their future realization due to improved financial areas, primarily finance receivables from customers, was performance, other foreign adjustments, including earnings approximately $20 million. taxed at different rates, the impact of Series B Convertible • $26 million charge related to the European Union Waste Preferred Stock dividends and state tax benefits. Directive, including the associated adoption of FASB Staff • Partially offset by tax expense for audit and other tax return Position No. 143-1, “Accounting for Electronic Equipment adjustments, as well as $19 million of unrecognized tax benefits Waste Obligations,” which provided guidance on accounting primarily related to recurring losses in certain jurisdictions for the European Union (EU) Directive on the disposal of elec- where we maintained deferred tax asset valuation allowances. tronic equipment. Refer to Note 1 – Summary of Significant Accounting Policies in the Consolidated Financial Statements. Our effective tax rate is based on recurring factors including the geographical mix of income before taxes and the related tax In 2003, all other expenses, net, included a $73 million loss on rates in those jurisdictions, as well as available foreign tax credits. early extinguishment of debt reflecting the write-off of the remain- In addition, our effective tax rate will change based on discrete ing unamortized fees associated with the 2002 Credit Facility. or other nonrecurring events (such as audit settlements) that Income tax (benefits) expenses were as follows (in millions): may not be predictable. We anticipate that our effective tax rate for 2006 will approximate 34.0%, excluding the effects of any Year Ended December 31, 2005 2004 2003 discrete items. Pre-tax income $ 830 $ 965 $ 436 Equity in Net Income of Unconsolidated Affiliates: Equity in net Income tax (benefits) expenses (5) 340 134 income of unconsolidated affiliates of $98 million, principally Effective tax rate (0.6)% 35.2% 30.7% related to our 25% share of Fuji Xerox income, decreased $53 million in 2005 as compared to 2004, reflecting the following: The 2005 effective tax rate of (0.6)% was lower than the U.S. • A $44 million decrease in our 25% share of Fuji Xerox’s net statutory tax rate primarily due to: income. The lower net income related to the absence of the • Tax benefits of $253 million associated with the finalization of $38 million pension settlement gain in 2004. Refer to Note 7 – the 1996-1998 IRS audit in the second quarter. Investments in Affiliates, at Equity in the Consolidated Financial • Tax benefits of $42 million primarily from the realization of Statements for condensed financial data of Fuji Xerox. foreign tax credits offset by the geographical mix of income • The absence of $7 million of equity income from Integic and the related tax rates in those jurisdictions. Corporation. In the first quarter of 2005, we sold our entire • Tax benefits of $31 million from the reversal of a valuation equity interest in Integic Corporation. 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. 38 Xerox Annual Repor t 2005

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    Xerox Corporation Equity in net income of unconsolidated affiliates increased As disclosed in Note 15 – Income and Other Taxes, in June 2005 $93 million in 2004 as compared to 2003, reflecting: we received notice that our 1996-1998 Internal Revenue Service • $38 million related to our share of a pension settlement gain (“IRS”) audit was finalized. Of the total tax benefits realized, recorded by Fuji Xerox subsequent to a transfer of a portion including the reversal of existing reserves, $53 million was of their pension obligation to the Japanese government in attributed to our discontinued operations. accordance with the Japan Welfare Pension Insurance Law. In the first quarter 2004, we sold all but 2% of our 75% ownership • The remainder of the 2004 increase is primarily due to the interest in ContentGuard Inc. (“ContentGuard”) to Microsoft improved operational performance of Fuji Xerox. Corporation and Time Warner Inc. for $66 million in cash. The sale resulted in an after-tax gain of approximately $83 million Income from Discontinued Operations: Income from discontinued ($109 million pre-tax) and reflects our recognition of cumulative operations, net of tax, for the years ended December 31, 2005 operating losses. The revenues, operating results and net assets and 2004 was as follows (in millions): of ContentGuard were immaterial for all periods presented. ContentGuard, which was originally created out of research 2005 2004 2003 developed at the Xerox Palo Alto Research Center (“PARC”), Insurance Group Operations licenses intellectual property and technologies related to digital tax benefits $53 $ – $– rights management. During 2005, we sold our remaining interest Gain on sale of ContentGuard, in ContentGuard. net of income taxes of $26 – 83 – Recent Accounting Pronouncements: Refer to Note 1 of the Total $53 $ 83 $– Consolidated Financial Statements for a description of recent accounting pronouncements including the respective dates of adoption and effects on results of operations and financial condition. Capital Resources and Liquidity Cash Flow Analysis: The following summarizes our cash flows for each of the three years ended December 31, 2005, as reported in our Consolidated Statements of Cash Flows in the accompanying Consolidated Financial Statements: 2005 2004 Amount Amount (in millions) 2005 2004 2003 Change Change Net cash provided by operating activities $ 1,420 $ 1,750 $ 1,879 $ (330) $ (129) Net cash (used in) provided by investing activities (295) 203 49 (498) 154 Net cash used in financing activities (2,962) (1,293) (2,470) (1,669) 1,177 Effect of exchange rate changes on cash and cash equivalents (59) 81 132 (140) (51) (Decrease) increase in cash and cash equivalents (1,896) 741 (410) (2,637) 1,151 Cash and cash equivalents at beginning of period 3,218 2,477 2,887 741 (410) Cash and cash equivalents at end of period $ 1,322 $ 3,218 $ 2,477 $(1,896) $ 741 Cash, cash equivalents and short-term investments reported in For the year ended December 31, 2005, net cash provided by our Consolidated Financial Statements were as follows: operating activities decreased $330 million from 2004, primarily as a result of the following: December 31, 2005 2004 • $258 million decrease due to modest growth in accounts Cash and cash equivalents $ 1,322 $ 3,218 receivable in 2005 compared to a decline in 2004. Short-term investments 244 – • $83 million decrease due to lower finance receivable run-off. Total Cash, cash equivalents and • $124 million decrease due to higher inventory growth in Short-term investments $ 1,566 $ 3,218 2005 compared to 2004, reflecting an increase in the number of new products. Xerox Annual Repor t 2005 39

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    M A N A G E M E N T ’ S D I S C U S S I O N A N D A N A LY S I S O F R E S U LT S O F O P E R A T I O N S A N D F I N A N C I A L C O N D I T I O N • Partially offsetting these items were lower tax payments of $96 • Decrease of $48 million due to lower proceeds from the sale million due to refunds from audit and other tax settlements, as of excess land and buildings. well as the timing of payments associated with restructuring. • Partially offsetting these items was a $15 million decrease in • Partially offsetting lower pension contributions of $21 million. capital and internal use software expenditures. For the year ended December 31, 2004, net cash provided by We expect 2006 capital expenditures including internal use operating activities decreased $129 million from 2003, primarily software to approximate $250 million. as a result of the following: For the year ended December 31, 2004, net cash from investing • Lower finance receivable reductions of $159 million reflecting activities increased $154 million from 2003, primarily as a result the increase in equipment sale revenue in 2004. of the following: • Higher cash usage related to inventory of $100 million to • An increase of $156 million in proceeds from the sale of busi- support new products. nesses and investments, consisting of the $191 million referred • Increased tax payments of $46 million due to increased income. to above, as offset by $35 million of proceeds from the 2003 • Lower cash generation from the early termination of interest divestitures of investments in South Africa, France and Germany. rate swaps of $62 million. • An increase of $43 million of proceeds from the sale of certain • Lower pension plan contributions of $263 million, partially excess land and buildings. offsetting the above cash outflows. • Partially offsetting these items was a $12 million decrease due to the acquisition of an additional interest in Xerox India in 2004, We expect 2006 operating cash flows to be at the high end of the and a $31 million decrease due to a lower net reduction of range of $1.2 billion to $1.5 billion, as compared to $1.4 billion in escrow and other restricted investments. 2003 investing cash 2005. This expectation reflects cash generation from a decrease flows included $235 million related to our former reinsurance in finance receivables that offsets cash usage from an increase obligations with our discontinued operations. in equipment on operating leases, resulting in a neutral impact on net operating cash flow. Since finance receivables and on-lease For the year ended December 31, 2005, net cash used in equipment are expected to be leveraged at a 7:1 debt-to-equity financing activities increased $1.7 billion from 2004, primarily ratio, if these items collectively use or provide cash the overall as a result of the following: impact on our total cash flows should be minimal, since our debt • A $1.5 billion reduction in proceeds from new secured should also increase or decrease as appropriate to maintain our financings, reflecting a rebalancing of our secured and current leverage. unsecured debt portfolio. For the year ended December 31, 2005, net cash from investing • $433 million cash usage for the acquisition of common stock activities decreased $498 million from 2004 primarily as a result under the authorized October 2005 share repurchase program. of the following: • A partially offsetting $235 million decrease in net payments on • $247 million from the net purchases of short-term investments term and other debt reflecting lower debt maturity obligations. which were intended to increase our return on available cash. For the year ended December 31, 2004, net cash used in • Decrease of $143 million due to a lower net reduction of escrow financing activities decreased $1.2 billion from 2003, primarily and other restricted investments due to the 2004 renegotiation of as a result of the following: certain secured borrowing arrangements and scheduled releases • A $2.6 billion decrease in net payments of term and other debt. from an escrow account of supporting interest payments on our • $889 million in proceeds received on the issuance of mandatory prior liability to a trust issuing preferred securities. redeemable preferred stock in 2003. • Decrease of $86 million due to lower proceeds from divestitures • A partially offsetting decrease of $404 million in proceeds from and investments, net, reflecting: the issuance of common stock and a decrease of $114 million – 2005 proceeds of $105 million primarily consisting in net proceeds from secured financing. 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. 40 Xerox Annual Repor t 2005

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    Xerox Corporation Customer Financing Activities and Debt: We provide equipment In addition to these third-party arrangements, we also support financing to the majority of our customers. Because the finance our customer finance leasing activities with cash generated from leases allow our customers to pay for equipment over time rather operations and through capital markets offerings. than at the date of installation, we maintain a certain level of debt Refer to Note 4 – Receivables, Net in the Consolidated Financial to support our investment in these customer finance leases. Statements for further information regarding our third-party During the last four years we had established a series of financing secured funding arrangements as well as a comparison of finance arrangements with a number of major financial institutions to receivables to our financing-related debt as of December 31, provide secured funding for our customer leasing activities in 2005 and 2004. several of the major countries in which we operate, specifically in As of December 31, 2005 and 2004, debt secured by finance Canada, France, the Netherlands, the U.K. and U.S. While terms receivables was approximately 41% and 44% of total debt, and conditions vary somewhat between countries, in general respectively. Consistent with our objective to rebalance the ratio these arrangements call for the financial counterparty to provide of secured and unsecured debt, we expect payments on secured loans secured by the sales-type lease originations in the country loans will continue to exceed proceeds from new secured loans for which it has been contracted to be the funding source. Most in 2006. The following represents our aggregate debt maturity arrangements are transacted through bankruptcy remote special schedule as of December 31, 2005: purpose entities and the transfers of receivables and equipment to these entities are generally intended to be true sales at law. Debt Secured Other Under these arrangements, secured debt matches the terms of Unsecured by Finance Secured Total the underlying finance receivables it supports, which eliminates (in millions) Debt Receivables Debt Debt certain significant refinancing, pricing and duration risks 2006 $ 66 $1,058 $ 15 $1,139(1) associated with our financing. 2007 258 1,139 185 1,582 At December 31, 2005 and 2004, all of the lease receivables 2008 28 643 307 978 and related secured debt are consolidated in our financial state- 2009 879 103 7 989 ments because we are determined to be the primary beneficiary 2010 688 36 3 727 of the arrangements and frequently the counterparties have Thereafter 1,826 3 34 1,863 various types of recourse to us. The lease receivables sold Total $3,745 $2,982 $551 $7,278 represent the collateral for the related secured debt and are not available for general corporate purposes until the related (1) Quarterly secured and unsecured total debt maturities (in millions) for 2006 are $353, $307, $256 and $223 for the first, second, third and fourth quarters, debt is paid off. Most of the secured financing arrangements respectively. include over-collateralization of approximately 10% of the lease amounts sold. All of these arrangements are subject to usual and The following table summarizes our secured and unsecured debt customary conditions of default including cross-defaults. In the as of December 31, 2005 and 2004: remote circumstance that an event of default occurs and remains December 31, December 31, uncured, in general, the counterparty can cease providing funding (in millions) 2005 2004 for new lease originations. Term Loan $ 300 $ 300 Information on restricted cash that is the result of these third- Debt secured by finance party secured funding arrangements is included in Note 1 – receivables 2,982 4,436 Restricted Cash and Investments to the Consolidated Financial Capital leases 38 58 Statements and disclosure of the amounts for new funding and Debt secured by other assets 213 235 debt repayments are included in the accompanying Consolidated Total Secured Debt 3,533 5,029 Statement of Cash Flows. Senior Notes 2,862 2,936 We also have arrangements in certain countries – Germany, Italy, Subordinated debt 19 19 the Nordic Countries, Brazil and Mexico – in which third-party Other Debt 864 2,140 financial institutions originate lease contracts directly with our Total Unsecured Debt 3,745 5,095 customers. In these arrangements, we sell and transfer title to the Total Debt $ 7,278 $10,124 equipment to these financial institutions and generally have no continuing ownership rights in the equipment subsequent to its sale. Xerox Annual Repor t 2005 41

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    M A N A G E M E N T ’ S D I S C U S S I O N A N D A N A LY S I S O F R E S U LT S O F O P E R A T I O N S A N D F I N A N C I A L C O N D I T I O N Liquidity: We manage our worldwide liquidity using internal cash The 2003 Credit Facility contains affirmative and negative management practices, which are subject to (1) the statutes, covenants as well as financial maintenance covenants. Subject to regulations and practices of each of the local jurisdictions in certain exceptions, we cannot pay cash dividends on our common which we operate, (2) the legal requirements of the agreements stock during the facility term, although we can pay cash dividends to which we are a party and (3) the policies and cooperation of on our preferred stock provided there is then no event of default. the financial institutions we utilize to maintain and provide cash In addition to other defaults customary for facilities of this type, management services. defaults on other debt, or bankruptcy, of Xerox, or certain of our subsidiaries, and a change in control of Xerox, would constitute With $1.6 billion of cash, cash equivalents and short-term events of default. At December 31, 2005, we were in compliance investments, as of December 31, 2005, borrowing capacity with the covenants of the 2003 Credit Facility and we expect to under our 2003 Credit Facility of approximately $700 million remain in compliance for at least the next twelve months. and funding available through our secured funding programs, we believe our liquidity (including operating and other cash flows Share Repurchase Program: In October 2005, the Board of that we expect to generate) will be sufficient to meet operating Directors authorized the repurchase of up to $500 million of the cash flow requirements as they occur and to satisfy all scheduled Company’s common stock during a period of up to one year. In debt maturities for at least the next twelve months. Our ability addition, during January 2006, the Board of Directors authorized to maintain positive liquidity going forward depends on our ability an additional repurchase of $500 million of the Company’s to continue to generate cash from operations and access the common stock to also occur during a period of up to one year. financial markets, both of which are subject to general economic, Refer to Note 18 – Common Stock in the Consolidated Financial financial, competitive, legislative, regulatory and other market Statements for further information. factors that are beyond our control. As of December 31, 2005, we had an active shelf registration statement with $1.75 billion of capacity that enables us to access the market on an opportunistic Other Financing Activity basis and offer both debt and equity securities. Financing Business: We currently fund our customer financing Credit Facility: The 2003 Credit Facility consists of a $300 million activity through third-party funding arrangements, cash generated term loan and a $700 million revolving credit facility, which from operations, cash on hand, capital markets offerings and includes a $200 million sub-facility for letters of credit. Xerox secured loans. In the United States, Canada, the Netherlands, Corporation is the only borrower of the term loan. The revolving the U.K. and France, we are currently funding a significant portion credit facility is available, without sub-limit, to Xerox Corporation of our customer financing activity through secured borrowing and certain of its foreign subsidiaries, including Xerox Canada arrangements with GE, De Lage Landen Bank (“DLL”) and Merrill Capital Limited, Xerox Capital (Europe) plc and other qualified Lynch. At the end of the third quarter of 2005, we repaid $120 foreign subsidiaries (excluding Xerox Corporation, the “Overseas million of secured debt through a transaction with our DLL Joint Borrowers”). The 2003 Credit Facility matures on September 30, Venture to purchase DLL’s parent’s 51% ownership interest in 2008. As of December 31, 2005, the $300 million term loan the Belgium and Spain leasing operations, which were previously and $15 million of letters of credit were outstanding and there sold to the joint venture in the fourth quarter of 2003. In connec- were no outstanding borrowings under the revolving credit facility. tion with the purchase, the secured borrowings to DLL’s parent in Since inception of the 2003 Credit Facility in June 2003, there these operations were repaid and the related finance receivables have been no borrowings under the revolving credit facility. are no longer encumbered. Other than the repayment of the secured debt, the effects from this transaction were immaterial. The term loan and the revolving loans each bear interest at In October 2005, we renegotiated our Loan Agreement with LIBOR plus a spread that varies between 1.75% and 3.00% or, GE, resulting in a reduction in applicable interest rates and the at our election, at a base rate plus a spread that depends on elimination of the monthly borrowing requirement. The interest the then-current leverage ratio, as defined, in the 2003 Credit rate reduction is applicable to existing and new loans. Additionally, Facility. This rate was 6.22% at December 31, 2005. in October 2005, we finalized renegotiation of our Loan Agreements with Merrill Lynch in France, resulting in an increase in the size of the facility from €350 million to €420 million ($414 million to $497 million), lower applicable interest rates and an extension for an additional 2 years at our option from the current expiration date of July 2007. Refer to Note 4 to the Consolidated Financial Statements for a more detailed discussion of our customer financing arrangements. 42 Xerox Annual Repor t 2005

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