Form 10-Q
Table of Contents

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 


 

FORM 10-Q

 


 

(Mark One)

 

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the quarterly period ended: September 30, 2003

 

OR

 

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the transition period from              to             

 

Commission File Number 1-4471

 


 

XEROX CORPORATION

(Exact Name of Registrant as specified in its charter)

 


 

New York   16-0468020
(State or other jurisdiction of incorporation or organization)   (IRS Employer Identification No.)

P.O. Box 1600

Stamford, Connecticut

  06904-1600
(Address of principal executive offices)   (Zip Code)

 

(203) 968-3000

(Registrant’s telephone number, including area code)

 


 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  x    No  ¨

 

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).    Yes  x    No  ¨

 

APPLICABLE ONLY TO CORPORATE ISSUERS:

 

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

 

Class


 

Outstanding at September 30, 2003


Common Stock, $1 par value

  791,857,130 shares

 



Table of Contents

Forward Looking Statements

 

From time to time we and our representatives may provide information, whether orally or in writing, including certain statements in this Quarterly Report on Form 10-Q which are forward-looking. These forward-looking statements and other information are based on our beliefs, as well as assumptions made by us based on information currently available.

 

The words “anticipate,” “believe,” “estimate,” “expect,” “intend,” “will,” and similar expressions, as they relate to us, are intended to identify forward-looking statements. Such statements reflect our current views with respect to future events and are subject to certain risks, uncertainties and assumptions. Should one or more of these risks or uncertainties materialize, or should underlying assumptions prove incorrect, actual results may vary materially from those described herein as anticipated, believed, estimated, expected or intended. We do not intend to update these forward-looking statements.

 

We are making investors aware that such forward-looking statements, because they relate to future events, are by their very nature subject to many important factors that could cause actual results to differ materially from those contained in the forward-looking statements. Such factors include, but are not limited to, the following:

 

Competition—We operate in an environment of significant competition, driven by rapid technological advances and the demands of customers to become more efficient. Our competitors range from large international companies to relatively small firms. Some of the large international companies have significant financial resources and compete with us globally to provide document processing products and services in each of the markets we serve. We compete primarily on the basis of technology, performance, price, quality, reliability, brand, distribution and customer service and support. Our success in future performance is largely dependent upon our ability to compete successfully in the markets we currently serve and to expand into additional market segments. To remain competitive, we must develop new products and services and periodically enhance our existing offerings. If we are unable to compete successfully, we could lose market share and important customers to our competitors and that could materially adversely affect our results of operations and financial condition.

 

Expansion of Color—Color printing and copying represents an important and growing segment of the market. A significant part of our strategy and ultimate success in this changing market is our ability to develop and market technology that produces color prints and copies quickly, easily and at reduced cost. Our continuing success in this strategy depends on our ability to make the investments and commit the necessary resources in this highly competitive market, as well as the pace of color adoption by our existing and prospective customers. If we are unable to develop and market advanced color technologies, we may be unable to capture these opportunities and it could materially adversely affect our results of operations and financial condition.

 

Pricing—Our success depends on our ability to obtain adequate pricing for our products and services which provides a reasonable return to our shareholders. Depending on competitive market factors, future prices we obtain for our products and services may decline from historical levels. In addition, pricing actions to offset the effect of currency devaluations may not prove sufficient to offset further devaluations or may not hold in the face of customer resistance and/or competition.

 

Customer Financing Activities—The long-term viability and profitability of our customer financing activities is dependent, in part, on our ability to borrow and the cost of borrowing in the credit markets. This ability and cost, in turn, is dependent on our credit ratings. We are currently funding much of our customer financing activity through third-party financing arrangements, including several with General Electric Capital Corporation (GECC) in various geographies, cash generated from operations, cash on hand, capital markets offerings and securitizations. There is no assurance that we will be able to continue to fund our customer financing activity at present levels. We continue to negotiate and implement third-party vendor financing programs and actively pursue alternative forms of financing including securitizations and secured borrowings. Our ability to offer customer financing and be successful in the placement of equipment with customers is largely dependent upon maintaining our third party financing arrangements.

 

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Productivity—Our ability to sustain and improve profit margins is largely dependent on our ability to continue to improve the cost efficiency of our operations through such programs as Lean Six Sigma and, to a lesser extent, our ability to successfully complete information technology initiatives. If we are unable to achieve productivity improvements through design efficiency and supplier and manufacturing cost improvements and information technology initiatives, our ability to offset labor cost inflation, potential materials cost increases and competitive price pressures would be impaired, all of which could materially adversely affect our results of operations and financial condition.

 

International Operations—We derive approximately 40 percent of our revenue from operations outside the United States. In addition, we manufacture or acquire many of our products and/or their components from outside the United States. Our future revenues, costs and results from operations could be affected by a number of factors, including changes in foreign currency exchange rates, changes in economic conditions from country to country, changes in a country’s political conditions, trade protection measures, licensing requirements and local tax issues. We generally hedge foreign currency denominated assets and liabilities, primarily through the use of currency derivative contracts. The use of these derivative contracts mitigates volatility in our results of operations.

 

New Products/Research and Development—The process of developing new high technology products and solutions is inherently complex and uncertain. It requires accurate anticipation of customers’ changing needs and emerging technological trends. We must make long-term investments and commit significant resources before knowing whether these investments will eventually result in products that achieve customer acceptance and generate the revenues required to provide desired returns from these investments. If we fail to accurately anticipate and meet our customers’ needs through the development of new products or if our new products are not widely accepted, we could lose our customers and that could materially adversely affect our results of operations and financial condition.

 

Revenue Trends—Our ability to return to and maintain a consistent trend of revenue growth over the intermediate to longer term is largely dependent upon expansion of our worldwide equipment placements, as well as sales of services and supplies occurring after the initial equipment placement (post sale revenue) in the key growth markets of color and multifunction devices. We expect that revenue growth can be further enhanced through our consulting services in the areas of document, content and knowledge management. The ability to achieve growth in our equipment placements is subject to the successful implementation of our initiatives to provide advanced systems, industry-oriented global solutions and services for major customers, improved direct sales productivity and expansion of our indirect distribution channels in the face of global competition and pricing pressures. Our ability to increase post sale revenue is largely dependent on our ability to increase equipment placements, equipment utilization and color adoption. Equipment placements typically occur through leases with original terms of three to five years. There will be a lag between the increase in equipment placements and an increase in post sale revenues. The ability to grow our customers’ usage of our products may continue to be adversely impacted by the movement toward distributed printing and electronic substitutes and the impact of lower equipment placements in prior periods. If we are unable to return to and maintain a consistent trend of revenue growth, it could materially adversely affect our results of operations and financial condition.

 

Restructuring Initiatives—Since early 2000, we have engaged in a series of restructuring programs related to downsizing our employee base, exiting certain businesses, outsourcing some internal functions and engaging in other actions designed to reduce our cost structure. These initiatives have resulted in more than $1 billion in annualized cost savings. If we are unable to continue to sustain our cost base at or below the current level and maintain process and systems changes resulting from the restructuring actions, it could materially adversely affect our results of operations and financial condition.

 

Debt —We have and will continue to have a substantial amount of debt and other obligations. As of September 30, 2003, we had $11.8 billion of total debt ($4.1 billion of which is secured by finance receivables) and $1.7 billion of mandatorily redeemable preferred securities. Cash and cash equivalents were $2.3 billion at September 30, 2003. Our substantial debt and other obligations could have important

 

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consequences. For example, it could (i) increase our vulnerability to general adverse economic and industry conditions; (ii) limit our ability to obtain additional financing for future working capital, capital expenditures, acquisitions and other general corporate requirements; (iii) increase our vulnerability to interest rate fluctuations because a portion of our debt has variable interest rates; (iv) require us to dedicate a substantial portion of our cash flows from operations to service debt and other obligations thereby reducing the availability of our cash flows from operations for other purposes; (v) limit our flexibility in planning for, or reacting to, changes in our business and the industry in which we operate; (vi) place us at a competitive disadvantage compared to our competitors that have less debt; and (vii) become due and payable upon a change in control. If new debt is added to our current debt levels, these related risks could increase.

 

Liquidity—The adequacy of our liquidity depends on our ability to successfully generate positive cash flow from an appropriate combination of operating improvements, financing from third parties, access to capital markets and additional asset sales, including sales or securitizations of our receivables portfolios. On June 25, 2003, we completed a $3.6 billion recapitalization (the “Recapitalization”) that included the offering and sale of 9.2 million shares of 6.25 percent Series C Mandatory Convertible Preferred Stock, 46 million shares of Common Stock, $700 million of 7 1/8 percent Senior Notes due 2010 and $550 million 7 5/8 percent Senior Notes due 2013 and the closing of our new $1.0 billion credit agreement which matures on September 30, 2008 (the “2003 Credit Facility”). The 2003 Credit Facility consists of a fully drawn $300 million term loan and a $700 million revolving credit facility (which includes a $200 million sub-facility for letters of credit). With $2.3 billion of cash and cash equivalents on hand at September 30, 2003 and borrowing capacity under our 2003 Credit Facility of $700 million less $78 million utilized for letters of credit, we believe our liquidity (including operating and other cash flows that we expect to generate) will be sufficient to meet operating cash flow requirements as they occur and to satisfy all scheduled debt maturities for at least the next twelve months; however, our ability to maintain positive liquidity going forward depends on our ability to generate cash from operations and access to the financial markets, both of which are subject to general economic, financial, competitive, legislative, regulatory and other market factors that are beyond our control.

 

The 2003 Credit Facility contains affirmative and negative covenants including limitations on: issuance of debt and preferred stock; investments and acquisitions; mergers; certain transactions with affiliates; creation of liens; asset transfers; hedging transactions; payment of dividends and certain other payments and intercompany loans. The 2003 Credit Facility contains financial maintenance covenants, including minimum EBITDA, as defined, maximum leverage (total adjusted debt divided by EBITDA), annual maximum capital expenditures limits and minimum consolidated net worth, as defined. The indentures governing our outstanding senior notes contain several affirmative and negative covenants. The senior notes do not, however, contain any financial maintenance covenants. Our U.S. Loan Agreement with GECC (effective through 2010) relating to our vendor financing program (the “Loan Agreement”) provides for a series of monthly secured loans up to $5 billion outstanding at any one time. As of September 30, 2003, $2.4 billion was outstanding under this Loan Agreement. The Loan Agreement, as well as similar loan agreements with GE in the U.K. and Canada, incorporates the financial maintenance covenants contained in the 2003 Credit Facility and contains other affirmative and negative covenants.

 

At September 30, 2003, we were in full compliance with the covenants and other provisions of the 2003 Credit Facility, the senior notes and the Loan Agreement and expect to remain in full compliance for at least the next twelve months. Any failure to be in compliance with any material provision or covenant of the 2003 Credit Facility or the senior notes could have a material adverse effect on our liquidity, results of operations and financial condition. Failure to be in compliance with the covenants in the Loan Agreement, including the financial maintenance covenants incorporated from the 2003 Credit Facility, would result in an event of termination under the Loan Agreement and in such case GECC would not be required to make further loans to us. If GECC were to make no further loans to us, it would materially adversely affect our liquidity and our ability to fund our customers’ purchases of our equipment and this could materially adversely affect our results of operations.

 

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Litigation—We have various contingent liabilities that are not reflected on our balance sheet, including those arising as a result of being a defendant in numerous litigation and regulatory matters involving securities law, patent law, environmental law, employment law and the Employee Retirement Income Security Act (ERISA), as discussed in Note 10 to the Condensed Consolidated Financial Statements contained in this Quarterly Report on Form 10-Q. As required by Statement of Financial Accounting Standards No. 5, “Accounting for Contingencies,” we determine whether an estimated loss from a contingency should be accrued by assessing whether a loss is deemed probable and can be reasonably estimated. We assess potential liability by analyzing our litigation and regulatory matters using available information. We develop our views on estimated losses in consultation with outside counsel handling our defense in these matters, which involves an analysis of potential results, assuming a combination of litigation and settlement strategies. In March 2003, we recorded a litigation charge of $183 million (after-tax) in connection with a case brought against our primary U.S. pension plan for salaried employees. Should developments in any of our other legal matters cause a change in our determination as to an unfavorable outcome and result in the need to recognize a material accrual, or should any of these matters result in a final adverse judgment or be settled for significant amounts, they could have a material adverse effect on our results of operations, cash flows and financial position in the period or periods in which such change in determination, judgment or settlement occurs.

 

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Xerox Corporation

 

Form 10-Q

 

September 30, 2003

 

Table of Contents

 

          Page

Part I — Financial Information

    

Item 1.

   Financial Statements (Unaudited)    7
     Condensed Consolidated Statements of Income    7
     Condensed Consolidated Balance Sheets    8
     Condensed Consolidated Statements of Cash Flows    9
     Notes to Condensed Consolidated Financial Statements    10

Item 2.

   Management’s Discussion and Analysis of Results of Operations and Financial Condition    47
     Results of Operations     
     Capital Resources and Liquidity    54
     Financial Risk Management    58

Item 3.

   Quantitative and Qualitative Disclosures About Market Risk    59

Item 4.

   Controls and Procedures    59

Part II — Other Information

    

Item 1.

   Legal Proceedings    60

Item 2.

   Changes in Securities    60

Item 6.

   Exhibits and Reports on Form 8-K    60

Signatures

   62

Exhibit Index- Exhibits Filed with this Report

   63

Computation of Ratio of Earnings to Fixed Charges and Computation of Ratio of Earnings to Combined Fixed Charges and Preferred Stock Dividends

    

Certifications Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

    

Certification of CEO and CFO Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

    

 

For additional information about Xerox Corporation and access to our Annual Reports to Shareholders and SEC filings, free of charge, please visit our World-Wide Web site at www.xerox.com/investor. Any information on or linked from the website is not incorporated by reference into this Form 10-Q.

 

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PART I—FINANCIAL INFORMATION

 

Item 1

 

Xerox Corporation

 

Condensed Consolidated Statements of Income (Unaudited)

 

    

Three Months

Ended

September 30,


   

Nine Months

Ended

September 30,


 
(In millions, except per share data)    2003

    2002

    2003

    2002

 

Revenues

                                

Sales

   $ 1,603     $ 1,593     $ 4,888     $ 4,838  

Service, outsourcing and rentals

     1,885       1,953       5,772       6,004  

Finance income

     244       247       749       761  
    


 


 


 


Total Revenues

     3,732       3,793       11,409       11,603  
    


 


 


 


Costs and Expenses

                                

Cost of sales

     1,050       1,018       3,120       3,056  

Cost of service, outsourcing and rentals

     1,060       1,074       3,245       3,391  

Equipment financing interest

     89       107       274       300  

Research and development expenses

     207       229       668       699  

Selling, administrative and general expenses

     1,028       1,023       3,137       3,302  

Restructuring and asset impairment charges

     11       63       56       262  

Provision for litigation

     —         —         300       —    

Gain on affiliate’s sale of stock

     (12 )     —         (13 )     —    

Other expenses, net

     133       103       420       317  
    


 


 


 


Total Costs and Expenses

     3,566       3,617       11,207       11,327  
    


 


 


 


Income before Income Taxes, Equity Income, Minorities’ Interests and Cumulative Effect of Change in Accounting Principle

     166       176       202       276  

Income taxes

     47       77       47       118  
    


 


 


 


Income before Equity Income, Minorities’ Interests and Cumulative Effect of Change in Accounting Principle

     119       99       155       158  

Equity in net income of unconsolidated affiliates

     13       17       43       43  

Minorities’ interests in earnings of subsidiaries

     (15 )     (17 )     (60 )     (66 )
    


 


 


 


Income before Cumulative Effect of Change in Accounting Principle

     117       99       138       135  

Cumulative effect of change in accounting principle

     —         —               (63 )
    


 


 


 


Net Income

   $ 117     $ 99     $ 138     $ 72  

Less: Preferred stock dividends, net

     (25 )     (63 )     (46 )     (63 )
    


 


 


 


Income Available to Common Shareholders

   $ 92     $ 36     $ 92     $ 9  
    


 


 


 


Basic Earnings per Share:

                                

Income before Cumulative Effect of Change in Accounting Principle

   $ 0.12     $ 0.05     $ 0.12     $ 0.10  

Net Income Per Share

   $ 0.12     $ 0.05     $ 0.12     $ 0.01  

Diluted Earnings per Share:

                                

Income before Cumulative Effect of Change in Accounting Principle

   $ 0.11     $ 0.04     $ 0.11     $ 0.09  

Net Income Per Share

   $ 0.11     $ 0.04     $ 0.11     $ 0.01  

 

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

 

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Xerox Corporation

 

Condensed Consolidated Balance Sheets (Unaudited)

 

(In millions, except share data in thousands)   

September 30,

2003


   

December 31,

2002


 

Assets

                

Cash and cash equivalents

   $ 2,270     $ 2,887  

Accounts receivable, net

     2,034       2,072  

Billed portion of finance receivables, net

     488       564  

Finance receivables, net

     2,952       3,088  

Inventories

     1,279       1,231  

Other current assets

     1,283       1,186  
    


 


Total Current Assets

     10,306       11,028  

Finance receivables due after one year, net

     5,146       5,353  

Equipment on operating leases, net

     360       450  

Land, buildings and equipment, net

     1,757       1,757  

Investments in affiliates, at equity

     553       628  

Intangible assets, net

     334       360  

Goodwill

     1,624       1,564  

Deferred tax assets, long-term

     1,557       1,592  

Other long-term assets

     2,737       2,726  
    


 


Total Assets

   $ 24,374     $ 25,458  
    


 


Liabilities and Equity

                

Short-term debt and current portion of long-term debt

   $ 4,150     $ 4,377  

Accounts payable

     798       839  

Accrued compensation and benefits costs

     404       481  

Unearned income

     227       257  

Other current liabilities

     1,400       1,833  
    


 


Total Current Liabilities

     6,979       7,787  

Long-term debt

     7,664       9,794  

Pension liabilities

     1,425       1,307  

Post-retirement medical benefits

     1,269       1,251  

Mandatory redeemable preferred securities

     697       —    

Other long-term liabilities

     1,203       1,144  
    


 


Total Liabilities

     19,237       21,283  

Minorities’ interests in equity of subsidiaries

     77       73  

Company-obligated, mandatorily redeemable preferred securities of subsidiary trusts holding solely subordinated debentures of the Company

     1,023       1,701  

Preferred stock

     508       550  

Deferred ESOP benefits

     (42 )     (42 )

Mandatory convertible preferred stock

     889       —    

Common stock, including additional paid-in capital

     3,229       2,739  

Retained earnings

     1,118       1,025  

Accumulated other comprehensive loss

     (1,665 )     (1,871 )
    


 


Total Liabilities and Equity

   $ 24,374     $ 25,458  
    


 


Shares of common stock issued and outstanding

     791,857       738,273  

 

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

 

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Xerox Corporation

 

Condensed Consolidated Statements of Cash Flows (Unaudited)

 

    

Three Months

Ended

September 30,


   

Nine Months

Ended

September 30,


 
(in millions)    2003

    2002

    2003

    2002

 

Cash Flows from Operating Activities

                                

Net Income

   $ 117     $ 99     $ 138     $ 72  

Adjustments required to reconcile net income to cash flows from operating activities:

                                

Provision for litigation

     —         —         300       —    

Depreciation and amortization

     178       213       566       772  

Impairment of goodwill

     —         —         —         63  

Provisions for receivables and inventory

     80       118       253       375  

Restructuring and asset impairment charges

     11       63       56       262  

Loss on early extinguishment of debt

     —         —         73       —    

Net gains on sales of businesses, assets and affiliate’s sale of stock

     (8 )     (14 )     —         (20 )

(Undistributed) distributed equity in net income of unconsolidated affiliates

     (13 )     2       (33 )     (24 )

Cash payments for restructurings

     (46 )     (93 )     (299 )     (276 )

Contributions to pension benefit plans

     (604 )     (99 )     (656 )     (129 )

(Increase) decrease in inventories

     (82 )     (17 )     (65 )     64  

Increase in on-lease equipment

     (35 )     (7 )     (107 )     (98 )

Decrease in finance receivables

     200       188       545       656  

Decrease (increase) in accounts receivable and billed portion of finance receivables

     99       91       174       (11 )

Increase (decrease) in accounts payable and accrued compensation

     185       (26 )     193       134  

Net change in income tax assets and liabilities

     18       56       (95 )     (269 )

(Decrease) increase in other current and long-term liabilities

     (6 )     35       (112 )     (108 )

Other, net

     (27 )     5       (23 )     (82 )
    


 


 


 


Net cash provided by operating activities

     67       614       908       1,381  
    


 


 


 


Cash Flows from Investing Activities

                                

Cost of additions to land, buildings and equipment

     (47 )     (38 )     (126 )     (109 )

Proceeds from sales of land, buildings and equipment

     1       14       5       18  

Cost of additions to internal use software

     (10 )     (16 )     (34 )     (30 )

Proceeds from divestitures, net

     —         67       29       340  

Net change in escrow and other restricted investments

     95       16       61       (137 )
    


 


 


 


Net cash provided by (used in) investing activities

     39       43       (65 )     82  
    


 


 


 


Cash Flows from Financing Activities

                                

Cash proceeds from new secured financings

     467       846       1,609       2,024  

Debt payments on secured financings

     (602 )     (445 )     (1,577 )     (1,249 )

Other cash changes in debt, net

     6       (690 )     (2,850 )     (4,013 )

Net proceeds from issuance of mandatory convertible preferred stock

     —         —         889       —    

Net proceeds from sales of common stock

     8       —         468       4  

Dividends on preferred stock

     (10 )     —         (32 )     —    

Dividends to minority shareholders

     (2 )     (2 )     (3 )     (2 )
    


 


 


 


Net cash used in financing activities

     (133 )     (291 )     (1,496 )     (3,236 )
    


 


 


 


Effect of exchange rate changes on cash and cash equivalents

     18       24       36       64  
    


 


 


 


(Decrease) increase in cash and cash equivalents

     (9 )     390       (617 )     (1,709 )

Cash and cash equivalents at beginning of period

     2,279       1,891       2,887       3,990  
    


 


 


 


Cash and cash equivalents at end of period

   $ 2,270     $ 2,281     $ 2,270     $ 2,281  
    


 


 


 


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

 

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Xerox Corporation

 

Notes to Condensed Consolidated Financial Statements

($ in millions except per share data and where otherwise noted)

 

1. Basis of Presentation:

 

References herein to “we,” “our” or “us” refer to Xerox Corporation and consolidated subsidiaries unless the context specifically requires otherwise.

 

We have prepared the accompanying unaudited condensed consolidated interim financial statements in accordance with the accounting policies described in our 2002 Consolidated Financial Statements included in our Current Report on Form 8-K dated July 23, 2003 and the interim reporting requirements of Form 10-Q. Accordingly, certain information and note disclosures normally included in financial statements prepared in accordance with U.S. generally accepted accounting principles (“GAAP”) have been condensed or omitted. You should read these condensed consolidated financial statements in conjunction with the 2002 consolidated financial statements. In our opinion, all adjustments which are necessary for a fair statement of financial position, operating results and cash flows for the interim periods presented have been made. Interim results of operations are not necessarily indicative of the results of the full year.

 

For convenience and ease of reference, we refer to the financial statement caption “ Income before Income Taxes, Equity Income, Minorities’ Interests and Cumulative Effect of Change in Accounting Principle” as “pre-tax income.”

 

Certain reclassifications have been made to prior year information to conform to the current year presentation.

 

In December 2002, we finalized our transitional goodwill impairment testing as a result of adopting Statement of Financial Accounting Standards (“SFAS”) No. 142, “Goodwill and Other Intangible Assets” (SFAS No. 142) and recorded an impairment charge of $63 as a cumulative effect of change in accounting principle in accordance with the provisions of SFAS No. 142 as of January 1, 2002.

 

Liquidity: We manage our worldwide liquidity using internal cash management practices which are subject to (1) the statutes, regulations and practices of each of the local jurisdictions in which we operate, (2) the legal requirements of the agreements to which we are a party and (3) the policies and cooperation of the financial institutions we utilize to maintain and provide cash management services. As described in our 2002 Consolidated Financial Statements, prior years’ operating and liquidity issues led to a series of credit rating downgrades, eventually to below investment grade. As a result, our access to capital and derivative markets was restricted.

 

On June 25, 2003, we completed a $3.6 billion recapitalization (the “Recapitalization”) that included the offering and sale of 9.2 million shares of 6.25% Series C Mandatory Convertible Preferred Stock, 46 million shares of Common Stock, $700 of 7 1/8% Senior Notes due 2010 and $550 of 7 5/8% Senior Notes due 2013 and the closing of our new $1.0 billion credit agreement which matures on September 30, 2008 (the “2003 Credit Facility”). The 2003 Credit Facility consists of a fully drawn $300 term loan and a $700 revolving credit facility (which includes a $200 sub-facility for letters of credit). The proceeds from the Recapitalization were used to repay the amounts outstanding under the Amended and Restated Credit Agreement we entered into in June 2002 (the “2002 Credit Facility”). Upon repayment of amounts outstanding, the 2002 Credit Facility was terminated and we incurred a $73 charge associated with unamortized debt issuance costs.

 

On September 30, 2003, we had $700 of borrowing capacity under the 2003 Credit Facility, less $78 utilized for letters of credit. The 2003 Credit Facility contains affirmative and negative covenants including limitations on: issuance of debt and preferred stock; investments and acquisitions; mergers; certain transactions with affiliates; creation of liens; asset transfers; hedging transactions; payment of dividends and certain other

 

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Table of Contents

Xerox Corporation

 

Notes to Condensed Consolidated Financial Statements—(Continued)

($ in millions except per share data and where otherwise noted)

 

payments and intercompany loans. The 2003 Credit Facility contains financial maintenance covenants, including minimum EBITDA, as defined, maximum leverage (total adjusted debt divided by EBITDA), annual maximum capital expenditures limits and minimum consolidated net worth, as defined. The indentures governing our outstanding senior notes contain several affirmative and negative covenants. The senior notes do not, however, contain any financial maintenance covenants. Our U.S. Loan Agreement with General Electric Capital Corporation (“GECC”) (effective through 2010) relating to our vendor financing program (the “Loan Agreement”) provides for a series of monthly secured loans up to $5 billion outstanding at any one time. As of September 30, 2003, $2.4 billion was outstanding under the Loan Agreement. The Loan Agreement, as well as similar loan agreements with GE in the U.K. and Canada that are discussed further in Note 9, incorporates the financial maintenance covenants contained in the 2003 Credit Facility and contains other affirmative and negative covenants.

 

At September 30, 2003, we were in full compliance with the covenants and other provisions of the 2003 Credit Facility, the senior notes and the Loan Agreement and we expect to remain in full compliance for at least the next twelve months. Any failure to be in compliance with any material provision or covenant of the 2003 Credit Facility or the senior notes could have a material adverse effect on our liquidity and operations. Failure to be in compliance with the covenants in the Loan Agreement, including the financial maintenance covenants incorporated from the 2003 Credit Facility, would result in an event of termination under the Loan Agreement and in such case GECC would not be required to make further loans to us. If GECC were to make no further loans to us, it would materially adversely affect our liquidity and our ability to fund our customers’ purchases of our equipment and this could materially adversely affect our results of operations.

 

With $2.3 billion of cash and cash equivalents on hand at September 30, 2003 and borrowing capacity under our 2003 Credit Facility of $700, less $78 utilized for letters of credit, we believe our liquidity (including operating and other cash flows that we expect to generate) will be sufficient to meet operating cash flow requirements as they occur and to satisfy all scheduled debt maturities for at least the next twelve months; however, our ability to maintain positive liquidity going forward depends on our ability to generate cash from operations and access to the financial markets, both of which are subject to general economic, financial, competitive, legislative, regulatory and other market factors that are beyond our control.

 

2. Accounting Changes and New Accounting Standards:

 

Revenue Recognition: In November 2002, the Emerging Issues Task Force (the “EITF”) reached a consensus on Issue 00-21, “Revenue Arrangements with Multiple Deliverables.” The EITF requires that the deliverables must be divided into separate units of accounting when the individual deliverables have value to the customer on a stand-alone basis, when there is objective and reliable evidence of the fair value of the undelivered elements, and, if the arrangement includes a general right to return the delivered element, delivery or performance of the undelivered element is considered probable. The relative fair value of each unit should be determined and the total consideration of the arrangement should be allocated among the individual units based on their relative fair value. With respect to bundled lease arrangements subject to SFAS No. 13, “Accounting for Leases,” this guidance only impacts the allocation of revenues to the aggregate lease and non-lease deliverables. Lease deliverables include executory costs, equipment and interest, while non-lease deliverables consist of the supplies and non-maintenance services component of the bundled lease arrangements. The lease deliverables must continue to be accounted for in accordance with SFAS No. 13, consistent with our current revenue recognition policies. The guidance in this issue was effective for revenue arrangements entered into after June 30, 2003. EITF 00-21 did not, and is not expected to, have a material effect on our financial position or results of operations. A full description of our revenue recognition policy associated with bundled contractual lease arrangements is included in Note 3 below.

 

Liabilities and Equity Classification: In May 2003, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity (“SFAS No. 150”). This statement establishes standards for how certain financial instruments with

 

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Xerox Corporation

 

Notes to Condensed Consolidated Financial Statements—(Continued)

($ in millions except per share data and where otherwise noted)

 

characteristics of liabilities and equity are classified in the balance sheet. We adopted SFAS No. 150 on July 1, 2003. As a result of adopting SFAS No. 150, certain securities (specifically, the Capital Trust I Securities and the Canadian Deferred Preferred Stock referred to in Note 16 to the 2002 consolidated financial statements) which had been included within the balance sheet caption “Company-obligated, mandatorily redeemable preferred securities of subsidiary trusts holding solely subordinated debentures of the Company” classified between liabilities and equity in our Condensed Consolidated Balance Sheet, were reclassified to “Mandatory redeemable preferred securities,” a new liability caption. As of September 30, 2003, the mandatorily redeemable preferred securities balance was $697. The distributions and accretion related to these instruments, which were previously reported net of tax as a component of “Minorities’ interests in earnings of subsidiaries” in our Condensed Consolidated Statements of Income, are now accounted for as interest expense within Other expenses, net, with the tax effects presented within the income tax provision. Distributions and related accretion associated with these instruments accounted for as interest expense was $14 for the three months ended September 30, 2003. SFAS No. 150 does not permit reclassification of prior year amounts to conform to the current year presentation.

 

Asset Retirement Obligations: In 2001, the FASB issued SFAS No. 143, “Accounting for Asset Retirement Obligations” (“SFAS No. 143”). This statement addresses financial accounting and reporting for obligations associated with the retirement of tangible long-lived assets and associated asset retirement costs. We adopted SFAS No. 143 on January 1, 2003 and its adoption did not have a material effect on our financial position or results of operations.

 

Variable Interest Entities: In January 2003, the FASB issued Interpretation No. 46, “Consolidation of Variable Interest Entities, an interpretation of ARB 51” (“FIN 46”). The primary objectives of FIN 46 are to provide guidance on the identification of entities for which control is achieved through means other than through voting rights and how to determine when and which business enterprise should consolidate the variable interest entity (“VIE”). This new model for consolidation applies to an entity in which either (1) the equity investors (if any) do not have a controlling financial interest or (2) the equity investment at risk is insufficient to finance that entity’s activities without receiving additional subordinated financial support from other parties.We adopted FIN 46 on July 1, 2003 and, as a result, we began consolidating our joint venture with De Lage Landen International BV (“DLL”), our vendor financing partnership in the Netherlands, effective July 1, 2003. Prior to the adoption of FIN 46, we accounted for our investment in DLL under the equity method of accounting. The impact of consolidating DLL was to record additional assets and liabilities of approximately $94. The adoption of FIN 46 did not have a material impact on our results of operations, financial position or liquidity.

 

Guarantees: In November 2002, the FASB issued Interpretation No. 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others” (“FIN 45”). This interpretation expands the disclosure requirements of guarantee obligations and requires the guarantor to recognize a liability for the fair value of the obligation assumed under a guarantee. In general, FIN 45 applies to contracts or indemnification agreements that contingently require the guarantor to make payments to the guaranteed party based on changes in an underlying instrument that is related to an asset, liability, or equity security of the guaranteed party. Other guarantees are subject to the disclosure requirements of FIN 45 but not to the recognition provisions and include, among others, a guarantee accounted for as a derivative instrument under SFAS No. 133, “Accounting for Derivatives and Hedging” (“SFAS No. 133”), a parent’s guarantee of debt owed to a third party by its subsidiary or vice versa, and a guarantee which is based on performance. The disclosure requirements of FIN 45 were effective as of December 31, 2002. The recognition requirements of FIN 45 are to be applied prospectively to guarantees issued or modified after December 31, 2002. Significant guarantees that we have entered are disclosed in Note 10. The requirements of FIN 45 did not have a material impact on our results of operations, financial position or liquidity.

 

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Xerox Corporation

 

Notes to Condensed Consolidated Financial Statements—(Continued)

($ in millions except per share data and where otherwise noted)

 

Stock-Based Compensation: In 2002 the FASB issued SFAS No. 148 “Accounting for Stock-Based Compensation—Transition and Disclosure, an amendment of FASB Statement No. 123” (“SFAS No. 148”) which provides alternative methods of transition for an entity that voluntarily changes to the fair value based method of accounting for stock-based employee compensation. It also amends the disclosure provisions of SFAS No. 123 to require prominent disclosure about the effects on reported net income of an entity’s accounting policy decisions with respect to stock-based employee compensation. Finally, this statement amends APB Opinion No. 28, “Interim Financial Reporting,” to require disclosure about those effects in interim financial information. We adopted SFAS No. 148 in the fourth quarter of 2002. Since we have not changed to a fair value method of stock-based compensation, the applicable portion of this statement only affects our disclosures.

 

We do not recognize compensation expense relating to employee stock options because we normally grant options with an exercise price equal to the fair value of the stock on the effective date of grant. If we had elected to recognize compensation expense using a fair value approach, and therefore determined the compensation based on the value as determined by the modified Black-Scholes option pricing model, our pro forma income and income (loss) per share would have been as follows:

 

    

Three Months

Ended

September 30


   

Nine Months

Ended

September 30


 
     2003

    2002

    2003

    2002

 

Net income, as reported

   $ 117     $ 99     $ 138     $ 72  

Deduct: Total stock-based employee compensation expense determined under fair value based methods for all awards, net of tax

     (28 )     (20 )     (66 )     (58 )
    


 


 


 


Net income – pro forma(1)

   $ 89     $ 79     $ 72     $ 14  
    


 


 


 


Earnings per share: (2)

                                

Basic – as reported

   $ 0.12     $ 0.05     $ 0.12     $ 0.01  

Basic – pro forma

   $ 0.08     $ 0.02     $ 0.03     $ (0.07 )

Diluted – as reported

   $ 0.11     $ 0.04     $ 0.11     $ 0.01  

Diluted – pro forma

   $ 0.08     $ 0.02     $ 0.03     $ (0.07 )

1 The nine months ended September 30, 2003 include a computational adjustment to increase compensation expense by $14 (after tax) related to options that had been previously excluded from the first and second quarters of 2003 of $4 and $10, respectively.
2 The calculation of earnings per share is impacted by preferred dividends in arriving at income available to common shareholders.

 

Dividends for the period are subtracted from net income when calculating earnings per share. See Note 11 for the earnings per share calculation.

 

Costs Associated with Exit or Disposal Activities: In 2002, the FASB issued SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities” (“SFAS No. 146”). This standard requires companies to recognize costs associated with exit or disposal activities when they are incurred, rather than at the date of a commitment to an exit or disposal plan. Examples of costs covered by the standard include lease termination costs and certain employee severance costs that are associated with a restructuring, plant closing, or other exit or disposal activity. SFAS No. 146 is required to be applied prospectively to exit or disposal activities initiated after December 31, 2002, with earlier application encouraged. We adopted SFAS No. 146 in the fourth quarter of 2002. Refer to Note 5 for further discussion.

 

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Xerox Corporation

 

Notes to Condensed Consolidated Financial Statements—(Continued)

($ in millions except per share data and where otherwise noted)

 

3. Revenue Recognition:

 

In the normal course of business, we generate revenue through the sale and rental of equipment, service and supplies and income associated with the financing of our equipment sales. Revenue is recognized when earned. More specifically, revenue related to sales of our products and services is recognized as follows:

 

Equipment: Revenues from the sale of equipment, including those from sales-type leases, are recognized at the time of sale or at the inception of the lease, as appropriate. For equipment sales that require us to install the product at the customer location, revenue is recognized when the equipment has been delivered to and installed at the customer location. Sales of customer installable products are recognized upon shipment or receipt by the customer according to the customer’s shipping terms. Revenues from equipment under other leases and similar arrangements are accounted for by the operating lease method and are recognized as earned over the lease term, which is generally on a straight-line basis.

 

Service: Service revenues are derived primarily from maintenance contracts on our equipment sold to customers and are recognized over the term of the contracts. A substantial portion of our products are sold with full service maintenance agreements for which the customer typically pays a base service fee plus a variable amount based on usage. As a consequence, we do not have any significant product warranty obligations, including any obligations under customer satisfaction programs.

 

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

 

Revenue Recognition Under Bundled Arrangements: We sell most of our products and services under bundled contract arrangements, which contain multiple deliverable elements. These contractual lease arrangements typically include equipment, service, supplies and financing components for which the customer pays a single negotiated price for all elements. These arrangements typically also include a variable component for page volumes in excess of contractual minimums, which are often expressed in terms of price per page, which we refer to as the “cost per copy.” In a typical bundled arrangement, our customer is quoted a fixed minimum monthly payment for 1) the equipment, 2) the associated services and other executory costs, 3) the supplies and 4) the financing element. The fixed minimum monthly payments are multiplied by the number of months in the contract term to arrive at the total fixed minimum payments that the customer is obligated to make (“fixed payments”) over the lease term. The payments associated with page volumes in excess of the minimums are contingent on whether or not such minimums are exceeded (“contingent payments”). The minimum contractual committed copy volumes are typically negotiated to equal the customer’s estimated copy volume at lease inception. In applying our lease accounting methodology, we consider the fixed payments for purposes of allocating to the relative fair value elements of the contract. We do not consider the contingent payments for purposes of allocating to the elements of the contract or recognizing revenue on the sale of the equipment, given the inherent uncertainties as to whether such amounts will ever be received. Contingent payments are recognized as revenue in the period when the customer exceeds the minimum copy volumes specified in the contract.

 

When separate prices are listed in multiple element customer contracts, such prices may not be representative of the fair values of those elements, because the prices of the different components of the arrangement may be modified through customer negotiations, although the aggregate consideration may remain the same. Revenues under bundled arrangements are allocated based upon the estimated fair values of each element (and for transactions entered into after July 1, 2003, revenues are allocated considering the relative fair values of the lease and non-lease deliverables in accordance with EITF 00-21). Our revenue allocation to the lease deliverables begins by allocating revenues to the maintenance and executory costs plus profit thereon, and

 

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Xerox Corporation

 

Notes to Condensed Consolidated Financial Statements—(Continued)

($ in millions except per share data and where otherwise noted)

 

second by allocating revenue to the equipment based on comparison of the equipment values in our accounting systems to a range of cash selling prices or, if applicable, other verifiable objective evidence of fair value. We perform extensive analyses of available verifiable objective evidence of equipment fair value based on cash selling prices during the applicable period. The cash selling prices are compared to the range of values included in our lease accounting systems. The range of cash selling prices must support the reasonableness of the lease selling prices, taking into account residual values that accrue to our benefit, in order for us to determine that such lease prices are indicative of fair value. Our interest rates are developed based upon a variety of factors including local prevailing rates in the marketplace and the customer’s credit history, industry and credit class. These rates are recorded within our pricing systems. The resultant implicit interest rate, which is the same as our pricing interest rate, unless adjustment to equipment values is required, is then compared to fair market value rates to assess the reasonableness of the fair value allocations to the multiple elements.

 

Determination of Appropriate Revenue Recognition for Leases: Our accounting for leases involves specific determinations under Statement of Financial Accounting Standards No. 13 “Accounting for Leases” (“SFAS No. 13”) which often involve complex provisions and significant judgments. The two primary criteria of SFAS No. 13 which we use to classify transactions as sales-type or operating leases are (1) a review of the lease term to determine if it is equal to or greater than 75 percent of the economic life of the equipment and (2) a review of the present value of the minimum lease payments to determine if they are equal to or greater than 90 percent of the fair market value of the equipment. Under our current product portfolio and business strategies, a non-cancelable lease of 45 months or more generally qualifies as a sale. Certain of our lease contracts are customized for larger customers, which results in complex terms and conditions and requires significant judgment in applying the above criteria. In addition to these, there are also other important criteria that are required to be assessed, including whether collectibility of the lease payments is reasonably predictable and whether there are important uncertainties related to costs that we have yet to incur with respect to the lease. In our opinion, our sales-type lease portfolios contain only normal credit and collection risks and have no important uncertainties with respect to future costs. Our leases in our Latin America operations have historically been recorded as operating leases since a majority of these leases are terminated significantly prior to the expiration of the contractual lease term. Specifically, because we generally do not collect the receivable from the initial transaction upon termination or during any subsequent lease term, the recoverability of the lease investment is deemed not to be predictable at lease inception. We continue to evaluate economic, business and political conditions in the Latin American region to determine if certain leases will qualify as sales type leases in future periods.

 

The critical estimates and judgments that we consider with respect to our lease accounting, are the determination of the economic life and the fair value of equipment, including the residual value. Those estimates are based upon historical experience with all our products. For purposes of estimating the economic life, we consider the most objective measure of historical experience to be the original contract term, since most equipment is returned by lessees at or near the end of the contracted term. The estimated economic life of most of our products is five years since this represents the most frequent contractual lease term for our principal products and only a small percentage of our leases have original terms longer than five years. We believe that this is representative of the period during which the equipment is expected to be economically usable, with normal service, for the purpose for which it is intended. We continually evaluate the economic life of both existing and newly introduced products for purposes of this determination. Residual values are established at lease inception using estimates of fair value at the end of the lease term. Our residual values are established with due consideration to forecasted supply and demand for our various products, product retirement and future product launch plans, end of lease customer behavior, remanufacturing strategies, used equipment markets if any, competition and technological changes.

 

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Xerox Corporation

 

Notes to Condensed Consolidated Financial Statements—(Continued)

($ in millions except per share data and where otherwise noted)

 

The vast majority of our leases that qualify as sales-type are non-cancelable and include cancellation penalties approximately equal to the full value of the leased equipment. A portion of our business involves sales to governmental units. Governmental units are those entities that have statutorily defined funding or annual budgets that are determined by their legislative bodies. Certain of our governmental contracts may have cancellation provisions or renewal clauses that are required by law, such as 1) those dependant on fiscal funding outside of a governmental unit’s control, 2) those that can be cancelled if deemed in the taxpayer’s best interest or 3) those that must be renewed each fiscal year, given limitations that may exist on entering multi-year contracts that are imposed by statute. In these circumstances and in accordance with the relevant accounting literature, we carefully evaluate these contracts to assess whether cancellation is remote because of the existence of substantive economic penalties upon cancellation or whether the renewal is reasonably assured due to the existence of a bargain renewal option. The evaluation of a lease agreement with a renewal option includes an assessment as to whether the renewal is reasonably assured based on the intent of such governmental unit and pricing terms as compared to those of short-term leases at lease inception. We further ensure that the contract provisions described above are offered only in instances where required by law. Where such contract terms are not legally required, we consider the arrangement to be cancelable and account for it as an operating lease.

 

Aside from the initial lease of equipment to our customers, we may enter subsequent transactions with the same customer whereby we extend the term. We evaluate the classification of lease extensions of sales-type leases using the originally determined economic life for each product. There may be instances where we have lease extensions for periods that are within the original economic life of the equipment. These are accounted for as sales-type leases only when the extensions occur in the last three months of the lease term and they otherwise meet the appropriate criteria of SFAS 13. All other lease extensions of this type are accounted for as direct financing leases. We generally account for lease extensions that go beyond the economic life as operating leases because of important uncertainties as to the amount of servicing and repair costs that we may incur.

 

4. Inventories:

 

Inventories consist of the following:

 

    

September 30,

2003


   December 31,
2002


Finished goods

   $ 1,005    $ 970

Work in process

     74      66

Raw materials

     200      195
    

  

Total inventories

   $ 1,279    $ 1,231
    

  

 

Inventories are carried at the lower of average cost or market. Inventories also include equipment that is returned at the end of the lease term. Returned equipment is recorded at the lower of remaining net book value or salvage value. Salvage value consists of the estimated market value (generally determined based on replacement cost) of the salvageable component parts, which are expected to be used in the remanufacturing process.

 

We regularly review inventory quantities and record a provision for excess and/or obsolete inventory based primarily on our estimated forecast of product demand, production requirements and servicing commitments. Several factors may influence the realizability of our inventories, including our decision to exit a product line, technological changes and new product development. The provision for excess and/or obsolete raw materials and equipment inventories is based primarily on near term forecasts of product demand and include consideration of new product introductions as well as changes in remanufacturing strategies. The provision for excess and/or obsolete service parts inventory is based primarily on projected servicing requirements over the life of the related equipment populations.

 

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Xerox Corporation

 

Notes to Condensed Consolidated Financial Statements—(Continued)

($ in millions except per share data and where otherwise noted)

 

5. Restructuring Programs:

 

Since early 2000, we have engaged in a series of restructuring programs related to downsizing our employee base, exiting certain businesses, outsourcing certain internal functions and engaging in other actions designed to reduce our cost structure. We accomplished these objectives through the undertaking of restructuring initiatives. As of December 31, 2002, all restructuring programs had been substantially completed, except for the previously announced Turnaround Program and the Restructuring Programs under SFAS No. 146, which continued through September 30, 2003. Management continues to evaluate the business and, therefore, there may be supplemental provisions for new plan initiatives as well as changes in estimates to amounts previously recorded, as payments are made or actions are completed. Detailed information related to the Restructuring Programs under SFAS No. 146 and the Turnaround Program is outlined below.

 

Restructuring Programs under SFAS No. 146: On October 1, 2002, we adopted the provisions of SFAS No. 146. During the fourth quarter of 2002, we announced a worldwide restructuring program and subsequently recorded a provision of $402. The provision consisted of $312 for severance and related costs, $45 of costs associated with lease terminations and future rental obligations, net of estimated future sublease rents and $45 for asset impairments. The severance and related costs were related to the elimination of approximately 4,700 positions worldwide. As of September 30, 2003, substantially all of the affected employees had been separated under the program. During the first nine months of 2003, we provided an additional $56 for restructuring programs, net of reversals of $13 related to changes in estimates for severance costs from previously recorded actions. The additional provision consisted of $35 related to the elimination of approximately 400 positions worldwide, $28 for pension settlements associated with prior severance actions and $6 for lease terminations. The reserve balance of the Restructuring Programs under SFAS No. 146 at September 30, 2003 is $94.

 

The following table summarizes the restructuring activity for the Restructuring Programs under SFAS No. 146 for the nine months ended September 30, 2003:

 

    

Severance and

Related Costs


   

Lease

Cancellation

and Other Costs


    Total

 

Balance at December 31, 2002

   $ 241     $ 45     $ 286  

Provisions, including accretion

     63       6       69  

Reversals

     (13 )     —         (13 )

Charges

     (234 )     (14 )     (248 )
    


 


 


Balance at September 30, 2003

   $ 57     $ 37     $ 94  
    


 


 


 

The following tables summarize the total amount of costs expected to be incurred in connection with the Restructuring Programs under SFAS No. 146 and the cumulative amount incurred as of September 30, 2003:

 

Segment Reporting:

 

    

Cumulative

amount

incurred as of

December 31, 2002


  

Net amount

incurred for the

nine months

ended

September 30, 2003


  

Cumulative

amount

incurred as of

September 30, 2003


  

Total expected

to be incurred *


Production

   $ 146    $ 27    $ 173    $ 188

Office

     102      21      123      134

DMO

     54      —        54      55

Other

     100      8      108      118
    

  

  

  

Net Provision

   $ 402    $ 56    $ 458    $ 495
    

  

  

  

 

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Xerox Corporation

 

Notes to Condensed Consolidated Financial Statements—(Continued)

($ in millions except per share data and where otherwise noted)

 


* The total amount of $495 represents the cumulative amount incurred through September 30, 2003 plus additional expected restructuring charges of $37 (of which $15 is expected in 2003) related to initiatives identified to date but not yet recognized in the consolidated financial statements. The expected restructuring provisions relate to pension settlements as well as additional severance and cost reductions, principally related to the integration of our Xerox Engineering Systems business.

 

Major Cost Reporting:

 

    

Cumulative

amount

incurred as of

December 31, 2002


  

Amount

incurred for the

nine months

ended

September 30, 2003


  

Cumulative

amount

incurred as of

September 30, 2003


  

Total expected

to be incurred *


Severance and related costs

   $ 312    $ 50    $ 362    $ 393

Lease cancellation and other costs

     45      6      51      57

Asset impairments

     45      —        45      45
    

  

  

  

Net Provision

   $ 402    $ 56    $ 458    $ 495
    

  

  

  

 

Turnaround Program. The Turnaround Program was put in place in October 2000 to reduce costs, improve operations, transition customer equipment financing to third-party vendors and sell certain assets. As of December 31, 2002, we had $131 of restructuring reserves remaining primarily related to employee severance as a result of our downsizing efforts. The Turnaround Program reserve balance at September 30, 2003 was $50.

 

The following table summarizes the restructuring activity for the Turnaround Program for the nine-month period ended September 30, 2003:

 

    

Severance

and related costs


   

Lease cancellation

and other costs


    Total

 

Balance at December 31, 2002

   $ 104     $ 27     $ 131  

Provisions

     4       1       5  

Reversal

     (4 )     (1 )     (5 )

Charges

     (70 )     (11 )     (81 )
    


 


 


Balance at September 30, 2003

   $ 34     $ 16     $ 50  
    


 


 


 

Reconciliation of Restructuring Charges to Statements of Cash Flows

 

The following is a reconciliation of charges to the restructuring reserves for all restructuring actions to the amounts reported in the Consolidated Statement of Cash Flows as cash payments for restructurings:

 

    

Nine Months ended
September 30,

2003


 

Charges to reserve, all programs

   $ (329 )

Non-cash items:

        

Pension settlements

     28  

Effects of foreign currency and other

     2  
    


Cash payments for restructurings

   $ (299 )
    


 

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Xerox Corporation

 

Notes to Condensed Consolidated Financial Statements—(Continued)

($ in millions except per share data and where otherwise noted)

 

6. Common Shareholders’ Equity:

 

Common shareholders’ equity consisted of:

 

    

September 30,

2003


   

December 31,

2002


 

Common stock (1)

   $ 793     $ 738  

Additional paid-in-capital (1)

     2,436       2,001  

Retained Earnings

     1,118       1,025  

Accumulated other comprehensive loss (2) (3)

     (1,665 )     (1,871 )
    


 


Total

   $ 2,682     $ 1,893  
    


 



(1) Amounts as of September 30, 2003 include the issuance of 46 million common shares in connection with the Recapitalization.
(2) Accumulated other comprehensive loss at September 30, 2003 was comprised of cumulative translation adjustments of $(1,238), a minimum pension liability of $(437), unrealized gains on marketable securities of $9, and cash flow hedging gains of $1.
(3) In September 2003, certain forward contracts used to hedge Yen denominated interest payments on our Yen notes due in 2005 and 2007 were designated and accounted for as cash flow hedges. Accordingly, the change in value of these derivatives is included in Accumulated other comprehensive loss. No amount of ineffectiveness was recorded in earnings during the period.

 

As of September 30, 2003, we had $889 of 6.25% Series C Mandatory Convertible Preferred Stock outstanding. These securities will convert to common stock at or prior to July 1, 2006. The conversion will result in the issuance of between approximately 75 and 90 million shares of our common stock depending on the market price of our common stock on the conversion date.

 

Comprehensive income for the three and nine months ended September 30, 2003 and 2002 was as follows:

 

     Three Months Ended

    Nine Months Ended

 
    

September 30,

2003


  

September 30,

2002


   

September 30,

2003


   

September 30,

2002


 

Net Income

   $ 117    $ 99     $ 138     $ 72  

Translation adjustments

     73      (103 )     287       27  

Unrealized gains on marketable securities

     9      —         9       —    

Adjustment for minimum pension liability (1)

     —        10       (92 )     (15 )

Cash flow hedge adjustments

     1      4       2       3  
    

  


 


 


Comprehensive income

   $ 200    $ 10     $ 344     $ 87  
    

  


 


 



(1) The change of $92 in the minimum pension liability since December 31, 2002 relates primarily to our portion of a minimum pension liability charge recorded by Fuji Xerox during the period.

 

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Xerox Corporation

 

Notes to Condensed Consolidated Financial Statements—(Continued)

($ in millions except per share data and where otherwise noted)

 

7. Interest Expense and Income:

 

Interest expense and interest income for the three and nine months ended September 30, 2003 and 2002 were as follows:

 

     Three Months Ended

    Nine Months Ended

 
    

September 30,

2003


   

September 30,

2002


   

September 30,

2003


   

September 30,

2002


 

Interest expense (1)

   $ 194     $ 199     $ 601     $ 550  

Interest income (2)

     (261 )     (268 )     (788 )     (825 )

(1) Includes Equipment financing interest, as well as non-financing interest expense that is included in Other expenses, net in the Condensed Consolidated Statements of Income.
(2) Includes Finance income, as well as interest income that is included in Other expenses, net in the Condensed Consolidated Statements of Income.

 

Equipment financing interest is determined based on a combination of actual interest expense incurred on financing debt, as well as our estimated cost of debt, applied against the estimated level of debt required to support our financed receivables. The estimate is based on an assumed ratio of debt as compared to our finance receivables. This ratio ranges from 80-90% of our average finance receivables. This methodology has been consistently applied for all periods presented.

 

8. Segment Reporting:

 

Our reportable segments are as follows: Production, Office, Developing Markets Operations (DMO) and Other. Effective January 1, 2003, Small Office/Home Office (SOHO), a business that we exited in 2001, is now reported in Other as it no longer meets the quantitative thresholds for separate reporting related to assets, revenues and profitability and its results are no longer regularly reviewed by our chief operating decision maker. In 2003, we reclassified our mid-range color products (11-40 pages per minute) from the Production segment to the Office segment to align our segment reporting with the marketplace and how we manage our business. As a result, 2002 revenue of $1,093 was reclassified from the Production segment to the Office segment. The quarterly impact was as follows: $237, $259, $259, $338 for the first, second, third, and fourth quarters of 2002, respectively. Operating profit was reclassified for this change as well as for certain changes in corporate and other expense allocations. The following table illustrates the impact of these changes on operating profit for 2002:

 

     Three Months Ended

 
     Mar. 31

    Jun. 30

    Sept. 30

    Dec. 31

    Total

 

Production

   $ (31 )   $ (29 )   $ (46 )   $ (69 )   $ (175 )

Office

     15       14       37       57       123  

DMO

     7       7       7       8       29  

Other

     9       8       2       4       23  
    


 


 


 


 


Total

     —         —         —         —         —    
    


 


 


 


 


 

The Production segment includes black and white products over 90 pages per minute and color products over 40 pages per minute. Products include the DocuTech, DocuPrint, Xerox 1010 and Xerox 2101 and DocuColor families as well as older technology light-lens products. These products are sold, predominantly through direct sales channels in North America and Europe, to Fortune 1000, graphic arts, government, education and other public sector customers.

 

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Xerox Corporation

 

Notes to Condensed Consolidated Financial Statements—(Continued)

($ in millions except per share data and where otherwise noted)

 

The Office segment includes black and white products up to 90 pages per minute and color devices up to 40 pages per minute. Products include our family of Document Centre digital multifunction products and our new suite of CopyCentre, WorkCentre, and WorkCentre Pro digital multifunction offerings, DocuColor color multifunction products, color laser, solid ink and monochrome laser desktop printers, digital and light-lens copiers, and facsimile products. These products are sold through direct and indirect sales channels in North America and Europe to global, national and mid-size commercial customers as well as government, education and other public sector customers.

 

The DMO segment includes our operations in Latin America, the Middle East, India, Eurasia, Russia and Africa. This segment includes sales of products that are typical to the aforementioned segments, however, management serves and evaluates these markets on an aggregate geographic, rather than product, basis.

 

The segment classified as Other, includes several units, none of which met the thresholds for separate segment reporting. This group primarily includes Xerox Supplies Group (“XSG”) (predominantly paper), SOHO, Xerox Engineering Systems (“XES”), Xerox Technology Enterprises (“XTE”) and consulting services, royalty and license revenues. Other segment profit (loss) includes the operating results from these entities, other less significant businesses, our equity income from Fuji Xerox, and certain costs which have not been allocated to the other segments including non-financing interest and other non-allocated costs. Other segments’ total assets include XSG, SOHO, XES, and our investment in Fuji Xerox.

 

Operating segment revenues and profitability for the three months ended September 30, 2003 and 2002 were as follows:

 

     Production

   Office

   DMO

   Other(1)

    Total

2003

                                   

Total segment revenues

   $ 1,057    $ 1,837    $ 403    $ 435     $ 3,732
    

  

  

  


 

Segment profit (loss)

   $ 53    $ 181    $ 24    $ (68 )   $ 190
    

  

  

  


 

2002

                                   

Total segment revenues

   $ 1,065    $ 1,844    $ 412    $ 472     $ 3,793
    

  

  

  


 

Segment profit (loss)

   $ 95    $ 154    $ 28    $ (21 )   $ 256
    

  

  

  


 

 

Operating segment revenues and profitability for the nine months ended September 30, 2003 and 2002 were as follows:

 

     Production

   Office

   DMO

   Other(1)(2)

    Total

2003

                                   

Total segment revenues

   $ 3,238    $ 5,609    $ 1,176    $ 1,386     $ 11,409
    

  

  

  


 

Segment profit (loss)

   $ 259    $ 496    $ 101    $ (255 )   $ 601
    

  

  

  


 

2002

                                   

Total segment revenues

   $ 3,258    $ 5,547    $ 1,322    $ 1,476     $ 11,603
    

  

  

  


 

Segment profit (loss)

   $ 267    $ 413    $ 44    $ (140 )   $ 584
    

  

  

  


 


(1) Other segment loss for the three and nine months ended September 30, 2002 included the ESOP benefit of $67 discussed in Note 13 to the 2002 consolidated financial statements.
(2) Other segment loss for the nine months ended September 30, 2003 included the $73 loss associated with extinguishment of debt on the 2002 Credit Facility as described in Note 1.

 

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Xerox Corporation

 

Notes to Condensed Consolidated Financial Statements—(Continued)

($ in millions except per share data and where otherwise noted)

 

The following is a reconciliation of segment profit to pre-tax income:

 

     Three Months Ended

    Nine Months Ended

 
    

September 30,

2003


   

September 30,

2002


   

September 30,

2003


   

September 30,

2002


 

Total segment profit

     190       256       601       584  

Reconciling items:

                                

Provision for litigation

     —         —         (300 )     —    

Restructuring and asset impairment charges

     (11 )     (63 )     (56 )     (262 )

Restructuring related inventory charge

     —         —         —         (3 )

Allocated item:

                                

Equity in net income of unconsolidated affiliates

     (13 )     (17 )     (43 )     (43 )
    


 


 


 


Pre-tax income

   $ 166     $ 176     $ 202     $ 276  
    


 


 


 


 

9. Debt and Vendor Financing:

 

2003 Credit Facility

 

We entered into the 2003 Credit Facility effective as of June 25, 2003. The 2003 Credit Facility replaced the 2002 Credit Facility. The 2003 Credit Facility consists of a fully drawn $300 term loan and a $700 revolving credit facility that includes a $200 letter of credit sub-facility, under which $78 of letters of credit were outstanding at September 30, 2003. Xerox is the only borrower of the term loan. The revolving credit facility is available, without sub-limit, to Xerox and certain foreign subsidiaries of Xerox, including Xerox Canada Capital Limited (“XCCL”), Xerox Capital (Europe) plc (“XCE”) and other qualified foreign subsidiaries (excluding Xerox, the “Overseas Borrowers”). The 2003 Credit Facility matures on September 30, 2008. In conjunction with the 2003 Credit Facility, debt issuance costs of $29 were deferred.

 

Subject to certain limits described in the following paragraph, the obligations under the 2003 Credit Facility are secured by liens on substantially all the assets of Xerox and each of our U.S. subsidiaries with a consolidated net worth from time to time of $100 or more (the “Material Subsidiaries”), excluding Xerox Credit Corporation (“XCC”) and certain other finance subsidiaries, and are guaranteed by certain Material Subsidiaries. Xerox is required to guarantee the obligations of the Overseas Borrowers.

 

Under the terms of certain of our outstanding public bond indentures, the amount of obligations under the 2003 Credit Facility that can be (1) secured by assets (the “Restricted Assets”) of (a) Xerox and (b) our non-financing subsidiaries that have a consolidated net worth of at least $100, without (2) triggering a requirement to also secure those indentures, is limited to the excess of (x) 20% of our consolidated net worth (as defined in the public bond indentures) over (y) the outstanding amount of certain other debt that is secured by the Restricted Assets. Accordingly, the amount of 2003 Credit Facility debt secured by the Restricted Assets will vary from time to time with changes in our consolidated net worth. The amount of security provided under this formula accrues ratably to the benefit of both the term loan and revolving loans under the 2003 Credit Facility.

 

The term loan and the revolving loans will each bear interest at LIBOR plus a spread that will vary between 1.75% and 3.00% (or, at our election, at the base rate plus a spread that will vary between 0.75% and 2.00%) depending on the then-current leverage ratio under the 2003 Credit Facility.

 

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Xerox Corporation

 

Notes to Condensed Consolidated Financial Statements—(Continued)

($ in millions except per share data and where otherwise noted)

 

The 2003 Credit Facility contains affirmative and negative covenants, as well as financial maintenance covenants. Certain of the more significant covenants under the 2003 Credit Facility are summarized below (this summary is not complete and is in all respects subject to the actual provisions of the 2003 Credit Facility):

 

(a) Limitations on the following will apply at all times under the 2003 Credit Facility:

 

Minimum consolidated net worth of not less than $3.0 billion; for this purpose, “consolidated net worth” generally means the sum of the amounts included on our Statement of Common Shareholders’ Equity as “Common shareholders’ equity,” and in our balance sheet as “Preferred stock,” and, so long as the same is not treated as indebtedness, “Company-obligated, mandatorily redeemable preferred securities of subsidiary trusts holding solely subordinated debentures of the Company,” except that the currency translation adjustment effects and the effects of compliance with SFAS No. 133 occurring after January 1, 2003 are disregarded, and the preferred securities (whether or not convertible) issued by us or by our subsidiaries which are outstanding on June 25, 2003, and any security that causes an increase in consolidated net worth under (and as defined in) our public bond indentures, will always be included, and any capital stock or similar equity interest issued after June 25, 2003 which matures or generally becomes mandatorily redeemable for cash or puttable at holders’ option prior to April 1, 2009 will always be excluded;

 

Maximum leverage ratio (a quarterly test that is calculated as total adjusted debt divided by EBITDA) ranging from 2.0 to 3.1; and

 

Creation and existence of liens, and certain fundamental changes to corporate structure and nature of business, including mergers.

 

(b) Limitations on the following will apply only until such time that Xerox’s senior unsecured debt is rated at least BBB- by S&P and Baa3 by Moody’s (the “Ratings Condition”), and thereafter do not apply:

 

Minimum EBITDA (a quarterly test that is based on rolling four quarters) ranging from $1.1 to $1.3 billion; for this purpose, “EBITDA” (earnings before interest, taxes, depreciation, amortization as well as certain non-recurring items, as defined) generally means EBITDA, excluding interest and financing income to the extent included in EBITDA as consolidated net income; and

 

Maximum capital expenditures (an annual test) of $405 during fiscal year 2003, and thereafter an amount per fiscal year equal to $330 plus any unused amount carried over from any prior fiscal year; additional capital expenditures can be made utilizing certain amounts that are otherwise available to make restricted payments and investments; for this purpose, “capital expenditures” generally means the amounts included on our statement of cash flows as “additions to land, buildings and equipment,” plus any capital lease obligations incurred.

 

(c) Limitations on the following will not apply at any time that the Ratings Condition is satisfied, and will be reinstated at any time that the Ratings Condition is not satisfied:

 

Issuance of debt and preferred stock; asset transfers; hedging transactions other than those entered into in the ordinary course of business; certain types of restricted payments relating to our, or our subsidiaries’, equity interests and subordinated debt, including (subject to certain exceptions) payment of cash dividends on our common stock; certain transactions with affiliates, including intercompany loans and asset transfers and acquisitions.

 

(d) Limitations on investments shall apply only at such times that Xerox’s senior unsecured debt is rated less than BB by S&P and Ba2 by Moody’s.

 

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Table of Contents

Xerox Corporation

 

Notes to Condensed Consolidated Financial Statements—(Continued)

($ in millions except per share data and where otherwise noted)

 

The 2003 Credit Facility generally does not affect our ability to continue to monetize receivables under the agreements with GECC and others. Subject to certain exceptions, we cannot pay cash dividends on our common stock during the term of the 2003 Credit Facility, although we can pay cash dividends on our preferred stock provided there is then no event of default under the 2003 Credit Facility. In addition to other defaults customary for facilities of this type, defaults on other debt, or bankruptcy, of Xerox, or certain of our subsidiaries, and a change in control of Xerox, would constitute events of default under the 2003 Credit Facility.

 

2010 and 2013 Senior Notes

 

On June 25, 2003, we issued $700 aggregate principal amount of Senior Notes due 2010 and $550 aggregate principal amount of Senior Notes due 2013. Interest on the Senior Notes due 2010 and 2013 accrues at the rate of 7 1/8 percent and 7 5/8 percent, respectively, per annum and is payable semiannually. In conjunction with the issuance of the 2010 and 2013 Senior Notes, debt issuance costs of $32 were deferred. These notes, along with our Senior Notes due 2009 which were issued in January 2002, are guaranteed by our wholly-owned subsidiaries Intelligent Electronics, Inc. and Xerox International Joint Marketing, Inc.

 

In September 2003, we entered into pay variable/receive fixed interest rate swaps with notional amounts of $250 associated with the 2010 Senior Notes and $250 associated with the 2013 Senior Notes. The swaps were structured to hedge the fair value of the debt by converting it from a fixed rate instrument to a variable-rate instrument based upon a spread over the six-month LIBOR. These interest rate swaps were designated and accounted for as fair value hedges. No ineffective portion was recorded to earnings during the period. In October 2003, we entered into additional pay variable/receive fixed interest rate swaps with notional amounts of $450 associated with the 2010 Senior Notes. Accordingly, the $700 aggregate principal amount of the 2010 Senior Notes is completely hedged. These interest rate swaps have likewise been designated and will be accounted for as fair value hedges.

 

2009 Senior Notes

 

In September 2003, we completed our offer to exchange the €225 million and $600 aggregate principal amount of our 9 3/4 percent unregistered senior notes due 2009 for a like principal amount of 9 3/4 percent senior notes due 2009 that have been registered under the U.S. Securities Act of 1933, as amended. As of the closing of the exchange offer, €224 million of Euro senior notes and $587 of dollar senior notes had been tendered for exchange and the incremental 0.5 percent interest, that was required prior to the exchange offer, ceased to accrue on all the outstanding senior notes, whether or not tendered for exchange.

 

Payment of Convertible Debt due 2018

 

In April 2003, $560 of convertible debt due 2018 was put back to us in accordance with terms of the debt and was paid in cash.

 

Vendor Financing

 

Our financing business, including our vendor financing outsourcing and securitization activities, is described in detail in our 2002 Consolidated Financial Statements. During the nine months ended September 30, 2003, we completed the following significant vendor financing outsourcing initiatives:

 

We received $1.1 billion secured by our finance receivables in connection with our U.S. Vendor Financing Agreement with GECC and affiliates (“GE”). The agreement with GE was amended in March 2003 to allow for the inclusion of state and local governmental contracts in future securitizations. Total amounts outstanding under this Loan Agreement were $2.4 billion at September 30, 2003.

 

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Table of Contents

Xerox Corporation

 

Notes to Condensed Consolidated Financial Statements—(Continued)

($ in millions except per share data and where otherwise noted)

 

In July 2003 we replaced the 364-day warehouse financing facility in France, received from Merrill Lynch in December 2002, with a long-term public secured financing and established a new warehouse financing facility. This facility can provide funding of up to €350 million (U.S. $407), outstanding at anytime, for new lease originations and may be securitized through a similar public offering within two years. Total amounts outstanding under this agreement and the original financing facility were $47 and $399, respectively, at September 30, 2003.

 

In August 2003, we announced a seven-year agreement in Canada, under which GE Vendor Financial Services Canada, became our primary equipment-financing provider in Canada through monthly fundings of new lease originations. The new agreement calls for GE to initially provide funding on new lease originations, of up to Cdn $850 million (U.S. $629), with the ability to increase the funding to Cdn $2 billion (U.S. $1.5 billion) outstanding at any time, subject to agreement between the parties. Under this agreement, we expect GE to fund approximately 80 percent of new lease originations at over-collateralization rates which vary over time but are expected to approximate 13 percent of the net receivables balance. The monthly interest rates will be consistent with rates for similar market based transactions. Consistent with the loans already received from GE both in the U.S. and Canada, the funding received under this new agreement will be recorded as secured borrowings and the associated receivables will be included in our Consolidated Balance Sheet. During the third quarter, we received $104 in conjunction with this program. Total amounts outstanding under this agreement (including balances previously funded) were $432 at September 30, 2003.

 

In September 2003, GE European Equipment Finance (EEF) and Xerox completed a four-year agreement for EEF to finance Xerox business in the United Kingdom through a £400 million (U.S. $665) revolving loan. This replaces the existing short-term facility which was scheduled to expire in June 2004. The agreement is renewable for an additional three years and the facility size may also be increased to £600 million (U.S. $998), subject to agreement between the parties. Total amounts outstanding under this agreement were $541 at September 30, 2003.

 

10. Litigation, Regulatory Matters and Other Contingencies:

 

Guarantees, Indemnifications and Warranty Liabilities:

 

As more fully discussed in Note 2, we apply the disclosure provisions of FIN 45 to our agreements that contain guarantee or indemnification clauses. These disclosures require that guarantors disclose certain types of guarantees, even if the likelihood of requiring the guarantor’s performance is remote. As of September 30, 2003, we have accrued our estimate of liability incurred under these indemnification arrangements and guarantees where we have determined that a loss is probable and estimable.

 

Indemnifications provided as part of contracts and agreements: We are a party to a variety of agreements pursuant to which we may be obligated to indemnify the other party with respect to certain matters. Typically, these obligations arise in the context of contracts that we entered into for the sale or purchase of businesses or real estate assets, under which we customarily agree to hold the other party harmless against losses arising from a breach of representations and covenants, including obligations to pay rent. These relate to such matters as adequate title to assets sold, intellectual property rights, specified environmental matters and certain income taxes. In addition, we have provided guarantees on behalf of our subsidiaries with respect to real estate leases. In certain instances, these lease guarantees may remain in effect subsequent to the sale of the subsidiary. Furthermore, in certain contracts we have agreed to indemnify various service providers, trustees and bank agents from any third party claims related to their performance on our behalf, with the exception of claims that result from their own willful misconduct or gross negligence. In each of these circumstances, our payment is conditioned on the other party making a claim pursuant to the procedures specified in the particular contract,

 

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Table of Contents

Xerox Corporation

 

Notes to Condensed Consolidated Financial Statements—(Continued)

($ in millions except per share data and where otherwise noted)

 

which procedures typically allow us to challenge the other party’s claims. In the case of lease guarantees, we may contest the liabilities asserted under the lease. Further, our obligations under these agreements and guarantees may be limited in terms of time and/or amount, and in some instances, we may have recourse against third parties for certain payments we made.

 

Indemnification of Officers and Directors: Our corporate by-laws require that, except to the extent expressly prohibited by law, we must indemnify our officers and directors against judgments, fines, penalties and amounts paid in settlement, including legal fees and all appeals, incurred in connection with civil or criminal action or proceedings, as it relates to their services to Xerox Corporation and our subsidiaries. The by-laws provide no limit on the amount of indemnification. The litigation matters and regulatory actions described below involve certain of our current and former directors and officers, all of whom are covered by the aforementioned indemnity.

 

The Securities and Exchange Commission (“SEC”) announced on June 5, 2003 that it had reached a settlement with several individuals who are former officers of Xerox Corporation regarding the same accounting and disclosure matters which were involved in its investigation of Xerox Corporation. These individuals neither admitted nor denied wrongdoing and agreed to pay fines, disgorgement and interest. These individuals are responsible for paying their own fines. However, because all of the individuals who settled were officers of Xerox Corporation, we were required under our by-laws to reimburse the individuals for the disgorgement, interest and legal fees of $19. We accrued these settlement expenses during the second half of 2002.

 

Product Warranty Liabilities:

 

In connection with our normal sales of equipment, including those under sales-type leases, we generally do not issue product warranties. Our arrangements typically involve a separate full service maintenance agreement with the customer. The agreements generally extend over a period equivalent to the lease term or the expected useful life under a cash sale. The service agreements involve the payment of fees in return for our performance of repairs and maintenance. As a consequence, we do not have any significant product warranty obligations including any obligations under customer satisfaction programs. In a few circumstances, particularly in certain cash sales, we may issue a limited product warranty if negotiated by the customer. We also issue warranties for certain of our lower-end products in the Office segment, where full service maintenance agreements are not available. In these instances, we record warranty obligations at the time of the sale. The following table summarizes product warranty activity for the nine months ended September 30, 2003:

 

    

Balance

December 31, 2002


  

Provisions

& Other


   Payments

 

Balance

September 30, 2003


Product warranty liabilities

   $25    $37    $(39)   $23

 

Tax related contingencies:

 

At September 30, 2003, our Brazilian operations had received assessments levied against it for indirect and other taxes which, inclusive of interest, were approximately $425. While unchanged from June 30, 2003, the increase since the December 31, 2002 disclosed amount of $260 is primarily due to currency changes, indexation, interest and additional assessments. These assessments principally relate to the internal transfer of inventory. We are disputing these assessments and intend to vigorously defend our position. Based on the opinion of legal counsel, we do not believe that the ultimate resolution of these assessments will materially impact our results of operations, financial position or cash flows. In connection with these proceedings, we may be required to make cash deposits of up to half of the total amount in dispute. Any such amounts would be refundable to the extent the matter is resolved in our favor.

 

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Table of Contents

Xerox Corporation

 

Notes to Condensed Consolidated Financial Statements—(Continued)

($ in millions except per share data and where otherwise noted)

 

We are subject to ongoing tax examinations and assessments in various jurisdictions. Accordingly, we may record incremental tax expense based upon the probable outcomes of such matters. In addition, when applicable, we adjust the previously recorded tax expense to reflect examination results.

 

Legal Matters:

 

As more fully discussed below, we are a defendant in numerous litigation and regulatory matters involving securities law, patent law, environmental law, employment law and the Employee Retirement Income Security Act (“ERISA”). As required by Statement of Financial Accounting Standards No. 5 “Accounting for Contingencies,” we determine whether an estimated loss from a contingency should be accrued by assessing whether a loss is deemed probable and can be reasonably estimated. We assess our potential liability by analyzing our litigation and regulatory matters using available information. We develop our views on estimated losses in consultation with outside counsel handling our defense in these matters, which involves an analysis of potential results, assuming a combination of litigation and settlement strategies. Should developments in any of these matters cause a change in our determination as to an unfavorable outcome and result in the need to recognize a material accrual, or should any of these matters result in a final adverse judgment or be settled for significant amounts, they could have a material adverse effect on our results of operations, cash flows and financial position in the period or periods in which such change in determination, judgment or settlement occurs.

 

Litigation Against the Company:

 

In re Xerox Corporation Securities Litigation: A consolidated securities law action (consisting of 17 cases) is pending in the United States District Court for the District of Connecticut. Defendants are the Company, Barry Romeril, Paul Allaire and G. Richard Thoman. The consolidated action purports to be a class action on behalf of the named plaintiffs and all other purchasers of common stock of the Company during the period between October 22, 1998 through October 7, 1999 (“Class Period”). The amended consolidated complaint in the action alleges that in violation of Section 10(b) and/or 20(a) of the Securities Exchange Act of 1934, as amended (“1934 Act”), and SEC Rule 10b-5 thereunder, each of the defendants is liable as a participant in a fraudulent scheme and course of business that operated as a fraud or deceit on purchasers of the Company’s common stock during the Class Period by disseminating materially false and misleading statements and/or concealing material facts relating to the defendants’ alleged failure to disclose the material negative impact that the April 1998 restructuring had on the Company’s operations and revenues. The amended complaint further alleges that the alleged scheme: (i) deceived the investing public regarding the economic capabilities, sales proficiencies, growth, operations and the intrinsic value of the Company’s common stock; (ii) allowed several corporate insiders, such as the named individual defendants, to sell shares of privately held common stock of the Company while in possession of materially adverse, non-public information; and (iii) caused the individual plaintiffs and the other members of the purported class to purchase common stock of the Company at inflated prices. The amended consolidated complaint seeks unspecified compensatory damages in favor of the plaintiffs and the other members of the purported class against all defendants, jointly and severally, for all damages sustained as a result of defendants’ alleged wrongdoing, including interest thereon, together with reasonable costs and expenses incurred in the action, including counsel fees and expert fees. On September 28, 2001, the court denied the defendants’ motion for dismissal of the complaint. On November 5, 2001, the defendants answered the complaint. On or about January 7, 2003, the plaintiffs filed a motion for class certification. That motion is currently pending. The parties are currently engaged in discovery. The individual defendants and we deny any wrongdoing and intend to vigorously defend the action. Based on the stage of the litigation, it is not possible to estimate the amount of loss or range of possible loss that might result from an adverse judgment or a settlement of this matter.

 

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Xerox Corporation

 

Notes to Condensed Consolidated Financial Statements—(Continued)

($ in millions except per share data and where otherwise noted)

 

Christine Abarca, et al. v. City of Pomona, et al. (Pomona Water Cases): On June 24, 1999, the Company was served with a summons and complaint filed in the Superior Court of the State of California for the County of Los Angeles. The complaint was filed on behalf of 681 individual plaintiffs claiming damages as a result of our alleged disposal and/or release of hazardous substances into the soil, air and groundwater. Subsequently, six additional complaints were filed in the same court on behalf of another 459 plaintiffs, with the same claims for damages as the June 1999 action. All seven cases have been served on the Company. Currently there are approximately 1,050 plaintiffs, as certain plaintiffs have been dismissed from the litigation. Plaintiffs in all seven cases further allege that they have been exposed to such hazardous substances by inhalation, ingestion and dermal contact, including but not limited to hazardous substances contained within the municipal drinking water supplied by the City of Pomona and the Southern California Water Company. Plaintiffs’ claims against the Company include personal injury, wrongful death, property damage, negligence, trespass, nuisance, and violation of the California Unfair Trade Practices Act. Damages are unspecified. The seven cases against the Company (“Abarca Group”) have been coordinated with approximately 13 unrelated cases against other defendants which involve alleged contaminated groundwater and drinking water in the San Gabriel Valley area of Los Angeles County. In all of those cases, plaintiffs have sued both the providers of drinking water and the industrial defendants who they contend contaminated the water. The body of groundwater involved in the Abarca cases, and allegedly contaminated by the Company, is separate and distinct from the body of groundwater that is involved in the San Gabriel Valley cases, and there is no allegation that the Company is involved in the San Gabriel Valley cases. Nonetheless, the court ordered both groups of cases to be coordinated because both groups concern allegations of groundwater and drinking water contamination, have similar theories of liability alleged against the defendants, and involve a number of similar legal issues, thus apparently making it more efficient, in the view of the court, for all of them to be handled by one judge. Discovery has begun and no trial date has been set. The Company denies any wrongdoing and is vigorously defending the actions. Based on the stage of the litigation, it is not possible to estimate the amount of loss or range of possible loss that might result from an adverse judgment or a settlement of this matter.

 

Carlson v. Xerox Corporation, et al.: A consolidated securities law action (consisting of 21 cases) is pending in the United States District Court for the District of Connecticut against the Company, KPMG and Paul A. Allaire, G. Richard Thoman, Anne M. Mulcahy, Barry D. Romeril, Gregory Tayler and Philip Fishbach. On September 11, 2002, the court entered an endorsement order granting plaintiffs’ motion to file a third consolidated amended complaint. The defendants’ motion to dismiss the second consolidated amended complaint was denied, as moot. According to the third consolidated amended complaint, plaintiffs purport to bring this case as a class action on behalf of an expanded class consisting of all persons and/or entities who purchased Xerox common stock and/or bonds during the period between February 17, 1998 through June 28, 2002 and who were purportedly damaged thereby (“Class”). The third consolidated amended complaint sets forth two claims: one alleging that each of the Company, KPMG, and the individual defendants violated Section 10(b) of the 1934 Act and SEC Rule 10b-5 thereunder; the other alleging that the individual defendants are also allegedly liable as “controlling persons” of the Company pursuant to Section 20(a) of the 1934 Act. Plaintiffs claim that the defendants participated in a fraudulent scheme that operated as a fraud and deceit on purchasers of the Company’s common stock and bonds by disseminating materially false and misleading statements and/or concealing material adverse facts relating to various of the Company’s accounting and reporting practices and financial condition. The plaintiffs further allege that this scheme deceived the investing public regarding the true state of the Company’s financial condition and caused the plaintiffs and other members of the alleged Class to purchase the Company’s common stock and bonds at artificially inflated prices, and prompted a SEC investigation that led to the April 11, 2002 settlement which, among other things, required the Company to pay a $10 penalty and restate its financials for the years 1997-2000 (including restatement of financials previously corrected in an earlier restatement which plaintiffs contend was improper). The third consolidated amended

 

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Notes to Condensed Consolidated Financial Statements—(Continued)

($ in millions except per share data and where otherwise noted)

 

complaint seeks unspecified compensatory damages in favor of the plaintiffs and the other Class members against all defendants, jointly and severally, including interest thereon, together with reasonable costs and expenses, including counsel fees and expert fees. On December 2, 2002, the Company and the individual defendants filed a motion to dismiss the complaint. That motion is currently pending. The individual defendants and we deny any wrongdoing and intend to vigorously defend the action. Based on the stage of the litigation, it is not possible to estimate the amount of loss or range of possible loss that might result from an adverse judgment or a settlement of this matter.

 

Bingham v. Xerox Corporation, et al: A lawsuit filed by James F. Bingham, a former employee of the Company, is pending in the Superior Court of Connecticut, Judicial District of Waterbury (Complex Litigation Docket) against the Company, Barry D. Romeril, Eunice M. Filter and Paul Allaire. The complaint alleges that the plaintiff was wrongfully terminated in violation of public policy because he attempted to disclose to senior management and to remedy alleged accounting fraud and reporting irregularities. The plaintiff further claims that the Company and the individual defendants violated the Company’s policies/commitments to refrain from retaliating against employees who report ethics issues. The plaintiff also asserts claims of defamation and tortious interference with a contract. He seeks: (i) unspecified compensatory damages in excess of $15 thousand, (ii) punitive damages, and (iii) the cost of bringing the action and other relief as deemed appropriate by the court. The court has scheduled trial during February to March 2004 and alternative trial dates in November 2003. The Company denies any wrongdoing. The parties are engaged in voluntary mediation in an attempt to resolve the matter. Should the mediation be unsuccessful, we intend to vigorously defend this action. It is not possible at this time to estimate the amount of loss that might result from an adverse judgment.

 

Berger, et al. v. RIGP: A class was certified in an action originally filed in the United States District Court for the Southern District of Illinois on July 25, 2000 against the Company’s Retirement Income Guarantee Plan (“RIGP”). The RIGP represents the primary U.S. pension plan for salaried employees. Plaintiffs brought this action on behalf of themselves and an alleged class of over 25,000 persons who received lump sum distributions from RIGP after January 1, 1990. Plaintiffs assert violations of the ERISA, claiming that the lump sum distributions were improperly calculated. On July 3, 2001, the court granted the Plaintiffs’ motion for summary judgment, finding the lump sum calculations violated ERISA. On September 30, 2002, the court entered a judgment on damages, stating it would adopt plaintiffs’ methodology for calculating such damages, resulting in a damage award of $284. Based on advice of legal counsel, RIGP concluded that success on appeal was probable and the judgment would be overturned based on significant errors of law in the lower court. RIGP appealed the District Court’s ruling with respect to both liability and damages. Subsequently, there were briefings, followed by an oral argument of the appeal to the Seventh Circuit Court of Appeals on April 9, 2003. Following the oral argument, RIGP and its counsel reassessed the probability of a favorable outcome related to the litigation which has resulted in the Company recording a charge equal to the amount of the initial judgment of $284 plus applicable interest, or $300 in the first quarter of 2003. Other than for the accrual of post-judgment interest, the charge will only be subject to adjustment upon final legal determination, or upon settlement of the parties. As sponsor of the Plan, we were required to record the charge related to our obligation as, under relevant accounting standards, the results of the reassessment required recognition of the judgment. On August 1, 2003, the Seventh Circuit Court of Appeals affirmed the lower court’s judgment in all material respects. On August 15, 2003, RIGP filed a petition for rehearing en banc which was rejected by the Court of Appeals on September 15, 2003. On September 19, 2003, RIGP filed a motion asking the Seventh Circuit to stay the issuance of its mandate, pending RIGP’s filing of a petition for writ of certiorari in the Supreme Court of the United States. On September 25, 2003, the Seventh Circuit denied the motion and issued its mandate. On October 3, 2003, RIGP filed an application for a recall of the mandate directly with the Supreme Court and asked the Court to stay enforcement of the judgment pending RIGP’s filing of its petition for writ of certiorari. This application was also denied.

 

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Xerox Corporation

 

Notes to Condensed Consolidated Financial Statements—(Continued)

($ in millions except per share data and where otherwise noted)

 

RIGP’s petition for writ of certiorari is due December 15, 2003. Any final judgment would be paid from RIGP assets. However, such payment may require the Company to make additional contributions in connection with this litigation in the future. Timing of such additional contributions under ERISA funding rules would not be required any earlier than 2005. However, plaintiffs may seek interim relief that, if successful, would require the Company to pay such judgment, or a portion thereof, as early as the fourth quarter of 2003. In such event, the Company intends to vigorously oppose any such relief.

 

Florida State Board of Administration, et al. v. Xerox Corporation, et al.: A securities law action brought by four institutional investors, namely the Florida State Board of Administration, the Teachers’ Retirement System of Louisiana, Franklin Mutual Advisers and PPM America, Inc., is pending in the United States District Court for the District of Connecticut against the Company, Paul Allaire, G. Richard Thoman, Barry Romeril, Anne Mulcahy, Philip Fishbach, Gregory Tayler and KPMG. The plaintiffs bring this action individually on their own behalves. In an amended complaint filed on October 3, 2002, one or more of the plaintiffs allege that each of the Company, the individual defendants and KPMG violated Sections 10(b) and 18 of the 1934 Act, SEC Rule 10b-5 thereunder, the Florida Securities Investors Protection Act, Fl. Stat. ss. 517.301, and the Louisiana Securities Act, R.S. 51:712(A). The plaintiffs further claim that the individual defendants are each liable as “controlling persons” of the Company pursuant to Section 20 of the 1934 Act and that each of the defendants is liable for common law fraud and negligent misrepresentation. The complaint generally alleges that the defendants participated in a scheme and course of conduct that deceived the investing public by disseminating materially false and misleading statements and/or concealing material adverse facts relating to the Company’s financial condition and accounting and reporting practices. The plaintiffs contend that in relying on false and misleading statements allegedly made by the defendants, at various times from 1997 through 2000 they bought shares of the Company’s common stock at artificially inflated prices. As a result, they allegedly suffered aggregated cash losses in excess of $200. The plaintiffs further contend that the alleged fraudulent scheme prompted a SEC investigation that led to the April 11, 2002 settlement which, among other things, required the Company to pay a $10 penalty and restate its financials for the years 1997-2000 including restatement of financials previously corrected in an earlier restatement which plaintiffs contend was false and misleading. The plaintiffs seek, among other things, unspecified compensatory damages against the Company, the individual defendants and KPMG, jointly and severally, including prejudgment interest thereon, together with the costs and disbursements of the action, including their actual attorneys’ and experts’ fees. On December 2, 2002, the Company and the individual defendants filed a motion to dismiss all claims in the complaint that are in common with the claims in the Carlson action. That motion is currently pending. The individual defendants and we deny any wrongdoing alleged in the complaint and intend to vigorously defend the action. Based on the stage of the litigation, it is not possible to estimate the amount of loss or range of possible loss that might result from an adverse judgment or a settlement of this matter.

 

In Re Xerox Corp. ERISA Litigation: On July 1, 2002, a class action complaint captioned Patti v. Xerox Corp. et al. was filed in the United States District Court for the District of Connecticut (Hartford) alleging violations of the ERISA. Three additional class actions (Hopkins, Uebele and Saba) were subsequently filed in the same court making substantially similar claims. On October 16, 2002, the four actions were consolidated as In Re Xerox Corporation ERISA Litigation. On November 15, 2002, a consolidated amended complaint was filed. A fifth class action (Wright) was filed in the District of Columbia. It has been transferred to Connecticut and consolidated with the other actions. The purported class includes all persons who invested or maintained investments in the Xerox Stock Fund in the Xerox 401(k) Plans (either salaried or union) during the proposed class period, May 12, 1997 through November 15, 2002, and allegedly exceeds 50,000 persons. The defendants include Xerox Corporation and the following individuals or groups of individuals during the proposed class period: the Plan Administrator, the Board of Directors, the Fiduciary Investment Review Committee, the Joint Administrative Board, the Finance Committee of the Board of Directors, and the Treasurer. The complaint claims

 

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Xerox Corporation

 

Notes to Condensed Consolidated Financial Statements—(Continued)

($ in millions except per share data and where otherwise noted)

 

that all the foregoing defendants were “named” or “de facto” fiduciaries of the Plan under ERISA and, as such, were obligated to protect the Plan’s assets and act in the best interest of Plan participants. The complaint alleges that the defendants failed to do so and thereby breached their fiduciary duties. Specifically, plaintiffs claim that the defendants failed to provide accurate and complete material information to participants concerning Xerox stock, including accounting practices which allegedly artificially inflated the value of the stock, and misled participants regarding the soundness of the stock and the prudence of investing retirement benefits in Xerox stock. Plaintiff also claims that defendants failed to ensure that Plan assets were invested prudently, to monitor the other fiduciaries and to disregard Plan directives they knew or should have known were imprudent. The complaint does not specify the amount of damages sought. However, it asks that the losses to the Plan be restored, which it describes as “millions of dollars.” It also seeks other legal and equitable relief, as appropriate, to remedy the alleged breaches of fiduciary duty, as well as interest, costs and attorneys’ fees. We and the other defendants deny any wrongdoing, intend to vigorously defend the action and have filed a motion to dismiss the complaint. The plaintiffs subsequently filed a motion for class certification and the defendants moved to stay the class issue pending a decision by the court on the motion to dismiss. Based on the stage of the litigation, it is not possible to estimate the amount of loss or range of possible loss that might result from an adverse judgment or a settlement of this matter.

 

Digwamaje et al. v. IBM et al: A purported class action was filed in the United States District Court for the Southern District of New York on September 27, 2002. Service of the First Amended Complaint on the Company was deemed effective as of December 6, 2002. On March 19, 2003, Plaintiffs filed a Second Amended Complaint that eliminated a number of corporate defendants but was otherwise identical in all material respects to the First Amended Complaint. The defendants include Xerox and a number of other corporate defendants who are accused of providing material assistance to the apartheid government in South Africa from 1948 to 1994, by engaging in commerce in South Africa and with the South African government and by employing forced labor, thereby violating both international and common law. Specifically, plaintiffs claim violations of the Alien Tort Claims Act, the Torture Victims Protection Act and RICO. They also assert human rights violations and crimes against humanity. Plaintiffs seek compensatory damages in excess of $200 billion and punitive damages in excess of $200 billion. The foregoing damages are being sought from all defendants, jointly and severally. Xerox has filed a motion to dismiss the Second Amended Complaint. Oral argument of the motion is scheduled to begin November 6, 2003. Xerox denies any wrongdoing and intends to vigorously defend the action. Based upon the stage of the litigation, it is not possible to estimate the amount of loss or range of possible loss that might result from an adverse judgment or a settlement of this matter.

 

Arbitration between MPI Technologies, Inc. and Xerox Canada Ltd. and Xerox Corporation: On November 15, 2001, MPI Technologies, Inc. (“MPI”) sent to the American Arbitration Association a Demand for Arbitration of a dispute arising under an Agreement made as of March 15, 1994 between MPI and Xerox Canada Ltd. (“XCL”) (“Agreement”). Subsequently, the Company became MPI’s primary interface for the Agreement and the activities thereunder. The Demand for Arbitration claimed that XCL and the Company owed royalties to MPI for software licensed under the Agreement and initially alleged damages “estimated to be in excess of $30 million.” In a subsequent claim submitted in the arbitration proceedings, MPI has alleged damages of $69 for royalties owed, $35 for breach of fiduciary duty, $35 in punitive damages and unspecified damages and injunctive relief with respect to a claim of copyright infringement. The parties have selected three arbitrators and have agreed to conduct the arbitration in Canada. The Company and XCL deny any liability or wrongdoing, including any royalties owed, have asserted a counterclaim against MPI for overpayment of royalties, breach of contract and copyright infringement and intend to vigorously defend the claim. Based on the stage of the arbitration, it is not possible to estimate the amount of loss or the range of possible loss that might result from an adverse ruling or a settlement of this matter.

 

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Xerox Corporation

 

Notes to Condensed Consolidated Financial Statements—(Continued)

($ in millions except per share data and where otherwise noted)

 

Accuscan, Inc. v. Xerox Corporation: On April 11, 1996, an action was commenced by Accuscan, Inc. (“Accuscan”), in the United States District Court for the Southern District of New York, against the Company seeking unspecified damages for infringement of a patent of Accuscan which expired in 1993. The suit, as amended, was directed to facsimile and certain other products containing scanning functions and sought damages for sales between 1990 and 1993. On April 1, 1998, the jury entered a verdict in favor of Accuscan for $40. However, on September 14, 1998, the court granted our motion for a new trial on damages. The trial ended on October 25, 1999 with a jury verdict of $10. Our motion to set aside the verdict or, in the alternative, to grant a new trial was denied by the court. We appealed to the Court of Appeals for the Federal Circuit (“CAFC”) which found the patent was not infringed, thereby terminating the lawsuit subject to an appeal which has been filed by Accuscan to the U.S. Supreme Court. The decision of the U.S. Supreme Court was to remand the case (along with eight others) back to the CAFC to consider its previous decision based on the U.S. Supreme Court’s May 28, 2002 ruling in the Festo case. Shortly after remand of the case to the CAFC, Accuscan sought reinstatement of a $10 supersedeas bond in the District Court for the Southern District of New York. On February 5, 2003, the District Court refused to re-impose the bond, despite the remand from the U.S. Supreme Court to the CAFC, stating that “it [appears] unlikely that the Federal Circuit will reverse itself.” On September 17, 2003 the CAFC reconsidered the case (in response to the remand from the U.S. Supreme Court) and again held that the patent was not infringed. The period for Accuscan to appeal the CAFC’s decision expires in mid-November 2003.

 

National Union Fire Insurance Company v. Xerox Corporation, et al.: On October 24, 2003, a declaratory judgment action was filed in the Supreme Court of the State of New York, County of New York against the Company and several current and former officers and/or members of the Board of Directors. Plaintiff claims that it issued an Excess Directors & Officers Liability and Corporate Reimbursement Policy to the Company in reliance on information from the Company that allegedly misrepresented the Company’s financial condition and outlook. The policy at issue provides for $25 of coverage as a component of the company reimbursement portion of an insurance program that provides for up to $135 coverage (after deductibles and coinsurance and subject to other policy limitations and requirements) over a three-year period. However, $10 of the entire amount may be unavailable due to the liquidation of one of the other insurers. Plaintiff seeks judgment (i) that it is entitled to rescind the policy as void from the outset; (ii) in the alternative, limiting coverage under the policy and awarding plaintiff damages in an unspecified amount representing that portion of any required payment under the policy that is attributable to the Company’s and the individual defendants’ own misconduct; and (iii) for the costs and disbursement of the action and such other relief as the court deems just and proper. The individual defendants and the Company deny any wrongdoing and intend to vigorously defend the action.

 

Derivative Litigation Brought on Behalf of the Company:

 

In re Xerox Derivative Actions: A consolidated putative shareholder derivative action is pending in the Supreme Court of the State of New York, County of New York against several current and former members of the Board of Directors including William F. Buehler, B.R. Inman, Antonia Ax:son Johnson, Vernon E. Jordan, Jr., Yotaro Kobayashi, Hilmar Kopper, Ralph Larsen, George J. Mitchell, N.J. Nicholas, Jr., John E. Pepper, Patricia Russo, Martha Seger, Thomas C. Theobald, Paul Allaire, G. Richard Thoman, Anne Mulcahy and Barry Romeril, and KPMG. The plaintiffs purportedly brought this action in the name of and for the benefit of the Company, which is named as a nominal defendant, and its public shareholders. The second consolidated amended complaint alleged that each of the director defendants breached their fiduciary duties to the Company and its shareholders by, among other things, ignoring indications of a lack of oversight at the Company and the existence of flawed business and accounting practices within the Company’s Mexican and other operations; failing to have in place sufficient controls and procedures to monitor the Company’s accounting practices; knowingly and recklessly disseminating and permitting to be disseminated, misleading information to

 

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Notes to Condensed Consolidated Financial Statements—(Continued)

($ in millions except per share data and where otherwise noted)

 

shareholders and the investing public; and permitting the Company to engage in improper accounting practices. The plaintiffs further alleged that each of the director defendants breached his/her duties of due care and diligence in the management and administration of the Company’s affairs and grossly mismanaged or aided and abetted the gross mismanagement of the Company and its assets. The second amended complaint also asserted claims of negligence, negligent misrepresentation, breach of contract and breach of fiduciary duty against KPMG. Additionally, plaintiffs claimed that KPMG is liable to Xerox for contribution, based on KPMG’s share of the responsibility for any injuries or damages for which Xerox is held liable to plaintiffs in related pending securities class action litigation. On behalf of the Company, the plaintiffs seek a judgment declaring that the director defendants violated and/or aided and abetted the breach of their fiduciary duties to the Company and its shareholders; awarding the Company unspecified compensatory damages against the director defendants, individually and severally, together with pre-judgment and post-judgment interest at the maximum rate allowable by law; awarding the Company punitive damages against the director defendants; awarding the Company compensatory damages against KPMG; and awarding plaintiffs the costs and disbursements of this action, including reasonable attorneys’ and experts’ fees. On December 16, 2002, the Company and the individual defendants answered the complaint. The plaintiffs filed a third consolidated and amended derivative action complaint on July 23, 2003 adding factual allegations relating to subsequent acts and transactions, namely indemnification of six former officers for disgorgements imposed pursuant to their respective settlements with the SEC and related legal fees, and adding a demand for injunctive relief with respect to that indemnification. On September 12, 2003, Xerox and the individuals filed an answer to the third consolidated and amended derivative action complaint. The individual defendants deny the wrongdoing alleged and intend to vigorously defend the litigation.

 

Pall v. Buehler, et al.: On May 16, 2002, a shareholder commenced a derivative action in the United States District Court for the District of Connecticut against KPMG. The Company was named as a nominal defendant. Plaintiff purported to bring this action derivatively in the right, and for the benefit, of the Company. He contended that he is excused from complying with the prerequisite to make a demand on the Xerox Board of Directors, and that such demand would be futile, because the directors are disabled from making a disinterested, independent decision about whether to prosecute this action. In the original complaint, plaintiff alleged that KPMG, the Company’s former outside auditor, breached its duties of loyalty and due care owed to Xerox by repeatedly acquiescing in, permitting and aiding and abetting the manipulation of Xerox’s accounting and financial records in order to improve the Company’s publicly reported financial results. He further claimed that KPMG committed malpractice and breached its duty to use such skill, prudence and diligence as other members of the accounting profession commonly possess and exercise. Plaintiff claimed that as a result of KPMG’s breaches of duties, the Company has suffered loss and damage. On May 29, 2002, plaintiff amended the complaint to add as defendants the present and certain former directors of the Company. He added claims against each of them for breach of fiduciary duty, and separate additional claims against the directors who are or were members of the Audit Committee of the Board of Directors, based upon the alleged failure, inter alia, to implement, supervise and maintain proper accounting systems, controls and practices. The amended derivative complaint demands a judgment declaring that the defendants have violated and/or aided and abetted the breach of fiduciary and professional duties to the Company and its shareholders; awarding the Company unspecified compensatory damages, together with pre-judgment and post-judgment interest at the maximum rate allowable by law; awarding the Company punitive damages; and awarding the plaintiff the costs and disbursements of the action, including reasonable attorneys’ and experts’ fees. On August 16, 2002, the individual defendants and Xerox filed a motion to dismiss the action. On March 27, 2003, the motion was granted. On April 22, 2003, the court entered judgment in favor of the defendants, dismissing the action in its entirety. The appeal period has expired. On May 12, 2003, the plaintiffs filed a motion seeking to amend the complaint. On August 22, 2003, the court denied the motion. The matter is now closed.

 

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Xerox Corporation

 

Notes to Condensed Consolidated Financial Statements—(Continued)

($ in millions except per share data and where otherwise noted)

 

Pall v. KPMG, et al.: On May 13, 2003, a shareholder commenced a derivative action in the United States District Court for the District of Connecticut against KPMG and four of its current or former partners. The Company was named as a nominal defendant. Plaintiff purports to bring this action derivatively on behalf and for the benefit of the Company seeking damages allegedly caused to the Company by KPMG and the named individual defendants. The plaintiff asserts claims for contribution, negligence, negligent misrepresentation, breach of contract, breach of fiduciary duty and indemnification. The plaintiff seeks unspecified compensatory damages (together with pre-judgment and post-judgment interest), a declaratory judgment that defendants violated and/or aided and abetted the breach of fiduciary and professional duties to the Company, an award of punitive damages for the Company against the defendants, plus the costs and disbursements of the action.

 

Lerner v. Allaire, et al.: On June 6, 2002, a shareholder, Stanley Lerner, commenced a derivative action in the United States District Court for the District of Connecticut against Paul A. Allaire, William F. Buehler, Barry D. Romeril, Anne M. Mulcahy and G. Richard Thoman. The plaintiff purports to bring the action derivatively, on behalf of the Company, which is named as a nominal defendant. Previously, on June 19, 2001, Lerner made a demand on the Board of Directors to commence suit against certain officers and directors to recover unspecified damages and compensation paid to these officers and directors. In his demand, Lerner contended, inter alia, that management was aware since 1998 of material accounting irregularities and failed to take action and that the Company has been mismanaged. At its September 26, 2001 meeting, the Board of Directors appointed a special committee to consider, investigate and respond to the demand. In this action, plaintiff alleges that the individual defendants breached their fiduciary duties of care and loyalty by disguising the true operating performance of the Company through improper undisclosed accounting mechanisms between 1997 and 2000. The complaint alleges that the defendants benefited personally, through compensation and the sale of company stock, and either participated in or approved the accounting procedures or failed to supervise adequately the accounting activities of the Company. The plaintiff demands a judgment declaring that defendants intentionally breached their fiduciary duties to the Company and its shareholders; awarding unspecified compensatory damages to the Company against the defendants, individually and severally, together with pre-judgment and post-judgment interest; awarding the Company punitive damages; and awarding the plaintiff the costs and disbursements of the action, including reasonable attorneys’ and experts’ fees. On September 18, 2002, the individual defendants and Xerox filed a motion to dismiss the action, or alternatively to stay the action pending the disposition of In re Xerox Derivative Actions. On September 29, 2003 the court issued an order granting the defendants’ motion to dismiss. The period for filing an appeal has not yet expired.

 

Other Matters:

 

Xerox Corporation v. 3Com Corporation, et al.: On April 28, 1997, we commenced an action in U.S. District Court for the Western District of New York against Palm for infringement of the Xerox “Unistrokes” handwriting recognition patent by the Palm Pilot using “Graffiti.” On January 14, 1999, the U.S. Patent and Trademark Office (“PTO”) granted the first of two 3Com/Palm requests for reexamination of the Unistrokes patent challenging its validity. The PTO concluded its reexaminations and confirmed the validity of all 16 claims of the original Unistrokes patent. On June 6, 2000, the judge narrowly interpreted the scope of the Unistrokes patent claims and, based on that narrow determination, found the Palm Pilot with Graffiti did not infringe the Unistrokes patent claims. On October 5, 2000, the Court of Appeals for the Federal Circuit reversed the finding of no infringement and sent the case back to the lower court to continue toward trial on the infringement claims. On December 20, 2001, the District Court granted our motions on infringement and for a finding of validity thus establishing liability. On December 21, 2001, Palm appealed to the Court of Appeals. We moved for a trial on damages and an injunction or bond in lieu of injunction. The District Court denied our motion for a temporary injunction, but ordered a $50 bond to be posted to protect us against future damages until the trial. Palm provided

 

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Xerox Corporation

 

Notes to Condensed Consolidated Financial Statements—(Continued)

($ in millions except per share data and where otherwise noted)

 

a $50 irrevocable letter of credit in favor of Xerox. In January 2003, after the oral argument, Palm announced that it would stop including Graffiti in its future operating systems. On February 20, 2003, the Court of Appeals affirmed the infringement of the Unistrokes patent by Palm’s handheld devices and that Xerox will be entitled to an injunction if the validity of the patent is favorably determined. It remanded the validity issues back to the District Court for further validity analysis. On March 20, 2003, we sought reconsideration of the Court of Appeals opinion, but such reconsideration was denied on April 8, 2003. The parties anticipate being contacted soon by the District Court regarding procedure to be followed on remand. Because the validity of the patent must be reconsidered, the basis for the protection bond no longer exists, and the $50 irrevocable letter of credit has been returned. We received a decision and order of the District Court on July 21, 2003 which sets a schedule for briefing of summary judgment with respect to the issue of validity of the patent in suit, with a hearing for argument scheduled to occur on December 10, 2003. Pursuant to a court order of July 17, 2003, (1) expert reports were exchanged between the parties during the third quarter 2003, (2) depositions of experts from both sides were taken shortly thereafter, and (3) summary judgment motions, directed solely to the issue of validity, were filed by the parties on October 10, 2003.

 

U.S. Attorney’s Office Investigation: As we announced on September 23, 2002, we learned that the U.S. attorney’s office in Bridgeport, Connecticut, is conducting an investigation into matters relating to Xerox. Xerox is a subject of this grand jury investigation. We believe that the U.S. Attorney’s office is focusing on accounting and disclosure issues during the period 1998 to 2000, particularly relating to the Company’s operations in Latin America. The accounting matters upon which the U.S. Attorney’s office appears to be focusing are ones that were investigated by the SEC and addressed in the Company’s restatements. It is not possible at this time to reasonably assess the final outcome of this investigation or its future impact on the Company. We are cooperating with the investigation and providing documents as requested.

 

Securities and Exchange Commission Investigation and Review: On April 1, 2002, we announced that we had reached a settlement with the SEC on the previously disclosed proposed allegations related to matters that had been under investigation since June 2000. As a result, on April 11, 2002, the SEC filed a complaint, which we simultaneously settled by consenting to the entry of an Order enjoining us from future violations of Section 17(a) of the Securities Act of 1933, Sections 10(b), 13(a) and 13(b) of the 1934 Act and Rules 10b-5, 12b-20, 13a-1, 13a-13 and 13b2-1 thereunder, requiring payment of a civil penalty of $10, and imposing other ancillary relief. We neither admitted nor denied the allegations of the complaint. The $10 civil penalty is included in Other Expenses, net in 2002 in the Consolidated Statement of Income. Under the terms of the settlement, in 2001 we restated our financial statements for the years 1997 through 2000.

 

As part of the settlement, a special committee of our Board of Directors retained Michael H. Sutton, former Chief Accountant of the SEC, as an independent consultant to review our material accounting controls and policies. Mr. Sutton commenced his review in July 2002. On February 21, 2003, Mr. Sutton delivered his final report, together with observations and recommendations, to members of the special committee. On April 18, 2003, a copy of Mr. Sutton’s report was delivered to the Board of Directors and the SEC. On June 17, 2003, the Board of Directors reported to the SEC the decisions taken as a result of the report. We have a comprehensive ongoing program addressing continued progress in enterprise risk management as well as our process and systems management. We are devoting significant additional resources to this end.

 

Other Matters: It is our policy to promptly and carefully investigate, often with the assistance of outside advisers, allegations of impropriety that may come to our attention. If the allegations are substantiated, appropriate prompt remedial action is taken. When and where appropriate, we report such matters to the U.S. Department of Justice and to the SEC, and/or make public disclosure.

 

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Xerox Corporation

 

Notes to Condensed Consolidated Financial Statements—(Continued)

($ in millions except per share data and where otherwise noted)

 

India. In recent years we have become aware of a number of issues at our Indian subsidiary that occurred over a period of several years much of which occurred before we obtained majority ownership of these operations in mid 1999. These issues include misappropriations of funds and payments to other companies, that may have been inaccurately recorded on the subsidiary’s books, and certain improper payments in connection with sales to government customers. These transactions were not material to the Company’s financial statements. We have reported these transactions to the Indian authorities, the U.S. Department of Justice and to the SEC.

 

South Africa. Certain transactions of our unconsolidated South African affiliate that appear to have been improperly recorded as part of an effort to sell supplies outside of its authorized territory have been investigated and a report of the results has been received by the Board of Directors of the South African affiliate. Disciplinary actions have been taken, and the adjustments to our financial statements were not material. Subsequent to these activities, in the second quarter of 2003, we sold our interest in the South African affiliate.

 

Nigeria. Following an investigation we have determined that certain inter-company and other balances in the local books and records of our majority-owned affiliate in Nigeria could not be substantiated. The Company’s records did not reflect these amounts and the local books have been adjusted to be consistent with them. This adjustment has had no effect on our financial statements. This matter has been reported to the SEC and the Department of Justice. We are in the process of liquidating this company in connection with the December 2002 sale of our interest in the Nigerian business to our local partner.

 

Eurasian Subsidiary. We have recently become aware of a number of transactions in a subsidiary in a Eurasian country that appear to have been improperly recorded in late 2002 and early 2003. Appropriate disciplinary actions have been taken and a charge of approximately $5 related to the periods prior to July 1, 2003 was made in our financial statements for the third quarter of 2003. This matter has been reported to the SEC.

 

36


Table of Contents

Xerox Corporation

 

Notes to Condensed Consolidated Financial Statements—(Continued)

($ in millions except per share data and where otherwise noted)

 

11. Earnings per Share:

 

The following tables summarize basic and diluted earnings per share for the three and nine months ended September 30, 2003 and 2002 (shares in thousands):

 

     Three Months Ended
September 30,


    Nine Months Ended
September 30,


 
     2003

    2002

    2003

    2002

 

I. Basic Earnings Per Common Share

                                

Income before cumulative effect of change in accounting principle

   $ 117     $ 99     $ 138     $ 135  

Accrued dividends on preferred stock, net of tax (1)

     (25 )     (63 )     (46 )     (63 )
    


 


 


 


Income available to common shareholders before cumulative effect of change in accounting principle

     92       36       92       72  
    


 


 


 


Cumulative effect of change in accounting principle

     —         —         —         (63 )
    


 


 


 


Income available to common shareholders

   $ 92     $ 36     $ 92     $ 9  
    


 


 


 


Weighted average shares outstanding for the period

     792,391       733,610       774,348       729,302  
    


 


 


 


Basic Earnings per share:

                                

Income before cumulative effect of change in accounting principle

   $ 0.12     $ 0.05     $ 0.12     $ 0.10  

Cumulative effect of change in accounting principle

     —         —         —         (0.09 )
    


 


 


 


Basic earnings per share

   $ 0.12     $ 0.05     $ 0.12     $ 0.01  
    


 


 


 


II. Diluted Earnings Per Common Share:

                                

Income before cumulative effect of change in accounting principle

   $ 117     $ 99     $ 138     $ 135  

ESOP expense adjustment, net of tax

     (10 )     (63 )     (30 )     (63 )

Accrued dividends on mandatory convertible preferred stock

     (15 )     —         (16 )     —    
    


 


 


 


Income before cumulative effect of change in accounting principle

   $ 92     $ 36     $ 92     $ 72  
    


 


 


 


Cumulative effect of change in accounting principle

     —         —         —         (63 )
    


 


 


 


Net income available to common shareholders

   $ 92     $ 36     $ 92     $ 9  
    


 


 


 


Weighted average common shares outstanding during the period

     792,391       733,610       774,348       729,302  

Common shares issuable with respect to:

                                

Stock options

     9,377       4,184       7,698       5,686  

ESOP preferred stock

     48,858       87,302       53,797       68,371  
    


 


 


 


Adjusted weighted average shares outstanding for the period

     850,626       825,096       835,843       803,359  
    


 


 


 


Diluted earnings per share:

                                

Income before cumulative effect of change in accounting principle

   $ 0.11     $ 0.04     $ 0.11     $ 0.09  

Cumulative effect of change in accounting principle

     —         —         —         (0.08 )
    


 


 


 


Diluted earnings per share

   $ 0.11     $ 0.04     $ 0.11     $ 0.01  
    


 


 


 


 

37


Table of Contents

Xerox Corporation

 

Notes to Condensed Consolidated Financial Statements—(Continued)

($ in millions except per share data and where otherwise noted)

 

(1) Preferred Stock dividends consist of those related to our ESOP plan as well as the mandatory convertible preferred stock issued in June 2003.

 

12. Investment in Fuji Xerox:

 

Our equity in net income of our unconsolidated affiliates for the three and nine months ended September 30, 2003 and 2002, was as follows:

 

    

Three Months

Ended

September 30,


  

Nine Months

Ended

September 30,


     2003

   2002

   2003

   2002

Fuji Xerox

   $ 11    $ 15    $ 30    $ 30

Other investments

     2      2      13      13
    

  

  

  

Total

   $ 13    $ 17    $ 43    $ 43
    

  

  

  

 

Fuji Xerox is headquartered in Tokyo and operates in Japan and other areas of the Pacific Rim, Australia, and New Zealand. We account for our 25% interest in Fuji Xerox under the equity method of accounting. Condensed financial data of Fuji Xerox for the three and nine months ended September 30, 2003 and 2002 was as follows:

 

    

Three Months
Ended

September 30,


  

Nine Months

Ended

September 30,


     2003

   2002

   2003

   2002

Summary of Operations

                           

Revenues

   $ 2,122    $ 2,035    $ 6,225    $ 5,612

Cost and Expenses

     2,018      1,906      5,911      5,355
    

  

  

  

Income before income taxes

     104      129      314      257

Income taxes

     42      52      154      96

Minorities interests

     8      8      27      26

Cumulative effect of change in accounting principle

     —        —        14      —  
    

  

  

  

Net income (1)

   $ 54    $ 69    $ 119    $ 135
    

  

  

  


(1) Net income for the nine months ended September 30, 2003 includes the effect of the adoption of SFAS No. 143.

 

Equity in net income of Fuji Xerox is affected by certain adjustments to reflect the deferral of profit associated with intercompany sales. These adjustments may result in recorded equity income that is different from that implied by our 25% ownership interest.

 

13. Financial Statements of Subsidiary Guarantors:

 

After effectiveness of the 2003 Credit Facility described in Notes 1 and 9, certain of our subsidiaries that were formerly required to guarantee our outstanding 9 3/4% Senior Notes due 2009 were no longer required to, and no longer, guarantee those notes. The Senior Notes due 2009 are now jointly and severally guaranteed only by Intelligent Electronics, Inc. and Xerox International Joint Marketing, Inc. (the “Guarantor Subsidiaries”), each of which is wholly-owned by Xerox Corporation (the “Parent Company”). The Senior Notes due 2010 and 2013 issued in connection with the Recapitalization are also guaranteed by the Guarantor Subsidiaries.

 

38


Table of Contents

Xerox Corporation

 

Notes to Condensed Consolidated Financial Statements—(Continued)

($ in millions except per share data and where otherwise noted)

 

The following supplemental financial information sets forth, on a condensed consolidating basis, the balance sheets, statements of income and statements of cash flows for the Parent Company, the Guarantor Subsidiaries, the non-guarantor subsidiaries and total consolidated Xerox Corporation and subsidiaries as of September 30, 2003 and December 31, 2002 and for the three and nine months ended September 30, 2003 and 2002.

 

Condensed Consolidating Statements of Income (Unaudited)

for the Three Months Ended September 30, 2003

 

     Parent
Company


    Guarantor
Subsidiaries


   

Non-

Guarantor
Subsidiaries


   Eliminations

   

Total

Company


 

Revenues

                                       

Sales

   $ 790     $ 13     $ 800    $ —       $ 1,603  

Service, outsourcing and rentals

     1,044       10       831      —         1,885  

Finance income

     85       —         183      (24 )     244  

Intercompany revenues

     126       —         93      (219 )     —    
    


 


 

  


 


Total Revenues

     2,045       23       1,907      (243 )     3,732  
    


 


 

  


 


Cost and Expenses

                                       

Cost of sales

     540       12       526      (28 )     1,050  

Cost of service, outsourcing and rentals

     572       12       479      (3 )     1,060  

Equipment financing interest

     20       —         93      (24 )     89  

Intercompany cost of sales

     109       —         73      (182 )     —    

Research and development expenses

     177       1       32      (3 )     207  

Selling, administrative and general expenses

     606       8       414      —         1,028  

Restructuring and asset impairment charges

     5       —         6      —         11  

Provision for litigation

     —         —         —        —         —    

Gain on affiliate’s sale of stock

     (12 )     —         —        —         (12 )

Other expenses (income), net

     46       (6 )     93      —         133  
    


 


 

  


 


Total Cost and Expenses

     2,063       27       1,716      (240 )     3,566  
    


 


 

  


 


Income (Loss) before Income Taxes (Benefits), Equity Income and Minorities’ Interests

     (18 )     (4 )     191      (3 )     166  

Income taxes (benefits)

     (13 )     2       59      (1 )     47  
    


 


 

  


 


Income (Loss) before Equity Income and Minorities’ Interests

     (5 )     (6 )     132      (2 )     119  

Equity in net income of unconsolidated affiliates

     (2 )     3       13      (1 )     13  

Equity in net income of consolidated affiliates

     124       —         —        (124 )     —    

Minorities’ interests in earnings of subsidiaries

     —         —         —        (15 )     (15 )
    


 


 

  


 


Net Income (Loss)

   $ 117     $ (3 )   $ 145    $ (142 )   $ 117  
    


 


 

  


 


 

39


Table of Contents

Xerox Corporation

 

Notes to Condensed Consolidated Financial Statements—(Continued)

($ in millions except per share data and where otherwise noted)

 

Condensed Consolidating Statements of Income (Unaudited)

for the Nine Months Ended September 30, 2003

 

     Parent
Company


    Guarantor
Subsidiaries


   

Non-

Guarantor
Subsidiaries


   Eliminations

   

Total

Company


 

Revenues

                                       

Sales

   $ 2,387     $ 41     $ 2,460    $ —       $ 4,888  

Service, outsourcing and rentals

     3,210       30       2,532      —         5,772  

Finance income

     250       —         569      (70 )     749  

Intercompany revenues

     370       —         315      (685 )     —    
    


 


 

  


 


Total Revenues

     6,217       71       5,876      (755 )     11,409  
    


 


 

  


 


Cost and Expenses

                                       

Cost of sales

     1,555       37       1,637      (109 )     3,120  

Cost of service, outsourcing and rentals

     1,751       38       1,464      (8 )     3,245  

Equipment financing interest

     70       —         274      (70 )     274  

Intercompany cost of sales

     328       —         251      (579 )     —    

Research and development expenses

     585       1       91      (9 )     668  

Selling, administrative and general expenses

     1,850       27       1,260      —         3,137  

Restructuring and asset impairment charges

     36       —         20      —         56  

Provision for litigation

     300       —         —        —         300  

Gain on affiliate’s sale of stock

     (13 )     —         —        —         (13 )

Other expenses (income), net

     250       (18 )     188      —         420  
    


 


 

  


 


Total Cost and Expenses

     6,712       85       5,185      (775 )     11,207  
    


 


 

  


 


Income (Loss) before Income Taxes (Benefits), Equity Income and Minorities’ Interests

     (495 )     (14 )     691      20       202  

Income taxes (benefits)

     (206 )     7       239      7       47  
    


 


 

  


 


Income (Loss) before Equity Income and Minorities’ Interests

     (289 )     (21 )     452      13       155  

Equity in net income of unconsolidated affiliates

     1       7       33      2       43  

Equity in net income of consolidated affiliates

     426       —         —        (426 )     —    

Minorities’ interests in earnings of subsidiaries

     —         —         —        (60 )     (60 )
    


 


 

  


 


Net Income (Loss)

   $ 138     $ (14 )   $ 485    $ (471 )   $ 138  
    


 


 

  


 


 

40


Table of Contents

Xerox Corporation

 

Notes to Condensed Consolidated Financial Statements—(Continued)

($ in millions except per share data and where otherwise noted)

 

Condensed Consolidating Balance Sheets (Unaudited)

as of September 30, 2003

 

    Parent
Company


    Guarantor
Subsidiaries


   

Non-

Guarantor
Subsidiaries


    Eliminations

   

Total

Company


 

Assets

                                       

Cash and cash equivalents

  $ 1,410     $ —       $ 860     $ —       $ 2,270  

Accounts receivable, net

    638       17       1,379       —         2,034  

Billed portion of finance receivables, net

    324       —         164       —         488  

Finance receivables, net

    476       —         2,476       —         2,952  

Inventories

    748       2       560       (31 )     1,279  

Other current assets

    577       4       702       —         1,283  
   


 


 


 


 


Total Current Assets

    4,173       23       6,141       (31 )     10,306  
   


 


 


 


 


Finance receivables due after one year, net

    861       —         4,285       —         5,146  

Equipment on operating leases, net

    192       —         194       (26 )     360  

Land, buildings and equipment, net

    1,020       2       735       —         1,757  

Investments in affiliates, at equity

    5       —         548       —         553  

Investments in and advances to consolidated subsidiaries

    7,457       52       183       (7,692 )     —    

Intangible assets, net

    334       —         —         —         334  

Goodwill

    491       296       837       —         1,624  

Other long-term assets

    1,560       2       2,732       —         4,294  
   


 


 


 


 


Total Assets

    16,093       375       15,655       (7,749 )     24,374  
   


 


 


 


 


Liabilities and Equity

                                       

Short-term debt and current portion of long-term debt

    1,442       —         2,708       —         4,150  

Accounts payable

    459       5       334       —         798  

Other current liabilities

    676       18       1,323       14       2,031  
   


 


 


 


 


Total Current Liabilities

    2,577       23       4,365       14       6,979  
   


 


 


 


 


Long-term debt

    2,840       —         4,824       —         7,664  

Intercompany payables, net

    3,629       (52 )     (3,580 )     3       —    

Mandatory redeemable preferred securities

    —         —         697       —         697  

Other long-term liabilities

    3,010       1       887       (1 )     3,897  
   


 


 


 


 


Total Liabilities

    12,056       (28 )     7,193       16       19,237  
   


 


 


 


 


Minorities’ interest in equity of subsidiaries

    —         —         —         77       77  

Company-obligated, mandatorily redeemable preferred securities of subsidiary trusts holding solely subordinated debentures of the Company

    —         —         1,023       —         1,023  

Preferred stock

    508       —         —         —         508  

Deferred ESOP benefits

    (42 )     —         —         —         (42 )

Mandatory convertible preferred stock

    889       —         —         —         889  

Common stock, including additional paid-in capital

    3,229       420       6,778       (7,198 )     3,229  

Retained earnings

    1,118       (17 )     2,119       (2,102 )     1,118  

Accumulated other comprehensive loss

    (1,665 )     —         (1,458 )     1,458       (1,665 )
   


 


 


 


 


Total Liabilities and Equity

  $ 16,093     $ 375     $ 15,655       (7,749 )   $ 24,374  
   


 


 


 


 


 

41


Table of Contents

Xerox Corporation

 

Notes to Condensed Consolidated Financial Statements—(Continued)

($ in millions except per share data and where otherwise noted)

 

Condensed Consolidating Statements of Cash Flows (Unaudited)

for the Nine Months Ended September 30, 2003

 

    Parent
Company


    Guarantor
Subsidiaries


  Non-Guarantor
Subsidiaries


    Total
Company


 

Net cash provided by (used in) operating activities

  $ 1,426     $ —     $ (518 )   $ 908  

Net cash (used in) provided by investing activities

    (259 )     —       194       (65 )

Net cash used in financing activities

    (1,429 )     —       (67 )     (1,496 )

Effect of exchange rate changes on cash and cash equivalents

    —         —       36       36  
   


 

 


 


Decrease in cash and cash equivalents

    (262 )           (355 )     (617 )

Cash and cash equivalents at beginning of period

    1,672       —       1,215       2,887  
   


 

 


 


Cash and cash equivalents at end of period

  $ 1,410       —     $ 860     $ 2,270  
   


 

 


 


 

42


Table of Contents

Xerox Corporation

 

Notes to Condensed Consolidated Financial Statements—(Continued)

($ in millions except per share data and where otherwise noted)

 

Condensed Consolidating Statements of Income (Unaudited)

for the Three Months Ended September 30, 2002

 

    Parent
Company


    Guarantor
Subsidiaries


   

Non-

Guarantor
Subsidiaries


  Eliminations

   

Total

Company


 

Revenues

                                     

Sales

  $ 856     $ 14     $ 723   $ —       $ 1,593  

Service, outsourcing and rentals

    1,098       12       843     —         1,953  

Finance income

    67       —         200     (20 )     247  

Intercompany revenues

    68       1       124     (193 )     —    
   


 


 

 


 


Total Revenues

    2,089       27       1,890     (213 )     3,793  
   


 


 

 


 


Cost and Expenses

                                     

Cost of sales

    504       14       510     (10 )     1,018  

Cost of service, outsourcing and rentals

    577       11       489     (3 )     1,074  

Equipment financing interest

    33       —         94     (20 )     107  

Intercompany cost of sales

    66       1       89     (156 )     —    

Research and development expenses

    198       —         34     (3 )     229  

Selling, administrative and general expenses

    601       8       414     —         1,023  

Restructuring and asset impairment charges

    9       —         54     —         63  

Other expenses (income), net

    27       (6 )     82     —         103  
   


 


 

 


 


Total Cost and Expenses

    2,015       28       1,766     (192 )     3,617  
   


 


 

 


 


Income (Loss) before Income Taxes (Benefits), Equity Income and Minorities’ Interests

    74       (1 )     124     (21 )     176  

Income taxes (benefits)

    3       2       80     (8 )     77  
   


 


 

 


 


Income (Loss) before Equity Income and Minorities’ Interests

    71       (3 )     44     (13 )     99  

Equity in net income of unconsolidated affiliates

    (2 )     3       16     —         17  

Equity in net income of consolidated affiliates

    30       —         —       (30 )     —    

Minorities’ interests in earnings of subsidiaries

    —         —         —       (17 )     (17 )
   


 


 

 


 


Net Income (Loss)

  $ 99     $ —       $ 60   $ (60 )   $ 99  
   


 


 

 


 


 

43


Table of Contents

Xerox Corporation

 

Notes to Condensed Consolidated Financial Statements—(Continued)

($ in millions except per share data and where otherwise noted)

 

Condensed Consolidating Statements of Income (Unaudited)

for the Nine Months Ended September 30, 2002

 

     Parent
Company


    Guarantor
Subsidiaries


   

Non-

Guarantor
Subsidiaries


    Eliminations

   

Total

Company


 

Revenues

                                        

Sales

   $ 2,472     $ 40     $ 2,326     $ —       $ 4,838  

Service, outsourcing and rentals

     3,402       36       2,566       —         6,004  

Finance income

     224       —         613       (76 )     761  

Intercompany revenues

     219       2       380       (601 )     —    
    


 


 


 


 


Total Revenues

     6,317       78       5,885       (677 )     11,603  
    


 


 


 


 


Cost and Expense

                                        

Cost of sales

     1,506       36       1,620       (106 )     3,056  

Cost of service, outsourcing and rentals

     1,869       36       1,497       (11 )     3,391  

Equipment financing interest

     80       —         296       (76 )     300  

Intercompany cost of sales

     211       2       282       (495 )     —    

Research and development expenses

     619       —         89       (9 )     699  

Selling, administrative and general expenses

     1,989       24       1,289       —         3,302  

Restructuring and asset impairment charges

     94       1       167       —         262  

Other expenses (income), net

     21       (18 )     314       —         317  
    


 


 


 


 


Total Cost and Expenses

     6,389       81       5,554       (697 )     11,327  
    


 


 


 


 


Income (Loss) before Income Taxes (Benefits), Equity Income, Minorities’ Interests and Cumulative Effect of Change in Accounting Principle

     (72 )     (3 )     331       20       276  

Income taxes (benefits)

     (58 )     7       162       7       118  
    


 


 


 


 


Income (Loss) before Equity Income, Minorities’ Interests and Cumulative Effect of Change in Accounting Principle

     (14 )     (10 )     169       13       158  

Equity in net income of unconsolidated affiliates

     (1 )     9       36       (1 )     43  

Equity in net income of consolidated affiliates

     150       —         —         (150 )     —    

Minorities’ interests in earnings of subsidiaries

     —         —         —         (66 )     (66 )
    


 


 


 


 


Income (Loss) before Cumulative Effect of Change in Accounting Principle

     135       (1 )     205       (204 )     135  

Cumulative effect of change in accounting principle

     (63 )     —         (62 )     62       (63 )
    


 


 


 


 


Net Income (Loss)

   $ 72     $ (1 )   $ 143     $ (142 )   $ 72  
    


 


 


 


 


 

44


Table of Contents

Xerox Corporation

 

Notes to Condensed Consolidated Financial Statements—(Continued)

($ in millions except per share data and where otherwise noted)

 

Condensed Consolidating Balance Sheets (Unaudited)

for December 31, 2002

 

    Parent
Company


   

Guarantor

Subsidiaries


   

Non-

Guarantor

Subsidiaries


    Eliminations

    Total
Company


 

Asset

                                       

Cash and cash equivalents

  $ 1,672       —       $ 1,215       —       $ 2,887  

Accounts receivable, net

    714       20       1,338       —         2,072  

Billed portion of finance receivables, net

    341       —         223       —         564  

Finance receivables, net

    392       —         2,696       —         3,088  

Inventories

    692       2       545       (8 )     1,231  

Other current assets

    554       5       693       (66 )     1,186  
   


 


 


 


 


Total Current Assets

    4,365       27       6,710       (74 )     11,028  
   


 


 


 


 


Finance receivables due after one year, net

    712       —         4,641       —         5,353  

Equipment on operating leases, net

    200       —         265       (15 )     450  

Land, buildings and equipment, net

    1,058       2       697       —         1,757  

Investment in affiliates, at equity

    32       41       555       —         628  

Investment in and advances to consolidated subsidiaries

    7,842       —         686       (8,528 )     —    

Intangible assets, net

    360       —         —         —         360  

Goodwill

    491       296       777       —         1,564  

Other long-term assets

    1,412       2       2,903       1       4,318  
   


 


 


 


 


Total Assets

  $ 16,472     $ 368     $ 17,234     $ (8,616 )   $ 25,458  

Liabilities and Equity

                                       

Short-term debt and current portion of long-term debt

    1,880       —         2,497       —         4,377  

Accounts payable

    447       6       386       —         839  

Other current liabilities

    793       30       1,608       140       2,571  
   


 


 


 


 


Total Current Liabilities

    3,120       36       4,491       140       7,787  
   


 


 


 


 


Long-term debt

    4,791       —         5,003       —         9,794  

Intercompany payables, net

    3,304       (95 )     (3,196 )     (13 )     —    

Other long-term liabilities

    2,856       —         839       7       3,702  
   


 


 


 


 


Total Liabilities

    14,071       (59 )     7,137       134       21,283  
   


 


 


 


 


Minorities’ interest in equity of subsidiaries

    —         —         —         73       73  

Company-obligated, mandatorily redeemable preferred securities of subsidiary trusts holding solely subordinated debentures of the Company

    —         —         1,701       —         1,701  

Preferred stock

    550       —         —         —         550 &nbs