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FORM 10-Q
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C.  20549

Commission file number:  1-8133

XEROX CREDIT CORPORATION
(Exact name of Registrant as specified in its charter)

Securities registered pursuant to Section 12(g) of the Act:  None

Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

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

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

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

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

Our liquidity is dependent upon the liquidity of our ultimate parent, Xerox Corporation (“XC”). Accordingly, certain disclosures contained herein relate to events and transactions that affect the liquidity of XC and its subsidiaries (collectively, “Xerox”).

Prior to 2002, Xerox financed approximately 80 percent of its equipment sales. To fund these arrangements, Xerox accessed the credit markets and used cash generated from operations. In 2001, XC announced several Framework Agreements with General Electric (“GE”), under which GE would become Xerox’s primary equipment-financing provider in the U.S., Canada, Germany and France. In connection therewith, in October 2002, XC completed an eight-year agreement in the U.S. (the “New U.S. Vendor Financing Agreement”), effective immediately, under which GE Vendor Financial Services became the primary equipment financing provider in the U.S., through monthly securitizations of Xerox’s new lease originations.  In addition to the $2.5 billion funded by GE prior to this transaction, which is secured by portions of Xerox’s current lease receivables in the U.S., the New U.S. Vendor Financing Agreement calls for GE to provide funding in the U.S., through 2010, of up to $5 billion, outstanding during any time, subject to normal customer acceptance criteria.  The New U.S. Vendor Financing Agreement also includes opportunities to increase financing levels over time, based on Xerox’s revenue growth.  Xerox is currently negotiating all of the other GE transactions contemplated under the respective Framework Agreements.

In anticipation of GE becoming the primary equipment financing provider for Xerox customers in the U.S., we stopped purchasing new contracts receivable from XC effective July 1, 2001 and our existing portfolio will ultimately run-off.  Further, pursuant to the New Credit Facility (discussed below), we are precluded from purchasing any new contracts receivable from XC in the future.  Xerox is considering monetizing portions of its existing U.S. finance receivables portfolio as it pursues alternative forms of financing, which could further reduce our portfolio.

The long-term viability and profitability of Xerox’s customer financing activities is dependent, in part, on Xerox’s ability to borrow and the cost of borrowing in the credit markets.  This ability and cost, in turn, is dependent on Xerox’s credit ratings.  Xerox is currently funding its customer financing activity from the aforementioned New U.S. Vendor Financing Agreement, cash generated from operations, as well as, from cash on hand, unregistered capital markets offerings and securitizations.  There is no assurance that Xerox will be able to continue to fund its customer financing activity at present levels. Xerox continues to negotiate and implement third-party vendor financing programs and securitizations of portions of our existing finance receivable

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portfolios and Xerox continues to actively pursue alternative forms of financing including securitizations and secured borrowings.  These initiatives are expected to improve Xerox’s liquidity going forward. Xerox’s ability to continue to offer customer financing and be successful in the placement of equipment with customers is largely dependent upon successful implementation of Xerox’s third party financing initiatives.

The adequacy of Xerox’s continuing liquidity depends on its ability to successfully generate positive cash flow from an appropriate combination of operating improvements, financing from third parties, access to capital markets and additional asset sales, including sales or securitizations of Xerox’s receivables portfolios.  Xerox believes its liquidity (including operating and other cash flows it will generate) will be sufficient to meet operating cash flow requirements as they occur and to satisfy all scheduled debt maturities for at least the next twelve months; however, Xerox’s ability to maintain positive liquidity going forward is highly dependent on achieving its expected operating results, including capturing the benefits from restructuring activities, and continuing to complete announced vendor financing and other initiatives that are discussed in this Quarterly Report on Form 10-Q. There is no assurance that these initiatives will be successful. Failure to successfully complete these initiatives could have a material adverse effect on Xerox’s liquidity and operations, and could require Xerox to consider further measures, including deferring planned capital expenditures, modifying current restructuring plans, reducing discretionary spending, selling additional assets and if necessary, restructuring existing debt. Because we are dependent upon XC for our liquidity, any such material adverse effect on Xerox’s liquidity and operations could also have a material adverse effect on our liquidity and operations.

As announced on June 21, 2002, Xerox successfully completed the renegotiation of its $7 billion Revolving Credit Agreement (the “Old Revolver”). Of the original $7 billion in loans outstanding under the Old Revolver, $3.5 billion has now been repaid (including all of our $1.02 billion of then outstanding) and the remaining $3.5 billion is outstanding under the new Amended and Restated Credit Agreement (the “New Credit Facility”). The New Credit Facility requires principal payments as well as prepayments in the case of certain events. A full discussion of these terms and the final maturity dates of the various loans is included in Note 7 and the Capital Resources and Liquidity section in this Quarterly Report on Form 10-Q. We cannot borrow under the New Credit Facility, and we are also precluded from purchasing new contracts from XC.  Subject to certain limits, all obligations under the New Credit Facility are secured by liens on substantially all domestic assets of XC and by liens on the assets of substantially all of its U.S. subsidiaries (excluding us) and are guaranteed by substantially all of its U.S. subsidiaries (including us).  Our guaranty of obligations under the New Credit Facility, however, is subordinated to all of our capital markets debt outstanding as of June 21, 2002. In connection with the New Credit Facility, substantially all of XC’s U.S. subsidiaries (including us) also guaranteed XC’s $600 million of 9-3/4% Senior Notes and Euro 225 million of 9-3/4% Senior Notes due 2009 (collectively, the “Senior Notes”).

The New Credit Facility contains affirmative and negative covenants including limitations on issuance of debt and preferred stock; certain fundamental changes, as defined; investments and acquisitions; mergers; certain transactions with affiliates; creation of liens; asset transfers; hedging transactions; payment of dividends; inter-company loans and certain restricted payments; and a requirement to transfer excess foreign cash, as defined, and excess cash, as defined, of ours to XC in certain circumstances.  It also contains additional financial covenants, including minimum EBITDA, as defined, maximum leverage (total adjusted debt divided by EBIDTA), annual maximum capital expenditures limits and minimum consolidated net worth, as defined. However, XC is, and expects to remain, in full compliance with the covenants and other provisions of the New Credit Facility. The Senior Notes contain several similar, though generally less restrictive, affirmative and negative covenants of Xerox.

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Any failure of Xerox to be in compliance with any material provision of the New Credit Facility or the Senior Notes could have a material adverse effect on XC’s liquidity and operations and, because we are dependent upon XC for our liquidity and have guaranteed the obligations of XC under the New Credit Facility and the Senior Notes, such failure by XC to be in compliance could also have a material adverse effect on our liquidity and operations.

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XEROX CREDIT CORPORATION
Form 10-Q
September 30, 2002

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PART I.   FINANCIAL INFORMATION
Item 1.   Condensed Consolidated Financial Statements

XEROX CREDIT CORPORATION
CONDENSED CONSOLIDATED BALANCE SHEETS
(In Millions)

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

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XEROX CREDIT CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF INCOME
 (UNAUDITED)
(In Millions)

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

*As Restated, see Note 2.

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XEROX CREDIT CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
 (In Millions)

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

* As restated, see Note 2.

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XEROX CREDIT CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(1)  Basis of Presentation:

The unaudited condensed consolidated interim financial statements presented herein have been prepared by Xerox Credit Corporation (referred to below as “us”, “we” or “our”) in accordance with the accounting policies described in our 2001 Annual Report on Form 10-K (the 2001 Annual Report) and the interim period reporting requirements of Form 10-Q.  Accordingly, certain information and note disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted.  You should read the unaudited condensed consolidated financial statements in conjunction with such 2001 Annual Report and the notes thereto.

In our opinion, all adjustments which are necessary for a fair presentation for the interim periods presented have been made.  Interim results of operations are not necessarily indicative of the results for the full year.

The prior year’s unaudited condensed consolidated financial statements as of and for the three months ended March 31, 2001 have been restated (See Note 2 to these Condensed Consolidated Financial Statements).

We and Xerox Corporation (“XC”) engage in extensive intercompany transactions and we receive most of our operational and administrative support from XC.  By their nature, transactions involving related parties cannot be presumed to be carried out on the same basis as transactions among wholly-unrelated parties.

Liquidity - Our liquidity is dependent upon the liquidity of our ultimate parent, XC (XC, together with its subsidiaries, “Xerox”). Accordingly, the following is a disclosure regarding the liquidity of both Xerox and us, even if it does not directly affect our liquidity.

Xerox manages its 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 Xerox operates, (2) the legal requirements of the agreements to which XC’s subsidiaries are parties and (3) the policies and cooperation of the financial institutions Xerox utilizes to maintain such cash management practices.  Beginning in 2000, Xerox-specific business challenges, which were discussed in the 2001 Annual Report, were exacerbated by significant competitive and industry changes, adverse economic conditions, and significant technology and acquisition spending.  Together, these conditions negatively impacted XC’s liquidity, which led to a series of credit rating downgrades from 2000 to 2002, eventually to below investment grade.  Consequently, Xerox’s access to capital and derivative markets has been restricted.  The downgrades also required Xerox to cash-collateralize certain derivative and securitization arrangements to prevent them from terminating, and to immediately settle terminating derivative contracts.   Additionally, Xerox is required to maintain minimum cash balances in escrow on certain borrowings and letters of credit.  These minimum cash balances are restricted and are, therefore, not considered cash or cash equivalents, but rather, are included in either Deferred taxes and other current assets or Other long-term assets, as appropriate, in the Condensed Consolidated Balance Sheets of Xerox.

In addition, the Securities and Exchange Commission (“SEC”) would not allow Xerox to publicly register any securities offerings while their investigation, which commenced in June 2000, was ongoing.  This additional constraint essentially prevented Xerox from raising funds from sources other than unregistered capital markets offerings and private lending or equity sources.  Xerox’s credit ratings, which were already under pressure, then came under even greater pressure since credit rating agencies often include access to other capital sources in their rating criteria.

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XEROX CREDIT CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

While the conclusion of the SEC investigation removes Xerox’s previous inability to access public capital markets, Xerox expects its ability to access unsecured credit sources to remain restricted as long as its credit ratings remain below investment grade, and Xerox expects its incremental cost of borrowing to increase as a result of such credit ratings.

In June 2002, Xerox entered into an Amended and Restated Credit Agreement (the “New Credit Facility”) with a group of lenders, replacing its prior $7 billion facility (the “Old Revolver”). At that time, Xerox permanently repaid $2.8 billion of the Old Revolver (including all of our $1.02 billion then outstanding).  The New Credit Facility ($3.5 billion outstanding as of September 30, 2002) consists of two tranches of term loans totaling $2.0 billion and a $1.5 billion revolving facility that includes a currently unutilized $200 letter of credit sub-facility.  XC is currently, and expects to remain, the borrower of the term loans. We are not and cannot borrow under the New Credit Facility. In addition, the New Credit Facility prohibits us from purchasing any new contracts receivable from XC.

The New Credit Facility is discussed in more detail under “Liquidity, Financial Flexibility and Funding Plans” of the portions of XC’s Management’s Discussion and Analysis of Results of Operations and Financial Condition (“MD&A”) included in our MD&A in this Report on Form 10-Q and in more detail in Note 12 to our consolidated financial statements included in our 2001 Form 10-K Report.  The New Credit Facility contains more stringent financial covenants than the Old Revolver, including the following:

Failure to be in compliance with any material provision of the New Credit Facility or the Senior Notes could have a material adverse effect on Xerox’s financial position, results of operations and cash flows and, because we are dependent upon XC for our liquidity and we have guaranteed XC’s obligations under the New Credit Facility and the Senior Notes, such failure by XC to be in compliance could also have a material adverse effect on our financial position, results of operations and cash flows.

In 2000, Xerox announced a global restructuring program, which included initiatives to improve liquidity.  In connection with this, Xerox decided to exit the financing business wherever practical in order to reduce its consolidated debt levels and accelerate the liquidity that is included in the finance receivable portfolios.  These initiatives have proven to be time-consuming due to the generally complex nature of leasing, complicated further by specific legal and regulatory requirements and competitive considerations in each of the countries and jurisdictions in which Xerox operates. In jurisdictions where a full exit from the financing business has proven to be impractical, or where such an exit would potentially interfere with Xerox’s desire to offer a full bundled solution to its customers, Xerox is pursuing other more conventional funding alternatives.  These alternatives, while not structured as full exits from the financing business, will nevertheless provide adequate liquidity and reduce Xerox’s funding requirements relative to those operations.

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XEROX CREDIT CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

In addition to exiting the financing business, other restructuring initiatives included selling certain assets, improving operations, and reducing annual costs.  These initiatives are expected to significantly improve Xerox’s liquidity going forward. Xerox has (1) securitized portions of its existing finance receivables portfolios, (2) implemented vendor financing programs with third parties in the United States, the Netherlands, the Nordic countries, Brazil, Mexico and Italy, (3) announced major initiatives with General Electric (“GE”) and other third party vendors to finance its customer equipment purchases in other countries (including the completion of the New U.S. Vendor Financing Agreement) and (4) sold several non-core assets.

With $2.3 billion of Cash and cash equivalents on hand at September 30, 2002, Xerox believes its liquidity (including operating and other cash flows it expects to generate) will be sufficient to meet operating cash flow requirements as they occur and to satisfy all scheduled debt maturities for at least the next twelve months. Xerox’s ability to maintain sufficient liquidity going forward is highly dependent on achieving expected operating results, including capturing the benefits from additional restructuring activities, and completing announced vendor financing and other initiatives. There is no assurance that these initiatives will be successful. Failure to successfully complete these initiatives could have a material adverse effect on Xerox’s liquidity and operations, and could require Xerox to consider further measures, including deferring planned capital expenditures, modifying current restructuring plans, reducing discretionary spending, selling additional assets and, if necessary, restructuring existing debt. Because we are dependent upon XC for our liquidity, any such material adverse effect on Xerox’s liquidity and operations could also have a material adverse effect on our liquidity and operations.

Xerox also expects that its ability to fully access commercial paper and other unsecured public debt markets will depend upon improvements in its debt ratings, which in turn depend on (1) its ability to demonstrate sustained profitability growth and operating cash generation and (2) continued progress on its vendor financing initiatives. Until such time, Xerox expects some bank lines to continue to be unavailable, and Xerox intends to access other segments of the capital markets as business conditions allow, which could provide significant sources of additional funds until full access to the unsecured public debt markets is restored.

(2)  Correction of Error in Comparative Financial Statements:

Our 2001 year-to-date unaudited condensed consolidated financial statements have been restated to reflect a correction to interest expense resulting from an error in calculating accrued interest on an interest rate swap in 2000.  The correction was also reflected in the annual 2000 consolidated financial statements, as restated.  A summary of the restated amounts are as follows:

* Net of $2 million of taxes

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XEROX CREDIT CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(3)  Xerox Corporation Support Agreement:

The terms of a Support Agreement with XC provide that we will receive income maintenance payments, to the extent necessary, so that our earnings shall not be less than 1.25 times our fixed charges.  For purposes of this calculation, both earnings and fixed charges are as formerly defined in Section 1404 Section 81(2) of the New York Insurance Law.  In addition, the agreement requires that XC retain 100 percent ownership of our voting capital stock.   There have been no payments made under this agreement since 1990.

(4)  Accounting Changes:

In 2001 and 2002, the Financial Accounting Standards Board (“FASB”) issued Statements of Financial Accounting Standards No. 141 “Business Combinations,” No. 142 “Goodwill and Other Intangible Assets,” No. 143 “Accounting for Asset Retirement Obligations,” No. 144 “Accounting for the Impairment or Disposal of Long-Lived Assets,” No. 145 “Rescission of FASB Statements No. 4, 44 and 64, Amendment of FASB Statement No. 13 and Technical Corrections,” and No. 146 “Accounting for Costs Associated with Exit or Disposal Activities.” We have adopted, or are planning to adopt, each of these statements as required, but we do not expect any of these statements to have any significant impact on our financial reporting because we do not have any transactions that are affected by these statements.

(5)  Sales of Contracts Receivable:

In November 2001, XC entered into an agreement with GE providing for the sale by XC, from time-to-time, of certain lease contracts in the U.S. to a special purpose entity (SPE) of XC, against which GE would provide a series of secured loans, up to a maximum amount of $2.6 billion (“Monetization Agreement”).  In connection with the Monetization Agreement, during the third   quarter and first nine months of 2002 we sold to XC an aggregate of $157 million and $410 million, respectively, of contracts receivable.  The sales to XC were accounted for as sales of contracts receivable at book value, which approximated fair value.  We have no continuing involvement nor retained interests in the receivables sold and all the risk of loss in such receivables  was transferred back to XC.

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XEROX CREDIT CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(6)  Notes Receivable - Xerox and affiliates:

We have made in the past, and will continue to make, demand loans to XC of all proceeds from the sale or collection of our receivables. Any of our cash balance which exceeds our ordinary course expenses and our debt and other obligations maturing within the then current quarter may continue to be loaned to XC as demand loans, consistent with the requirements of the New Credit Facility. As of September 30, 2002 and December 31, 2001, demand loans to XC totaled $1,873 million and $1,377 million, respectively.  These loans bear interest at a rate equal to two percent plus the average of the H.15 Two-Year Swap Rate and H.15 Three-Year Swap Rate (each as defined in the master demand note dated November 20, 2001(“Master Demand Note”) between XC and us).  Consistent with the provisions of the New Credit Facility, we will demand repayment of these loan amounts from XC to the extent necessary to repay our maturing debt obligations and fund our operations. A copy of the Master Demand Note is filed as an exhibit to our Annual Report on Form 10-K for the Year Ended December 31, 2001.

The H.15 is a Federal Reserve Board Statistical Release (published weekly) which contains daily interest rates for selected U.S. Treasury, money market and capital markets instruments.

(7)  Notes Payable:

Subject to certain limits, all obligations under the New Credit Facility are secured by liens on substantially all domestic assets of XC and by liens on the assets of substantially all of its U.S. subsidiaries (excluding us) and are guaranteed by substantially all of XC’s U.S. subsidiaries, including us.  Our guaranty is subordinated to all of our capital markets debt outstanding as of June 21, 2002. In connection with the New Credit Facility, we also guaranteed XC’s Senior Notes. Accordingly, information is presented below relating to the New Credit Facility.

On June 21, 2002, Xerox entered into the New Credit Facility, which replaced its $7 billion credit facility which had a stated maturity date of October 2002 (the “Old Revolver”). In connection with entering into the New Credit Facility, Xerox made a partial pay down on the Old Revolver of $2.8 billion (including all of our $1.02 billion then outstanding)and a scheduled payment of $700 million on September 13, 2002. Accordingly, as of September 30, 2002, $3.5 billion was outstanding under the New Credit Facility, consisting of two tranches of term loans totaling $2.0 billion term loan (Tranche A and Tranche B) and a $1.5 billion revolving facility (the “Revolving Facility”), which may be repaid and reborrowed. Within the Revolving Facility is a $200 letter of credit facility, which remains unutilized. XC is currently and expects to remain the borrower of the term loans.  The New Credit Facility is available to XC, without sub-limit and to certain subsidiaries, including Xerox Canada Capital Limited, Xerox Capital Europe plc, and other foreign subsidiaries as defined.

As of September 30, 2002, the contractual maturities of the loans under the New Credit Facility were as follows:

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XEROX CREDIT CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

XC could be required to repay portions of these loans earlier than their scheduled maturities with specified percentages of any proceeds it receives from capital market debt issuances, equity issuances or asset sales during the term of the New Credit Facility, except that the revolving loan commitment cannot be reduced below $1 billion after repayment of the Tranche loans, as a result of such prepayments. Additionally, all loans under the New Credit Facility become due and payable upon the occurrence of a change in control.

The New Credit Facility loans generally bear interest at LIBOR plus 4.50 percent, except that the Tranche B term loan bears interest at LIBOR plus a spread that varies between 4.00 percent and 4.50 percent, depending on the amount secured. In addition, the interest spread on the Tranche B loan is subject to adjustment based upon the amount secured.

The final stated maturity of the New Credit Facility is April 30, 2005.

(8)  Joint Venture:

On May 1, 2002, Xerox Capital Services, LLC (XCS), XC’s U.S. venture with GE, became operational.  XCS, a consolidated entity of XC, manages Xerox’s customer administration and leasing activities in the U.S. including credit approval, order processing, billing and collections. Upon commencement of the XCS joint venture, XCS replaced XC as the provider of billing, collection and other administrative services to us.   Accordingly, subsequent to May 2002, we pay a fee to XCS rather than to XC for these services. The rate paid per contract is expected to be equal to the rate we formerly paid to XC.

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Item 2.  Management’s Discussion and Analysis of Results of Operations and Financial Condition 

Because our liquidity is dependent upon the liquidity of XC, Item 2 includes both our Management’s Discussion and Analysis of Financial Condition and Results of Operations (MD&A) and portions of XC’s MD&A.  Each MD&A, or portion thereof, is separately presented.  Certain matters discussed in XC’s MD&A will relate to events and transactions that do not affect us directly.

RESULTS OF OPERATIONS - XEROX CREDIT CORPORATION

Until July 2001, our sole business was to purchase non-cancelable contracts receivable arising from installment sales and lease contracts originated by the domestic marketing operations of XC.  Substantially all commercial, federal government and taxable state and local government transactions originated by XC were sold to us.  However, in anticipation of the agreements between XC and GE, we stopped purchasing new contracts receivable from XC effective July 1, 2001.  Our existing portfolio of contracts receivable will ultimately run-off or we will sell contracts back to XC as part of its continued monetization efforts.

Contracts receivable income represents income earned under an agreement with XC pursuant to which we undertook the purchases noted above. Income from the Xerox note receivable represents amounts earned on funds we have advanced to XC under the Master Demand Note.

Total earned income was $58 million and $91 million for the third quarter of 2002 and 2001, respectively, and $225 million and $338 million for the first nine months of 2002 and 2001, respectively.  Contracts receivable income declined by $53 million and $189 million for the third quarter and first nine months of 2002,respectively, compared to the third quarter and first nine months of 2001 reflecting the decrease in the portfolio of contracts receivable as a result of our decision to discontinue purchasing receivables from XC in July 2001 as well as the sales of receivables back to XC in 2001 and 2002. Earned income of $20 million and $76 million in the third quarter and first nine months of 2002, respectively, on the XC Master Demand Note partially offset the decline in contracts receivable income.

Interest expense was $27 million and $63 million for the third quarter of 2002 and 2001, respectively, and $96 million and $224 million for the first nine months of 2002 and 2001, respectively.  The decrease reflects lower debt levels, as collections and sales of existing receivables together with our cessation of new contract purchases have allowed us to reduce our debt. Further, as a result of most of our match funding swaps (pay fixed/receive variable) either maturing or terminating in 2001 and 2002, the majority of our debt bears interest at variable rates and therefore we benefited from the lower interest rates in the third quarter and first nine months of 2002 as compared to the third quarter and first nine months of 2001. 

The mark-to-market valuation of our interest rate derivatives resulted in a net loss of $5 million for the third quarter and a net loss of $6 million in the first nine months of 2002 as compared to a net loss of $15 million and $22 million in the third quarter and first nine months of 2001, respectively. The year-to-date loss in 2002 primarily reflects the accretion of the loss booked at the adoption of SFAS No. 133 in Accumulated Other Comprehensive Income for our match funding (pay fixed/receive variable) swaps. This was partially offset by net gains on our cross-currency interest rate swaps associated with our Yen denominated borrowings. While all of our derivative instruments are intended to economically hedge currency and interest rate risk, differences between the contract terms of our derivatives and the underlying related debt result in our inability to obtain hedge accounting treatment in accordance with SFAS No. 133. This results in mark-to-market valuation of these derivatives directly through earnings, which increases volatility in our earnings.

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General and administrative expenses were $1 million and $3 million for the third quarters of 2002 and 2001, respectively, and $5 million and $9 million for the year to date periods of 2002 and 2001, respectively. These expenses are primarily incurred to administer the contracts receivable purchased from XC.  The decline reflects the lower level of receivables in 2002 compared to the prior year level.

The effective income tax rate for the third quarter of 2002 was 38.9%, which is unchanged from the third quarter and full year of 2001.

CAPITAL RESOURCES AND LIQUIDITY - XEROX CREDIT CORPORATION

XC manages our cash and liquidity resources as part of its U.S. cash management system. Accordingly, any cash we generate is remitted to XC, and we do not maintain cash balances.  Our liquidity is dependent on the continued liquidity of XC.  Due to our cessation of receivables purchases from XC in 2001 and our decision to run-off or sell our existing portfolio of contracts receivable, funds collected since mid-2001 have been loaned to XC under an interest bearing Master Demand Note.  We have made in the past, and will continue to make, demand loans to XC of all proceeds from the sale or collection of our receivables. Any of our cash balance which exceeds our ordinary course expenses and our debt and other obligations maturing within the then current quarter may continue to be loaned to XC as demand loans, consistent with the requirements of the New Credit Facility. We will continue to demand repayment of these loan amounts by XC as and to the extent necessary to repay our maturing debt obligations and fund our operations.

Net cash provided by operating activities was $122 million in the first nine months  of  2002 compared to $36 million in the first nine months of 2001. The increase was primarily due to $40 million reduction in the cash collateral requirements on certain cross-currency derivative contracts. In addition, higher net income due primarily to lower interest expense also contributed to the increase. The adjustment for the net change in the Due to Xerox Corporation account of $4 million in the first nine months of 2002 compared to $(31) million in the first nine months of 2001 is primarily the result of the timing of income tax accruals due to Xerox versus payments made. 

Net cash provided by investing activities was $1,064 million in the first nine months of 2002 compared to $1,265 million in the first nine months of 2001.  Both amounts reflect the run-off of our contracts receivable portfolio as a result of the decision to discontinue purchasing new receivables from XC after July 1, 2001. Accordingly, net collections from investments were $1,094 million and $1,237 million in 2002 and 2001, respectively, as new purchases of investments ceased in the second quarter of 2001. 2002 also reflects proceeds of $410 million from the sale of receivables back to XC as described in Note 5 to the Condensed Consolidated Financial Statements. In 2002, contract collections and proceeds from the sale of receivables were partially offset by net advances to XC as required and described in Note 6.  The advances to XC reflect our receipt of $1,020 million from XC in the second quarter that we used to repay our revolver debt in connection with XC’s negotiation of the New Credit Facility as described in Note 7. 2001 includes $28 million associated with the sale of certain assets.

In connection with XC’s Monetization Agreement with GE, during 2002, we sold back to XC an aggregate of $410 million of contracts receivable.  The sales to XC were accounted for as sales of contracts receivable at book value, which approximated fair value.  We have no continuing involvement or retained interests in the receivables sold and all the risk of loss in such receivables was transferred back to XC. XC continues to pursue alternative forms of financing including monetization of portions of its U.S. finance receivables portfolio, which underlies our contracts receivable.  Any such future monetizations by XC could further reduce our portfolio if we sell contracts

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receivable back to XC.  Any funds received on such sales will be loaned to XC under the interest bearing Master Demand Note.

The changes in operating and investing cash flows resulted in net cash used in financing activities of $1,186 million in the first nine months of 2002 compared to $1,301 million in the first nine months of 2001. 2002 reflects principal payments on long-term debt, primarily the $1,020 million repayment of our revolver debt, as no proceeds from new debt were received. 2001 reflects payments on notes with Xerox and affiliates and principal payments on long-term debt of $1,042 million and $227 million, respectively. 2001 also includes payments of $32 million on commercial paper.

As of September 30, 2002, we had approximately $2.4 billion of debt outstanding of which approximately $600 million is expected to be paid in the fourth quarter of 2002.  We believe that the funds collected from our existing portfolio of contracts receivable as well as amounts due under the Master Demand Note with XC will be sufficient to meet our remaining maturing obligations.

New Credit Facility
On June 21, 2002, Xerox entered into an Amended and Restated Credit Agreement (the “New Credit Facility”) with a group of lenders, replacing the prior $7 Billion Revolving Credit Agreement (the “Old Revolver”).  On June 21, 2002 we repaid the entire $1.02 billion we owed under the Old Revolver in connection with the New Credit Facility.  We are not, and will not become, a borrower under the New Credit Facility.  In addition, the New Credit Facility prohibits us from purchasing any new contracts receivable from XC. 

The New Credit Facility ($3.5 billion outstanding as of September 30, 2002) consists of two tranches of term loans totaling $2.0 billion and a $1.5 billion revolving facility that includes a currently unutilized $200 million letter of credit sub-facility. XC is currently, and expects to remain, the borrower of the term loans. The revolving loans are available, without sub-limit, to Xerox Corporation and to Xerox Canada Capital Limited (XCCL), Xerox Capital Europe plc (XCE), and other foreign subsidiaries as defined.  The size and contractual maturities of the loans are as follows ($ millions):

XC could be required to repay portions of the loans earlier than their scheduled maturities with specified percentages of any proceeds Xerox receives from capital market debt issuances, equity issuances or asset sales during the term of the New Credit Facility, except that the revolving loan commitment cannot be reduced below $1 billion as a result of such prepayments. Additionally, all loans under the New Credit Facility become due and payable upon the occurrence of a change in control.

Financial Risk Management

We are exposed to market risk from changes in interest rates and foreign currency exchange rates that could affect our results of operations and financial condition.  We have historically entered into certain derivative contracts, including interest rate swap agreements and foreign currency swap agreements, to manage interest rate and foreign currency exposures.  However, the recent downgrades of our and XC’s indebtedness have effectively eliminated our ability to manage this exposure as our ability to currently enter into new derivative contracts is severely constrained. Furthermore, the debt downgrades triggered various contractual provisions, which required us to collateralize

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or repurchase a number of derivative contracts, which were then outstanding. While we have been able to replace some derivatives on a limited basis, our current debt ratings restrict our ability to utilize derivative agreements to manage the risks associated with interest rate and some foreign currency fluctuations, including our ability to continue effectively employing our match funding strategy described below. For this reason, we anticipate volatility in our results of operations due to market changes in interest rates and foreign currency rates. Therefore, while our overall risk management strategy is as explained below, our ability to employ that strategy effectively has been severely limited. Any further downgrades of XC’s or our debt could further limit our ability to execute this risk management strategy effectively.

To assist in managing our interest rate exposure and match funding our principal assets, we had routinely used certain financial instruments, primarily interest rate swap agreements to manage interest rate exposure, although the recent downgrades of our indebtedness have limited our ability to manage this exposure. Virtually all customer financing assets earn fixed rates of interest. Accordingly, through the use of interest rate swaps in conjunction with the contractual maturity terms of outstanding debt, we “lock in” an interest spread by arranging fixed- rate interest obligations with maturities similar to the underlying assets.  This practice effectively eliminates the risk of a major decline in interest margins resulting from adverse changes in the interest rate environment.  Conversely, this practice also effectively eliminates the opportunity to materially increase margins when interest rates are declining. More specifically, pay-fixed/receive-variable interest rate swaps are often used in place of more expensive fixed-rate debt for the purpose of match funding fixed-rate customer contracts. Pay-variable/receive-variable interest rate swaps (basis swaps) are used to transform variable rate, medium-term debt into commercial paper or local currency LIBOR rate obligations. Pay-variable/receive-fixed interest rate swaps are used to transform term fixed- rate debt into variable rate obligations. Where possible, the transactions performed within each of these three categories have enabled the cost- effective management of interest rate exposures. We do not enter into derivative instrument transactions for trading purposes and employ long- standing policies prescribing that derivative instruments are only to be used to achieve a set of very limited match funding and liquidity objectives.

Parent Company Disclosures
Since our liquidity is heavily dependent upon the liquidity of our ultimate parent, XC, we are including the following excerpts from Management’s Discussion and Analysis of Financial Statements and Results of Operations,  including Capital Resources and Liquidity, as reported in the Xerox  Corporation Quarterly Report on Form 10-Q for the Quarter Ended September 30, 2002.

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READER’S NOTE: THE FOLLOWING DISCUSSION HAS BEEN EXCERPTED DIRECTLY FROM XEROX CORPORATION’S QUARTERLY REPORT ON FORM 10-Q FOR THE QUARTER ENDED SEPTEMBER 30, 2002. DEFINED TERMS HEREIN MAY NOT NECESSARILY HAVE THE SAME MEANING AS THE SAME DEFINED TERMS HAVE IN OTHER PARTS OF THIS DOCUMENT.  SUCH TERMS SHOULD BE READ IN THE NARROW CONTEXT IN WHICH THEY ARE DEFINED IN THIS SECTION. REFERENCES TO “WE”, “OUR”, AND “US” REFER TO XEROX CORPORATION.  ADDITIONALLY, AMOUNTS AND EXPLANATIONS CONTAINED IN THIS SECTION ARE MEANT TO GIVE THE READER ONLY A GENERAL SENSE OF XC’S OPERATIONS, CAPITAL RESOURCES AND LIQUIDITY.  ACCORDINGLY, THESE EXCERPTS SHOULD BE READ IN THE CONTEXT OF THE XC CONDENSED CONSOLIDATED FINANCIAL STATEMENTS, WHICH ARE INCLUDED IN XEROX CORPORATION’S QUARTERLY REPORT ON FORM 10-Q FOR THE QUARTER ENDED SEPTEMBER 30, 2002 FILED SEPARATELY WITH THE SEC.

Revenue
Total third quarter 2002 revenues of $3.8 billion declined 6 percent from $4.1 billion in the 2001 third quarter, representing a reduced rate of decline from prior periods, as equipment sale declines moderated reflecting the success of our new product launches in several of our target markets.  Approximately half the total revenue decline was due to our second half 2001 exit from the Small Office/Home Office (“SOHO”) business and declines in our Developing Markets Operations (“DMO”) as we continue to prioritize profitable revenue.  The rest of the decline reflects continued economic weakness and marketplace competition as production monochrome and office light-lens declines were only partially offset by growth in the key areas of office monochrome digital multifunction, as well as production and office color.  Cost and expense actions, consistent with improving our business model, enabled further progress in gross margins and reduced selling, administrative and general (“SAG”) expenses.  

Total revenues of $11.6 billion declined 8 percent from $12.6 billion in the nine months ended September 30, 2002. Approximately one third of the year-to-date decline was due to declines in SOHO and DMO. The remaining decline occurred in all operating segments reflecting the effects of lower equipment population in most geographies, competitive pressures, a weak economic environment and our focus on more profitable revenue. Growth in digital multifunction and production and office color were more than offset by declines in production and office monochrome, particularly in light-lens. 

Net Income (Loss)
Third quarter 2002 net income of $105 million or five cents per diluted share included after-tax restructuring charges of $49 million ($63 million pre-tax).  The third quarter 2001 net loss of $64 million, or nine cents per diluted share, included after-tax restructuring charges of $47 million ($63 million pre-tax), net after-tax losses from foreign unhedged currency exposures of $38 million ($59 million pre-tax) and after-tax goodwill amortization of $15 million ($16 million pre-tax) that was amortized prior to our adoption of SFAS No.142. 

Net income for the nine months ended September 30, 2002 was $152 million, or eleven cents per diluted share compared with $62 million or seven cents per diluted share for the same period in the prior year. Net income for the nine months ended September 30, 2002 included after-tax restructuring charges of $191 million ($262 million pre-tax) and an after-tax charge of $44 million ($72 million pre-tax) for permanently impaired capitalized software and net after tax losses from currency exposures of $53 million ($69 million pre-tax). Net income for the nine months ended September 30, 2001 included the following items: a $300 million after-tax gain ($769 million pre-tax) on the sale of half our interest in Fuji Xerox, after-tax restructuring charges of $350 million ($487 million pre-tax), after-tax goodwill amortization of $46 million ($49 million pre-tax), an after-tax gain of $36 million ($59 million pre-tax) reflecting the early extinguishment of debt and net after-tax losses from unhedged foreign currency exposures of $4 million ($8 million pre-tax).

As previously disclosed in our 2001 Annual Report, beginning in the second quarter of 2001, the Board of Directors suspended the dividend on the

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Company’s Preferred Stock held by its Employee Stock Ownership plan (“ESOP”). The ESOP is required to be funded by a combination of dividends and compensation payments over the term of the plan for pre-determined amounts each period. The dividends do not affect our income statement, while compensation is recorded as expense in our income statement.  In order to meet ESOP debt service requirements since dividends were suspended, we incurred additional ESOP-related compensation expense for each period that the dividends were not declared.  On September 9, 2002, the Board of Directors declared preferred dividends totaling $67 million. This resulted in a reversal of the previously recorded compensation expense through the third quarter 2002and a corresponding increase to net income of $63 million.  There is no corresponding earnings per share (“EPS”) improvement since the EPS calculation requires deduction of dividends declared from reported net income in arriving at income available to common shareholders.

Operations Review

Pre-Currency Amounts

To understand the trends in the business, we believe that it is helpful to adjust revenue and expense growth (except for ratios) to exclude the impact of changes in the translation of European and Canadian currencies into U.S. dollars. We refer to this adjusted growth as “pre-currency growth.”   Latin American results are shown at actual exchange rates for both pre-currency and post-currency reporting, since these countries generally have volatile currency and inflationary environments.

A substantial portion of our consolidated revenues is 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 and Canadian currencies on a revenue-weighted basis, the U.S. dollar was approximately 7 percent weaker in the 2002 third quarter than in the 2001 third quarter and 2 percent weaker on a year-to-date basis than in the comparable period of the prior year.  As a result, foreign currency translation favorably impacted revenue growth by approximately 2 percentage points in the third quarter 2002 and one percentage point for the first nine months of 2002.

Revenues by Type

Year-over-year post currency percent increases (decreases) by type of revenue on a quarterly basis were as follows:

Year-over-year post currency percent decreases by type of revenue on a year-to-date basis were as follows:

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Equipment sales typically represent approximately 20-25 percent of total revenue. Equipment sales in the third quarter 2002 declined 9 percent (11 percent pre-currency) from the third quarter 2001 with approximately 40 percent of the decline due to our exit from the SOHO business.  In addition, continued competitive pressures and economic weakness impacted equipment sales particularly in production monochrome.  In November, we will launch our new 101 pages per minute (ppm) monochrome system, the Xerox 1010, our latest digital entry in the “light production” market and the least expensive and most advanced system in its class.  In the third quarter, new products delivered growth in production color, monochrome digital multi-function and office color printing. Demand for the new Document Centre 500 Series exceeded our expectations and contributed to a backlog, which we expect to install in the fourth quarter.

Equipment sales in the nine months ended September 30, 2002 declined 13 percent (13 percent pre-currency) from the comparable period in the prior year reflecting competitive pressures, continued weakness in the economy and our focus on profitable revenue.  However, the trend has been improving throughout the year, as new products are launched. Approximately 25 percent of the year-to-date decline was due to our previously discussed exit from SOHO.

Post sale and other revenues include service, document outsourcing, rentals, supplies and paper, which represent the revenue streams that follow equipment placement, as well as revenue not associated with equipment placement, such as royalties.  Third quarter 2002 post sale and other revenues declined 5 percent (7 percent pre-currency) from the 2001 third quarter, as declines in North America and DMO were only partially offset by growth in Europe. The declines reflect lower equipment populations due to reduced placements in earlier periods, lower page print volumes, and lower rental revenue in Latin America. Growth in Europe reflected the profile of the installed base, which has a higher proportion of digital products than North America, as well as longer average lease duration. Third quarter 2002 document outsourcing revenue declined from the third quarter 2001 as declines in North America outpaced revenue growth in Europe.  We expect document outsourcing revenue will continue to decline as we continue to focus on more profitable contracts.

Year-to-date Post sale and other revenues declined by 6 percent (7 percent pre-currency). Revenue continues to grow in key areas of production color, office digital multifunction and color due to growth in the installed base.  This growth only partially offsets declines in light-lens office and monochrome production, particularly in North America.   Our ability to increase post sale revenue is largely dependent on our ability to increase equipment placements. Equipment placements typically occur through leases with original terms of three to five years.  Our leases generate contractual and contingent post sale revenue during the terms.  Once equipment placements start to increase, there will be a lag before post sale revenues also start to increase.

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Finance Income declined 10 percent (12 percent pre-currency) in the third quarter 2002 from the third quarter 2001 and 11 percent (11 percent pre-currency) on a year-to-date basis reflecting continued equipment sale declines, primarily in North America, and the effects of the sale of our financing businesses in the Nordic countries and Italy.

Key Ratios and Expenses

The key ratios for 2002 and 2001 were as follows:

(1)  As a percentage of Total Revenue

Year-to-date key ratios for 2002 and 2001 were as follows:

⁽¹⁾  As a percentage of Total Revenue

Third quarter 2002 gross margin of 42.0 percent improved 4.4 percentage points from 37.6 percent in the third quarter 2001.  Approximately two percentage points of the improvement reflect the prior liquidation of equipment inventory associated with our SOHO exit.  In addition, the improvement reflects improved manufacturing and service productivity partially offset by the impact of competitive price pressures.  The applicable portion of the previously discussed ESOP expense adjustment benefited the third quarter 2002 gross margin by $28 million or 0.7 percentage points.  Year-to-date gross margin of 41.9 percent improved 4.8 percentage points from 37.1 percent in the comparable period of the prior year. Improved manufacturing and service productivity, favorable product mix, our SOHO exit and lower cost of borrowings for our finance businesses more than offset the adverse impact of competitive price pressures.

Research and development (R&D) expenses of $229 million were $28 million lower in the 2002 third quarter than the third quarter 2001. Year-to-date 2002 R&D spending of $699 million was $66 million lower than in the first nine months of 2001.  The R&D expense reduction reflects benefits from restructuring actions, the $11 million applicable portion of the ESOP expense adjustment and our SOHO exit. R&D spending in the 2002 third quarter and year-to-date represented 6 percent of revenue as we continue to invest in technological development, particularly color, in order to maintain our position in the rapidly changing document processing market.  We expect 2002 R&D spending will represent approximately 6 percent of revenue, a level that we believe is adequate to remain technologically competitive. Xerox’s R&D remains strategically coordinated with Fuji Xerox.

Selling, administrative and general (SAG) expenses declined by $152 million in the 2002 third quarter to $1,023 million primarily reflecting business model improvements from our cost reductions, the $28 million applicable portion of

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the ESOP expense adjustment, a $34 million favorable property tax adjustment, lower bad debt provisions and a $26 million loss associated with leased facilities.  The $34 million property tax adjustment resulted from a change in the estimated amounts payable to the numerous domestic state and local property tax jurisdictions where we place our equipment through sale or lease.  Such change was due to our reviews of property tax rates, experience in property tax audits and amounts of leased equipment at customer sites.  The $26 million loss associated with leased facilities represents a change in the estimated loss we expect to incur related to our decision not to utilize existing lease facilities, as well as changes in our estimates of certain sublease rentals at a lower rate than our lease costs.  The third quarter 2002 bad debt provision of $87 million was $64 million lower than 2001 primarily due to improved aging and historical write-off trends for accounts and finance receivables as well as lower provisions in North America due to improved customer administration and tighter credit control policies.  The third quarter 2001 was negatively impacted by provisions required for many high-risk small customers. 

Year-to-date 2002 SAG expense of $3,302 million declined $242 million or 7 percent from the comparable period in the prior year. The reduction reflects benefits from our restructurings, the applicable portion of the ESOP expense adjustment, the $34 million favorable property tax adjustment and lower bad debt provisions partially offset by a write-off of $72 million for permanently impaired capitalized software. Year-to-date bad debt expense of $258 million was $70 million lower than the comparable period in the prior year, due to improved aging and historical write-off trends for accounts and finance receivables as well as lower provisions in North America resulting from improvements in customer administration and tighter credit control policies, partially offset by higher provisions in Europe and DMO.

We have been initiating restructuring actions in order to cut costs and prioritize resources in strategic areas of our business.  We recorded a restructuring charge in the three and nine months ended September 30, 2002 of $63 million and $262 million to reflect these actions.  The third quarter charge primarily consisted of severance and employee benefits related to the termination of approximately 1,100 employees worldwide, as well as certain costs related to the consolidation of excess facilities. The third quarter and year-to-date actions are expected to reduce annualized costs by approximately $75 million and $250 million, respectively.  We expect additional provisions will be required in the fourth quarter 2002 as additional plans are finalized and are committed to. The fourth quarter provision is expected to be higher than the average of the first 3 quarters of 2002 but cannot be estimated until the plans are finalized. The reserve balance for all restructuring actions at September 30, 2002 was $191 million.

Worldwide employment was 69,900 at the end of the 2002 third quarter primarily reflecting reductions due to our restructuring programs.

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Other expenses, net for the three and nine months ended September 30, 2002 and 2001 were as follows:

Other expenses, net were $93 million in the third quarter 2002and $125 million in the third quarter 2001.  Higher non-financing interest expense primarily reflects higher borrowing costs associated with the terms of the New Credit Facility.  Non-financing interest expense also includes net gains from the mark-to-market of interest rate swaps, including “received fixed/pay variable” type swaps. These gains are the result of a declining interest rate environment and totaled $29 million and $46 million in the third quarter of 2002 and 2001, respectively. The decline in gains is the result of a smaller swap portfolio and a lower relative interest rate decline in 2002 as compared to 2001.

Non-financing interest expense was $224 million year-to-date 2002 as compared to $344 million in the same period of the prior year due to lower 2002 debt levels and reduced borrowing costs in the first half of the year, partially offset by higher borrowing costs in the third quarter associated with the terms of the New Credit Facility and lower net gains from mark-to-market interest rate swaps. The proportion of our debt that is subject to variable rates has increased significantly from 2001 which, coupled with the significant reduction in market interest rates has resulted in a significant reduction in interest expense as compared to prior year periods. However, the increased variable rate debt leaves us exposed to higher interest expense if interest rates rise.

Net currency losses of $12 million in the 2002 third quarter primarily represent the cost of hedging our foreign currency denominated exposures in markets where we have been able to restore economic hedging capability, as well as lower foreign exchange volatility on unhedged currency exposures.  Gains and losses on unhedged exposures were immaterial on a net basis in the quarter.  The $59 million loss in the third quarter 2001 resulted from losses on unhedged exposures, largely due to our restricted access to the derivatives markets in 2001. Year-to-date 2002 currency losses were $69 million compared to $8 million in the comparable period of the prior year primarily reflecting the Brazilian exchange losses incurred in the second quarter and the devaluation of the Argentine Peso.  The 2001 year-to-date loss was primarily related to Yen denominated debt.

Effective January 1, 2002, we adopted the provisions of SFAS No. 142 “Goodwill and Other Intangible Assets.”  Accordingly, the amortization of goodwill was discontinued in 2002.

Interest income is derived from our invested cash balances and income tax receivables.  In the future, we expect interest income will decline, as cash balances are lower than prior years following a $3.2 billion net decrease in debt in 2002.

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Effective April 1, 2002, we adopted the provisions of SFAS No. 145 “Rescission of FASB Statements No. 4, 44 and 64, Amendment of FASB Statement No. 13, and Technical Corrections.” Accordingly, we have reclassified the extraordinary gain on extinguishment of debt, which was previously reported in the Consolidated Statements of Income as an extraordinary item to Other expenses, net. The effect of this reclassification was a decrease in Other expenses, net of $1 million and $59 million and an increase in Income taxes (Benefits) of less than $1 million and $23 million for the three and nine months ended September 30, 2001.

In July 2002, we sold our 22 percent investment in Katun Corporation, a supplier of aftermarket copier/printer parts and supplies, for net proceeds of $67 million, which resulted in a pre-tax gain of $12 million.  After-tax, the sale was essentially break-even, as the taxable basis of Katun was lower than our carrying value on the sale date resulting in a high rate of income tax.

In the second quarter 2002, we sold our Italian leasing subsidiary to a third party for $200 million cash plus the assumption of $20 million of debt. The loss on this transaction totaled $16 million, primarily related to recognition of cumulative translation adjustment losses and final sale contingency settlements. In addition, in the first half of 2002, the sale of Prudential Insurance Company common stock associated with that company’s demutualization generated a $19 million gain. The $10 million civil penalty is associated with our April 2002 settlement with the SEC.

All other, net for the 2002 third quarter includes $20 million of expenses related to certain litigation and associated claims.  The 2001 third quarter included $10 million of property losses related to the September 11 attacks as well as numerous other individually insignificant items.

Income Taxes, Equity in Net Income of Unconsolidated Affiliates and Minorities’ Interests in Earnings of Subsidiaries

The following table summarizes our consolidated Income taxes (benefits) and the related effective tax rate for each respective period:

The difference between the 2002 third quarter and year-to-date effective tax rates and the U.S. statutory tax rate primarily related to additional tax expense recorded for the sale of our interest in Katun Corporation, the on-going examination in India as well as losses in certain jurisdictions where we are not providing tax benefits.  Such expense is offset, in part, by certain benefits arising from tax law changes and the retroactive declaration of ESOP dividends.

The 2001 third quarter effective tax rate was higher than the U.S. statutory tax rate primarily due to the favorable resolution of certain tax audit issues, partially offset by losses in low tax jurisdictions or jurisdictions where we are not providing tax benefits.  On a year-to-date basis through September 30, 2001 the effective tax rate was higher than the U.S. statutory tax rate primarily due to the taxes incurred in connection with the sale of one-half of our ownership interest in Fuji Xerox as well as losses in low tax jurisdictions or jurisdictions where we are not providing tax benefits, partially offset by the favorable resolution of certain tax audit issues.

Our effective tax rate will change based on nonrecurring events (such as new restructuring initiatives) as well as recurring factors including the

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geographical mix of income before taxes and the related tax rates in those jurisdictions. We expect that our consolidated 2002 effective tax rate will approximate 45 percent. Before restructuring charges, we expect that our 2002 effective tax rate will approximate 40 percent.

We are subject to ongoing tax examinations in various jurisdictions.   Accordingly, we provide for additional tax expense based upon the probable outcomes of such tax examinations.  In addition, when applicable, we adjust the previously recorded tax expense to reflect favorable examination results.

As a result of the investigations in India, as discussed in Note 12 to our Condensed Consolidated Financial Statements, and an expansion of those investigations to other years, we have recorded a tax liability based upon our best estimate of the probable loss resulting from the disallowable deductions.

Equity in Net income of unconsolidated affiliates consists of our 25 percent share of Fuji Xerox income as well as income from other smaller equity investments. Higher equity in net income for the third quarter and nine months ended 2002 primarily reflects improved Fuji Xerox performance including strong revenue growth and improved gross margins.     

Minorities interest in earnings of subsidiaries increased by $8 million to $17 million in the third quarter 2002 and by $40 million to $66 million year-to-date primarily due to the quarterly distributions on the November 2001 Convertible Trust Preferred Securities.

Business Performance by Operating Segment

Our operating segments are as follows: Production, Office, DMO, SOHO, and Other. The following table summarizes our business performance by segment.  Revenue and year-over-year revenue percentage changes by segment are as follows ($ in millions):

*   As restated

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Operating segment profit (loss) and margins were as follows (in millions):