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Xerox 10-K 2010
Annual Report

EXHIBIT 13

ANNUAL REPORT

TABLE OF CONTENTS

 

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

  1

Executive Overview

  1

Financial Overview

  2

Currency Impacts

  3

Summary Results

  3

Application of Critical Accounting Policies

  5

Operations Review of Segment Revenue and Operating Profit

  10

Costs, Expenses and Other Income

  12

Gross Margin

  12

Research, Development and Engineering Expenses

  13

Selling, Administrative and General Expenses

  14

Restructuring and Asset Impairment Charges

  14

Acquisition-Related Costs

  15

Worldwide Employment

  15

Other Expenses, Net

  15

Income Taxes

  16

Equity in Net Income of Unconsolidated Affiliates

  17

Subsequent Events

  17

Recent Accounting Pronouncements

  18

Capital Resources and Liquidity

  18

Cash Flow Analysis

  18

Financing Activities, Credit Facility and Capital Markets

  20

Liquidity and Financial Flexibility

  22

Contractual Cash Obligations and Other Commercial Commitments and Contingencies

  23

Off-Balance Sheet Arrangements

  25

Financial Risk Management

  26

Non-GAAP Financial Measures

  26

Forward-Looking Statements

  27

Audited Consolidated Financial Statements

 

Consolidated Statements of Income

  28

Consolidated Balance Sheets

  29

Consolidated Statements of Cash Flows

  30

Consolidated Statements of Shareholders’ Equity

  31

 

Xerox 2009 Annual Report   i


Notes to the Consolidated Financial Statements   32
1.   Summary of Significant Accounting Policies   32
2.   Segment Reporting   42
3.   Acquisitions   44
4.   Receivables, Net   46
5.   Inventories and Equipment on Operating Leases, Net   47
6.   Land, Buildings and Equipment, Net   48
7.   Investments in Affiliates, at Equity   49
8.   Goodwill and Intangible Assets, Net   51
9.   Restructuring and Asset Impairment Charges   52
10.   Supplementary Financial Information   53
11.   Debt   54
12.   Liability to Subsidiary Trust Issuing Preferred Securities   58
13.   Financial Instruments   59
14.   Employee Benefit Plans   65
15.   Income and Other Taxes   72
16.   Contingencies   75
17.   Shareholders’ Equity   79
18.   Earnings per Share   83
19.   Subsequent Events   83
Reports of Management   85
Report of Independent Registered Public Accounting Firm   86
Quarterly Results of Operations   87
Five Years in Review   88
Corporate Information   89

 

Xerox 2009 Annual Report   ii


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

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

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

Executive Overview

We are a technology and services enterprise and a leader in the global document market. We develop, manufacture, market, service and finance the industry’s broadest portfolio of document equipment, software, solutions and services. The global document market continues to see significant trends toward color, enterprise print services, and electronic document management. Our broad portfolio of production, office and service offerings provide value to our customers and enable Xerox to lead and grow in the $132 billion market we serve.

In 2009, we agreed to acquire Affiliated Computer Services, Inc. (“ACS”). The acquisition was completed in February 2010. This acquisition transforms us into the world’s leading enterprise for business process and document management and accelerates our growth in an expanding market. ACS is one of the largest providers of business process outsourcing (“BPO”) and information technology (“IT”) services and solutions to commercial and government clients worldwide. ACS’s revenues for the calendar year ended December 31, 2009 were $6.6 billion and they employed 78,000 people and operated in over 100 countries. With the acquisition of ACS we have greatly expanded our market opportunity. The BPO market is estimated at $150 billion and the ITO market is estimated at $250 billion.

Our business strategy is built upon an annuity model that yields consistent strong cash flow, expanded earnings and enables us to provide good returns to shareholders. The majority of our revenue (supplies, service, paper, outsourcing, rentals and financing) is recurring, which we collectively refer to as post sale revenue. This recurring revenue provides a significant degree of stability to our revenue, profits and cash flow. Post sale revenue currently represents more than 75 percent of the Company’s revenue and is driven by the amount of equipment installed at customer locations and the utilization of that equipment. As such, our critical success factors include equipment installations, which stabilize and grow our installed base of equipment at customer locations, page volume growth and higher revenue per page. Key drivers to increase equipment installations, usage and associated post-sale revenue include the following:

 

 

Accelerate transition to color

 

 

Build on services leadership

 

 

Strengthening our leadership in digital production printing.

The transition to color is a primary driver to improve revenue per page, as color documents typically require significantly more toner coverage per page than traditional black-and-white printing. We have the broadest color portfolio in the industry and leading technologies. Our growing services business helps customers reduce their costs. We lead the industry with end-to-end managed print services. Lastly, we continue to create new market opportunities with digital printing as a complement to traditional offset printing.

We operate in a global business environment, serving a wide range of customers with about 50 percent of our revenue generated from customers outside the U.S. Our markets are competitive. Customers are demanding document services such as assessment consulting, managed print services, imaging and hosting and document-intensive business process improvements. Additionally, our customers demand improved technology solutions, such as the ability to print offset quality color documents on-demand; improved product functionality, such as the ability to print, copy, fax and scan from a single device; and lower prices for the same functionality.

 

Xerox 2009 Annual Report   1


Accretive acquisitions and expanded distribution to drive organic growth are also key elements of our business strategy. In addition to the ACS acquisition, in 2009 Global Imaging Systems, Inc. (“GIS”) acquired ComDoc, Inc. (“ComDoc”), one of the larger independent dealers in the U.S., expanding coverage in Ohio, Pennsylvania, New York and West Virginia.

Financial Overview

Although we began to see some improvements in our markets in the fourth quarter 2009, we faced significant external challenges in 2009 including:

 

 

A worldwide recession driving down demand and volumes;

 

 

A credit market crisis impacting access, rates and creating liquidity pressures on our channels and customers; and

 

 

The negative effects of currency changes on our revenue and costs.

The overall slowdown in business activity reduced print volumes, especially in heavily document-driven processes, and our customers, in an effort to manage costs, are delaying spending on technology upgrades until there are stronger signs of economic improvement. The weak economies in developing markets, like Russia and Eurasia, where access to credit is still quite limited, also impacted our revenues. We reacted to these challenges by prioritizing cash generation and taking actions on cost and expense to help mitigate the effects of lower revenue.

The following is a summary of key 2009 highlights:

 

 

Delivered strong operating cash flow and reduced spending;

 

 

Operational performance continues to improve sequentially;

 

 

Competitive position strengthened through innovative technology and industry leading Managed Print Services offering; and

 

 

ACS acquisition opens new market opportunities and strengthens financial position.

Total revenue of $15,179 million for 2009 declined 14% from the prior year including a 3-percentage point negative impact from currency. Equipment sales of $3,550 million for 2009 decreased 24% from the prior year primarily reflecting the continued industry-wide slowdown in technology spending. Post-sale revenue of $11,629 million for 2009 was down 10% from the prior year primarily reflecting lower supplies revenue as distributors maintained lower inventory levels and businesses implemented their own cost-cutting measures.

The benefits from restructuring and operational cost improvements helped to relieve the pressure from revenue declines. Gross margins of 39.7% for 2009 increased 0.8-percentage points from the prior year despite the continued effect of higher product costs due to the strength of the Japanese Yen. Selling, administrative and general expenses (“SAG”) for 2009 declined $385 million reflecting favorable currency, the benefits from restructuring and operational cost improvements, partially offset by increased bad debt expense.

Cash flows from operations of $2,208 million in 2009 were primarily driven by working capital improvements. Cash used in investing activities of $343 million reflected well controlled capital expenditures of $193 million, as well as $145 million for GIS’s acquisition of ComDoc in the first quarter of 2009.

We continue to maintain debt levels primarily to support our customer financing operations and, at the end of 2009, to fund the ACS acquisition. Total Debt at December 31, 2009 of $9,264 million increased $880 million from the prior year as net debt repayments of approximately $1.8 billion were more than offset by the issuance of $2,750 million in Senior Notes. Our 2009 public offerings included $750 million of Senior Notes issued in May and $2.0 billion of Senior Notes issued in December. The net proceeds from the December Senior Notes offering were used in connection with the acquisition of ACS. We finished the year with cash and cash equivalents of $3,799 billion, which included funds subsequently used for the acquisition of ACS.

 

Xerox 2009 Annual Report   2


Our 2010 priorities include:

 

 

Effective ACS transition, including synergies capture;

 

 

Grow revenue and maintain leadership in innovation;

 

 

Continue to aggressively manage spending and resize our cost base to align to current revenues; and

 

 

Drive operating cash flow and achieve debt reduction goals.

Our 2010 balance sheet and cash flow strategy includes: sustaining our working capital improvements; maintaining our investment grade credit ratings; achieving an optimal cost of capital; and effectively deploying cash to deliver and maximize shareholder value through acquisitions and dividends. Our strategy also includes appropriately leveraging our financing assets (finance receivables and equipment on operating leases).

Currency Impacts

To understand the trends in our business, we believe that it is helpful to analyze the impact of changes in the translation of foreign currencies into U.S. Dollars on revenues and expenses. We refer to this analysis as “currency impact” or “the impact from currency”. Revenues and expenses from our developing markets are analyzed at actual exchange rates for all periods presented, since these countries generally have volatile currency and inflationary environments, and our operations in these countries have historically implemented pricing actions to recover the impact of inflation and devaluation. We do not hedge the translation effect of revenues or expenses denominated in currencies where the local currency is the functional currency.

Approximately 50% of our consolidated revenues are derived from operations outside of the United States where the U.S. Dollar is not the functional currency. When compared with the average of the major European currencies and Canadian Dollar on a revenue-weighted basis, the U.S. Dollar was 7% stronger in 2009 and 3% weaker in 2008, each compared to the prior year. As a result, the foreign currency translation impact on revenue was a 3% detriment in 2009 and a 1% benefit in 2008.

Summary Results

Revenue

Revenues for the three years ended December 31, 2009 were as follows:

 

(in millions)    Year Ended December 31,    Percent Change
         2009            2008            2007            2009            2008    

Equipment sales

     $ 3,550         $ 4,679         $ 4,753       (24)%      (2)%  

Post sale revenue (1)

     11,629         12,929         12,475       (10)%      4 %  
                          

Total Revenue

     $     15,179         $     17,608         $     17,228       (14)%      2 %  
                          

Reconciliation to Consolidated Statements of Income

              

Sales

     $ 6,646         $ 8,325         $ 8,192         

Less: Supplies, paper and other sales

     (3,096)        (3,646)        (3,439)        
                          

Equipment Sales

     $ 3,550         $ 4,679         $ 4,753         
                          

Service, outsourcing and rentals

     $ 7,820         $ 8,485         $ 8,214         

Finance income

     713         798         822         

Add: Supplies, paper and other sales

     3,096         3,646         3,439         
                          

Post Sale Revenue

     $ 11,629         $ 12,929         $ 12,475         
                          

Memo: Color (2)

     $ 5,972         $ 6,669         $ 6,356       (10)%      5%  
                          

 

Xerox 2009 Annual Report   3


Revenue 2009

Revenue decreased 14% compared to the prior year, including a 3-percentage point negative impact from currency. Although moderating in the fourth quarter 2009, worldwide economic weakness negatively impacted our major market segments during the year. Total revenues included the following:

 

10% decrease in post sale revenue including a 3-percentage point negative impact from currency. The components of post sale revenue decreased as follows:

  - 8% decrease in service, outsourcing and rentals revenue to $7,820 million reflecting a 3-percentage point negative impact from currency and an overall decline in page volume. Total digital pages declined 6% despite an increase in color pages of 10%.
  - Supplies, paper, and other sales of $3,096 million decreased 15% due primarily to currency, which had a 2-percentage point negative impact, and declines in channel supplies purchases, including lower purchases within developing markets, and lower paper sales.
 

24% decrease in equipment sales revenue, including a 1-percentage point negative impact from currency. The overall decline in install activity was the primary driver along with price declines of approximately 5% across the Production and Office segments.

 

10% decrease in color revenue (2) including a 2-percentage point negative impact from currency. Color revenue of $5,972 million in 2009 comprised 43% of total revenue, excluding GIS,(3) compared to 41% in 2008 reflecting:

  -

5% decrease in color post sale revenue including a 3-percentage point negative impact from currency. The decline was partially driven by lower channel color printer supplies purchases. Color represented 40% and 37% of post sale revenue in 2009 and 2008 excluding GIS, (3), respectively.

  -

22% decrease in color equipment sales revenue including a 2-percentage point negative impact from currency and lower installs driven by the impact of the economic environment. Color sales represented 53% and 50% of total equipment sales in 2009 and 2008, excluding GIS,(3) respectively.

  -

10%(4) growth in color pages. Color pages (4) represented 21% and 18% of total pages in 2009 and 2008, respectively.

Revenue 2008

Revenue increased 2% compared to the prior year and was flat when including GIS in our 2007 results.(5) Currency had a 1-percentage point positive impact on total revenues. Total revenues included the following:

 

4% increase in post sale revenue, or 2% including GIS in our 2007 results.(5) This included a 1-percentage point benefit from currency. Growth in GIS, color products and document management services offset the declines in high-volume black-and-white printing systems, black-and-white multifunction devices and light lens product revenue. The components of post sale revenue increased as follows:

  - 3% increase in service, outsourcing, and rentals revenue to $8,485 million reflected the full year inclusion of GIS and growth in document management services.
  - Supplies, paper, and other sales of $3,646 million grew 6% year-over-year due to the full year inclusion of GIS, as well as growth in color supplies and paper sales.
 

2% decrease in equipment sales revenue. There was no impact from currency on equipment sales revenue. When including GIS in our 2007 results,(5) equipment sales revenue decreased 5%, with a 1-percentage point benefit from currency. Overall price declines of between 5% - 10%, as well as product mix, more than offset overall growth in install activity.

 

5% growth in color revenue.(2) Color revenue of $6,669 million in 2008 represented 41% of total revenue, excluding GIS(3), compared to 39% in 2007 reflecting:

  -

10% growth in color post sale revenue to $4,590 million. Color post sale revenue represented 37% and 35% of post sale revenue in 2008 and 2007, respectively. (3)

 

Xerox 2009 Annual Report   4


  -

Color equipment sales revenue declined 4% to $2,079 million. Color equipment sales represented 50% of total equipment sales in 2008 and 2007,(3) respectively.

  -

24%(4) growth in color pages. Color pages (4) represented 18% and 12% of total pages in 2008 and 2007, respectively.

 

(1)

Post sale revenue is largely a function of the equipment placed at customer locations, the volume of prints and copies that our customers make on that equipment, the mix of color pages and associated services.

(2)

Color revenues represent a subset of total revenue and excludes the impact of GIS’s revenues.

(3)

As of December 31, 2009 and 2008, total color, color post sale and color equipment sales revenues comprised 39%, 37% and 46%; and 38%, 36% and 44%, respectively, if calculated on total, total post sale, and total equipment sales revenues, including GIS. GIS is excluded from the color information presented because the breakout of the information required to make this computation for all periods is not available.

(4)

Pages include estimates for developing markets, GIS and printers.

(5)

The percentage point impacts from GIS reflect the revenue growth year-over-year after including GIS’s results for 2007 on a proforma basis. We acquired GIS in May 2007. See “Non-GAAP Financial Measures” section for an explanation of this non-GAAP measure.

Net Income

Net income and diluted earnings per share for the three years ended December 31, 2009 were as follows:

 

(in millions, except per share amounts)

           2009                    2008                    2007        

Net income attributable to Xerox

     $ 485          $ 230          $ 1,135    

Diluted earnings per share

     $ 0.55          $ 0.26          $ 1.19    

Net Income 2009

Net income attributable to Xerox of $485 million, or $0.55 per diluted share, included the following:

 

A $49 million after-tax ($72 million pre-tax) charge, or $0.06 per diluted share, related to costs associated with the acquisition of ACS.

 

A charge of $46 million or $0.05 per diluted share, for our share of Fuji Xerox’s after-tax restructuring charge.

Net Income 2008

Net income of $230 million, or $0.26 per diluted share, included the following:

 

$491 million after-tax charges ($774 million pre-tax) associated with securities-related litigation matters, as well as other probable litigation-related losses, including $36 million for the Brazilian labor-related contingencies.

 

$292 million after-tax charge ($426 million pre-tax) for the second, third and fourth quarter 2008 restructuring and asset impairment actions.

 

$24 million after-tax charge ($39 million pre-tax) for an Office product line equipment write-off.

 

$41 million income tax benefit from the settlement of certain previously unrecognized tax benefits.

Application of Critical Accounting Policies

In preparing our Consolidated Financial Statements and accounting for the underlying transactions and balances, we apply various accounting policies. Senior management has discussed the development and selection of the critical accounting policies, estimates and related disclosures included herein with the Audit Committee of the Board of Directors. We consider the policies discussed below as critical to understanding our Consolidated Financial Statements, as their application places the most significant demands on management’s judgment, since financial reporting results rely on estimates of the effects of matters that are inherently uncertain. In instances where different estimates could have reasonably been used, we disclosed the impact of these different estimates on our operations. In certain instances, like revenue recognition for leases, the accounting rules are prescriptive; therefore, it would not have been possible to reasonably use different estimates. Changes in assumptions and estimates are reflected in the period in which they occur. The impact of such changes could be material to our results of operations and financial condition in any quarterly or annual period.

 

Xerox 2009 Annual Report   5


Specific risks associated with these critical accounting policies are discussed throughout the MD&A, where such policies affect our reported and expected financial results. For a detailed discussion of the application of these and other accounting policies, refer to Note 1 - Summary of Significant Accounting Policies, in the Consolidated Financial Statements.

Revenue Recognition for Leases

Our accounting for leases involves specific determinations under applicable lease accounting standards, which often involve complex and prescriptive provisions. These provisions affect the timing of revenue recognition for our equipment. If a lease qualifies as a sales-type capital lease, equipment revenue is recognized upon delivery or installation of the equipment as sale revenue as opposed to ratably over the lease term. The critical elements that we consider with respect to our lease accounting are the determination of the economic life and the fair value of equipment, including the residual value. For purposes of determining the economic life, we consider the most objective measure to be the original contract term, since most equipment is returned by lessees at or near the end of the contracted term. The economic life of most of our products is five years since this represents the most frequent contractual lease term for our principal products and only a small percentage of our leases are for original terms longer than five years. There is no significant after-market for our used equipment. We believe five years is representative of the period during which the equipment is expected to be economically usable, with normal service, for the purpose for which it is intended.

Revenue Recognition Under Bundled Arrangements

We sell the majority of our products and services under bundled lease arrangements, which typically include equipment, service, supplies and financing components for which the customer pays a single negotiated monthly fixed price for all elements over the contractual lease term. Typically these arrangements include an incremental, variable component for page volumes in excess of contractual page volume minimums, which are often expressed in terms of price per page. Revenues under these arrangements are allocated, considering the relative fair values of the lease and non-lease deliverables included in the bundled arrangement, based upon the estimated relative fair values of each element. Lease deliverables include maintenance and executory costs, equipment and financing, while non-lease deliverables generally consist of supplies and non-maintenance services. Our revenue allocation for lease deliverables begins by allocating revenues to the maintenance and executory costs plus profit thereon. The remaining amounts are allocated to the equipment and financing elements. We perform analyses of available verifiable objective evidence of equipment fair value based on cash selling prices during the applicable period. The cash selling prices are compared to the range of values included in our lease accounting systems. The range of cash selling prices must be reasonably consistent with the lease selling prices, taking into account residual values, in order for us to determine that such lease prices are indicative of fair value.

Our pricing interest rates, which are used in determining customer payments, are developed based upon a variety of factors including local prevailing rates in the marketplace and the customer’s credit history, industry and credit class. We reassess our pricing interest rates quarterly based on changes in the local prevailing rates in the marketplace. These interest rates have been generally adjusted if the rates vary by twenty-five basis points or more, cumulatively, from the last rate in effect. The pricing interest rates generally equal the implicit rates within the leases, as corroborated by our comparisons of cash to lease selling prices.

Allowance for Doubtful Accounts and Credit Losses

We perform ongoing credit evaluations of our customers and adjust credit limits based upon customer payment history and current creditworthiness. We continuously monitor collections and payments from our customers and maintain a provision for estimated credit losses based upon our historical experience and any specific customer collection issues that have been identified. We cannot guarantee that we will continue to experience credit loss rates similar to those we have experienced in the past. Measurement of such losses requires consideration of historical loss experience, including the need to adjust for current conditions, and judgments about the probable effects of relevant observable data, including present economic conditions such as delinquency rates and financial health of specific customers. We recorded bad debt provisions of $291 million, $188 million and $134 million in SAG expenses in our Consolidated Statements of Income for the years ended December 31, 2009, 2008 and 2007, respectively.

 

Xerox 2009 Annual Report   6


Historically, the majority of the bad debt provision relates to our finance receivables portfolio. This provision is inherently more difficult to estimate than the provision for trade accounts receivable because the underlying lease portfolio has an average maturity, at any time, of approximately two to three years and contains past due billed amounts, as well as unbilled amounts. The estimated credit quality of any given customer and class of customer or geographic location can significantly change during the life of the portfolio. We consider all available information in our quarterly assessments of the adequacy of the provision for doubtful accounts.

The current economic environment has increased the risk of non-collection of receivables. We have accordingly considered this increased risk in the evaluation and assessment of our allowance for doubtful accounts at year-end. Bad debt provisions increased by $103 million in 2009 and reserves as a percentage of trade and finance receivables increased to 4.1% at December 31, 2009 as compared to 3.4% at December 31, 2008. However, collection risk is somewhat mitigated by the fact that our receivables are fairly well dispersed among a diverse customer base both in size and geography. Days sales outstanding improved slightly year-over-year. In addition, accounts receivable balances greater than 90 days outstanding were about 12% of total gross accounts receivables at December 31, 2009, which was relatively flat as compared to the prior year. However, we continue to assess our receivable portfolio in light of the current economic environment and its impact on our estimation of the adequacy of the allowance for doubtful accounts.

As discussed above, in preparing our Consolidated Financial Statements for the three year period ended December 31, 2009, we estimated our provision for doubtful accounts based on historical experience and customer-specific collection issues. This methodology has been consistently applied for all periods presented. During the five year period ended December 31, 2009, our reserve for doubtful accounts ranged from 3.0% to 4.1% of gross receivables. Holding all other assumptions constant, a 1-percentage point increase or decrease in the reserve from the December 31, 2009 rate of 4.1% would change the 2009 provision by approximately $91 million.

Pension and Post-retirement Benefit Plan Assumptions

We sponsor defined benefit pension plans in various forms in several countries covering substantially all employees who meet eligibility requirements. Post-retirement benefit plans cover primarily U.S. employees for retirement medical costs. Several statistical and other factors that attempt to anticipate future events are used in calculating the expense, liability and asset values related to our pension and post-retirement benefit plans. These factors include assumptions we make about the discount rate, expected return on plan assets, rate of increase in healthcare costs, the rate of future compensation increases and mortality. Differences between these assumptions and actual experiences are reported as net actuarial gains and losses and are subject to amortization to net periodic pension cost generally over the average remaining service lives of the employees participating in the pension plan.

Cumulative actuarial losses for our pension plans of $1.8 billion as of December 31, 2009 were flat as compared to December 31, 2008. Positive returns on plan assets in 2009 as compared to expected returns offset a decrease in discount rates. The total actuarial loss will be amortized in the future, subject to offsetting gains or losses that will change the future amortization amount.

We have utilized a weighted average expected rate of return on plan assets of 7.4% for 2009 and 7.6% for both 2008 and 2007, on a worldwide basis.

During 2009, the actual return on plan assets was $720 million, primarily as a result of an improvement in the equity markets. In estimating the 2010 expected rate of return, in addition to assessing recent performance, we considered the historical returns earned on plan assets, the rates of return expected in the future and our investment strategy and asset mix with respect to the plans’ funds. The weighted average expected rate of return on plan assets we will utilize for 2010 will be 7.3% as compared to 7.4% in 2009 and 7.6% in 2008.

 

Xerox 2009 Annual Report   7


For purposes of determining the expected return on plan assets, we utilize a calculated value approach in determining the value of the pension plan assets, as opposed to a fair market value approach. The primary difference between the two methods relates to a systematic recognition of changes in fair value over time (generally two years) versus immediate recognition of changes in fair value. Our expected rate of return on plan assets is then applied to the calculated asset value to determine the amount of the expected return on plan assets to be used in the determination of the net periodic pension cost. The calculated value approach reduces the volatility in net periodic pension cost that can result from using the fair market value approach. The difference between the actual return on plan assets and the expected return on plan assets is added to, or subtracted from, any cumulative differences that arose in prior years. This amount is a component of the net actuarial gain or loss.

Another significant assumption affecting our pension and post-retirement benefit obligations and the net periodic pension and other post-retirement benefit cost is the rate that we use to discount our future anticipated benefit obligations. The discount rate reflects the current rate at which the pension liabilities could be effectively settled considering the timing of expected payments for plan participants. In estimating this rate, we consider rates of return on high quality fixed-income investments included in various published bond indices, adjusted to eliminate the effects of call provisions and differences in the timing and amounts of cash outflows related to the bonds. In the U.S. and the U.K., which comprise approximately 80% of our projected benefit obligations, we consider the Moody’s Aa Corporate Bond Index and the International Index Company’s iBoxx Sterling Corporate AA Cash Bond Index, respectively, in the determination of the appropriate discount rate assumptions. The weighted average discount rate we utilized to measure our pension obligation as of December 31, 2009 and to calculate our 2010 expense was 5.7%, which is a decrease of 0.6% from 6.3% used in determining our 2009 expense.

Assuming settlement losses in 2010 are consistent with 2009, our 2010 net periodic defined benefit pension cost is expected to be approximately $70 million higher than 2009, primarily as a result of a decrease in the discount rate and increased amortization of actuarial losses, which includes the impact of the significant asset losses in 2008.

On a consolidated basis, we recognized net periodic pension cost of $270 million, $254 million and $315 million for the years ended December 31, 2009, 2008 and 2007, respectively. The costs associated with our defined contribution plans, which are included in net periodic pension cost, were $38 million, $80 million and $80 million for the years ended December 31, 2009, 2008 and 2007, respectively. The decrease in 2009 was primarily due to the April 2009 suspension of the 401(k) match in the U.S. Pension cost is included in several income statement components based on the related underlying employee costs. Pension and post-retirement benefit plan assumptions are included in Note 14 - Employee Benefit Plans in the Consolidated Financial Statements. Holding all other assumptions constant, a 0.25% increase or decrease in the discount rate would change the 2010 projected net periodic pension cost by $12 million. Likewise, a 0.25% increase or decrease in the expected return on plan assets would change the 2010 projected net periodic pension cost by $11 million.

Income Taxes and Tax Valuation Allowances

We record the estimated future tax effects of temporary differences between the tax bases of assets and liabilities and amounts reported in our Consolidated Balance Sheets, as well as operating loss and tax credit carryforwards. We follow very specific and detailed guidelines in each tax jurisdiction regarding the recoverability of any tax assets recorded in our Consolidated Balance Sheets and provide valuation allowances as required. We regularly review our deferred tax assets for recoverability considering historical profitability, projected future taxable income, the expected timing of the reversals of existing temporary differences and tax planning strategies. If we continue to operate at a loss in certain jurisdictions or are unable to generate sufficient future taxable income, or if there is a material change in the actual effective tax rates or time period within which the underlying temporary differences become taxable or deductible, we could be required to increase the valuation allowance against all or a significant portion of our deferred tax assets resulting in a substantial increase in our effective tax rate and a material adverse impact on our operating results. Conversely, if and when our operations in some jurisdictions were to become sufficiently profitable to recover previously reserved deferred tax assets, we would reduce all or a portion of the applicable valuation allowance in the period when such determination is made. This would result in an increase to reported earnings in such period. Adjustments to our valuation allowance, through (credits) charges to income tax expense, were $(11) million, $17 million and $14 million for the years ended December 31, 2009, 2008 and 2007, respectively. There were other (decreases) increases to our valuation allowance, including the effects of currency, of $55 million, $(136) million and $86 million for the years ended December 31, 2009, 2008 and 2007, respectively, that did not affect income tax expense in total as there was a corresponding adjustment to deferred tax assets or other comprehensive income. Gross deferred tax assets of $3.7 billion and $3.8 billion had valuation allowances of $672 million and $628 million at December 31, 2009 and 2008, respectively.

 

Xerox 2009 Annual Report   8


We are subject to ongoing tax examinations and assessments in various jurisdictions. Accordingly, we may incur additional tax expense based upon our assessment of the more-likely-than-not outcomes of such matters. In addition, when applicable, we adjust the previously recorded tax expense to reflect examination results. Our ongoing assessments of the more-likely-than-not outcomes of the examinations and related tax positions require judgment and can materially increase or decrease our effective tax rate, as well as impact our operating results.

We file income tax returns in the U.S. Federal jurisdiction and various foreign jurisdictions. In the U.S. we are no longer subject to U.S. Federal income tax examinations by tax authorities for years before 2007. With respect to our major foreign jurisdictions, we are no longer subject to tax examinations by tax authorities for years before 2000.

Legal Contingencies

We are involved in a variety of claims, lawsuits, investigations and proceedings concerning securities law, intellectual property law, environmental law, employment law and ERISA, as discussed in Note 16 - Contingencies in the Consolidated Financial Statements. We determine whether an estimated loss from a contingency should be accrued by assessing whether a loss is deemed probable and can be reasonably estimated. We assess our potential liability by analyzing our litigation and regulatory matters using available information. We develop our views on estimated losses in consultation with outside counsel handling our defense in these matters, which involves an analysis of potential results, assuming a combination of litigation and settlement strategies. Should developments in any of these matters cause a change in our determination as to an unfavorable outcome and result in the need to recognize a material accrual, or should any of these matters result in a final adverse judgment or be settled for significant amounts, they could have a material adverse effect on our results of operations, cash flows and financial position in the period or periods in which such change in determination, judgment or settlement occurs.

Business Combinations and Goodwill

The application of the purchase method of accounting for business combinations requires the use of significant estimates and assumptions in the determination of the fair value of assets acquired and liabilities assumed in order to properly allocate purchase price consideration between assets that are depreciated and amortized from goodwill. Our estimates of the fair values of assets and liabilities acquired are based upon assumptions believed to be reasonable, and when appropriate, include assistance from independent third-party appraisal firms.

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

Our annual impairment test of goodwill was performed in the fourth quarter. The estimated fair values of our reporting units were based on discounted cash flow models derived from internal earnings forecasts and assumptions. The assumptions and estimates used in those valuations incorporated the current economic environment. In performing our 2009 impairment test, the following were the overall composite assumptions regarding revenue and expense growth, which were the basis for estimating future cash flows used in the discounted cash flow model: 1) revenue growth 2-4%; 2) gross margin 39-40%; 3) RD&E 4-5%; 4) SAG 24-25%; and 5) return on sales 8-9%. We believe these estimated assumptions are appropriate for our circumstances, in-line with historical results, consistent with our forecasted long-term business model and give consideration to the current economic environment. Our forecast does not include the impact of the ACS acquisition completed in February 2010 since our impairment test was limited to goodwill as of the fourth quarter 2009.

 

Xerox 2009 Annual Report   9


Based on these valuations, we determined that the fair values of our reporting units exceeded their carrying values and no goodwill impairment charge was required during the fourth quarter 2009.

Refer to Note 1 – Summary of Significant Accounting Policies – “Goodwill and Intangible Assets” for further information regarding our goodwill impairment testing, as well as Note 8 - Goodwill and Intangible Assets, Net in the Consolidated Financial Statements for further information regarding goodwill by operating segment.

Operations Review of Segment Revenue and Operating Profit

Our reportable segments are consistent with how we manage the business and view the markets we serve. Our reportable segments are Production, Office and Other. See Note 2 – Segment Reporting in the Consolidated Financial Statements for further discussion on our segment operating revenues and segment operating profit.

Revenues by segment for the years ended 2009, 2008 and 2007 were as follows:

 

     Year Ended December 31,  

(in millions)

           Production                     Office                     Other                     Total          

2009

        

Equipment sales

     $ 1,031          $ 2,363          $ 156          $ 3,550     

Post sale revenue

     3,514          6,213          1,902          11,629     
                                

Total Revenues

     $ 4,545          $ 8,576          $ 2,058          $ 15,179     
                                

Segment Profit (Loss)

     $ 217          $ 835          $ (274)          $ 778     
                                

Operating Margin

     4.8%         9.7%         (13.3)%        5.1%    
                                

2008

        

Equipment sales

     $ 1,325          $ 3,105          $ 249          $ 4,679     

Post sale revenue

     3,912          6,723          2,294          12,929     
                                

Total Revenues

     $ 5,237          $ 9,828          $ 2,543          $ 17,608     
                                

Segment Profit (Loss)

     $ 394          $ 1,062          $ (165)          $ 1,291     
                                

Operating Margin

     7.5%         10.8%         (6.5)%         7.3%    
                                

2007

        

Equipment sales

     $ 1,471          $ 3,030          $ 252          $ 4,753     

Post sale revenue

     3,844          6,443          2,188          12,475     
                                

Total Revenues

     $ 5,315          $ 9,473          $ 2,440          $ 17,228     
                                

Segment Profit (Loss)

     $ 562          $ 1,115          $ (89)          $ 1,588     
                                

Operating Margin

     10.6%         11.8%         (3.7)%         9.2%    
                                

Note: Install activity percentages include the Xerox-branded product shipments to GIS.

Production

Revenue 2009

Production revenue of $4,545 million decreased 13%, including a 3-percentage point negative impact from currency, reflecting:

 

 

10% decrease in post sale revenue with a 3-percentage point negative impact from currency, as declines were driven in part by lower black-and-white page volumes and lower revenue from entry production color products which reflect the weak economic environment during the year.

 

Xerox 2009 Annual Report   10


 

22% decrease in equipment sales revenue, with a 2-percentage point negative impact from currency. The decline in revenue across all product groups reflects lower installs driven by the weak economic environment and delays in customer spending on technology.

 

11% decline in installs of production color products, as entry production color declines were partially offset by increased Xerox 700 installs and iGen4TM.

 

22% decline in installs of production black-and-white systems, reflecting declines in all product groups.

Revenue 2008

Production revenue of $5,237 million decreased 1%, including a 1-percentage point benefit from currency, reflecting:

 

2% increase in post sale revenue as growth from color, continuous feed and light production products offset declines in revenue from black-and-white high-volume printing systems and light lens devices.

 

10% decrease in equipment sales revenue, primarily reflecting pricing declines in both black-and-white and color production systems, driven in part by weakness in the U.S.

 

1% increase in installs of production color products driven in part by Xerox 700 and iGen4 activity, as well as color continuous feed.

 

6% decline in installs of production black-and-white systems driven primarily by declines in installs of light production systems.

Operating Profit 2009

Production operating profit of $217 million decreased $177 million from 2008. The decrease is primarily the result of lower gross profit flow-through from revenue declines which were partially offset by lower RD&E and SAG spending as a result of favorable currency and cost reductions. The improvement in SAG was mitigated by an increase in bad debt provisions.

Operating Profit 2008

Production operating profit of $394 million decreased $168 million from 2007. The decrease is primarily the result of lower revenue and lower gross margins due to pricing and product mix, as well as increased SAG expenses.

Office

Revenue 2009

Office revenue of $8,576 million decreased 13%, including a 2-percentage point negative impact from currency, reflecting:

 

8% decrease in post sale revenue with a 3-percentage point negative impact from currency. Revenue declined across most product segments and reflects lower channel supplies purchases, including purchases within developing markets, which more than offset the growth in GIS.

 

24% decrease in equipment sales revenue, including a 1-percentage point negative impact from currency. The decline in revenue across most product groups reflects lower installs driven by the weak economic environment during this year.

 

20% decline in installs of color multifunction devices driven by lower overall demand, which more than offset the impact of new products including the ColorQube and Office version of the Xerox 700.

 

37% decline in installs of black-and-white copiers and multifunction devices, including an 83% decline in the low dollar value Segment 1 products (11-20 ppm), driven primarily by lower activity in developing markets, offset by a 4% increase in Segment 2–5 products (21-90 ppm). Segment 2–5 installs include the Xerox 4595, a 95 ppm device with an embedded controller.

 

34% decline in installs of color printers due to lower demand and lower sales to OEM partners.

Revenue 2008

Office revenue of $9,828 million increased 4%, including a 1-percentage point benefit from currency, as well as the benefits from our expansion in the SMB market through GIS and Veenman. Revenue for 2008 reflects:

 

4% increase in post sale revenue, reflecting the full year inclusion of GIS, as well as growth from color multifunction devices and color printers partially offset by declines in black-and-white digital devices. Office post sale revenue was negatively impacted in the fourth quarter of 2008 by declines in channel supply purchases, including lower purchases within developing markets.

 

Xerox 2009 Annual Report   11


 

2% increase in equipment sales revenue, reflecting the full year inclusion of GIS, as well as growth from color digital products which more than offset declines from black-and-white devices primarily due to price declines and product mix.

 

24% color multifunction device install growth led by strong demand for Xerox WorkCentre® and Phaser® products.

 

8% increase in installs of black-and-white copiers and multifunction devices, including 8% growth in Segment 1&2 products (11-30 ppm) and 8% growth in Segment 3-5 products (31-90 ppm). Segment 3-5 installs include the Xerox 4595, a 95 ppm device with an embedded controller.

 

12% increase in color printer installs.

Operating Profit 2009

Office operating profit of $835 million decreased $227 million from 2008, as revenue declines were partially offset by lower RD&E and SAG as a result of favorable currency and cost actions. The improvement in SAG was mitigated by an increase in bad debt provisions.

Operating Profit 2008

Office operating profit of $1,062 million decreased $53 million from 2007. The decrease was primarily due to lower gross profits reflecting lower margins, as well as higher SAG expenses partially offset by the full year inclusion of GIS.

Other

Revenue 2009

Other revenue of $2,058 million decreased 19%, including a 2-percentage point negative impact from currency, primarily driven by declines in revenue from paper, wide format systems and licensing and royalty arrangements. Paper comprised approximately 50% of the Other segment revenue.

Revenue 2008

Other revenue of $2,543 million increased 4%, primarily reflecting the full year inclusion of GIS and increased paper revenue partially offset by lower revenue from wide format systems. There was no impact from currency. Paper comprised approximately 50% of the Other segment revenue.

Operating Loss 2009

Other operating loss of $274 million increased $109 million from 2008, primarily due to lower revenue, as well as lower interest income and equity income.

Operating Loss 2008

Other operating loss of $165 million increased $76 million from 2007, reflecting lower wide format revenue, higher foreign exchange losses and lower interest income partially offset by gains on sales of assets.

Costs, Expenses and Other Income

Gross Margin

Gross margins by revenue classification were as follows:

 

     Year Ended December 31,
               2009                       2008                       2007          

Sales

   33.9%   33.7%   35.9%

Service, outsourcing and rentals

   42.6%   41.9%   42.7%

Finance income

   62.0%   61.8%   61.6%

Total Gross Margin

   39.7%   38.9%   40.3%

 

Xerox 2009 Annual Report   12


Gross Margin 2009

Total gross margin increased 0.8-percentage points compared to 2008, primarily driven by cost improvements enabled by restructuring and our cost actions, which were partially offset by the 0.5-percentage point unfavorable impact of transaction currency, primarily the Yen, and price declines of 1.0-percentage points.

 

 

Sales gross margin increased 0.2-percentage points primarily due to the cost improvements and the positive mix of revenues partially offset by the adverse impact of transaction currency on our inventory purchases of 1.0-percentage point and price declines of 1.2-percentage points.

 

Service, outsourcing and rentals margin increased 0.7-percentage points primarily due to the positive impact from the reduction in costs driven by our restructuring and cost actions of 1.5-percentage points. These cost improvements more than offset the approximate 0.9-percentage points impact of pricing.

 

Financing income margin of 62% remained comparable to 2008.

Gross Margin 2008

2008 Total gross margin decreased 1.4-percentage points compared to 2007 as price declines and mix of approximately 2.0-percentage points were only partially offset by cost productivity improvements. Cost improvements were limited by an unfavorable impact on product costs of approximately 0.5-percentage points from the significant strengthening of the Yen versus the U.S. Dollar and Euro. The negative impact of 0.3-percentage points from an Office product line equipment write-off was offset by positive adjustments related to the capitalized costs for equipment on operating leases and European product disposal costs.

 

 

Sales gross margin decreased 2.2-percentage points primarily due to the approximately 2.5-percentage point impact of price declines, as well as channel and product mix. Cost improvements, which historically tend to offset price declines, were limited in 2008 by the adverse impact of the strengthening Yen on our inventory purchases.

 

Service, outsourcing and rentals margin decreased 0.8-percentage points primarily due to mix as price declines of 1.3-percentage points were offset by cost improvements. Mix reflects margin pressure from document management services.

 

Financing income margin of approximately 62% remained comparable to 2007.

 

Since a large portion of our inventory procurement is from Japan, the strengthening of the Yen versus the U.S. Dollar and Euro in 2008 significantly impacted our product cost. The Yen strengthened approximately 14% against the U.S. Dollar and 6% against the Euro in 2008 as compared to 2007. A significant portion of that strengthening occurred in the fourth quarter 2008 when the Yen strengthened 17% against the U.S. Dollar and 29% against the Euro as compared to prior year.

Research, Development and Engineering Expenses (“RD&E”)

We invest in technological development, particularly in color, and believe our RD&E spending is sufficient to remain technologically competitive. Our R&D is strategically coordinated with that of Fuji Xerox.

 

     Year Ended December 31,     Change  

(in millions)

         2009                 2008                 2007                 2009                 2008        
                                

RD&E % Revenue

     5.5%           5.0%           5.3%           0.5pts           (0.3)pts        

R&D

     $ 713            $ 750            $ 764            $ (37)            $ (14)       

Sustaining Engineering

     127            134            148            (7)            (14)       
                                        

Total RD&E Expenses

     $ 840            $ 884            $ 912            $ (44)            $ (28)       
                                        

R&D Investment by Fuji Xerox (1)

     $ 796            $ 788            $ 672            $ 8            $ 116       

 

(1)

Increase in Fuji Xerox R&D was primarily due to changes in foreign exchange rates.

RD&E 2009: The decrease in RD&E spending for 2009 reflects our restructuring and cost actions which consolidated the Production and Office development and engineering infrastructures.

 

Xerox 2009 Annual Report   13


RD&E 2008: The decrease in R&D spending for 2008 reflects the capture of efficiencies following a significant number of new product launches over the previous two years, as well as leveraging our current R,D&E investments to support our GIS operations. Sustaining engineering costs declined in 2008 due primarily to lower spending related to environmental compliance activities and maturing product platforms in the Production segment.

Selling, Administrative and General Expenses (“SAG”)

 

    Year Ended December 31,   Change

(in millions)

  2009   2008   2007   2009   2008

Total SAG

      $   4,149       $   4,534       $   4,312         $   (385)         $   222        

SAG as a % of revenue

    27.3 %     25.7 %     25.0 %     1.6pts     0.7pts

Bad Debt Expense

      $ 291       $ 188       $ 134         $ 103         $ 54        

Bad Debt as a % of revenue

    1.9 %     1.1 %     0.8 %     0.8pts     0.3pts

SAG 2009

SAG of $4,149 million was $385 million lower than 2008, including a $126 million benefit from currency. The SAG decrease was the result of the following:

 

$311 million decrease in selling expenses reflecting favorable currency; benefits from restructuring, an overall reduction in marketing spend and lower commissions.

 

$177 million decrease in general and administrative (“G&A”) expenses reflecting favorable currency and benefits from restructuring and cost actions partially offset by higher compensation accruals.

 

$103 million increase in bad debt expense reflecting increased write-offs in North America and Europe.

SAG 2008

SAG of $4,534 million was $222 million higher than 2007, including a $12 million unfavorable impact from currency. The SAG increase was the result of the following:

 

$94 million increase in selling expenses primarily reflecting the full year inclusion of GIS, investments in selling resources and marketing communications and unfavorable currency partially offset by lower compensation.

 

$75 million increase in G&A expenses primarily from the full year inclusion of GIS and unfavorable currency.

 

$54 million increase in bad debt expense reflecting increased write-offs, particularly in the fourth quarter 2008, which included several high value account bankruptcies in the U.S., U.K. and Germany.

Bad debt expense, which is included in SAG, increased $103 million in 2009 and reserves as a percentage of trade and finance receivables increased to 4.1% at December 31, 2009 as compared to 3.4% at December 31, 2008. These increases reflect the weak worldwide economic conditions and the increased level of customer bankruptcies in certain industry groups during the year. Bad debts provision and write-offs in the fourth quarter 2009 were flat as compared to the prior year.

Restructuring and Asset Impairment Charges

For the years ended December 31, 2009, 2008 and 2007, we recorded net restructuring and asset impairment (credits)/charges of $(8) million, $429 million and $(6) million, respectively.

 

Restructuring activity was minimal in 2009, and the credit of $8 million primarily reflected changes in estimates for prior year’s initiatives.

 

The 2008 net charge included $357 million related to head count reductions of approximately 4,900 employees primarily in North America and Europe and lease termination and asset impairment charges of $72 million primarily reflecting the exit from certain leased and owned facilities resulting from a rationalization of our worldwide operating locations. These actions applied equally to both North America and Europe with approximately half focused on SAG reductions, approximately a third on gross margin improvements and the remainder focused on the optimization of RD&E investments. Estimated savings from these initiatives were approximately $250 million in 2009.

 

Xerox 2009 Annual Report   14


 

Restructuring activity was minimal in 2007 and the related credit of $6 million primarily reflected changes in estimates for prior year’s severance costs.

The restructuring reserve balance as of December 31, 2009, for all programs was $74 million, of which approximately $64 million is expected to be spent over the next twelve months. Refer to Note 9 - Restructuring and Asset Impairment Charges in the Consolidated Financial Statements for further information regarding our restructuring programs.

2010 Expected Actions

In connection with our continued objective to align our cost base to current revenues, we expect to record pre-tax restructuring charges of approximately $280 million in 2010, of which $250 million is expected to be recorded in the first quarter. These actions are expected to impact all geographies and segments with approximately equal focus on SAG reductions, gross margin improvements and optimization of RD&E investments. The restructuring is also expected to involve the rationalization of some of our facilities.

Acquisition-Related Costs

Acquisition-related costs of $72 million were incurred and expensed during 2009 in connection with our acquisition of ACS. $58 million of the costs relate to the write-off of fees associated with the Bridge Loan Facility commitment which was terminated as a result of securing permanent financing to fund the acquisition. The remainder of the costs represents transaction costs such as banking, legal and accounting fees, as well as some pre-integration costs such as external consulting services. Consistent with the new accounting guidance with respect to business combinations, adopted in 2009, all acquisition-related costs must be expensed as incurred.

Worldwide Employment

Worldwide employment of 53,600 as of December 31, 2009 decreased approximately 3,500 from December 31, 2008, primarily reflecting restructuring reductions, partially offset by additional headcount related to GIS acquisitions. Worldwide employment was approximately 57,100 and 57,400 at December 31, 2008 and 2007, respectively.

Other Expenses, Net

Other expenses, net for the years ended December 31, 2009, 2008 and 2007 consisted of the following:

 

     Year Ended December 31,

(in millions)

   2009    2008    2007

Non-financing interest expense

   $ 256         $ 262         $ 263     

Interest income

     (21)          (35)          (55)    

Gain on sales of businesses and assets

     (16)          (21)          (7)    

Currency losses, net

     26           34           8     

Amortization of intangible assets

     60           54           42     

Litigation matters

     9           781           (6)    

All Other expenses, net

     31           12           20     
                    

Total Other Expenses, Net

   $     345         $     1,087         $     265     
                    

Non-financing interest expense: 2009 non-financing interest expense decreased compared to 2008, as interest expense associated with our $2.0 billion Senior Note offering for the funding of the ACS acquisition was more than offset by lower interest rates on the remaining debt.

In 2008, non-financing interest expense was flat compared to 2007, as the benefit of lower interest rates was offset by higher average non-financing debt balances.

 

Xerox 2009 Annual Report   15


Interest income: Interest income is derived primarily from our invested cash and cash equivalent balances. The decline in interest income in 2009 and 2008 was primarily due to lower average cash balances and rates of return.

Gain on sales of businesses and assets: 2009 and 2008 gain on sales of business and assets primarily consisted of the sales of certain surplus facilities in Latin America.

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

The 2009 currency losses were primarily due to the significant movement in exchange rates among the U.S. Dollar, Euro and Yen in the first quarter of 2009, as well as the increased cost of hedging, particularly in developing markets.

The 2008 currency losses were primarily due to net re-measurement losses associated with our Yen-denominated payables, foreign currency denominated assets and liabilities in our developing markets and the cost of hedging. The currency losses on Yen-denominated payables were largely limited to the first quarter 2008 as a result of the significant and rapid weakening of the U.S. Dollar and Euro versus the Yen.

Amortization of intangible assets: The increase in 2009 and 2008 amortization as compared to prior years primarily reflects the full-year amortization of the assets acquired as part of our recent acquisitions.

Litigation matters: In 2008 legal matters consisted of the following:

 

$721 million reflecting provisions for the $670 million court approved settlement of Carlson v. Xerox Corporation (“Carlson”) and other pending securities-related cases, net of expected insurance recoveries. On January 14, 2009, the United States Court for the District of Connecticut entered a Final Order and Judgment approving the settlement of the Carlson litigation.

 

$36 million for probable losses on Brazilian labor-related contingencies. Following an assessment of the most recent trend in the outcomes of these matters, we reassessed the probable estimated loss and, as a result, recorded an additional reserve of $36 million in the fourth quarter of 2008.

 

$24 million associated with probable losses from various other legal matters.

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

All other expenses, net: All Other expenses in 2009 were $19 million higher than the prior year primarily due to fees associated with the sale of receivables, as well as an increase in interest expense related to Brazil tax and labor contingencies.

Income Taxes

 

     Year Ended December 31,

(in millions)

   2009    2008    2007

Pre-tax income (loss)

       $     627              $ (79)              $     1,468      

Income tax expense (benefit)

     152            (231)            400      

Effective tax rate

     24.2 %            292.4 %        27.2 %  

 

Xerox 2009 Annual Report   16


The 2009 effective tax rate of 24.2% was lower than the U.S. statutory tax rate primarily reflecting the benefit to taxes from the geographical mix of income before taxes and the related effective tax rates in those jurisdictions, and the settlement of certain previously unrecognized tax benefits partially offset by a reduction in the utilization of foreign tax credits.

The 2008 effective tax rate of 292.4% reflected the tax benefits from certain discrete items including the net provision for litigation matters; the second, third and fourth quarter restructuring and asset impairment charges; the product line equipment write-off; and the settlement of certain previously unrecognized tax benefits. Excluding these items, the adjusted effective tax rate was 20.9%*. The adjusted 2008 effective tax rate was lower than the U.S. statutory tax rate primarily reflecting the benefit to taxes from the geographical mix of income before taxes and the related effective tax rates in those jurisdictions, the utilization of foreign tax credits and tax law changes.

The 2007 effective tax rate of 27.2% was lower than the U.S. statutory rate primarily reflecting tax benefits from the geographical mix of income before taxes and the related effective tax rates in those jurisdictions and the utilization of foreign tax credits, as well as the resolution of other tax matters. These benefits were partially offset by changes in tax law.

Our effective tax rate will change based on nonrecurring events as well as recurring factors including the geographical mix of income before taxes and the related effective tax rates in those jurisdictions and available foreign tax credits. In addition, our effective tax rate will change based on discrete or other nonrecurring events (such as audit settlements) that may not be predictable. Including the results from ACS, we anticipate that our effective tax rate for 2010 will be approximately 32%, excluding the effects of any discrete events.

Refer to Note 15 – Income and Other Taxes in the Consolidated Financial Statements for additional information.

* See the “Non-GAAP Measures” section for additional information.

Equity in Net Income of Unconsolidated Affiliates

2009 equity in net income of unconsolidated affiliates of $41 million is principally related to our 25% share of Fuji Xerox income. The $72 million decrease from 2008 is primarily due to Fuji Xerox’s lower net income, which has been impacted by the worldwide economic weakness, and includes $46 million related to our share of Fuji Xerox after-tax restructuring costs.

2008 equity in net income of unconsolidated affiliates of $113 million increased by $16 million from 2007, primarily due to a $14 million reduction in our share of Fuji Xerox restructuring charges.

Subsequent Events

We have operations in Venezuela where the U.S. Dollar is the functional currency. At December 31, 2009 our Venezuelan operations had approximately 90 million in net Bolivar-denominated monetary assets that were re-measured to U.S. Dollars at the official exchange rate of 2.15 Bolivars to the Dollar. In January 2010, Venezuela announced a devaluation of the Bolivar to an official rate of 4.30 Bolivars to the Dollar for our products. As a result of this devaluation, we expect to record a loss of approximately $21 million in the first quarter of 2010 for the re-measurement of our net Bolivar-denominated monetary assets. Other than the loss from re-measurement, we do not expect the devaluation to materially impact our results of operations or financial position in 2010 since we derive less than 0.5% of our total revenue from Venezuela and expect to take actions to lessen the effect of the devaluation.

On January 20, 2010, we acquired Irish Business Systems Limited (“IBS”) for approximately $31 million. This acquisition expands our reach into the small and mid-sized business (SMB) market in Ireland. IBS, with eight offices located throughout Ireland, is a managed print services provider and the largest independent supplier of digital imaging and printing solutions in Ireland.

 

Xerox 2009 Annual Report   17


On February 5, 2010, we completed the acquisition of ACS. Refer to Note 3-Acquisitions, Note 11-Debt and Note 17-Shareholders’ Equity for further information regarding the acquisition and associated funding for it.

Recent Accounting Pronouncements

On January 1, 2009, we adopted SFAS No. 160 “Noncontrolling Interests in Consolidated Financial Statements – an amendment of ARB No. 51”, (Accounting Standards CodificationTM Topic 810-10-65). This guidance requires that minority interests be renamed noncontrolling interests and be presented as a separate component of equity. In addition, the Company must report a consolidated net income (loss) measure that includes the amount attributable to such noncontrolling interests for all periods presented.

Refer to Note 1 - Summary of Significant Accounting Policies in the Consolidated Financial Statements for a description of all recent accounting pronouncements including the respective dates of adoption and the effects on results of operations and financial condition.

Capital Resources and Liquidity

Cash Flow Analysis

The following summarizes our cash flows for the three years ended December 31, 2009, as reported in our Consolidated Statements of Cash Flows in the accompanying Consolidated Financial Statements:

 

     Year Ended December 31,    Change

(in millions)

   2009    2008    2007    2009    2008

Net cash provided by operating activities

   $ 2,208       $ 939       $ 1,871      $ 1,269      $ (932)  

Net cash used in investing activities

     (343)        (441)        (1,612)        98            1,171   

Net cash provided by (used in) financing activities

     692         (311)        (619)        1,003        308   

Effect of exchange rate changes on cash and cash equivalents

     13         (57)        60        70        (117)  
                                  

Increase (decrease) in cash and cash equivalents

     2,570         130         (300)        2,440        430   

Cash and cash equivalents at beginning of year

     1,229         1,099         1,399        130        (300)  
                                  

Cash and Cash Equivalents at End of Year

   $     3,799       $     1,229       $     1,099      $     2,570      $ 130   
                                  

Cash Flows from Operating Activities

Net cash provided by operating activities was $2,208 million for the year ended December 31, 2009. The $1,269 million increase from 2008 was primarily due to the following:

 

$587 million increase due to the absence of payments for securities-related litigation settlements.

 

$433 million increase as a result of lower inventory levels reflecting aggressive supply chain actions in light of lower sales volume.

 

$410 million increase from accounts receivables reflecting the benefits from sales of accounts receivables, lower revenue and strong collection effectiveness.

 

$177 million increase due to lower contributions to our defined pension benefit plans. The lower contributions are primarily in the U.S. as no contributions were required due to the availability of prior years’ credit balances.

 

$116 million increase due to lower net tax payments.

 

$84 million increase due to higher net run-off of finance receivables.

 

$64 million increase due to lower placements of equipment on operating leases reflecting lower install activity.

 

$440 million decrease in pre-tax income before litigation, restructuring and acquisition costs.

 

$139 million decrease due to higher restructuring payments related to prior years’ actions.

 

Xerox 2009 Annual Report   18


 

$54 million decrease due to lower accounts payable and accrued compensation primarily related to lower purchases and the timing of payments to suppliers.

Net cash provided by operating activities was $939 million for the year ended December 31, 2008. The $932 million decrease from 2007 was primarily due to the following:

 

$615 million decrease due to net payments for the settlement of the securities-related litigation.

 

$330 million decrease in pre-tax income before litigation and restructuring.

 

$90 million decrease due to higher net income tax payments, primarily resulting from the absence of prior year tax refunds.

 

$74 million decrease primarily due to lower benefit and compensation accruals.

 

$71 million decrease due to higher inventory levels as a result of lower equipment and supplies sales in 2008.

 

$136 million increase from accounts receivable due to strong collection effectiveness throughout 2008.

 

$107 million increase from derivatives, primarily due to the termination of certain interest rate swaps in fourth quarter 2008.

Cash Flows from Investing Activities

Net cash used in investing activities was $343 million for the year ended December 31, 2009. The $98 million increase from 2008 was primarily due to the following:

 

$142 million increase due to lower capital expenditures (including internal use software), reflecting very stringent spending controls.

 

$21 million decrease due to lower cash proceeds from asset sales.

Net cash used in investing activities was $441 million for the year ended December 31, 2008. The $1,171 million increase from 2007 was primarily due to the following:

 

$1,460 million increase due to less cash used for acquisitions. 2008 acquisitions included $138 million for Veenman B.V. and Saxon Business Systems as compared to $1,568 million for GIS and its additional acquisitions in the prior year.

 

$192 million decrease due to lower funds from escrow and other restricted investments in 2008. The prior year reflected funds received from the run-off of our secured borrowing programs.

 

$134 million decrease in other investing cash flows due to the absence of proceeds from liquidations of short-term investments.

Cash Flows from Financing Activities

Net cash provided by financing activities was $692 million for the year ended December 31, 2009. The $1,003 million increase from 2008 was primarily due to the following:

 

$812 million increase because no purchases were made under our share repurchase program during 2009.

 

$170 million increase from lower net repayments on secured debt.

 

$21 million increase due to lower share repurchases related to employee withholding taxes on stock-based compensation vesting.

 

$3 million decrease due to lower net debt proceeds. 2009 reflects the repayment of $1,029 million for Senior Notes due in 2009, net payments of $448 million for Zero Coupon Notes, net payments of $246 million on the Credit Facility, net payments of $35 million primarily for foreign short-term borrowings and $44 million of debt issuance costs for the Bridge Loan Facility commitment, which was recently terminated. These payments were partially offset by net proceeds of $2,725 million from the issuance of Senior Notes in May and December 2009. 2008 reflects the issuance of $1.4 billion in Senior Notes, $250 million in Zero Coupon Notes and net payments of $354 million on the Credit Facility and $370 million on other debt.

 

Xerox 2009 Annual Report   19


Net cash used in financing activities was $311 million for the year ended December 31, 2008. The $308 million increase from 2007 was primarily due to the following:

 

$1,642 million increase from lower net repayments on secured debt. 2007 reflects termination of our secured financing programs with GE in the United Kingdom and Canada of $634 million and Merrill Lynch in France for $469 million as well as the repayment of secured borrowings to DLL of $153 million. The remainder reflects lower payments associated with our GE U.S. secured borrowings.

 

$888 million decrease from lower net cash proceeds from unsecured debt. 2008 reflects the issuance of $1.4 billion in Senior Notes, $250 million from a private placement borrowing and net payments of $354 million on the Credit Facility and $370 million on other debt. 2007 reflects the issuance of $1.1 billion Senior Notes, $400 million from private placement borrowings and net proceeds of $600 million on the Credit Facility, offset by net payments of $286 million on other debt.

 

$180 million decrease due to additional purchases under our share repurchase program.

 

$154 million decrease due to common stock dividend payments.

 

$79 million decrease due to lower proceeds from the issuance of common stock, reflecting a decrease in stock option exercises as well as lower related tax benefits.

 

$33 million decrease due to share repurchases related to employee withholding taxes on stock-based compensation vesting.

Financing Activities, Credit Facility and Capital Markets

Customer Financing Activities

We provide lease equipment financing to the majority of our customers. Our lease contracts permit customers to pay for equipment over time rather than at the date of installation. Our investment in these contracts is reflected in Total finance assets, net. We currently fund our customer financing activity through cash generated from operations, cash on hand, borrowings under bank credit facilities and proceeds from capital markets offerings.

We have arrangements in certain international countries and domestically through GIS, where third party financial institutions independently provide lease financing, on a non-recourse basis to Xerox, directly to our customers. In these arrangements, we sell and transfer title of the equipment to these financial institutions. Generally, we have no continuing ownership rights in the equipment subsequent to its sale; therefore, the unrelated third party finance receivable and debt are not included in our Consolidated Financial Statements.

The following represents Total finance assets associated with our lease and finance operations as of December 31, 2009 and 2008:

 

(in millions)

   2009    2008

Total Finance receivables, net (1)

     $ 7,027        $ 7,278    

Equipment on operating leases, net

     551        594    
             

Total Finance Assets, net

     $             7,578        $             7,872    
             

 

(1)

Includes (i) billed portion of finance receivables, net, (ii) finance receivables, net and (iii) finance receivables due after one year, net as included in the Consolidated Balance Sheets as of December 31, 2009 and 2008.

The decrease of $294 million in Total finance assets, net includes favorable currency of $224 million.

 

Xerox 2009 Annual Report   20


We maintain a certain level of debt, referred to as financing debt, in order to support our investment in our lease contracts. We maintain an assumed 7:1 leverage ratio of debt to equity as compared to our finance assets for this financing aspect of our business. Based on this leverage, the following represents the breakdown of Total debt between financing debt and core debt as of December 31, 2009 and 2008:

 

(in millions)

   2009    2008

Financing debt (1)

    $ 6,631         $ 6,888  

Core debt (2)

     2,633          1,496  
             

Total Debt

    $             9,264         $             8,384  
             

 

(1)

Financing debt includes $6,149 million and $6,368 million as of December 2009 and 2008, respectively, of debt associated with Total finance receivables, net and is the basis for our calculation of “equipment financing interest” expense. The remainder of the financing debt is associated with Equipment on operating leases.

(2)

Core debt at December 31, 2009 includes the $2.0 billion Senior Notes issuance which was used to fund the acquisition of ACS.

The following summarizes our debt:

 

(in millions)

   2009    2008

Principal debt balance(3)

    $ 9,122       $ 8,201  

Net unamortized discount

     (11)        (6)  

Fair value adjustments

     153        189  
             

Total Debt (3)

     9,264        8,384  

Less: Current maturities and short-term debt

     (988)        (1,610)  
             

Total Long-term Debt(3)

    $             8,276       $             6,774  
             

 

(3)

Total debt at December 31, 2009 includes the $2.0 billion Senior Notes issuance which was used to fund the acquisition of ACS.

Principal debt balance at December 31, 2008 includes short-term debt of $61 million. Refer to Note 11 – Debt in the Consolidated Financial Statements for additional information regarding the above balances.

Financial Instruments

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

Share Repurchase Programs

Refer to Note 17 – Shareholders’ Equity – “Treasury Stock” in the Consolidated Financial Statements for further information regarding our share repurchase programs.

Dividends

The Board of Directors declared a 4.25 cent per share dividend on common stock in each quarter of 2009 and 2008.

Credit Facility

In October 2009, in connection with our anticipated acquisition of ACS, we amended our $2.0 billion Credit Facility and entered into a Bridge Loan Facility commitment as noted below. The Credit Facility amendment extended the maximum permitted leverage ratio of 4.25x through September 30, 2010, which will change to 4.00x through December 31, 2010, and to 3.75x thereafter. The amendment also included the following changes:

 

 

The definition of principal debt was changed such that principal debt was calculated as of December 31, 2009 net of cash proceeds from the Senior Notes issued in connection with the pre-funding of the ACS acquisition.

 

Xerox 2009 Annual Report   21


 

A portion of the Credit Facility that had a maturity date of April 30, 2012, was extended to a maturity date of April 30, 2013, consistent with the majority of the facility. Accordingly, after this amendment, approximately $1.6 billion, or approximately 80% of the Credit Facility, has a maturity date of April 30, 2013.

Capital Markets Offerings

In 2009, we raised net proceeds of $745 million and $1,980 million through the issuance of Senior Notes of $750 million in May and $2.0 billion in December, respectively. The net proceeds from the Senior Notes issued in December 2009 were used to fund the acquisition of ACS.

Refer to Note 3 – Acquisitions in the Consolidated Financial Statements for further information regarding the ACS acquisition, as well as Note 11 – Debt in the Consolidated Financial Statements for additional information regarding the Debt activity.

Bridge Loan Facility Commitment

In connection with the agreement to acquire ACS, in September 2009 we entered into a commitment for a syndicated $3.0 billion Bridge Loan Facility with several banks that was to be used for funding the acquisition in the event the transaction closed prior to obtaining permanent financing in the capital markets. Debt issuance costs for the Bridge Loan Facility commitment were $58 million. On December 4, 2009, the debt commitment was reduced to $500 million following our issuance of $2.0 billion of Senior Notes. On January 8, 2010, we terminated the remaining commitment because we concluded we had sufficient liquidity to complete the ACS acquisition without having to borrow under the Bridge Loan Facility.

Liquidity and Financial Flexibility

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.

Our liquidity is a function of our ability to successfully generate cash flows from a combination of efficient operations and access to capital markets. Our ability to maintain positive liquidity going forward depends on our ability to continue to generate cash from operations and access to financial markets, both of which are subject to general economic, financial, competitive, legislative, regulatory and other market factors that are beyond our control.

The following is a discussion of our liquidity position as of December 31, 2009:

 

 

As of December 31, 2009, total cash and cash equivalents was $3.8 billion and our borrowing capacity under our Credit Facility was $2.0 billion, reflecting no outstanding borrowings or letters of credit. Cash and cash equivalents at December 31, 2009 included the net proceeds from the $2.0 billion Senior Notes issued in December 2009, which were used to fund the acquisition of ACS.

 

Over the past three years we have consistently delivered strong cash flow from operations, driven by the strength of our annuity based revenue model. Cash flows from operations were $2,208 million, $939 million and $1,871 million for the years ended December 31, 2009, 2008 and 2007, respectively. Cash flows from operations in 2008 included $615 million in net payments for our securities litigation.

 

Xerox 2009 Annual Report   22


 

Our principal debt maturities are in line with historical and projected cash flows and are spread over the next ten years as follows (in millions):

 

Year

   Amount     

2010

   $ 988   

2011

     802   

2012

     1,101   

2013

     961   

2014

     819   

2015

     1,000   

2016

     950   

2017

     500   

2018

     1,001   

2019 and thereafter

     1,000   
         

Total

   $             9,122   
         

In February 2010, in connection with the closing of our acquisition of ACS, we borrowed $649 million under our Credit Facility.

Loan Covenants and Compliance

At December 31, 2009, we were in full compliance with the covenants and other provisions of the Credit Facility, our Senior Notes and our Bridge Loan Facility commitment (which was terminated on January 8, 2010). We have the right to prepay any outstanding loans or to terminate the Credit Facility without penalty. Failure to be in compliance with any material provision or covenant of these agreements could have a material adverse effect on our liquidity and operations and our ability to continue to fund our customers’ purchase of Xerox equipment.

Refer to Note 11 – Debt for further information regarding debt arrangements.

Credit Ratings: We are currently rated investment grade by all major rating agencies. As of February 8, 2010 the ratings were as follows:

 

    

Senior Unsecured Debt

  

Outlook

    

Moody’s

   Baa2    Stable   

Standard & Poors

   BBB-    Stable   

Fitch

   BBB    Negative   

Contractual Cash Obligations and Other Commercial Commitments and Contingencies

At December 31, 2009, we had the following contractual cash obligations and other commercial commitments and contingencies (in millions):

 

     2010    2011    2012    2013    2014    Thereafter
Long-term debt, including capital lease obligations (1)     $ 988         $ 802         $ 1,101         $ 961         $ 819         $ 4,451    
Minimum operating lease commitments (2)      224          181          128          99          70          80    
Liability to subsidiary trust issuing preferred securities (3)      —          —          —          —          —          649    
Retiree Health Payments      103          101          100          100          98          457    
Purchase Commitments                  

Flextronics (4)

     503          —          —          —          —          —    

Fuji Xerox(5)

     1,256          —          —          —          —          —    

EDS Contracts (6)

     113          77          77          77          19          —    

Other IM service contracts(7)

     80          77          61          56          44          18    
                                         

Total Contractual Cash Obligations

    $     3,267         $     1,238         $     1,467         $     1,293         $     1,050         $     5,655    
                                         

 

(1) Refer to Note 11 - Debt in our Consolidated Financial Statements for additional information and interest payments related to long-term debt (amounts above include principal portion only).
(2) Refer to Note 6 - Land, Buildings and Equipment, Net in our Consolidated Financial Statements for additional information related to minimum operating lease commitments.
(3) Refer to Note 12 - Liability to Subsidiary Trust Issuing Preferred Securities in our Consolidated Financial Statements for additional information and interest payments (amounts above include principal portion only).

 

Xerox 2009 Annual Report   23


(4) Flextronics: We outsource certain manufacturing activities to Flextronics and are currently in the third year of the Master Supply Agreement. The term of this agreement is three years, with two additional one year extension periods at our option. The amount included in the table reflects our estimate of purchases over the next year and is not a contractual commitment.
(5) Fuji Xerox: The amount included in the table reflects our estimate of purchases over the next year and is not a contractual commitment.
(6) EDS contract: We have an information management contract with Electronic Data Systems Corp. (“EDS”) through March 2014. Services to be provided under this contract include support for European and Brazilian mainframe system processing and application maintenance through June 2010, as well as workplace and service desk and voice and data network management through March 2014. There are no minimum payments required under this contract. The amounts disclosed in the table reflect our estimate of probable minimum payments for the periods shown. We can terminate the contract for convenience with six months prior notice, as defined in the contract, with no termination fee and with payment to EDS for costs incurred as of the termination date. Should we terminate the contract for convenience, we have an option to purchase the assets placed in service under the EDS contract.
(7) IM (Information Management) services: During 2009 we terminated several agreements with EDS for information management services and entered into new agreements for similar services with several providers. Services to be provided under these contracts include support for data network transport; mainframe application processing, development and support; and mid-range applications processing and support. These contracts have various terms through 2015. Some of the contracts require minimum payments and include termination penalties. The amounts disclosed in this table reflect our estimate of probable minimum payments.

Pension and Other Post-retirement Benefit Plans

We sponsor pension and other post-retirement benefit plans that may require periodic cash contributions. Our 2009 contributions for these plans were $122 million for pensions and $107 million for our retiree health plans. We expect to make contributions of approximately $260 million to our worldwide defined benefit pension plans and $103 million to our retiree health benefit plans in 2010. Once the January 1, 2010 actuarial valuations are finalized for our U.S. qualified pension plans, we will reassess the need for additional contributions for these plans. No additional contributions were made in 2009, due to the ERISA funded status of our U.S. qualified pension plans and the availability of a credit balance that had resulted from funding in prior periods in excess of minimum requirements. In 2008, we made additional contributions above what was disclosed in the 2007 Annual Report of $165 million to our U.S. qualified pension plans.

Our retiree health benefit plans are non-funded and are almost entirely related to domestic operations. Cash contributions are made each year to cover medical claims costs incurred in that year. The amounts reported in the above table as retiree health payments represent our estimated future benefit payments.

Fuji Xerox

We purchased products, including parts and supplies, from Fuji Xerox totaling $1.6 billion, $2.1 billion and $1.9 billion in 2009, 2008 and 2007, respectively. Our purchase commitments with Fuji Xerox are in the normal course of business and typically have a lead time of three months. Related party transactions with Fuji Xerox are discussed in Note 7 - Investments in Affiliates, at Equity in the Consolidated Financial Statements.

 

Xerox 2009 Annual Report   24


Brazil Tax and Labor Contingencies

Our Brazilian operations were involved in various litigation matters and have received or been the subject of numerous governmental assessments related to indirect and other taxes, as well as disputes associated with former employees and contract labor. The tax matters, which comprise a significant portion of the total contingencies, principally relate to claims for taxes on the internal transfer of inventory, municipal service taxes on rentals and gross revenue taxes. We are disputing these tax matters and intend to vigorously defend our position. Based on the opinion of legal counsel and current reserves for those matters deemed probable of loss, we do not believe that the ultimate resolution of these matters will materially impact our results of operations, financial position or cash flows. The labor matters principally relate to claims made by former employees and contract labor for the equivalent payment of all social security and other related labor benefits, as well as consequential tax claims, as if they were regular employees. As of December 31, 2009, the total amounts related to the unreserved portion of the tax and labor contingencies, inclusive of any related interest, amounted to approximately $1,225 million, with the increase from the December 31, 2008 balance of $839 million primarily related to currency and current year interest indexation. In connection with the above proceedings, customary local regulations may require us to make escrow cash deposits or post other security of up to half of the total amount in dispute. As of December 31, 2009 we had $240 million of escrow cash deposits for matters we are disputing and there are liens on certain Brazilian assets with a net book value of $19 million and additional letters of credit of approximately $137 million. Generally, any escrowed amounts would be refundable and any liens would be removed to the extent the matters are resolved in our favor. We routinely assess all these matters as to probability of ultimately incurring a liability against our Brazilian operations and record our best estimate of the ultimate loss in situations where we assess the likelihood of an ultimate loss as probable.

Other Contingencies and Commitments

As more fully discussed in Note 16 – Contingencies in the Consolidated Financial Statements, we are involved in a variety of claims, lawsuits, investigations and proceedings concerning securities law, intellectual property law, environmental law, employment law and the Employee Retirement Income Security Act. In addition, guarantees, indemnifications and claims may arise during the ordinary course of business from relationships with suppliers, customers and nonconsolidated affiliates. Nonperformance under a contract including a guarantee, indemnification or claim could trigger an obligation of the Company. 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. Should developments in any of these areas 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.

Unrecognized Tax Benefits

As of December 31, 2009, we had $148 million of unrecognized tax benefits. This represents the tax benefits associated with various tax positions taken, or expected to be taken, on domestic and international tax returns that have not been recognized in our financial statements due to uncertainty regarding their resolution. The resolution or settlement of these tax positions with the taxing authorities is at various stages and therefore we are unable to make a reliable estimate of the eventual cash flows by period that may be required to settle these matters. In addition, certain of these matters may not require cash settlement due to the existence of credit and net operating loss carryforwards, as well as other offsets, including the indirect benefit from other taxing jurisdictions that may be available.

Off-Balance Sheet Arrangements

Although we rarely utilize off-balance sheet arrangements in our operations, we enter into operating leases in the normal course of business. The nature of these lease arrangements is discussed in Note 6 - Land, Buildings and Equipment, Net in the Consolidated Financial Statements. In addition, we have facilities in the U.S., Canada and several countries in Europe that enable us to sell, on an on-going basis, certain short-term accounts receivable without recourse to third parties. Refer to Note 4 – Receivables, Net in the Consolidated Financial Statements for further information.

Refer to Note 16 – Contingencies in the Consolidated Financial Statements for further information regarding our guarantees, indemnifications and warranty liabilities.

 

Xerox 2009 Annual Report   25


Financial Risk Management

We are exposed to market risk from foreign currency exchange rates and interest rates, which could affect operating results, financial position and cash flows. We manage our exposure to these market risks through our regular operating and financing activities and, when appropriate, through the use of derivative financial instruments. These derivative financial instruments are utilized to hedge economic exposures, as well as reduce earnings and cash flow volatility resulting from shifts in market rates.

Recent market events have not required us to materially modify or change our financial risk management strategies with respect to our exposures to interest rate and foreign currency risk. Refer to Note 13 – Financial Instruments in the Consolidated Financial Statements for further discussion on our financial risk management.

Foreign Exchange Risk Management

Assuming a 10% appreciation or depreciation in foreign currency exchange rates from the quoted foreign currency exchange rates at December 31, 2009, the potential change in the fair value of foreign currency-denominated assets and liabilities in each entity would not be significant because all material currency asset and liability exposures were economically hedged as of December 31, 2009. A 10% appreciation or depreciation of the U.S. Dollar against all currencies from the quoted foreign currency exchange rates at December 31, 2009 would have a $689 million impact on our cumulative translation adjustment portion of equity. The net amount invested in foreign subsidiaries and affiliates primarily Xerox Limited, Fuji Xerox, Xerox Canada Inc. and Xerox do Brasil, and translated into Dollars using the year-end exchange rates, was $6.9 billion at December 31, 2009.

Interest Rate Risk Management

The consolidated weighted-average interest rates related to our total debt and liability to subsidiary trust issuing preferred securities for 2009, 2008 and 2007 approximated 6.1%, 6.6%, and 7.1%, respectively. Interest expense includes the impact of our interest rate derivatives.

Virtually all customer-financing assets earn fixed rates of interest. The interest rates on a significant portion of the Company’s term debt are fixed.

As of December 31, 2009, $2.4 billion of our total debt carried variable interest rates, including the effect of pay variable interest rate swaps we are utilizing with the intent to reduce the effective interest rate on our fixed coupon debt.

The fair market values of our fixed-rate financial instruments are sensitive to changes in interest rates. At December 31, 2009, a 10% change in market interest rates would change the fair values of such financial instruments by approximately $274 million.

Non-GAAP Financial Measures

We have reported our financial results in accordance with generally accepted accounting principles (“GAAP”). A reconciliation of the following non-GAAP financial measures to the most directly comparable financial measures calculated and presented in accordance with GAAP are set forth below:

Adjusted Revenue

We discussed the revenue growth for the year ended December 31, 2008 using non-GAAP financial measures. To understand trends in the business, we believe that it is helpful to adjust the revenue growth rates to illustrate the impact of the acquisition of GIS by including their estimated revenue for the comparable 2007 period. We refer to this adjusted revenue as “As Adjusted” in the following reconciliation table. Revenue “As Adjusted” adds GIS’s revenues from January 1, 2007 to May 8, 2007 to our 2007 reported revenue. Management believes these measures give investors an additional perspective on revenue trends, as well as the impact to the Company of the acquisition of GIS that was completed in May 2007.

 

Xerox 2009 Annual Report   26


     December 31,          

(in millions)

   2008    2007        Change       

Equipment Sales Revenue:

           

As Reported

     $ 4,679          $ 4,753        (2)%       

As Adjusted

     $ 4,679          $ 4,938        (5)%       

Post Sale Revenue:

           

As Reported

     $ 12,929          $ 12,475        4%       

As Adjusted

     $ 12,929          $ 12,681        2%       

Total Revenues:

           

As Reported

     $ 17,608          $ 17,228        2%       

As Adjusted

     $         17,608          $         17,619        —       

Adjusted Effective Tax Rate

The effective tax rate for the year ended December 31, 2008 is discussed using a non-GAAP financial measure that excludes the effect of charges associated with an equipment write-off; restructuring and asset impairments; certain litigation matters and the settlement of certain previously unrecognized tax benefits. Management believes that it is helpful to exclude these effects to better understand, analyze and compare 2008’s income tax expense and effective tax rate to the 2007 amounts given the discrete nature and size of these items in 2008.

 

     Year Ended December 31, 2008     

(in millions)

   Pre-Tax Income    Income
Taxes
   Effective Tax
Rate
  

As Reported

     $ (79)          $ (231)        292.4%     

Restructuring and asset impairment charges

     426          134          

Equipment write-off

     39          15          

Provision for securities litigation matters

     774          283          

Tax settlements

     —          41          
                     

As Adjusted

     $         1,160          $         242                20.9%     
                     

Management believes that these non-GAAP financial measures provide an additional means of analyzing the current period results against the corresponding prior period results. However, non-GAAP financial measures should be viewed in addition to, and not as a substitute for, the Company’s reported results prepared in accordance with GAAP.

Forward-Looking Statements

This Annual Report contains forward-looking statements as defined in the Private Securities Litigation Reform Act of 1995. The words “anticipate,” “believe,” “estimate,” “expect,” “intend,” “will,” “should” and similar expressions, as they relate to us, are intended to identify forward-looking statements. These statements reflect management’s current beliefs, assumptions and expectations and are subject to a number of factors that may cause actual results to differ materially. Information concerning these factors is included in our 2009 Annual Report on Form 10-K filed with the Securities and Exchange Commission (“SEC”). We do not intend to update these forward-looking statements, except as required by law.

 

Xerox 2009 Annual Report   27


XEROX CORPORATION

CONSOLIDATED STATEMENTS OF INCOME

 

    Year Ended December 31,

(in millions, except per-share data)

  2009   2008   2007

Revenues

     

Sales

  $ 6,646     $ 8,325       $ 8,192    

Service, outsourcing and rentals

    7,820       8,485         8,214    

Finance income

    713       798         822    
                 

Total Revenues

        15,179           17,608             17,228    

Costs and Expenses

     

Cost of sales

    4,395       5,519         5,254    

Cost of service, outsourcing and rentals

    4,488       4,929         4,707    

Equipment financing interest

    271       305         316    

Research, development and engineering expenses

    840       884         912    

Selling, administrative and general expenses

    4,149       4,534         4,312    

Restructuring and asset impairment charges

    (8)       429         (6)    

Acquisition-related costs

    72       —         —    

Other expenses, net

    345       1,087         265    
                 

Total Costs and Expenses

    14,552       17,687         15,760    

Income (Loss) before Income Taxes and Equity Income

    627       (79)         1,468    

Income tax expense (benefit)

    152       (231)         400    

Equity in net income of unconsolidated affiliates

    41       113         97    
                 

Net Income

    516       265         1,165    

Less: Net income attributable to noncontrolling interests

    31       35         30    
                 

Net Income Attributable to Xerox

  $ 485     $ 230       $ 1,135    
                 

Basic Earnings per Share

  $ 0.56     $ 0.26       $ 1.21    

Diluted Earnings per Share

  $ 0.55     $ 0.26       $ 1.19    

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

 

Xerox 2009 Annual Report   28


XEROX CORPORATION

CONSOLIDATED BALANCE SHEETS

 

     December 31,
(in millions, except share data in thousands)    2009   2008

Assets

    

Cash and cash equivalents

   $ 3,799         $ 1,229  

Accounts receivable, net

     1,702           2,184  

Billed portion of finance receivables, net

     226           254  

Finance receivables, net

     2,396           2,461  

Inventories

     900           1,232  

Other current assets

     708           790  
            

Total current assets

     9,731           8,150  

Finance receivables due after one year, net

     4,405           4,563  

Equipment on operating leases, net

     551           594  

Land, buildings and equipment, net

     1,309           1,419  

Investments in affiliates, at equity

     1,056           1,080  

Intangible assets, net

     598           610  

Goodwill

     3,422           3,182  

Deferred tax assets, long-term

     1,640           1,692  

Other long-term assets

     1,320           1,157  
            

Total Assets

   $ 24,032         $ 22,447  
            

Liabilities and Equity

    

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

   $ 988         $ 1,610  

Accounts payable

     1,451           1,446  

Accrued compensation and benefits costs

     695           625  

Other current liabilities

     1,327           1,769  
            

Total current liabilities

     4,461           5,450  

Long-term debt

     8,276           6,774  

Liability to subsidiary trust issuing preferred securities

     649           648  

Pension and other benefit liabilities

     1,884           1,747  

Post-retirement medical benefits

     999           896  

Other long-term liabilities

     572           574  
            

Total Liabilities

     16,841           16,089  
            

Common stock

     871           866  

Additional paid-in capital

     2,493           2,447  

Retained earnings

     5,674           5,341  

Accumulated other comprehensive loss

     (1,988)           (2,416) 
            

Xerox Shareholders’ Equity

     7,050           6,238  

Noncontrolling interests

     141           120  
            

Total Equity

     7,191           6,358  
            

Total Liabilities and Equity

   $       24,032         $ 22,447  
            

Shares of Common Stock Issued and Outstanding

     869,381           864,777  
            

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

 

Xerox 2009 Annual Report   29


XEROX CORPORATION

CONSOLIDATED STATEMENTS OF CASH FLOWS

 

     Year Ended December 31,
(in millions)      2009    2008    2007

Cash Flows from Operating Activities:

        

Net income

   $       516      $ 265      $ 1,165  

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

        

Depreciation and amortization

     698        669        656  

Provision for receivables

     289        199        131  

Provision for inventory

     52        115        66  

Deferred tax expense (benefit) 

     120        (324)       224  

Net gain on sales of businesses and assets

     (16)        (21)       (7) 

Undistributed equity in net income of unconsolidated affiliates

     (25)        (53)       (60) 

Stock-based compensation

     85        85        89  

Provision for litigation, net

     —        781        —  

Payments for securities litigation, net

     (28)        (615)       —  

Restructuring and asset impairment charges

     (8)        429        (6) 

Payments for restructurings

     (270)        (131)       (235) 

Contributions to pension benefit plans

     (122)        (299)       (298) 

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

     467        57        (79) 

Decrease (increase)  in inventories

     319        (114)       (43) 

Increase in equipment on operating leases

     (267)        (331)       (331) 

Decrease in finance receivables

     248        164        119  

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

     129        (8)       130  

Increase in accounts payable and accrued compensation

     157        211        285  

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

     (100)        (174)       38  

Net change in income tax assets and liabilities

     (18)        (92)       73  

Net change in derivative assets and liabilities

     (56)        230        (10) 

Other operating, net

     38        (104)       (36) 
                    

Net cash provided by operating activities

     2,208        939        1,871  
                    

Cash Flows from Investing Activities:

        

Cost of additions to land, buildings and equipment

     (95)        (206)       (236) 

Proceeds from sales of land, buildings and equipment

     17        38        25  

Cost of additions to internal use software

     (98)        (129)       (123) 

Acquisitions, net of cash acquired

     (163)        (155)       (1,615) 

Net change in escrow and other restricted investments

     (6)        8        200  

Other investing, net

     2        3        137  
                    

Net cash used in investing activities

     (343)        (441)       (1,612) 
                    

Cash Flows from Financing Activities:

        

Net payments on secured financings

     (57)        (227)       (1,869) 

Net proceeds on other debt

     923        926        1,814 

Common stock dividends

     (149)        (154)       —  

Proceeds from issuances of common stock

     1        6        65  

Excess tax benefits from stock-based compensation

     —        2        22  

Payments to acquire treasury stock, including fees

     —        (812)       (632) 

Repurchases related to stock-based compensation

     (12)        (33)       —  

Other financing

     (14)        (19)       (19) 
                    

Net cash provided by (used in)  financing activities

     692        (311)       (619) 
                    

Effect of exchange rate changes on cash and cash equivalents

     13        (57)       60  
                    

Increase (decrease)  in cash and cash equivalents

     2,570        130        (300) 

Cash and cash equivalents at beginning of year

     1,229        1,099        1,399  
                    

Cash and Cash Equivalents at End of Year

   $ 3,799      $       1,229      $       1,099  
                    

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

 

Xerox 2009 Annual Report   30


XEROX CORPORATION

CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY

 

(in millions)

   Common
Stock
    Additional
Paid-in
Capital
    Treasury
Stock
    Retained
Earnings
    AOCL (1)     Xerox
Shareholders’
Equity
    Non-
controlling
Interests
    Total
Equity
 

Balance at December 31, 2006

       $ 956      $ 3,710          $ (141       $ 4,202          $ (1,647       $ 7,080      $ 108        $ 7,188   
                                                                

Net income

     —          —          —          1,135        —          1,135        30        1,165   

Translation adjustments

     —          —          —          —          501        501        1        502   

Cumulative effect of change in accounting principles

     —          —          —          (9     —          (9     —          (9

Changes in defined benefit plans (2)

     —          —          —          —          382        382        —          382   

Other unrealized losses

     —          —          —          —          (1     (1     —          (1
                                  

Comprehensive Income

                 $ 2,008          $ 31        $ 2,039   
                                  

Cash dividends declared on common stock(3)

     —          —          —          (40     —          (40     —          (40

Stock option and incentive plans, net

     7        165        —          —          —          172        —          172   

Payments to acquire treasury stock

     —          —          (632     —          —          (632     —          (632

Cancellation of treasury stock

     (43     (699     742        —          —          —          —          —     

Distributions to noncontrolling interests

     —          —          —          —          —          —          (19     (19 )

Purchase of noncontrolling interests(4)

     —          —          —          —          —          —          (17     (17 )
                                                                

Balance at December 31, 2007

       $ 920          $ 3,176          $ (31       $ 5,288          $ (765       $ 8,588          $ 103        $ 8,691   
                                                                

Net income

     —          —          —          230        —          230        35        265   

Translation adjustments

     —          —          —          —          (1,364     (1,364     (3     (1,367

Cumulative effect of change in accounting principles

     —          —          —          (25     —          (25     —          (25

Changes in defined benefit plans (2)

     —          —          —          —          (286     (286     —          (286

Other unrealized losses, net

     —          —          —          —          (1     (1     —          (1
                                  

Comprehensive (Loss) Income

                 $ (1,446       $ 32        $ (1,414
                                  

Cash dividends declared on common stock(3)

     —          —          —          (152     —          (152     —          (152

Stock option and incentive plans, net

     5        55        —          —          —          60        —          60   

Payments to acquire treasury stock

     —          —          (812     —          —          (812     —          (812

Cancellation of treasury stock

     (59     (784     843        —          —          —          —          —     

Distributions to noncontrolling interests

     —          —          —          —          —          —          (15     (15 )
                                                                

Balance at December 31, 2008

       $ 866          $ 2,447          $ —            $ 5,341          $ (2,416       $ 6,238          $ 120        $ 6,358   
                                                                
                

Net income

     —          —          —          485        —          485        31        516   

Translation adjustments

     —          —          —          —          595        595        1        596   

Changes in defined benefit plans (2) 

     —          —          —          —          (169     (169     —          (169

Other unrealized gains

     —          —          —          —          2       2        —          2   
                                  

Comprehensive Income

                 $ 913          $ 32        $ 945   
                                  

Cash dividends declared on common stock(3)

     —          —          —          (152     —          (152     —          (152

Stock option and incentive plans, net

     5        67        —          —          —          72        —          72   

Tax loss on stock option and incentive plans, net

     —          (21     —          —          —          (21     —          (21

Distributions to noncontrolling interests

     —          —          —          —          —          —          (11     (11
                                                                

Balance at December 31, 2009

       $ 871          $ 2,493          $ —            $ 5,674          $ (1,988       $ 7,050          $ 141        $ 7,191   
                                                                

 

 

(1) Refer to Note 1 “Accumulated Other Comprehensive Loss (AOCL)” section for additional information.
(2) Refer to Note 14 - Employee Benefit Plans for additional information.
(3) Cash dividends declared of $0.0425 in the fourth quarter 2007 and in each of the four quarters in 2008 and 2009.
(4) Represents purchase of De Lage Landen’s 51% ownership interest in our lease finance joint venture in the Netherlands.

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

 

Xerox 2009 Annual Report   31


Notes to the Consolidated Financial Statements

Dollars in millions, except per share data and unless otherwise indicated.

Note 1 – Summary of Significant Accounting Policies

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

Description of Business and Basis of Presentation

We are a technology and services enterprise and a leader in the global document market. We develop, manufacture, market, service and finance a complete range of document equipment, software, solutions and services.

Basis of Consolidation

The Consolidated Financial Statements include the accounts of Xerox Corporation and all of our controlled subsidiary companies. All significant intercompany accounts and transactions have been eliminated. Investments in business entities in which we do not have control, but we have the ability to exercise significant influence over operating and financial policies (generally 20% to 50% ownership) are accounted for using the equity method of accounting. Operating results of acquired businesses are included in the Consolidated Statements of Income from the date of acquisition.

We consolidate variable interest entities if we are deemed to be the primary beneficiary of the entity. Operating results for variable interest entities in which we are determined to be the primary beneficiary are included in the Consolidated Statements of Income from the date such determination is made.

For convenience and ease of reference, we refer to the financial statement caption “Income (Loss) before Income Taxes and Equity Income” as “Pre-tax Income” or “Pre-tax Loss” throughout the Notes to the Consolidated Financial Statements.

In 2009, we changed the presentation of our financial statements for noncontrolling (minority) interests. Refer to “Business Combinations and Noncontrolling Interests” below for additional information.

Use of Estimates

The preparation of our Consolidated Financial Statements, in accordance with accounting principles generally accepted in the United States of America, requires that we make estimates and assumptions that affect the reported amounts of assets and liabilities, as well as the disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period. Significant estimates and assumptions are used for, but not limited to: (i) allocation of revenues and fair values in leases and other multiple element arrangements; (ii) accounting for residual values; (iii) economic lives of leased assets; (iv) allowance for doubtful accounts; (v) inventory valuation; (vi) restructuring and related charges; (vii) asset impairments; (viii) depreciable lives of assets; (ix) useful lives of intangible assets; (x) pension and post-retirement benefit plans; (xi) income tax reserves and valuation allowances; and (xii) contingency and litigation reserves. Future events and their effects cannot be predicted with certainty; accordingly, our accounting estimates require the exercise of judgment. The accounting estimates used in the preparation of our Consolidated Financial Statements will change as new events occur, as more experience is acquired, as additional information is obtained and as our operating environment changes. Actual results could differ from those estimates.

 

Xerox 2009 Annual Report   32


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

 

     Year Ended December 31,
     2009    2008    2007

Restructuring provisions and asset impairments

   $ (8)      $ 429      $ (6)  

Amortization of acquired intangible assets(1)

     64         58        46   

Provisions for receivables

     289         199        131   

Provisions for obsolete and excess inventory

     52         115        66   

Provisions for litigation and regulatory matters

     9         781        (6)  

Depreciation and obsolescence of equipment on operating leases

     329         298        269   

Depreciation of buildings and equipment

     247         257        262   

Amortization of internal use and product software

     58         56        79   

Defined pension benefits – net periodic benefit cost

     232         174        235   

Other post-retirement benefits – net periodic benefit cost

     26         77        102   

Deferred tax asset valuation allowance provisions

     (11)        17        14   

 

(1)

Note this includes amortization of $4 for patents which is included in cost of sales.

Changes in Estimates

In the ordinary course of accounting for items discussed above, we make changes in estimates as appropriate and as we become aware of circumstances surrounding those estimates. Such changes and refinements in estimation methodologies are reflected in reported results of operations in the period in which the changes are made and, if material, their effects are disclosed in the Notes to the Consolidated Financial Statements.

New Accounting Standards and Accounting Changes

FASB Establishes Accounting Standards Codification™

In 2009, the FASB issued Accounting Standards Update No. 2009-01, “Generally Accepted Accounting Principles” (ASC Topic 105) which establishes the FASB Accounting Standards Codification (“the Codification” or “ASC”) as the official single source of authoritative U.S. generally accepted accounting principles (“GAAP”). All existing accounting standards are superseded. All other accounting guidance not included in the Codification will be considered non-authoritative. The Codification also includes all relevant Securities and Exchange Commission (“SEC”) guidance organized using the same topical structure in separate sections within the Codification.

Following the Codification, the Board will not issue new standards in the form of Statements, FASB Staff Positions or Emerging Issues Task Force Abstracts. Instead, it will issue Accounting Standards Updates (“ASU”) which will serve to update the Codification, provide background information about the guidance and provide the basis for conclusions on the changes to the Codification.

The Codification is not intended to change GAAP, but it will change the way GAAP is organized and presented. The Codification was effective for our third-quarter 2009 financial statements and the principal impact on our financial statements is limited to disclosures as all future references to authoritative accounting literature will be referenced in accordance with the Codification. In order to ease the transition to the Codification, we are providing the Codification cross-reference alongside the references to the standards issued and adopted prior to the adoption of the Codification.

Fair Value Accounting

In 2006, the FASB issued SFAS No. 157, “Fair Value Measurements” (ASC Topic 820) which defines fair value, establishes a market-based framework or hierarchy for measuring fair value and expands disclosures about fair value

 

Xerox 2009 Annual Report   33


measurements. This guidance is applicable whenever another accounting pronouncement requires or permits assets and liabilities to be measured at fair value. It does not expand or require any new fair value measures; however the application of this statement may change current practice. We adopted this guidance for financial assets and liabilities effective January 1, 2008 and for non-financial assets and liabilities effective January 1, 2009. The adoption of this guidance, which primarily affected the valuation of our derivative contracts, did not have a material effect on our financial condition or results of operations.

In 2009, the FASB issued the following updates that provide additional application guidance and enhance disclosures regarding fair value measurements and impairments of securities:

 

   

FSP FAS 157-4, “Determining Fair Value When the Volume and Level of Activity for the Asset or Liability Have Significantly Decreased and Identifying Transactions That Are Not Orderly” (ASC Topic 820-10-65).

   

FSP FAS 115-2 and FAS 124-2, “Recognition and Presentation of Other-Than-Temporary Impairments” (ASC Topic 320-10-65).

   

FSP FAS 107-1 and APB 28-1, “Interim Disclosures about Fair Value of Financial Instruments” (ASC Topic 320-10-65).

We elected to early adopt these updates effective March 31, 2009 and the adoption did not have a material effect on our financial condition or results of operations.

In 2009, the FASB issued ASU No. 2009-05 which amends Fair Value Measurements and Disclosures – Overall (ASC Topic 820-10) to provide guidance on the fair value measurement of liabilities. This update provides clarification for circumstances in which a quoted price in an active market for the identical liability is not available. This update was effective October 1, 2009 (our fourth quarter) and did not have a material effect on our financial condition or results of operations.

In 2010, the FASB issued ASU No. 2010-06 which amends Fair Value Measurements and Disclosures – Overall (ASC Topic 820-10). This update requires a gross presentation of activities within the Level 3 roll forward and adds a new requirement to disclose transfers in and out of Level 1 and 2 measurements. The update also clarifies the following existing disclosure requirements in ASC 820-10 regarding: i) the level of disaggregation of fair value measurements; and ii) the disclosures regarding inputs and valuation techniques. This update is effective for our fiscal year beginning January 1, 2010 except for the gross presentation of the Level 3 roll forward information, which is effective for our fiscal year beginning January 1, 2011. The principle impact from this update will be expanded disclosures regarding our fair value measurements.

Business Combinations and Noncontrolling Interests

In 2007, the FASB issued SFAS No. 141 (revised 2007), “Business Combinations” (ASC Topic 805). This guidance requires the acquiring entity in a business combination to recognize the full fair value of assets acquired and liabilities assumed in the transaction (whether a full or partial acquisition); establishes the acquisition date fair value as the measurement objective for all assets acquired and liabilities assumed; requires expensing of most transaction and restructuring costs; and requires the acquirer to disclose the information needed to evaluate and understand the nature and financial effect of the business combination. We adopted this guidance effective January 1, 2009 and have applied it to all business combinations prospectively from that date. The impact of ASC Topic 805 on our consolidated financial statements will depend upon the nature, terms and size of the acquisitions we consummate in the future.

In 2009, the FASB issued Staff Position No. FSP FAS 141(R)-1; “Accounting for Assets Acquired and Liabilities Assumed in a Business Combination That Arise from Contingencies” (ASC Topic 805-20). This updated guidance amended the accounting treatment for assets and liabilities arising from contingencies in a business combination and requires that pre-acquisition contingencies be recognized at fair value, if fair value can be reasonably determined. If fair value cannot be reasonably determined, measurement should be based on the best estimate in accordance with SFAS No. 5, “Accounting for Contingencies” (ASC Topic 405). This updated guidance was effective January 1, 2009.

 

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In 2007, the FASB issued SFAS No. 160, “Noncontrolling Interests in Consolidated Financial Statements—an amendment of Accounting Research Bulletin No. 51” (ASC Topic 810-10-65). This guidance requires companies to present noncontrolling (minority) interests as equity (as opposed to a liability) and provides guidance on the accounting for transactions between an entity and noncontrolling interests. In addition, it requires companies to report a consolidated net income (loss) measure that includes the amount attributable to such noncontrolling interests. We adopted this guidance effective January 1, 2009, and have applied it to noncontrolling interests prospectively from that date. The presentation and disclosure requirements were applied retrospectively for all periods presented. As a result of this adoption, we reclassified noncontrolling interests in the amount of $120 from Other long-term liabilities to equity in the December 31, 2008 balance sheet.

Revenue Recognition

In 2009, the FASB issued the following ASUs:

 

   

ASU No. 2009-13, Revenue Recognition (ASC Topic 605) - Multiple-Deliverable Revenue Arrangements, a consensus of the FASB Emerging Issues Task Force. This guidance modifies the fair value requirements of ASC subtopic 605-25 Revenue Recognition-Multiple Element Arrangements by allowing the use of the “best estimate of selling price” in addition to VSOE and VOE (now referred to as TPE standing for third-party evidence) for determining the selling price of a deliverable. A vendor is now required to use its best estimate of the selling price when VSOE or TPE of the selling price cannot be determined. In addition, the residual method of allocating arrangement consideration is no longer permitted.

   

ASU No. 2009-14, Software (ASC Topic 985) - Certain Revenue Arrangements That Include Software Elements, a consensus of the FASB Emerging Issues Task Force. This guidance modifies the scope of ASC subtopic 985-605 Software-Revenue Recognition to exclude from its requirements (a) non-software components of tangible products and (b) software components of tangible products that are sold, licensed or leased with tangible products when the software components and non-software components of the tangible product function together to deliver the tangible product’s essential functionality.

These updates require expanded qualitative and quantitative disclosures and are effective for fiscal years beginning on or after June 15, 2010. We have elected to adopt these updates effective for our fiscal year beginning January 1, 2010 and we will apply them prospectively from that date for new or materially modified arrangements. We do not believe adoption of these updates will have a material effect on our financial condition or results of operations.

Benefit Plans Accounting

In 2008, the FASB issued Staff Position No. FAS 132(R)-1, “Employers’ Disclosures about Postretirement Benefit Plan Assets” (ASC Topic 715-20-65). This guidance expands disclosure by requiring the following new disclosures: 1) how investment allocation decisions are made by management; 2) major categories of plan assets; 3) a roll-forward of assets valued with non-observable market inputs; and 4) significant concentrations of risk. Additionally, ASC 715-20-65 requires an employer to disclose information about the valuation of plan assets similar to that required in ASC Topic 820 Fair Value Measurements and Disclosures. This guidance was effective for our fiscal year ending December 31, 2009. The only impact from this standard was to require us to expand disclosures regarding our benefit plan assets. Refer to Note 14-Employee Benefit Plans for expanded disclosures.

Other Accounting Changes

In January 2010, the FASB issued the following Codification updates:

 

   

ASU 2010-01 which amends Equity (ASC Topic 505): Accounting for Distributions to Shareholders with Components of Stock and Cash—a consensus of the FASB Emerging Issues Task Force. This update clarifies that the stock portion of a distribution to shareholders that allows them to elect to receive cash or stock with a potential limitation on the total amount of cash that all shareholders can elect to receive in the aggregate is considered a share issuance that is reflected in EPS prospectively and is not a stock dividend for purposes of applying ASC Topics 505 and 260 (Equity and Earnings Per Share). This update was effective October 1, 2009 (our fourth quarter) and did not have a material effect on our financial condition or results of operations.

 

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ASU 2010-02 which amends Consolidation (ASC Topic 810): Accounting and Reporting for Decreases in Ownership of a Subsidiary—a Scope Clarification. This update provides amendments to ASC Topic 810 to clarify the scope of the decrease in ownership provisions of the topic and related guidance. This update was effective October 1, 2009 (our fourth quarter) and did not have a material effect on our financial condition or results of operations.

In 2009, the FASB issued the following codification updates:

 

   

ASU 2009-16 which amends Transfers and Servicing (ASC Topic 860): Accounting for Transfers of Financial Assets. This update removed the concept of a qualifying special-purpose entity and removed the exception from applying consolidation guidance to these entities. This update also clarified the requirements for isolation and limitations on portions of financial assets that are eligible for sale accounting. We adopted this update effective for our fiscal year beginning January 1, 2010. We have certain accounts receivable sale arrangements that will require modification in order to qualify for sale accounting under this updated guidance. Assuming those arrangements are modified, we do not believe adoption of this update will have a material effect on our financial condition or results of operations.

 

   

ASU 2009-17 which amends Consolidations (ASC Topic 810): Improvements to Financial Reporting by Enterprises Involved with Variable Interest Entities. This update requires an analysis to determine whether a variable interest gives the entity a controlling financial interest in a variable interest entity. It also requires an ongoing reassessment and eliminates the quantitative approach previously required for determining whether an entity is the primary beneficiary. We adopted this update effective for our fiscal year beginning January 1, 2010 and we do not believe adoption of this update will have a material effect on our financial condition or results of operations.

 

   

In 2009, the FASB issued SFAS No. 165, “Subsequent Events” (ASC Topic 855). This guidance is intended to establish general standards of accounting for and disclosures of events that occur after the balance sheet date but before financial statements are issued or are available to be issued. This guidance was effective for our second quarter ended June 30, 2009.

During 2009 and early 2010, the FASB has issued several ASUs – ASU No. 2009-02 through ASU No. 2009-17 and ASU No. 2010-01 through ASU No. 2010-08. Except for ASUs No. 2009-05, 2009-13, 2009-14, 2009-16, 2009-17, 2010-01, 2010-02 and 2010-06 discussed above, the remaining ASUs entail technical corrections to existing guidance or affect guidance related to specialized industries or entities and therefore have minimal, if any, impact on the Company.

Summary of Accounting Policies

Revenue Recognition

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

Equipment: Revenues from the sale of equipment, including those from sales-type leases, are recognized at the time of sale or at the inception of the lease, as appropriate. For equipment sales that require us to install the product at the customer location, revenue is recognized when the equipment has been delivered 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.

 

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

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

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

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

Software: Software included within our equipment and services is generally considered incidental and is therefore accounted for as part of the equipment sales or services revenues. Software accessories sold in connection with our equipment sales, as well as free-standing software sales are accounted for as separate deliverables or elements. In most cases, these software products are sold as part of multiple element arrangements and include software maintenance agreements for the delivery of technical service, as well as unspecified upgrades or enhancements on a when-and-if-available basis. In those software accessory and free-standing software arrangements that include more than one element, we allocate the revenue among the elements based on vendor-specific objective evidence (“VSOE”) of fair value. VSOE of fair value is based on the price charged when the deliverable is sold separately by us on a regular basis and not as part of the multiple-element arrangement. Revenue allocated to software is normally recognized upon delivery while revenue allocated to the software maintenance element is recognized ratably over the term of the arrangement.

Leases: Our accounting for leases involves specific determinations regarding complex accounting provisions, as well as significant judgments. The two primary accounting provisions which we use to classify transactions as sales-type or operating leases are: 1) a review of the lease term to determine if it is equal to or greater than 75% of the economic life of the equipment and 2) a review of the present value of the minimum lease payments to determine if they are equal to or greater than 90% of the fair market value of the equipment at the inception of the lease. Our leases in our Latin America operations have historically been recorded as operating leases given the cancellable nature of the contract or because the recoverability of the lease investment is deemed not to be predictable at lease inception.

The critical elements that we consider with respect to our lease accounting are the determination of the economic life and the fair value of equipment, including the residual value. For purposes of determining the economic life, we consider the most objective measure to be the original contract term, since most equipment is returned by lessees at or near the end of the contracted term. The economic life of most of our products is five years since this represents the most frequent contractual lease term for our principal products and only a small percentage of our leases have original terms longer than five years. We continually evaluate the economic life of both existing and newly introduced products for purposes of this determination. Residual values, if any, are established at lease inception using estimates of fair value at the end of the lease term.

 

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The vast majority of our leases that qualify as sales-type are non-cancelable and include cancellation penalties approximately equal to the full value of the lease receivables. A portion of our business involves sales to governmental units. Governmental units are those entities that have statutorily defined funding or annual budgets that are determined by their legislative bodies. Certain of our governmental contracts may have cancellation provisions or renewal clauses that are required by law, such as 1) those dependant on fiscal funding outside of a governmental unit’s control, 2) those that can be cancelled if deemed in the best interest of the governmental unit’s taxpayers or 3) those that must be renewed each fiscal year, given limitations that may exist on entering into multi-year contracts that are imposed by statute. In these circumstances, we carefully evaluate these contracts to assess whether cancellation is remote. The evaluation of a lease agreement with a renewal option includes an assessment as to whether the renewal is reasonably assured based on the apparent intent and our experience of such governmental unit. 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 the lease as an operating lease.

After the initial lease of equipment to our customers, we may enter subsequent transactions with the same customer whereby we extend the term. Revenue from such lease extensions is typically recognized over the extension period.

Bundled Arrangements: We sell our products and services under bundled lease arrangements, which typically include equipment, service, supplies and financing components for which the customer pays a single negotiated fixed minimum monthly payment for all elements over the contractual lease term. These arrangements also typically include an incremental, variable component for page volumes in excess of contractual page volume minimums, which are often expressed in terms of price per page. The fixed minimum monthly payments are multiplied by the number of months in the contract term to arrive at the total fixed minimum payments that the customer is obligated to make (“fixed payments”) over the lease term. The payments associated with page volumes in excess of the minimums are contingent on whether or not such minimums are exceeded (“contingent payments”). The minimum contractual committed page volumes are typically negotiated to equal the customer’s estimated page volume at lease inception. In applying our lease accounting methodology, we only consider the fixed payments for purposes of allocating to the relative fair value elements of the contract. Contingent payments, if any, are inherently uncertain and therefore are recognized as revenue in the period when the customer exceeds the minimum copy volumes specified in the contract. Revenues under bundled arrangements are allocated considering the relative fair values of the lease and non-lease deliverables included in the bundled arrangement based upon the estimated relative fair values of each element. Lease deliverables include maintenance and executory costs, equipment and financing, while non-lease deliverables generally consist of the supplies and non-maintenance services. Our revenue allocation for the lease deliverables begins by allocating revenues to the maintenance and executory costs plus profit thereon. The remaining amounts are allocated to the equipment and financing elements.

Cash and Cash Equivalents

Cash and cash equivalents consist of cash on hand, including money-market funds, and investments with original maturities of three months or less.

Restricted Cash and Investments

As more fully discussed in Note 16 - Contingencies, various litigation matters in Brazil require us to make cash deposits as a condition of continuing the litigation. In addition, several of our secured financing arrangements and other contracts require us to post cash collateral or maintain minimum cash balances in escrow. These cash amounts are classified in our Consolidated Balance Sheets based on when the cash will be contractually or judicially released (refer to Note 10-Supplementary Financial Information for classification of amounts). At December 31, 2009 and 2008, such restricted cash amounts were as follows:

 

     December 31,
     2009    2008

Tax and other litigation deposits in Brazil

       $ 240        $ 167

Escrow and cash collections related to receivable sales and secured borrowing arrangements

     29      16

Other restricted cash

     20      20
             

Total Restricted Cash and Investments

       $             289        $         203
             

 

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Provisions for Losses on Uncollectible Receivables

The provisions for losses on uncollectible trade and finance receivables are determined principally on the basis of past collection experience applied to ongoing evaluations of our receivables and evaluations of the default risks of repayment.

Allowances for doubtful accounts as of December 31, 2009 and 2008 were as follows:

 

     December 31,
     2009    2008

Allowance for doubtful accounts receivables

       $ 148        $ 131

Allowance for doubtful finance receivables

       $             222        $             198

Inventories

Inventories are carried at the lower of average cost or market. Inventories also include equipment that is returned at the end of the lease term. Returned equipment is recorded at the lower of remaining net book value or salvage value. Salvage value consists of the estimated market value (generally determined based on replacement cost) of the salvageable component parts, which are expected to be used in the remanufacturing process. We regularly review inventory quantities and record a provision for excess and/or obsolete inventory based primarily on our estimated forecast of product demand, production requirements and servicing commitments. Several factors may influence the realizability of our inventories, including our decision to exit a product line, technological changes and new product development. The provision for excess and/or obsolete raw materials and equipment inventories is based primarily on near term forecasts of product demand and include consideration of new product introductions, as well as changes in remanufacturing strategies. The provision for excess and/or obsolete service parts inventory is based primarily on projected servicing requirements over the life of the related equipment populations.

Land, Buildings and Equipment and Equipment on Operating Leases

Land, buildings and equipment are recorded at cost. Buildings and equipment are depreciated over their estimated useful lives. Leasehold improvements are depreciated over the shorter of the lease term or the estimated useful life. Equipment on operating leases is depreciated to estimated salvage value over the lease term. Depreciation is computed using the straight-line method. Significant improvements are capitalized and maintenance and repairs are expensed. Refer to Note 5 - Inventories and Equipment on Operating Leases, Net and Note 6 - Land, Buildings and Equipment, Net for further discussion.

Internal Use Software

We capitalize direct costs associated with developing, purchasing or otherwise acquiring software for internal use and amortize these costs on a straight-line basis over the expected useful life of the software, beginning when the software is implemented. Useful lives of the software generally vary from three to seven years. Amortization expense was $53, $50, and $76 for the years ended December 31, 2009, 2008 and 2007, respectively. Capitalized costs were $354 and $288 as of December 31, 2009 and 2008, respectively.

 

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Goodwill and Other Intangible Assets

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

Other intangible assets primarily consist of assets obtained in connection with business acquisitions, including installed customer base and distribution network relationships, patents on existing technology and trademarks. We apply an impairment evaluation whenever events or changes in business circumstances indicate that the carrying value of our intangible assets may not be recoverable. Other intangible assets are amortized on a straight-line basis over their estimated economic lives. We believe that the straight-line method of amortization reflects an appropriate allocation of the cost of the intangible assets to earnings in proportion to the amount of economic benefits obtained annually by the Company. Refer to Note 8 – Goodwill and Intangible Assets, Net for further information.

Impairment of Long-Lived Assets

We review the recoverability of our long-lived assets, including buildings, equipment, internal-use software and other intangible assets, when events or changes in circumstances occur that indicate that the carrying value of the asset may not be recoverable. The assessment of possible impairment is based on our ability to recover the carrying value of the asset from the expected future pre-tax cash flows (undiscounted and without interest charges) of the related operations. If these cash flows are less than the carrying value of such asset, an impairment loss is recognized for the difference between estimated fair value and carrying value. Our primary measure of fair value is based on discounted cash flows.

Treasury Stock

We account for repurchased common stock under the cost method and include such treasury stock as a component of our Common shareholders’ equity. Retirement of Treasury stock is recorded as a reduction of Common stock and Additional paid-in-capital at the time such retirement is approved by our Board of Directors.

Research, Development and Engineering (“RD&E”)

Research, development and engineering costs are expensed as incurred. Sustaining engineering costs are incurred with respect to on-going product improvements or environmental compliance after initial product launch. Our RD&E expense for the three years ended December 31, 2009 was as follows:

 

     December 31,
     2009    2008    2007

R&D

   $ 713     $ 750     $ 764 

Sustaining engineering

     127       134       148 
                    

Total RD&E Expense

   $         840     $         884     $         912 
                    

Restructuring Charges

Costs associated with exit or disposal activities, including lease termination costs and certain employee severance costs associated with restructuring, plant closing or other activity, are recognized when they are incurred. In those geographies where we have either a formal severance plan or a history of consistently providing severance benefits representing a substantive plan, we recognize severance costs when they are both probable and reasonably estimable. Refer to Note 9 – Restructuring and Asset Impairment Charges for further information.

 

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Pension and Post-Retirement Benefit Obligations

We sponsor pension plans in various forms in several countries covering substantially all employees who meet eligibility requirements. Post-retirement benefit plans cover U.S. and Canadian employees for retirement medical costs. We employ a delayed recognition feature in measuring the costs of pension and post-retirement benefit plans. This requires changes in the benefit obligations and changes in the value of assets set aside to meet those obligations to be recognized not as they occur, but systematically and gradually over subsequent periods. All changes are ultimately recognized as components of net periodic benefit cost, except to the extent they may be offset by subsequent changes. At any point, changes that have been identified and quantified but not recognized as components of net periodic benefit cost, are recognized in Accumulated other comprehensive loss, net of tax.

Several statistical and other factors that attempt to anticipate future events are used in calculating the expense, liability and asset values related to our pension and post-retirement benefit plans. These factors include assumptions we make about the discount rate, expected return on plan assets, rate of increase in healthcare costs, the rate of future compensation increases, and mortality among others. Actual returns on plan assets are not immediately recognized in our income statement, due to the delayed recognition requirement. In calculating the expected return on the plan asset component of our net periodic pension cost, we apply our estimate of the long-term rate of return to the plan assets that support our pension obligations, after deducting assets that are specifically allocated to Transitional Retirement Accounts (which are accounted for based on specific plan terms).

For purposes of determining the expected return on plan assets, we utilize a calculated value approach in determining the value of the pension plan assets, as opposed to a fair market value approach. The primary difference between the two methods relates to systematic recognition of changes in fair value over time (generally two years) versus immediate recognition of changes in fair value. Our expected rate of return on plan assets is then applied to the calculated asset value to determine the amount of the expected return on plan assets to be used in the determination of the net periodic pension cost. The calculated value approach reduces the volatility in net periodic pension cost that results from using the fair market value approach.

The discount rate is used to present value our future anticipated benefit obligations. In estimating our discount rate, we consider rates of return on high quality fixed-income investments included in various published bond indexes, adjusted to eliminate the effects of call provisions and differences in the timing and amounts of cash outflows related to the bonds, as well as the expected timing of pension and other benefit payments. In the U.S. and the U.K., which comprise approximately 80% of our projected benefit obligation, we consider the Moody’s Aa Corporate Bond Index and the International Index Company’s iBoxx Sterling Corporate AA Cash Bond Index, respectively, in the determination of the appropriate discount rate assumptions. Refer to Note 14 - Employee Benefit Plans for further information.

Each year, the difference between the actual return on plan assets and the expected return on plan assets, as well as increases or decreases in the benefit obligation as a result of changes in the discount rate are added to or subtracted from any cumulative actuarial gain or loss that arose in prior years. This resultant amount is the net actuarial gain or loss recognized in Accumulated other comprehensive loss and is subject to subsequent amortization to net periodic pension cost in future periods over the remaining service lives of the employees participating in the pension plan.

Foreign Currency Translation and Re-measurement

The functional currency for most foreign operations is the local currency. Net assets are translated at current rates of exchange and income, expense and cash flow items are translated at average exchange rates for the applicable period. The translation adjustments are recorded in Accumulated other comprehensive loss.

The U.S. Dollar is used as the functional currency for certain subsidiaries that conduct their business in U.S. Dollars. A combination of current and historical exchange rates is used in re-measuring the local currency transactions of these subsidiaries and the resulting exchange adjustments are included in income.

Foreign currency losses were $26, $34 and $8 in 2009, 2008 and 2007, respectively, and are included in Other expenses, net in the accompanying Consolidated Statements of Income.

 

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We have operations in Venezuela where the U.S. Dollar is the functional currency. At December 31, 2009 our Venezuelan operations had approximately 90 million in net Bolivar-denominated monetary assets that were re-measured to U.S. Dollars at the official exchange rate of 2.15 Bolivars to the Dollar. In January 2010, Venezuela announced a devaluation of the Bolivar to an official rate of 4.30 Bolivars to the Dollar for our products. As a result of this devaluation, we expect to record a loss of approximately $21 in the first quarter of 2010 for the re-measurement of our net Bolivar-denominated monetary assets.

Accumulated Other Comprehensive Loss (“AOCL”)

AOCL is composed of the following for the three years ending December 31, 2009:

 

     December 31,
     2009    2008    2007

Cumulative translation adjustments

   $ (800)      $ (1,395)        $ (31)  

Benefit plans net actuarial losses and prior service credits(1)

     (1,190)        (1,021)          (735)  

Other unrealized (losses) gains, net

     2         —            1   
                    

Total Accumulated Other Comprehensive Loss

   $   (1,988)      $     (2,416)        $      (765)  
                    

 

 

(1)

Includes our share of Fuji Xerox.

Note 2 – Segment Reporting

Our reportable segments are consistent with how we manage the business and view the markets we serve. Our reportable segments are Production, Office and Other. The Production and Office segments are centered on strategic product groups which share common technology, manufacturing and product platforms, as well as classes of customers.

The Production segment includes black-and-white products which operate at speeds over 90 pages per minute (“ppm”) excluding 95 ppm with an embedded controller and color products which operate at speeds over 40 ppm excluding 50, 60 and 70 ppm products with an embedded controller. Products include the Xerox iGen3 and iGen4 digital color production press, Xerox Nuvera®, DocuTech®, DocuPrint® and DocuColor families, as well as older technology light-lens products. These products are sold predominantly through direct sales channels to Fortune 1000, graphic arts, government, education and other public sector customers.

The Office segment includes black-and-white products which operate at speeds up to 95 ppm and color devices up to 85 ppm. Products include our family of ColorQube™, WorkCentre® multifunction printers, Phaser® desktop printers and digital multifunction printers., DocuColor color multifunction products, color laser, solid ink color printers and multifunction devices, monochrome laser desktop printers, digital and light-lens copiers and facsimile products and non-Xerox branded products with similar specifications. These products are sold through direct and indirect sales channels to global, national and mid-size commercial customers, as well as government, education and other public sector customers.

The segment classified as Other includes several units, none of which met the thresholds for separate segment reporting. This group primarily includes Xerox Supplies Business Group (predominantly paper sales), Value-Added Services, Wide Format Systems, Xerox Technology Enterprises, royalty and licensing revenues, GIS network integration solutions and electronic presentation systems, equity net income and non-allocated Corporate items. Other segment profit (loss) includes the operating results from these entities, other less significant businesses, our equity income from Fuji Xerox, and certain costs which have not been allocated to the Production and Office segments, including non-financing interest, as well as other items included in Other expenses, net.

 

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Selected financial information for our Operating segments for each of the years ended December 31, 2009, 2008 and 2007, respectively, was as follows:

 

     Production    Office    Other    Total

2009(1)

           

Revenues

     $ 4,287      $ 8,135      $ 2,044       $ 14,466  

Finance income

     258        441        14         713  
                           

Total Segment Revenues

     $ 4,545      $ 8,576      $ 2,058       $ 15,179  
                           

Interest expense

     $ 101      $ 165      $ 261       $ 527  

Segment profit (loss) (2)

     $ 217      $ 835      $ (274)     $ 778  

Equity in net income of unconsolidated affiliates

     $ —        $ —        $ 41       $ 41  

2008(1)

           

Revenues

     $ 4,937      $ 9,347      $ 2,526       $ 16,810  

Finance income

     300        481        17         798  
                           

Total Segment Revenues

     $         5,237      $ 9,828      $ 2,543       $ 17,608  
                           

Interest expense

     $ 117      $ 181      $ 269       $ 567  

Segment profit (loss) (2)

     $ 394      $ 1,062      $ (165)     $ 1,291  

Equity in net income of unconsolidated affiliates

     $ —        $ —        $ 113       $ 113  

2007(1)

           

Revenues

     $ 5,001      $ 8,980      $ 2,425       $ 16,406  

Finance income

     314        493        15         822  
                           

Total Segment Revenues

     $ 5,315      $       9,473      $      2,440       $     17,228  
                           

Interest expense

     $ 123      $ 186      $ 270       $ 579  

Segment profit (loss) (2)

     $ 562      $ 1,115      $ (89)     $ 1,588  

Equity in net income of unconsolidated affiliates

     $ —        $ —        $ 97       $ 97  

 

 

(1)

Asset information on a segment basis is not disclosed as this information is not separately identified and internally reported to our chief executive officer.

(2)

Depreciation and amortization expense, which is recorded in cost of sales, RD&E and SAG are included in segment profit above. This information is neither identified nor internally reported to our chief executive officer. The separate identification of this information for purposes of segment disclosure is impracticable, as it is not readily available and the cost to develop it would be excessive.

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

 

     Year Ended December 31,
     2009    2008    2007

Total Segment profit

     $ 778          $     1,291          $     1,588     

Reconciling items:

        

Restructuring and asset impairment charges

     8            (429)            6     

Restructuring charges of Fuji Xerox

     (46)            (16)            (30)    

Litigation matters (1)

     —               (774)            —       

Equipment write-off

     —               (39)            —       

ACS acquisition-related costs

     (72)            —              —       

Equity in net income of unconsolidated affiliates

     (41)            (113)            (97)    

Other

     —              1             1     
                    

Pre-tax Income (Loss)

     $     627           $ (79)           $ 1,468     
                    

 

(1)

The 2008 provision for litigation represents $670 for the Carlson v. Xerox Corporation court approved settlement, as well as provisions for other litigation matters including $36 for the probable loss related to the Brazil labor related contingencies. Refer to Note 16 – Contingencies for further discussion.

 

Xerox 2009 Annual Report   43


Geographic area data is based upon the location of the subsidiary reporting the revenue or long-lived assets and is as follows:

 

     Revenues    Long-Lived Assets (1)
     2009    2008    2007    2009    2008    2007

United States

    $     8,156       $     9,122       $     9,078       $     1,245       $     1,386       $   1,375  

Europe

     4,971        6,011        5,888        717        680        746  

Other Areas

     2,052        2,475        2,262        260        248        341  
                                         

Total Revenues and Long-Lived Assets

    $ 15,179       $ 17,608       $ 17,228       $ 2,222       $ 2,314       $ 2,462  
                                         

 

(1)

Long-lived assets are comprised of (i) land, buildings and equipment, net, (ii) equipment on operating leases, net, (iii) internal use software, net and (iv) capitalized software costs, net.

Note 3 – Acquisitions

Affiliated Computer Services, Inc.

In September 2009, we entered into a definitive agreement to acquire Affiliated Computer Services, Inc. (“ACS”) in a cash and stock transaction. The acquisition closed on February 5, 2010, at which time 100% of the outstanding shares of ACS common stock were converted into a combination of 4.935 shares of Xerox common stock and $18.60 in cash for a combined value of $60.40 per share, or approximately $6.0 billion based on the closing price of Xerox common stock of $8.47 on date of closing. Approximately 489,800 thousand shares of common stock were issued to holders of ACS Class A and Class B common stock.

Xerox assumed all outstanding ACS stock options at closing. Each assumed ACS option became exercisable for 7.085289 Xerox common shares for a total of approximately 96,700 thousand shares at a weighted average exercise price of $6.79 per option. The estimated fair value associated with the Xerox options issued in exchange for the ACS options was approximately $222 based on a Black-Scholes valuation model. Approximately $168 of the estimated fair value is expected to be recorded as part of the acquisition fair value and $54 will be expensed over the remaining vesting period which is estimated to be approximately 3.9 years.

As part of the closing, we repaid $1.7 billion of ACS’s debt and assumed an additional $0.6 billion. We also issued convertible preferred stock with a liquidation value of $300 to ACS’s Class B shareholder (see Note 17 – Shareholders’ Equity for further information). The cash portion of the acquisition, as well as the repayment of ACS’s debt, was funded through a combination of cash-on-hand, borrowing under our existing Credit Facility and the issuance of senior notes in the capital markets. (Refer to Note 11 – Debt for further information).

ACS provides business process outsourcing (“BPO”) and information technology (“IT”) services and solutions to commercial and government clients worldwide. ACS delivers a full range of BPO and IT services, as well as end-to-end solutions to the public and private sectors and supports a variety of industries including education, energy, financial, government, healthcare, retail and transportation. ACS’s revenues for the calendar year ended December 31, 2009 were $6.6 billion and they employed 78,000 people and operated in over 100 countries.

All information regarding the fair values of the assets acquired and liabilities assumed, including assets and liabilities arising from contingencies, is not yet available. However, the purchase price is expected to be primarily allocated to intangible assets and goodwill based on third-party valuations and management’s estimates which have not yet been finalized.

 

Xerox 2009 Annual Report   44


The unaudited pro forma results presented below include the effects of the ACS acquisition as if it had been consummated as of January 1, 2008. The pro-forma results include the amortization associated with a preliminary estimate for the acquired intangible assets and interest expense associated with debt used to fund the acquisition. However, pro forma results do not include any anticipated synergies or other expected benefits of the acquisition. Accordingly, the unaudited pro forma financial information below is not necessarily indicative of either future results of operations or results that might have been achieved had the acquisition been consummated as of January 1, 2008:

 

     Year Ended December 31,
           2009                2008      

Revenue

   $ 21,802    $ 23,941

Net income attributable to Xerox

     700      359

Basic earnings per share

     0.50      0.24

Diluted earnings per share

     0.49      0.24

We are still evaluating and assessing the impact of the ACS acquisition on our internal organizational and reporting structure as well as its related impact on our reportable segment disclosures. Accordingly, in the first quarter 2010, we currently expect to report ACS as a separate reportable segment, pending completion of that evaluation and assessment.

Veenman B.V.

In 2008, we acquired Veenman B.V. (“Veenman”), expanding our reach into the small and mid-sized business market in Europe, for approximately $69 (44 million) in cash, including transaction costs. Veenman is the Netherlands’ leading independent distributor of office printers, copiers and multifunction devices serving small and mid-size businesses. The operating results of Veenman are not material to our financial statements, and are included within our Office segment from the date of acquisition. The purchase price was primarily allocated to intangible assets and goodwill based on third-party valuations and management’s estimates.

Global Imaging Systems, Inc.

In 2007, we acquired GIS, a provider of office technology for small and mid-size businesses in the United States. The acquisition of GIS expanded our access to the U.S. small and mid-size business market. The aggregate purchase price was approximately $1.5 billion. In addition, in connection with the closing, we also repaid $200 of GIS’s then outstanding bank debt. The results of operations for GIS are included in our Consolidated Statements of Income as of May 9, 2007.

The total cost of the acquisition was allocated to the assets acquired and the liabilities assumed based on their respective estimated fair values. Goodwill of $1,335 and intangible assets of $363 were recorded in connection with the acquisition based on third-party valuations and management’s estimates for those acquired intangible assets. The majority of the goodwill is not deductible for tax purposes and the primary elements that generated goodwill are the value of the acquired assembled workforce, specialized processes and procedures and operating synergies, none of which qualify as a separate intangible asset. Intangible assets included customer relationships of $189 with a 12-year weighted average useful life and trade names of $174 with a 20-year weighted average useful life.

The unaudited pro forma results presented below include the effects of the GIS acquisition as if it had been consummated as of January 1, 2007.

 

     Year Ended
    December 31, 2007    

Revenue

   $            17,619

Net income attributable to Xerox

   1,139

Basic earnings per share

   1.22

Diluted earnings per share

   1.20

 

Xerox 2009 Annual Report   45


GIS Acquisitions

In February 2009, GIS acquired ComDoc, Inc. (“ComDoc”) for approximately $145 in cash. ComDoc is one of the larger independent office technology dealers in the U.S. and expands GIS’s coverage in Ohio, Pennsylvania, New York and West Virginia. GIS also acquired another business in 2009 for $18 in cash. In 2008, GIS acquired Saxon Business Systems, an office equipment supplier in Florida, for approximately $69 in cash, including transaction costs. GIS acquired three other similar businesses in 2008 for a total of $17 in cash. In 2007, GIS acquired four businesses that provide office-imaging solutions and related services for $39 in cash.

These acquisitions continue the development of GIS’s national network of office technology suppliers to serve its expanding base of small and mid-size businesses. The operating results of these acquired entities are not material to our financial statements and are included within our Office segment from the dates of acquisition. The purchase prices were primarily allocated to intangible assets and goodwill based on third-party valuations and management’s estimates.

Advectis, Inc.

In 2007, we acquired Advectis, Inc. (“Advectis”), a privately-owned provider of a web-based solution to electronically manage the process needed to underwrite, audit, collaborate, deliver and archive mortgage loan documents, for $30 in cash. The operating results of Advectis are not material to our financial statements, and are included within our Other segment from the date of acquisition. The purchase price was primarily allocated to intangible assets and goodwill based on management’s estimates.

Note 4 – Receivables, Net

Finance Receivables

Finance receivables result from installment arrangements and sales-type leases arising from the marketing of our equipment. These receivables are typically collateralized by a security interest in the underlying assets. Finance receivables, net at December 31, 2009 and 2008 were as follows:

 

                 2009                            2008            

Gross receivables

   $ 8,427         $ 8,718     

Unearned income

     (1,197)          (1,273)    

Residual values

     19           31     

Allowance for doubtful accounts

     (222)          (198)    
             

Finance receivables, net

   $ 7,027         $ 7,278     

Less: Billed portion of finance receivables, net

     (226)          (254)    

Less: Current portion of finance receivables not billed, net

     (2,396)          (2,461)    
             

Finance Receivables Due After One Year, net

   $ 4,405         $ 4,563     
             

Contractual maturities of our gross finance receivables as of December 31, 2009 were as follows (including those already billed of $226):

 

      2010          

         2011                    2012                    2013                    2014                    Thereafter                    Total          
$    3,191    $    2,334    $    1,622    $    910    $    327    $    43    $    8,427

 

Xerox 2009 Annual Report   46


Accounts Receivable Sales Arrangements

We have facilities in the U.S., Canada and several countries in Europe that enable us to sell, on an on-going basis, certain accounts receivable without recourse to third-parties. The accounts receivables sold are generally short-term trade receivables with a payment due date of less than 60 days. In some of the agreements we continue to service the sold receivables and hold beneficial interests. When applicable, a servicing liability is recorded for the estimated fair value of

the servicing. Beneficial interests are included in the caption “Other current assets” in the accompanying Consolidated Balance Sheets and are recorded at estimated fair value. The amounts associated with the servicing liability and beneficial interests were not material at December 31, 2009 and 2008, respectively. Accounts receivables sales for the three years ended December 31, 2009 were as follows:

 

             2009                    2008                    2007        

Accounts receivables sales

   $     1,566        $     717        $     326    

Fees associated with sales

     13          4          2    

Estimated impact of sales on operating cash flows

     309          51          147    

Note 5 – Inventories and Equipment on Operating Leases, Net

Inventories at December 31, 2009 and 2008 were as follows:

 

             2009                    2008        

Finished goods

   $     772      $     1,044  

Work-in-process

     43        80  

Raw materials

     85        108  
             

Total Inventories

   $ 900      $ 1,232  
             

Cost of sales in 2008 included a charge of $39 associated with an Office segment product line equipment and residual value write-off. The write-off was the result of a 2008 change in strategy reflecting our decision to discontinue the remanufacture of end-of-lease returned inventory from a certain Office segment product line following an assessment of the current and expected market for these products.

The transfer of equipment from our inventories to equipment subject to an operating lease is presented in our Consolidated Statements of Cash Flows in the operating activities section as a non-cash adjustment. Equipment on operating leases and similar arrangements consists of our equipment rented to customers and depreciated to estimated salvage value at the end of the lease term. We recorded $52, $115 and $66 in inventory write-down charges for the years ended December 31, 2009, 2008 and 2007, respectively.

Equipment on operating leases and the related accumulated depreciation at December 31, 2009 and 2008 were as follows:

 

             2009                    2008        

Equipment on operating leases

   $ 1,583      $ 1,507  

Accumulated depreciation

     (1,032)        (913)  
             

Equipment on Operating Leases, net

   $ 551      $ 594  
             

Depreciable lives generally vary from three to four years consistent with our planned and historical usage of the equipment subject to operating leases. Depreciation and obsolescence expense for equipment on operating leases was $329, $298 and $269 for the years ended December 31, 2009, 2008 and 2007, respectively. Our equipment operating lease terms vary, generally from 12 to 36 months. Scheduled minimum future rental revenues on operating leases with original terms of one year or longer are:

 

        2010            

           2011                        2012                        2013                        2014                        Thereafter        
$        385    $        281    $        181    $        94    $        46    $        45

Total contingent rentals on operating leases, consisting principally of usage charges in excess of minimum contracted amounts, for the years ended December 31, 2009, 2008 and 2007 amounted to $125, $117 and $117, respectively.

 

Xerox 2009 Annual Report   47


Note 6 – Land, Buildings and Equipment, Net

Land, buildings and equipment, net at December 31, 2009 and 2008 were as follows:

 

     Estimated
    Useful Lives     
(Years)
           2009                    2008        

Land

   —      $ 45       $ 45   

Buildings and building equipment

   25 to 50      1,192         1,156   

Leasehold improvements

   Varies      328         372   

Plant machinery

   5 to 12      1,686         1,597   

Office furniture and equipment

   3 to 15      994         973   

Other

   4 to 20      100         100   

Construction in progress

   —        33         95   
                

Subtotal

        4,378         4,338   

Accumulated depreciation

        (3,069)        (2,919)   
                

Land, Buildings and Equipment, net

      $ 1,309       $ 1,419   
                

Depreciation expense and operating lease rent expense for the years ended December 31, 2009, 2008 and 2007 were as follows:

 

             2009                    2008                    2007        

Depreciation expense

   $ 247      $ 257      $ 262  

Operating lease rent expense (1)

   $ 267      $ 252      $ 286  

 

(1)

We lease certain land, buildings and equipment, substantially all of which are accounted for as operating leases.

Future minimum operating lease commitments that have initial or remaining non-cancelable lease terms in excess of one year at December 31, 2009 were as follows:

 

        2010        

           2011                    2012            <