FORM 10-K
                      SECURITIES AND EXCHANGE COMMISSION
                           Washington, D.C.  20549
(Mark One)
(X)  Annual Report Pursuant to Section 13 or 15(d) of the Securities
     Exchange Act of 1934   For the fiscal year ended:  December 31, 1998 

( )  Transition Report Pursuant to Section 13 or 15(d) of the Securities
     Exchange Act of 1934   For the transition period from: ______ to ______
 
                              XEROX CORPORATION
            (Exact name of registrant as specified in its charter)
 
                                    1-4471
                           (Commission file number)
 
New York                                                            16-0468020
(State of incorporation)                  (I.R.S. Employer Identification No.)

P.O. Box 1600, Stamford, Connecticut                                     06904
(Address of principal executive offices)                            (Zip Code)

       Registrant's telephone number, including area code: (203) 968-3000
 
          Securities registered pursuant to Section 12(b) of the Act:
 
                                                       Name of Each Exchange
Title of Each Class                                    on Which Registered

Common Stock, $1 par value                             New York Stock 
Exchange
                                                       Chicago Stock 
Exchange


       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.
                                                       Yes: (X)  No: (  )
 
Indicate by check mark if disclosure of delinquent filers pursuant to Item 
405 of Regulation S-K is not contained herein, and will not be contained, to 
the best of registrant's knowledge, in definitive proxy or information 
statements incorporated by reference in Part III of this Form 10-K or any 
amendment to this Form 10-K.
                                                            ( )

The aggregate market value of the voting stock of the registrant held by 
non-affiliates as of February 26, 1999 was:                $39,661,401,412.

                            (Cover Page Continued)


Indicate the number of shares outstanding of each of the registrant's 
classes of common stock, as of the latest practicable date:
 
Class                                       Outstanding at February 26,1999

Common Stock, $1 Par Value                                  659,328,281 
Shares


                      Documents Incorporated By Reference
 
Portions of the following documents are incorporated herein by reference:
 
                                                       Part of 10-K in
Document                                               Which Incorporated

Xerox Corporation 1998 Annual Report to Shareholders          I & II

Xerox Corporation Notice of 1999 Annual Meeting of           III & IV
Shareholders and Proxy Statement (to be filed not 
later than 120 days after the close of the fiscal 
year covered by this report on Form 10-K).


Forward-Looking Statements

From time to time Xerox Corporation (the Registrant or the Company) and its 
representatives may provide information, whether orally or in writing, 
including certain statements in this Form 10-K under "Management's 
Discussion and Analysis of Results of Operations and Financial Condition," 
which are deemed to be "forward-looking" within the meaning of the Private 
Securities Litigation Reform Act of 1995 ("Litigation Reform Act").  These 
forward-looking statements and other information relating to the Company are 
based on the beliefs of management as well as assumptions made by and 
information currently available to management.

The words "anticipate," "believe," "estimate," "expect," "intend," "will," 
and similar expressions, as they relate to the Company or the Company's 
management, are intended to identify forward-looking statements.  Such 
statements reflect the current views of the Registrant 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 or expected.  The Registrant does not intend to update 
these forward-looking statements.

In accordance with the provisions of the Litigation Reform Act 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:

Competition - the Registrant operates in an environment of significant 
competition, driven by rapid technological advances and the demands of 
customers to become more efficient.  There are a number of companies 
worldwide with significant financial resources which compete with the 
Registrant to provide document processing products and services in each of 
the markets served by the Registrant, some of whom operate on a global 
basis.  The Registrant's success in its future performance is largely 
dependent upon its ability to compete successfully in its currently-served  
markets and to expand into additional market segments.  

Transition to Digital - presently black and white light-lens copiers 
represent approximately 40% of the Registrant's revenues.  This segment of 
the general office market is mature with anticipated declining industry 
revenues as the market transitions to digital technology.  Some of the 
Registrant's new digital products replace or compete with the Registrant's 
current light-lens equipment.  Changes in the mix of products from light-
lens to digital, and the pace of that change as well as competitive 
developments could cause actual results to vary from those expected.

Pricing - the Registrant's ability to succeed is dependent upon its ability 
to obtain adequate pricing for its products and services which provide a 
reasonable return to shareholders.  Depending on competitive market factors, 
future prices the Registrant can obtain for its products and services may 
vary from historical levels.

Financing Business - a significant portion of the Registrant's profits arise 
from the financing of its customers' purchases of the Registrant's 
equipment.  On average, 75 to 80 percent of equipment sales are financed 
through the Registrant. The Registrant's ability to provide such financing 
at competitive rates and realize profitable spreads is highly dependent upon 
its own costs of borrowing which, in turn, depend upon its credit ratings.  
Significant changes in such ratings could reduce the profitability of such 
financing business and/or make the Registrant's financing less attractive to 
customers thus reducing the volume of financing business done.  The 
Registrant's present credit ratings permit ready access to the credit 
markets.  There is no assurance that these credit ratings can be maintained 
and/or ready access to the credit markets can be assured.

Productivity - the Registrant's ability to sustain and improve its profit 
margins is largely dependent on its ability to maintain an efficient, cost-
effective operation.  Productivity improvements through process 
reengineering, design efficiency and supplier cost improvements are required 
to offset labor cost inflation and potential materials cost changes and 
competitive price pressures.

International Operations - the Registrant derives approximately half its 
revenue from operations outside of the United States.  In addition, the 
Registrant manufactures many of its products and/or their components outside 
the United States.  The Registrant's future revenue, cost and profit results 
could be affected by a number of factors, including changes in foreign 
currency exchange rates, changes in economic conditions from country to 
country, changes in a country's political conditions, trade protection 
measures, licensing requirements and local tax issues.

New Products/Research and Development - the process of developing new high 
technology products and solutions is inherently complex and uncertain.  It 
requires accurate anticipation of customers' changing needs and emerging 
technological trends.  The Registrant must then make long-term investments 
and commit significant resources before knowing whether these investments 
will eventually result in products that achieve customer acceptance and 
generate the revenues required to provide anticipated returns from these 
investments.

Restructuring - the Registrant's ability to ultimately reduce pre-tax annual 
expenditures by approximately $1 billion is dependent upon its ability to 
successfully implement the 1998 restructuring program including the 
elimination of 9,000 net jobs worldwide, the closing and consolidation of 
facilities, and the successful implementation of process and systems 
changes.  

Year 2000 - the Registrant's ability to complete its Year 2000 plan is 
dependent upon the availability of resources, the Registrant's ability to 
discover and correct the potential Year 2000 sensitive problems which could 
have a serious impact on the Registrant's information management systems, 
facilities and products, and the ability of the Registrant's suppliers and 
customers to bring their systems into Year 2000 compliance.


                                    PART I


Item 1. Business

Overview

Xerox Corporation (Xerox or the Company) is The Document Company and a 
leader in the global document market, providing document solutions that 
enhance business productivity.  References herein to "us" or "our" refer to 
Xerox and consolidated subsidiaries unless the context specifically requires 
otherwise.  We distribute our products in the Western Hemisphere through 
divisions and wholly-owned subsidiaries. In Europe, Africa, the Middle East 
and parts of Asia including India, China and Hong Kong, we distribute 
through Xerox Limited and related companies (collectively Xerox Limited). 
Fuji Xerox, an unconsolidated entity jointly owned by Xerox Limited and Fuji 
Photo Film Company, Limited develops, manufactures and distributes document 
processing products in Japan and the Pacific Rim.  Japan represents 
approximately 90 percent of Fuji Xerox revenues, and Australia, New Zealand, 
Singapore, Malaysia and Korea represent the remaining 10 percent.  Fuji 
Xerox conducts business in other Pacific Rim countries through joint 
ventures and distributors.

Since 1995, the results of our Insurance operations have been accounted for 
as discontinued operations and the Document Processing business has been the 
only component of continuing operations.

Our Document Processing activities encompass developing, manufacturing, 
marketing, servicing and financing a complete range of document processing 
products and solutions designed to make offices around the world more 
productive. We believe that the document is a tool for productivity, and 
that documents - both electronic and paper - are at the heart of most 
business processes.  Documents are the means for storing, managing, and 
sharing business knowledge.  Document technology is key to improving 
productivity through information sharing and knowledge management and we 
believe no one knows the document - paper to digital, digital to paper - 
better than we do.  The financing of Xerox equipment is generally carried 
out by Xerox Credit Corporation (XCC) in the United States and 
internationally by foreign financing subsidiaries and divisions in most 
countries. Document Processing operations had 92,700 Xerox employees at 
year-end 1998.

Continuing Operations

The Document Processing Strategy

We believe that documents represent the knowledge base of an organization 
and play a dynamic and central role in business, government, education and 
other organizations:

- - Increasingly, documents are being created and stored in digital 
electronic form.  In addition, the internet is increasing the amount of 
information which can be accessed in the form of electronic documents.
- - While the percentage of printed documents will decline, the total of all 
documents produced by organizations (printed and electronic) will grow at 
an even faster rate.
- - This will result in an overall continuing increase in the volume of 
printed documents.

As The Document Company, we believe that by helping our customers navigate 
and manage the world of documents, we can help them improve their 
productivity and grow their businesses.  We help customers make documents 
better, make better documents, and work better with documents.

We create customer value by providing innovative document technologies, 
products, systems, services and solutions that allow our customers to:

- -   Move easily within and between the electronic and paper forms of 
documents.

- -  Scan, store, retrieve, view, revise and distribute documents 
electronically anywhere in the world.

- -  Print or publish documents on demand, at the point closest to their 
needs, including those locations of our customers' customers.

- -  Integrate the currently separate modes of producing documents, such as 
the data center, production publishing and office environments into a 
seamless, user-friendly enterprise-wide document systems network - with 
technology acting as an enabler.

We have formed alliances to bring together the diverse infrastructures that 
currently exist and to nurture the development of an open document services 
and solutions environment to support complementary products from our 
partners and customers.  We are working with more than 50 industry 
organizations to make office, production and electronic printing an 
integrated, seamless part of today's digital work place.

Market Overview

We estimate that the global document market that we serve, excluding Japan 
and the Pacific Rim countries served by Fuji Xerox, was approximately $120 
billion in 1998 and is estimated to grow to over $200 billion in 2001. With 
our many new product introductions during this decade and in particular, the 
transition from light-lens to digital technology, our participation in the 
global document market has been considerably broadened from the slower 
growing segments of the market to the faster growing segments of the market. 
We are leading the transition in our industry from light-lens to digital 
technology, from standalone devices to network-connected systems, from black 
and white to color capable devices, and from box sales to services and 
solutions which solve customer problems. Xerox growth will be driven by the 
transition to digital copying and printing in the office, the transfer of 
document production from offset printing to digital publishing, the increase 
in customer requirements for network and distributed printing, the 
accelerating demand for color documents, and increasingly, our participation 
in the small office / home office / personal document processing market.

We have traditionally had a strong position in the general office document 
market, the largest segment, which is projected to reach approximately $79 
billion in 2001. Growth in this market is driven by the transition to the 
use of digital and color documents.  The production market, which includes 
production publishing and production printing, is expected to reach $27 
billion in 2001.  The small office / home office / personal document 
processing market is growing at an annual rate of more than 25 percent to 
$48 billion by 2001 due to increases in the number of home offices and small 
businesses.  This market segment acquires product primarily through indirect 
distribution channels.  Document outsourcing, the fastest growing served 
market segment, is projected to grow 35 to 40 percent annually, reaching $18 
billion by 2001, as customers' increasingly focus on their core competencies 
and outsource their document processing requirements.  Finally, the portion 
of the professional services market in which we participate through our 1998 
acquisition of XLConnect, now Xerox Connect, an information technology 
services company, is growing very rapidly, to $20 billion by 2001.


Xerox Focus

We believe that our competitive advantages lie in our ability to continually 
improve the features and performance of our document processing products, 
services and solutions based on demonstrated customer needs; competitive 
pricing; our excellent reputation for performance and service; our 
substantial on-going investment in research and development; expanded sales 
coverage through our global direct sales force, agents and concessionaires; 
our leadership position in the rapidly growing document outsourcing 
business; maintenance of our strong market position in emerging markets; and 
building on the strength of the Xerox brand, an expanded presence in the 
burgeoning small office / home office / personal document processing market 
through expansion of retail chains, value added resellers and systems 
integrators, and increasingly telesales and e-commerce.  As a result, we 
believe we are well positioned to participate in the anticipated growth in 
the market segments in which we compete.

Digital Products

Our digital products consist of five categories: black-and-white production 
publishing, black-and-white production printing, color copying and printing, 
black-and-white digital copiers, and channels/other.  On a pre-currency 
basis, digital product revenues grew 36 percent in 1998, 25 percent in 1997, 
and 23 percent in 1996. The acceleration in digital product revenue growth 
resulted in 1998 digital revenues exceeding light-lens copier revenues for 
the first time. Revenues from digital products were 46 percent of total 
revenues in 1998, 36 percent in 1997, and 30 percent in 1996.

Production Publishing

In 1990, we launched the era of production publishing when we announced the 
introduction of our DocuTech Production Publishing family which was a major 
step beyond our traditional reprographics market into the publishing 
industry.  Having installed more than 20,000 DocuTech systems around the 
world to date, our production publishing revenues in 1998 grew 15 percent 
pre-currency to $2.3 billion.

Digital production publishing technology is increasingly replacing older, 
traditional short-run offset printing as customers seek improved 
productivity and cost savings, faster turnaround of document preparation, 
and the ability to print documents "on demand."  We offer the widest range 
of solutions available in the marketplace - from dial-up lines through the 
Internet to state-of-the-art networks - and we are committed to expanding 
these print-on-demand solutions as new technology and applications are 
developed. 

The DocuTech family of digital production publishers scans paper documents 
and converts them into digital documents, or accepts digital documents 
directly from networked personal computers or workstations.  A user-friendly 
electronic cut-and-paste workstation allows the manipulation of images or 
the creation of new documents.  For example, in only a few minutes, a page 
of word-processed text, received over a network, can be combined with a 
scanned photograph and enhanced electronically: cropped, positioned 
precisely, rotated, brightened or sharpened.  Digital masters can be 
prepared in a fraction of the time necessary to prepare offset printing 
plates, thereby allowing fast turnaround time.  Further time can be saved, 
and frequently significant inventory and shipping costs, by transmitting 
electronically and printing where and when the documents are required.  In 
1998, we introduced DigiPath Production Software, a major productivity tool, 
which allows a printer's customers to use the World Wide Web to streamline 
print job submission and subsequent archiving, preparation, proofing, and 
reprinting.

DocuTech prints high-resolution (600 dots per inch) pages at up to 180 
impressions per minute.  The in-line finisher staples completed sets or 
finishes booklets with covers and thermal-adhesive bindings.  Because the 
finished document can be stored as a digital document, hard copy documents 
can be printed on demand, or only as required, thus avoiding the long 
production runs and high storage and obsolescence costs associated with 
offset printing.  The concept of print-on-demand took another major step 
forward in 1995 when we introduced the DocuTech 6135.  It makes print-for-
one publishing practical; personalized publishing runs can now be as short 
as one or two prints. Further steps forward were taken in 1997 when the 
DocuTech 6180 was introduced, increasing output speed to 180 cut-sheet pages 
per minute and again in 1998 with the introduction of DocuTech 65 (65 pages 
per minute) and DocuTech 6100, (96 pages per minute) making the technology 
affordable for much smaller customers.

Production Printing

Revenue from monochrome production printing was $2.3 billion in 1998. 

This market has largely consisted of high-end host-connected printers. We 
expect future growth for robust, fully featured printers serving multiple 
users on networks.  This growth will be driven by the increase in personal 
computers and workstations on networks, client-server processing, 
accelerating growth in the demand for enterprise-wide distributed printing, 
and declining electronics costs.  These faster, more reliable printers print 
collated multiple sets on both sides of the paper, insert covers and tabs, 
and staple or bind, but without the labor-intensive steps of printing an 
original and manually preparing the documents on copiers.  In addition, 
documents can be printed on these printers from remote data center 
computers, enabling the efficiencies of distributing electronically and then 
printing, rather than printing paper documents and then distributing them.

We have held the leading position in the production, high-volume computer 
printing market segment since 1977.  We are well positioned to capitalize on 
the growth in the computer printing market because of our innovative 
technologies and our understanding of customer requirements for distributed 
printing from desktop and host computers.  Our goal is to integrate office, 
production and data-center computer printing into a single, seamless, user-
friendly network. 

Xerox pioneered and continues to be a worldwide leader in computer laser 
printing, which combines computer, laser, communications and xerographic 
technologies.  We market a broad line of robust printers with speeds up to 
the industry's fastest cut-sheet printer at 180 pages per minute, and 
continuous-feed production printers at speeds up to 1300 images per minute.  
Many of these printers have simultaneous interfaces that can be connected to 
multiple host computers as well as local area networks.

Breakthrough technology in our highlight color printers allows printing, in 
a single pass, black-and-white plus one customer-changeable color (as well 
as shades, tints, textures and mixtures of each) at production speeds up to 
184 pages per minute.  Other manufacturers' highlight color printers require 
additional passes to add variable color, which increase cost, reduce speed 
and reliability and introduce the possibility of color misalignment.

Productivity-enhancing features include printing collated multiple sets on 
both sides of the paper, inserting covers and tabs, printing checks with 
magnetic ink character recognition (MICR), and stapling or finishing with a 
thermal adhesive binding; all on cut sheet plain paper, with sizes up to 11 
by 17 inches.

In 1995, we significantly expanded our opportunities with the introduction 
of two major new printer series that redefine our role in the electronic 
production printing industry.  With the DocuPrint CF Series family, we 
entered the market for very high-volume, continuous-feed printers at speeds 
up to 420 pages per minute.  The DocuPrint IPS Series makes the IBM Advanced 
Function Presentation (AFP) architecture directly available to our 
production printing customers.

In 1997, we introduced the DocuPrint 180 that prints on one or both sides of 
a page, on a wide variety of paper sizes and weights, and at 180 pages per 
minute.  We also introduced the DocuPrint 184 hc (highlight color) which 
pairs two 92 page-per-minute Xerox highlight color laser printers with one 
print server for cut-sheet, highlight color production speeds up to 184 
pages per minute.

In 1998, we demonstrated the DocuPrint 900 and the DocuPrint 1300 models, 
the first in a new class of ultra high-speed continuous feed production 
printing systems.  Printing at up to 900 and 1300 duplex impressions per 
minute (200 and 300 feet per minute, respectively), these DocuPrint models 
combine the high reliability and throughput of web printing with the 
flexibility of electronic printing for unsurpassed productivity.  These 
models also offer a number of in-line finishing options, including cut-
sheet, fanfold, or roll and are compatible with many third party post-
processing devices.

Color Copying and Printing 

Our revenues from color copying and printing grew 19 percent pre-currency in 
1998 to $1.9 billion.

The use of color originals in the office is accelerating. Independent 
studies have concluded that color documents are more effective at 
communicating information and that decision-making performance improves with 
the use of color documents.  The vast majority of industry shipments of 
workstations and personal computers have color monitors, creating the need 
for economical, convenient and reliable, high-quality color copying and 
printing. 

The color market has largely consisted of ink-jet and laser copiers and 
printers.  Laser copiers and printers offer near-offset image quality, 
excellent printing speeds, and the accessories necessary to produce finished 
sets.

We entered the color laser market in 1991 with the introduction of a color 
laser copier/printer and a color laser printer, each of which printed at 7.5 
pages per minute.  More recent product introductions include the DocuColor 
40, introduced in early 1996, which copies and prints at 40 full-color pages 
per minute and is the industry's fastest and most affordable digital color 
document production system.  It has a market share of more than 50 percent. 
In 1997, we introduced the DocuColor 70, a continuous feed full-color 
digital press, based on a print engine from Xeikon with Xerox-exclusive 
digital front-ends, that produces 70 high-quality, full-color impressions 
per minute and in 1998, we introduced the DocuColor 100 Digital Color Press, 
also based on a Xeikon print engine with Xerox-exclusive digital front-ends, 
that produces 100 high-quality full-color impressions per minute.

For the general office, in 1997 we introduced the DocuColor 5750 Empress 
copier/printer which produces 6 full color copies per minute and the 
DocuColor 5799 which operates at 9 full color copies per minute. For 
networked workgroups, we introduced the DocuPrint C55, a full-featured, 
compact color laser printer that prints three full color pages per minute 
and includes automatic image enhancement and an embedded web server. In 
1998, we introduced the DocuColor Office 6, a networked color copier/printer 
for the office that operates at twice the speed of most desktop color laser 
printers at the price of a mid-volume black and white copier. Also in 1998, 
we expanded the DocuColor 40 line, adding the DocuColor 40 CP, a network-
connected color copier/printer equipped with a newly designed digital 
controller, designed to provide digital walk up copying as well as network 
printing for lower-volume environments. In March, 1999, we introduced the 
DocuColor 30 Pro and the DocuColor 30 CP, both 30 page per minute digital 
color copier/printers intended for entry-level production environments and 
high-end color intensive offices and the DocuColor 4 LP, a laser printer 
that operates at four full-color pages or 16 black and white pages per 
minute. Finally, in the latter part of 1998 we announced our first entry 
into the fast growing network color inkjet market, the DocuPrint C20 Color 
Inkjet Printer that costs about one-third the price of a color laser printer 
and have followed that with 1999 announcements including inkjet multi-
function devices.

Black and White Digital Copiers

The volume of paper documents used in the office continues to grow.  Pages 
per worker per day in the U.S. have doubled in the last decade and 
productivity has been impaired by the need to manage documents on computer 
monitors and as hard-copy originals.

We intend to help customers improve productivity by controlling their 
documents from a common interface; managing from the desktop; eliminating 
gaps, steps and devices in the work process; and moving smoothly from 
digital to paper and back.

Our strategy is to build from our current strength, the copier.  We know how 
to design and build copiers with superior marking, paper handling and 
finishing technology.  We know our customers, their requirements and how to 
sell sophisticated, fully featured copiers.  In April 1997, we introduced 
the Document Centre family of black and white digital copiers at speeds 
ranging from 20 to 65 pages per minute, that are better quality, more 
reliable, and more feature rich than light-lens copiers and are priced at a 
modest premium over comparable light-lens copiers.  This family is modular 
in design, offering the capability of upgrading the standalone copier to 
full network connectivity when the customer is ready.

Beginning in 1998, we began connecting the digital copiers to customers' 
networks so that their digital copiers can also be used as robust, high-
speed network printers to gain incremental volume from computer printing and 
ultimately to replace desktop printers and single-purpose copiers and fax 
machines.  The fax option and network upgrades have compelling economics 
versus the alternative of purchasing comparable printers and faxes since the 
print engine, output mechanics and most of the software required are part of 
the base digital copier.

Revenue from the Document Centre family more than quadrupled in 1998, 
reaching $1.8 billion. This product family alone represented about two-
thirds of the company's digital revenue growth.  The proportion of digital 
copiers installed with network connectivity continued to grow, with 
approximately 45 percent of new 20 and 30 page per minute Document Centre 
installations being network connected in December.  Early results for the 65 
page per minute Document Centre are equally promising; in the areas where 
available, roughly 40 percent of December Document Centre 265 installations 
were network connected. 

Channels and Other Products

Revenues in this category grew 73 percent pre-currency to $0.7 billion in 
1998, reflecting primarily network black and white laser printers sold 
through indirect sales channels such as retail, dealers, and value added 
resellers.  

Significant market growth in the small office/home office and networked 
office is represented by customers who typically acquire product through 
indirect sales channels. In September, 1997, we launched the DocuPrint 
family of monochrome network laser printers which initially included 24 and 
32 page per minute laser printers and which were faster, more advanced and 
less expensive than competitive models, offering "copier-like" features such 
as multiple-set printing, stapling and collating.  In 1998, we expanded the 
DocuPrint line to include monochrome laser printers at speeds ranging from 8 
- - 40 pages per minute.


Light-lens Copying

Our revenues from light-lens copiers declined 11 percent pre-currency in 
1998 to $7.9 billion.  The decline in light-lens copier revenues reflects 
several important factors, including customer transition to our new digital 
black-and-white products and continued price pressures.  We believe the 
trend over the past few years will continue whereby digital products' 
revenues represent an increasing share of total revenues and light-lens 
copier revenues represent a declining share of total revenues.  Revenues 
from light-lens copying represented 41 percent of total revenues in 1998, 51 
percent in 1997 and 56 percent in 1996.

We market the broadest line of light-lens copiers and duplicators in the 
industry, ranging from a three copies-per-minute personal copier to a 135 
copies-per-minute full-featured duplicator. Many of our state-of-the-art 
products have improved ease of use, reliability, copy quality, job recovery 
and ergonomics as well as productivity-enhancing features, including zoom 
enlargement and reduction, highlight color, copying on both sides of the 
paper, and collating and stapling which allow the preparation of completed 
document sets.

We have a strong position with major accounts that demand a consistently 
high level of service worldwide.  Our competitive advantages include a focus 
on customer call response times, diagnostic equipment that is state-of-the-
art and availability of 24-hour-a-day, seven-day-a-week service.

We also are increasing our leadership position in the most competitive 
copier market segment - small commercial accounts and small offices/home 
offices - through increased indirect sales coverage including sales through 
independent agents, retail outlets and trade associations and increased 
marketing programs, such as telemarketing and advertising.
 
We expect that light-lens copiers will increasingly be replaced by digital 
copiers.  However, some portions of the market will continue to use light-
lens copiers for many years, such as customers who care principally about 
price or whose work processes do not require digital products.  Therefore, 
we intend to continually upgrade our light-lens products to maintain a 
leadership position in the industry.

Paper and Other Products

We also offer a wide range of other document processing products including 
devices designed to reproduce large engineering and architectural drawings 
up to 3 feet by 4 feet in size, facsimile products, and personal computer 
and workstation software.

We also sell cut-sheet paper to our customers for use in their document 
processing products.

Summary of Revenues by Product Category

The following table summarizes our revenues by major product category.  The 
revenues for light-lens copiers and digital products include equipment and 
supplies sales, service, rental and document outsourcing revenues, and 
finance income.

     Year ended December 31 (in billions)   1998       1997       1996
     Digital products                      $ 9.0      $ 6.6      $ 5.3
     Light-lens copiers                      7.9        8.9        9.7
     Paper and other products                2.5        2.6        2.4
       Total revenues                      $19.4      $18.1      $17.4

Xerox Competitive Advantages

Customer Satisfaction

Our highest priority is customer satisfaction.  Our research shows that 
satisfied customers are far more likely to repurchase products and that the 
cost of selling a replacement product to a satisfied customer is far less 
than selling to a "new" customer.  We regularly survey customers on their 
satisfaction, measure the results, analyze the root causes of 
dissatisfaction, and take steps to correct any problems.

Because of our emphasis on customer satisfaction, we offer a Total 
Satisfaction Guarantee, one of the simplest and most comprehensive offered 
in any industry:  "If you are not satisfied with our equipment, we will 
replace it without charge with an identical model or a machine with 
comparable features and capabilities."  This guarantee applies for at least 
three years to equipment acquired from and continuously maintained by Xerox 
or its authorized agents.

Quality

We were an early pioneer in total quality management and are the only 
company to have won all three of the following prestigious quality awards: 
the Malcolm Baldrige National Quality Award in the United States in 1989; 
the European Quality Award in 1992; and the Deming Prize in Japan, won by 
Fuji Xerox in 1980. Xerox Business Services, our document outsourcing 
division, also won the Baldrige Award in the service category in 1997.  In 
addition, we have won top quality awards in Argentina, Australia, Belgium, 
Brazil, Canada, China (Shanghai), Colombia, France, Germany, Hong Kong, 
India, Ireland, Mexico, the Netherlands, Norway, Portugal, the United 
Kingdom, and Uruguay.  Our "Leadership Through Quality" program has enabled 
us to improve productivity, accelerate the introduction of new products, 
improve customer satisfaction and increase market share.  Xerox products 
have been consistently rated among the worlds best by independent testing 
organizations. In 1997, Xerox reinforced its position as an environmental 
leader among Fortune 500 companies by receiving ISO 14001 certification for 
all its major manufacturing sites worldwide, as set by the International 
Standards Organization.

Research and Development

Xerox research and development (R&D) is directed toward the development of 
new products and capabilities in support of our document processing 
strategy.  Our research scientists are deeply involved in the formulation of 
corporate strategy and key business decisions.  They regularly meet with 
customers and have dialogues with our business divisions to ensure they 
understand customer requirements and are focused on products that can be 
commercialized.

In 1998, R&D expense was $1,043 million compared with $1,065 million in 1997 
and $1,044 million in 1996.  The modest reduction in 1998 reflected a 
reprioritization of our spending to focus on areas intended to produce 
significant growth, such as digital, color and solutions.  We continue to 
invest in technological development to maintain our premier position in the 
rapidly changing document processing market with a heightened focus on 
increasing the effectiveness of our R&D investment as well as time to 
market. We expect the 1999 R&D growth rate will exceed the 1999 revenue 
growth rate. Xerox R&D is strategically coordinated with Fuji Xerox, which 
invested $636 million in R&D in 1998 for a combined total of $1.7 billion. 




Marketing

Xerox document processing products are principally sold directly to 
customers by our worldwide sales force, a source of competitive advantage, 
totaling approximately 13,000 employees and through a network of independent 
agents, dealers, retail chains, value-added resellers and systems 
integrators.  To market low-end copiers, laser printers, and multi-function 
devices, we are significantly expanding our indirect distribution channels.  
We currently have arrangements with U.S. retail marketing channels including 
CompUSA, Office Depot, OfficeMax, and Staples, and office channels that 
include distributors and value added resellers like Pinacor (formerly 
MicroAge), Ingram Micro, Tech Data, and Computer 2000.  In 1998 we expanded 
our worldwide network of retail outlets and resellers by more than 40 
percent.  Our strategy is to target high-growth markets through high-volume 
distribution of laser and ink-jet printers, multi-function products, 
personal copiers, fax machines, and supplies, both for Xerox and competitive 
equipment, with a goal to be the fastest growing source of personal and 
networked document solutions in retail and reseller channels worldwide. In 
1998 we began a major redesign of our Internet site to make it a more 
powerful tool for electronic commerce.  We have begun to sell Xerox 
equipment and supplies over the Internet and will expand this initiative in 
1999.  We also plan to significantly expand our telebusiness capacity over 
the next three years, including opening new telebusiness centers in North 
America and Europe. Finally, we have increased our advertising spending.

Service

We have a worldwide service force of approximately 24,000 employees.  In our 
opinion, this direct service force represents a significant competitive 
advantage: the service force is continually trained on our new products and 
its diagnostic equipment is state-of-the-art.  24-hour-a-day, seven-day-a-
week service is available in most metropolitan areas in the United States.  
We are able to guarantee a consistent level of service nationwide and 
worldwide because we do not rely on independent local dealers for service 
and our service force is not focused exclusively on metropolitan areas.


Revenues

Our total document processing revenues were $19.4 billion in 1998, of which 
52 percent were generated in the United States, 28 percent in Europe, and 20 
percent in the remainder of the world, principally Brazil, the rest of Latin 
America, Canada, and China. The unconsolidated $6.8 billion of Fuji Xerox 
revenues were generated in Japan and much of the Pacific Rim.

Revenues from supplies, paper, service, rentals, document outsourcing and 
other revenues, and income from customer financing represented 62 percent of 
total revenues in 1998, 63 percent in 1997, and 65 percent in 1996.  Because 
these revenues are derived from the installed base of equipment and are 
therefore less volatile than equipment sales revenues, they provide 
significant stability to overall revenues.  Growth in these revenues is 
primarily a function of the growth in our installed population of equipment, 
usage and pricing.  The balance of our revenues is derived from equipment 
sales.  These sales, which drive the non-equipment revenues, depend on the 
flow of new products and are more affected by economic cycles from country 
to country.

Most of our customers have their equipment serviced by and use supplies sold 
by us.  The market for cut-sheet paper is highly competitive and revenue 
growth is significantly affected by pricing.  Our strategy is to charge a 
spread over mill wholesale prices.  Rental revenues declined in 1998 and 
1997 and were flat in 1996, due primarily to customers' preference for 
document outsourcing and the continuing trend of increased equipment sales.

Our document outsourcing business provides printing, publishing, duplicating 
and related services at more than 6,000 customer locations in 40 countries, 
including legal and accounting firms, financial institutions, insurance 
agencies and manufacturing companies.  Revenues from our document 
outsourcing business were $2.7 billion in 1998.  Document outsourcing 
revenues are split between equipment sales and document outsourcing.  Where 
document outsourcing contracts include revenue accounted for as equipment 
sales, this revenue is included in equipment sales on the income statement.  
All other document outsourcing revenue, including service, equipment rental, 
supplies, paper and labor are included in document outsourcing.  This has 
the effect of diverting some revenues from supplies, paper, service, rental, 
and finance income.

We offer our document processing customers financing of their purchases of 
Xerox equipment primarily through XCC in the United States, largely through 
wholly-owned financing subsidiaries in Europe, and through divisions in 
Canada and Latin America.  While competition for this business from banks 
and other finance companies remains extensive, we actively market our 
equipment financing services on the basis of customer service, convenience 
and competitive rates.  On average, 75 to 80 percent of equipment sales are 
financed through Xerox.

International Operations

Our international operations account for 48 percent of Document Processing 
revenues.  Our largest interest outside the United States is Xerox Limited.  
Marketing and manufacturing operations are also conducted through joint 
ventures in India and China.  Marketing and manufacturing in Latin America 
are conducted through subsidiaries or distributors in over 35 countries.  
Fuji Xerox develops, manufactures and distributes document processing 
products in Japan and other areas of the Pacific Rim, Australia and New 
Zealand.

Revenues in Brazil were $1.6 billion in 1998, $1.8 billion in 1997 and $1.6 
billion in 1996.  In the early part of 1999, the Brazilian real devalued 
substantially against the U.S. dollar.  Such devaluation could adversely 
effect the Brazilian economy.  However, we currently are unable to determine 
what effect, if any, this situation will have on our customers' intent or 
ability to purchase our products in 1999.

Our financial results by geographical area for 1998, 1997 and 1996, which 
are presented on pages 24, 25, and 47 of the Company's 1998 Annual Report to 
Shareholders, are hereby incorporated by reference in this document in 
partial answer to this item.

Restructuring

On April 7, 1998, we announced a worldwide restructuring program associated 
with enhancing our competitive position and lowering our overall cost 
structure.  In connection with this program, we recorded a second quarter 
pretax provision of $1,644 million ($1,107 million after taxes, including 
our $18 million share of a restructuring charge recorded by Fuji Xerox).  
The program includes the elimination of approximately 9,000 jobs, net, 
worldwide, the closing and consolidation of facilities, and the write-down 
of certain assets.

Key initiatives of the restructuring include:
1. Consolidation of 56 European customer support centers into one facility 
and implementing a shared services organization for order entry, 
invoicing, and other back-office and sales operations.
2. Streamlining manufacturing logistics, distribution and service 
operations.  This will include centralizing U.S. parts depots and 
outsourcing storage and distribution.
3. Overhauling our internal processes and associated resources, including 
closing one of four geographically-organized U.S. customer administrative 
centers with the remaining three refocused by customer segment, enabling 
improved customer support at lower cost.

When fully implemented, the ongoing pre-tax savings from the restructuring 
initiatives will be approximately $1 billion annually.  Initially, more than 
half of the savings is being reinvested to implement business process and 
systems changes in order to enable the restructuring, and in ongoing efforts 
to broaden and strengthen marketing programs and distribution channels to 
enhance revenue growth.  Selling, administrative and general expenses as a 
percentage of revenue will move from the high 20's to the low 20's over 
time, driven primarily by large reductions in overhead costs.  Manufacturing 
and service productivity will also improve.  These benefits will be somewhat 
offset by lower gross margins overall due to the increasing proportion of 
business conducted through indirect sales channels and outsourcing.

Our restructuring disclosure, presented on pages 28, 29, 42, and 43 of the 
Company's 1998 Annual Report to Shareholders, is hereby incorporated by 
reference in this document.

Acquisition of XLConnect Solutions
In May 1998, we acquired XLConnect Solutions, Inc. (XLConnect), an 
information technology services company, and its parent company, Intelligent 
Electronics, Inc. for $413 million in cash.  The operating results of these 
companies, which are not material, have been included in our consolidated 
statements of income from the date of the acquisition.  Based on the 
allocation of the purchase price, the transaction resulted in goodwill of 
$395 million (including transaction costs) which is being amortized over 25 
years.

Discontinued Operations - Insurance and Other Financial Services

The discussion under the caption "Discontinued Operations - Insurance and 
Other Financial Services" on pages 38 and 39 set forth under the caption 
"Financial Review" and the information set forth under Note 10 "Discontinued 
Operations" on pages 47 through 49 in the Company's 1998 Annual Report to 
Shareholders are hereby incorporated by reference in this document in 
partial answer to this item.

As discussed in the incorporated sections referenced in the preceding 
paragraph, in 1998, the last remaining Talegen Holdings, Inc. insurance 
companies were sold and an additional after-tax charge of $190 million was 
recorded. At the end of 1998, our sole remaining Insurance operation is the 
Ridge Reinsurance Limited reinsurance business.  Our other discontinued 
businesses, consisting of Other Financial Services and Third Party Financing 
and Real Estate, are primarily in asset and liability run-off.



I
tem 2. Properties

The Company owns a total of eleven principal manufacturing and engineering 
facilities and leases an additional such facility.  The domestic facilities 
are located in California, New York and Oklahoma, while the international 
facilities are located in Brazil, Canada, England, France, Holland and 
Mexico.  The Company also has four principal research facilities; two are 
owned facilities in New York and Canada, and two are leased facilities in 
California and France.

In addition, within the Company, there are numerous facilities that 
encompass general offices, sales offices, service locations and distribution 
centers.  The principal owned facilities are located in the United States, 
England, and Mexico.  The principal leased facilities are located in the 
United States, Brazil, Canada, England, Mexico, France, Germany and Italy.

The Company's Corporate Headquarters facility, located in Connecticut, is 
leased.  A training facility, located in Virginia, is owned by the Company.  
In the opinion of Xerox management, its properties have been well 
maintained, are in sound operating condition and contain all the necessary 
equipment and facilities to perform the Company's functions.


Item 3. Legal Proceedings

The information set forth under Note 15 "Litigation" on pages 57 and 58 of 
the Company's 1998 Annual Report to Shareholders is incorporated by 
reference in this document in answer to this item. 



Item 4. Submission of Matters to a Vote of Security Holders

None.




                                   PART II


Item 5. Market for the Registrant's Common Equity and Related Stockholder
        Matters

Market Information, Holders and Dividends

The information set forth under the following captions on the indicated 
pages of the Company's 1998 Annual Report to Shareholders is hereby 
incorporated by reference in this document in answer to this Item:

              Caption                                           Page No.

      Stock Listed and Traded                                      68
      Xerox Common Stock Prices and Dividends                      68
      Eleven Years in Review - Common Shareholders
        of Record at Year-End                                  64 and 65

Recent Sales of Unregistered Securities

During the quarter ended December 31, 1998, Registrant issued the following 
securities in transactions that were not registered under the Securities Act 
of 1933, as amended (the Act):

(a)  Securities Sold:  On October 1, 1998, Registrant issued 1,215 shares of 
Common stock, par value $1 per share.

(b)  No underwriters participated.  The shares were issued to each of the 
non-employee Directors of Registrant: B.R. Inman, A.A.Johnson, V.E. Jordan, 
Jr., Y. Kobayashi, H. Kopper, R.S. Larsen, G.J. Mitchell, N.J. Nicholas, 
Jr., J.E. Pepper, P. F. Russo, M.R. Seger and T.C.Theobald.

(c)  The shares were issued at a deemed purchase price of $84.75 per share 
(aggregate price $102,625), based upon the market value on the date of 
issuance, in payment of the quarterly Directors' fees pursuant to 
Registrant's Restricted Stock Plan for Directors.

(d)  Exemption from registration under the Act was claimed based upon 
Section 4(2) as a sale by an issuer not involving a public offering.


Item 6. Selected Financial Data

The following information, as of and for the five years ended December 31, 
1998, as set forth and included under the caption "Eleven Years in Review" 
on pages 64 and 65 of the Company's 1998 Annual Report to Shareholders, is 
hereby incorporated by reference in this document in answer to this Item:

        Revenues
        Income (loss) from continuing operations
        Per-Share Data - Earnings (loss) from continuing operations
        Total assets
        Long-term debt
        Preferred stock
        Per-Share Data - Dividends declared



Item 7. Management's Discussion and Analysis of Financial Condition and 
        Results of Operations

The information set forth under the caption  "Results of Operations and 
Financial Condition" under the caption "Financial Review" on pages 22, 24-
32, 34-35, and 37-39 of the Company's 1998 Annual Report to Shareholders 
other than the pictures and captions to the pictures is hereby incorporated 
by reference in this document in answer to this Item.


Item 7A. Quantitative and Qualitative Disclosures About Market Risk

The information set forth under the caption  "Risk Management" on pages 35
and 37 of the Company's 1998 Annual Report to Shareholders other than the 
picture and caption to the picture is hereby incorporated by reference in 
this document in answer to this Item.


Item 8. Financial Statements and Supplementary Data

The consolidated financial statements of Xerox Corporation and subsidiaries 
and the notes thereto and the report thereon of KPMG LLP, independent 
auditors, which appear on pages 23, 33, 36, 40-61 and 63 of the Company's 
1998 Annual Report to Shareholders, are hereby incorporated by reference in 
this document in answer to this Item.  In addition, also included is the 
quarterly financial data included under the caption "Quarterly Results of 
Operations (Unaudited)" on page 62 of the Company's 1998 Annual Report to 
Shareholders.

The financial statement schedule required herein is filed as "Financial 
Statement Schedules" pursuant to Item 14 of this Report on Form 10-K.


Item 9. Changes in and Disagreements with Accountants on Accounting and 
        Financial Disclosure

Not applicable.



                                   PART III

The information set forth in "Proposal 1--Election of Directors" in the 
Company's Notice of the 1999 Annual Meeting of Shareholders and Proxy 
Statement, to be filed pursuant to Regulation 14A not later than 120 days 
after the close of the fiscal year covered by this report on Form 10-K, is 
hereby incorporated by reference in this document in answer to this Part 
III.

Executive Officers of Xerox

The following is a list of the executive officers of Xerox, their current 
ages, their present positions and the year appointed to their present 
positions.  There are no family relationships between any of the executive 
officers named.

Each officer is elected to hold office until the meeting of the Board of 
Directors held on the day of the next annual meeting of shareholders, 
subject to the provisions of the By-Laws.
                                                             Year
                                                           Appointed
                                                          to Present   Officer
     Name           Age         Present Position           Position     Since_

Paul A. Allaire*     60    Chairman of the Board, Chief       1991       1983
                           Executive Officer and Chairman
                           of the Executive Committee

G. Richard Thoman*   54    President and Chief                1997       1997
                           Operating Officer

William F. Buehler   59    Executive Vice President           1999       1991
                           Industry Solutions Operations

Allan E. Dugan       58    Executive Vice President           1999       1990
                           Business Group Operations

Anne M. Mulcahy      46    Executive Vice President           1999       1992
                           General Markets Operations

Carlos Pascual       53    Executive Vice President           1999       1994
                           Deputy Executive Officer,
                           Industry Solutions Operations

Barry D. Romeril     55    Executive Vice President and       1993       1993
                           Chief Financial Officer

Patrick J. Martin    58    Senior Vice President              1999       1992
                           President, Developing Markets
                           Operations

Michael Miron        43    Senior Vice President              1998       1998
                           Corporate Business Strategy 
                           and Development

Hector J. Motroni    55    Senior Vice President and          1999       1994
                           Chief Staff Officer


* Member of Xerox Board of Directors.

Executive Officers of Xerox, Continued

                                                             Year
                                                           Appointed
                                                          to Present   Officer
     Name           Age         Present Position           Position     Since_

Mark B. Myers        60    Senior Vice President              1992       1989
                           Xerox Research and Technology 

Richard S. Paul      57    Senior Vice President and          1992       1989
                           General Counsel

Eunice M. Filter     58    Vice President, Treasurer          1990       1984
                           and Secretary

Philip D. Fishbach   57    Vice President and Controller      1995       1990


Each officer named above, with the exception of G. Richard Thoman and 
Michael Miron, has been an officer or an executive of Xerox or its 
subsidiaries for at least the past five years.

Prior to joining Xerox in 1997, Mr. Thoman had been with International 
Business Machines Corporation (IBM) where he was Senior Vice President and 
Chief Financial Officer from 1995 to 1997, and Group Executive for the 
Personal Systems Group from 1994 to 1995.  He was President and CEO of 
Nabisco International from 1992 to 1994.  He was Chairman and Co-CEO of 
Travel Related Services for American Express from 1989 to 1992.  

Prior to joining Xerox in 1998, Mr. Miron had been with Airtouch 
Communications where he was Vice President, Corporate Strategy and 
Development from 1996 to 1998.  Prior to this he was with Salomon Brothers 
Inc. where he was Managing Director, Strategic Planning and Analysis from 
1994 to 1996, and Director, Strategy and Consulting Group from 1990 to 1993.



                                   PART IV


Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K.

(a)  (1) and (2)  The financial statements, independent auditors' reports 
      and Item 8 financial statement schedules being filed herewith or 
      incorporated herein by reference are set forth in the Index to  
Financial Statements and Schedule included herein.

     (3)  The exhibits filed herewith or incorporated herein by reference 
are set forth in the Index of Exhibits included herein.

(b)  No Current Reports on Form 8-K were filed during the last quarter of 
the period covered by this Report.

(c)  The management contracts or compensatory plans or arrangements listed
     in the Index of Exhibits that are applicable to the executive officers
     named in the Summary Compensation Table which appears in Registrant's
     1999 Proxy Statement are preceded by an asterisk (*).


Pursuant to the requirements of Section 13 or 15(d) of the Securities 
Exchange Act of 1934, the registrant has duly caused this report to be 
signed on its behalf by the undersigned, thereunto duly authorized.

                                                 XEROX CORPORATION


                                            By:  /s/ Barry D. Romeril_________
                                                 Executive Vice President and 
                                                 Chief Financial Officer
March 22, 1999

Pursuant to the requirements of the Securities Exchange Act of 1934, this 
report has been signed below by the following persons on behalf of the 
registrant and in the capacities and on the date indicated.

March 22, 1999



    Signature                                 Title

Principal Executive Officer:

Paul A. Allaire                              /s/ Paul A. Allaire______________

                                             Chairman, Chief Executive Officer
                                             and Director


Principal Financial Officer:

Barry D. Romeril                             /s/ Barry D. Romeril_____________

                                             Executive Vice President and
                                             Chief Financial Officer


Principal Accounting Officer:

Philip D. Fishbach                           /s/ Philip D. Fishbach___________

                                             Vice President and Controller

Directors:


/s/ B. R. Inman                                      Director


/s/ Antonia Ax:son Johnson                           Director


/s/ Vernon E. Jordan, Jr.                            Director


/s/ Hilmar Kopper                                    Director


/s/ Ralph S. Larsen                                  Director


/s/ George J. Mitchell                               Director


/s/ N. J. Nicholas, Jr.                              Director


/s/ John E. Pepper                                   Director


/s/ Patricia F. Russo                                Director


/s/ Martha R. Seger                                  Director


/s/ Thomas C. Theobald                               Director


/s/ G. Richard Thoman                                Director




Report of Independent Auditors



To the Board of Directors and Shareholders of Xerox Corporation


Under date of January 25, 1999, we reported on the consolidated balance 
sheets of Xerox Corporation and subsidiaries as of December 31, 1998 and 
1997, and the related consolidated statements of income, cash flows and 
shareholders' equity for each of the years in the three-year period ended 
December 31, 1998, as contained in the Xerox Corporation 1998 Annual Report 
to Shareholders on pages 23, 33, 36, and 40-61.  These consolidated 
financial statements and our report thereon are incorporated by reference in 
the 1998 Annual Report on Form 10-K.  In connection with our audits of the 
aforementioned consolidated financial statements, we also have audited the 
related financial statement schedule listed in the accompanying index.  This 
financial statement schedule is the responsibility of the Company's 
management.  Our responsibility is to express an opinion on this financial 
statement schedule based on our audits.

In our opinion, such financial statement schedule, when considered in 
relation to the basic consolidated financial statements taken as a whole, 
presents fairly, in all material respects, the information set forth 
therein.


                                             KPMG LLP
                                                



Stamford, Connecticut
January 25, 1999



Index to Financial Statements and Schedule

Financial Statements:

   Consolidated statements of income of Xerox Corporation and subsidiaries   
     for each of the years in the three-year period ended December 31, 1998

   Consolidated balance sheets of Xerox Corporation and subsidiaries as of 
     December 31, 1998 and 1997

   Consolidated statements of cash flows of Xerox Corporation and 
     subsidiaries for each of the years in the three-year period ended 
     December 31, 1998

   Consolidated statements of shareholders' equity of Xerox Corporation
     and subsidiaries for each of the years in the three-year period ended 
     December 31, 1998


   Notes to consolidated financial statements

   Report of Independent Auditors

   Quarterly Results of Operations (unaudited)

      The above consolidated financial statements, related notes, report 
      thereon and the quarterly results of operations which appear on pages 
      23, 33, 36, 40-61, 63, and 62 of the Company's 1998 Annual Report to 
      Shareholders are hereby incorporated by reference in this document.

Commercial and Industrial (Article 5) Schedule:

II - Valuation and qualifying accounts


All other schedules are omitted as they are not applicable, or the 
information required is included in the financial statements or notes 
thereto.

 
                                                                SCHEDULE II
Valuation and Qualifying Accounts
Year ended December 31, 1998, 1997 and 1996

                                           Additions
                             Balance at    charged to   Deductions,  Balance
                              beginning     costs and     net of      at end
(in millions)                 of period     expenses    recoveries of period

1998
Allowance for Losses on:
   Accounts Receivable          $ 92          $ 78         $ 68         $102
   Finance Receivables           389           223          171          441
Deferred Tax Valuation 
   Allowance                       -             -            -            -
                                $481          $301         $239         $543

1997
Allowance for Losses on:
   Accounts Receivable          $ 92          $ 84         $ 84         $ 92
   Finance Receivables           347           181          139          389
Deferred Tax Valuation 
   Allowance                       -             -            -            -

                                $439          $265         $223         $481

1996
Allowance for Losses on:
   Accounts Receivable          $ 90          $ 73         $ 71         $ 92
   Finance Receivables           322           186          161          347
Deferred Tax Valuation 
   Allowance                      20            -            20            - 

                                $432          $259         $252         $439































Index of Exhibits

Document and Location
  
(3) (a)     Restated Certificate of Incorporation of Registrant filed by the 
            Department of State of New York on October 29, 1996.
  
            Incorporated by reference to Exhibit 3(a)(1) to Registrant's 
            Quarterly Report on Form 10-Q for the Quarter Ended September 30, 
            1996.

    (b)     By-Laws of Registrant, as amended through January 25, 1999.

            Incorporated by reference to Exhibit (2) to Amendment No. 4 to 
            Registrant's Registration Statement on Form 8-A dated January 26, 
            1999.

(4) (a)     Indenture dated as of January 15, 1990 between Registrant and 
            BankAmerica National Trust Company (as successor in interest to
            Security Pacific National Trust Company (New York)) relating 
            to unlimited amounts of debt securities which may be issued 
            from time to time by Registrant when and as authorized by or
            pursuant to a resolution of Registrant's Board of Directors.

            Incorporated by reference to Exhibit 4(a) to Registration No. 
            33-33150.

    (b)     Indenture dated as of December 1, 1991 between Registrant and 
            Citibank, N.A. relating to unlimited amounts of debt securities 
            which may be issued from time to time by Registrant when and 
            as authorized by or pursuant to a resolution of Registrant's 
            Board of Directors.
  
            Incorporated by reference to Exhibit 4(a) to Registration Nos. 
            33-44597, 33-49177 and 33-54629.
 
    (c)     Indenture dated as of September 20, 1996 between Registrant and 
            Citibank, N.A. relating to unlimited amounts of debt securities 
            which may be issued from time to time by Registrant when and as 
            authorized by or pursuant to a resolution of Registrant's Board 
            of Directors.

            Incorporated by reference to Exhibit 4(a) to Registration 
            Statement No. 333-13179.

    (d)     Indenture dated as of October 1, 1997 among Registrant, Xerox 
            Overseas Holding Limited (formerly Xerox Overseas Holding PLC), 
            Xerox Capital (Europe) plc (formerly Xerox Capital (Europe) plc) 
            and Citibank, N.A. relating to unlimited amounts of debt 
            securities which may be issued from time to time by Registrant and 
            unlimited amounts of guaranteed debt securities which may be 
            issued from time to time by the other issuers when and as 
            authorized by or pursuant to a resolution or resolutions of the 
            Board of Directors of Registrant or the other issuers, as 
            applicable.

            Incorporated by reference to Exhibit 4(b) to Registration 
            Statement Nos. 333-34333, 333-34333-01 and 333-34333-02.

    (e)     Indenture dated as of April 21, 1998 between Registrant and The 
            First National Bank of Chicago relating to $1,012,198,000 
            principal amount at maturity of Registrant's Convertible 
            Subordinated Debentures due 2018.

            Incorporated by reference to Exhibit 4(b) to Registration 
            Statement No. 333-59355. 

    (f)     Indenture dated as of March 1, 1988, as supplemented by the First 
            Supplemental Indenture dated as of July 1, 1988, between Xerox 
            Credit Corporation (XCC) and The First National Bank of Chicago 
            relating to unlimited amounts of debt securities which may be 
            issued from time to time by XCC when and as authorized by XCC's 
            Board of Directors or the Executive Committee of the Board of 
            Directors.

            Incorporated by reference to Exhibit 4(a) to XCC's Registration 
            Statement No. 33-20640 and to Exhibit 4(a)(2) to XCC's Current 
            Report on Form 8-K dated July 13, 1988.

    (g)     Indenture dated as of March 1, 1989, as supplemented by the First 
            Supplemental Indenture dated as of October 1, 1989, between XCC 
            and Citibank, N.A. relating to unlimited amounts of debt 
            securities which may be issued from time to time by XCC when and 
            as authorized by XCC's Board of Directors or Executive Committee 
            of the Board of Directors.
  
            Incorporated by reference to Exhibit 4(a) to XCC's Registration 
            Statement No. 33-27525.

    (h)     Indenture dated as of October 2, 1995, between XCC and State 
            Street Bank and Trust Company relating to unlimited amounts of 
            debt securities which may be issued from time to time by XCC when 
            and as authorized by XCC's Board of Directors or Executive 
            Committee of the Board of Directors.

            Incorporated by reference to Exhibit 4(a) to XCC's Registration
            Statement Nos. 33-61481 and 333-29677.

    (i)     Instruments with respect to long-term debt where the total amount 
            of securities authorized thereunder does not exceed 10% of the 
            total assets of the Registrant and its subsidiaries on a 
            consolidated basis have not been filed.  The Registrant agrees to 
            furnish to the Commission a copy of each such instrument upon 
            request. 
  
(10)        The management contracts or compensatory plans or arrangements 
            listed below that are applicable to the executive officers named 
            in the Summary Compensation Table which appears in Registrant's 
            1999 Proxy Statement are preceded by an asterisk (*).
 
   *(a)     Registrant's 1976 Executive Long-Term Incentive Plan, as amended 
            through February 4, 1991.
 
            Incorporated by reference to Exhibit (10)(a) to the Registrant's 
            Annual Report on Form 10-K for the Year Ended December 31, 1991.

   *(b)     Registrant's 1991 Long-Term Incentive Plan, as amended through 
            May 15, 1997.

            Incorporated by reference to Registrant's Notice of the 1997 
            Annual Meeting of Shareholders and Proxy Statement pursuant to
            Regulation 14A.
  
    (c)     Registrant's 1996 Non-Employee Director Stock Option Plan.

            Incorporated by reference to Registrant's Notice of the 1996 
            Annual Meeting of Shareholders and Proxy Statement pursuant to
            Regulation 14A.
  
   *(d)     Description of Registrant's Annual Performance Incentive Plan.

   *(e)     Registrant's 1997 Restatement of Registrant's Unfunded Retirement 
            Income Guarantee Plan.

            Incorporated by reference to Exhibit 10(e) to Registrant's 
            Quarterly Report on Form 10-Q for the Quarter Ended September 30, 
            1997.

   *(f)     1997 Restatement of Registrant's Unfunded Supplemental Retirement 
            Plan.

            Incorporated by reference to Exhibit 10(f) to Registrant's 
            Quarterly Report on Form 10-Q for the Quarter Ended September 30, 
            1997.

    (g)     Registrant's 1981 Deferred Compensation Plan, 1985 
            Restatement, as amended through April 2, 1990.

            Incorporated by reference to Exhibit 10(h) to Registrant's 
            Quarterly Report on Form 10-Q for the Quarter Ended March 31, 
            1990.

    (h)     1996 Amendment and Restatement of Registrant's Restricted Stock 
            Plan for Directors.

            Incorporated by reference to Registrant's Notice of the 1996 
            Annual Meeting of Shareholders and Proxy Statement pursuant to
            Regulation 14A.

   *(i)     Form of severance agreement entered into with various executive
            officers.

            Incorporated by reference to Exhibit 10(j) to Registrant's 
            Quarterly Report on Form 10-Q for the Quarter ended June 30, 
            1989.

   *(j)     Registrant's Contributory Life Insurance Program, as amended as of 
            January 30, 1998.

            Incorporated by reference to Exhibit 10(j) to Registrant's 
            Annual Report on Form 10-K for the Year Ended December 31, 1997.
 
    (k)     Registrant's Deferred Compensation Plan for Directors, 1997 
            Amendment and Restatement.
            Incorporated by reference to Exhibit 10(k) to Registrant's 
            Quarterly Report on Form 10-Q for the Quarter Ended September 30, 
            1997.

   *(l)     Registrant's Deferred Compensation Plan for Executives, 1997 
            Amendment and Restatement.

            Incorporated by reference to Exhibit 10(l) to Registrant's 
            Quarterly Report on Form 10-Q for the Quarter Ended September 30, 
            1997.

   *(m)     Executive Performance Incentive Plan.

            Incorporated by reference to Registrant's Notice of the 1995 
            Annual Meeting of Shareholders and Proxy Statement pursuant to
            Regulation 14A.

   *(n)     Registrant's 1998 Employee Stock Option Plan.

            Incorporated by reference to Registrant's Notice of the 1998 
            Annual Meeting of Shareholders and Proxy Statement pursuant to
            Regulation 14A.

(11)        Statement re computation of per share earnings.
 
(12)        Computation of Ratio of Earnings to Fixed charges.

(13)        Pages 22 through 65 and 68 of Registrant's 1998 Annual Report
            to Shareholders.

(21)        Subsidiaries of the Registrant.

(23)        Consent of KPMG LLP.

(27)        Financial Data Schedule (in electronic form only).








                                                               EXHIBIT 10(d)
Annual Performance Incentive Plan 

Under the Annual Performance Incentive Plan, executive officers of the 
Company may be entitled to receive performance related cash payments 
provided that annual, Committee-established performance objectives are met. 
At the beginning of the year, the Executive Compensation and Benefits 
Committee approves for each officer not participating in the Executive 
Performance Incentive Plan, an annual incentive target and maximum 
opportunity expressed as a percentage of annual base salary.  The Committee 
also establishes overall Document Processing threshold, target and maximum 
measures of performance and associated payment schedules.  For 1998, the 
performance measures were earnings per share (35%), revenue growth (25%), 
cash generation (10%), customer satisfaction (10%), customer loyalty (10%) 
and employee satisfaction (10%).  Additional goals are also established for 
each officer that include business unit specific and/or individual 
performance goals and objectives.  The weights associated with each business 
unit specific or individual performance goal and objective used vary and 
range from 20 percent to 50 percent of the total.  Actual performance
 
payments are subject to approval by the Committee following the end of the 
year.




Computation of Net Income Per Common Share

(Dollars in millions, except per-share data; shares in thousands)
I. Basic Net Income (Loss) Per Common Share
     Income (loss) from continuing operations
     Accrued dividends on ESOP preferred stock, net
     Accrued dividends on redeemable preferred stock   
     Call premium on redeemable preferred stock 
     Adjusted income (loss) from continuing operations
     Discontinued operations
     Adjusted net income (loss)

     Average common shares outstanding during the period
     Common shares issuable with respect to
              exchangeable shares
     Adjusted average shares outstanding for the period

     Basic earnings (loss) per share:
       Continuing operations
       Discontinued operations
     Basic earnings (loss) per share


II. Diluted Net Income (Loss) Per Common Share
     Income (loss) from continuing operations
     Accrued dividends on ESOP preferred stock, net
     Accrued dividends on redeemable preferred stock 
     Call premium on redeemable preferred stock
     ESOP expense adjustment, net of tax
     Interest on convertible debt, net of tax
     Adjusted income (loss) from continuing operations
     Discontinued operations
     Adjusted net income (loss)

     Average common shares outstanding during the period
     Common shares issuable with respect
 to:
       Stock options, incentive and exchangeable shares
       Convertible debt
       ESOP preferred stock
     Adjusted average shares outstanding for the period

     Diluted earnings (loss) per share:
       Continuing operations
       Discontinued operations
     Diluted earnings (loss) per share

                                                                  EXHIBIT 11

         1998            1997            1996            1995          1994

     $    585        $  1,452        $  1,206        $  1,174      $    794
          (46)            (44)            (43)            (42)          (41)
            -               -              (1)             (3)          (12)
            -               -               -               -           (11)
          539           1,408           1,162           1,129           730
         (190)              -               -          (1,646)            -
     $    349        $  1,408        $  1,162        $   (517)     $    730

      655,676         649,608         648,924         644,174       632,550

        3,280           3,763           5,464           7,854        10,160
      658,956         653,371         654,388         652,028       642,710


     $    .82        $   2.16        $   1.78        $   1.73      $   1.14
         (.29)              -               -           (2.53)            -
     $    .53        $   2.16        $   1.78        $  ( .80)     $   1.14



     $    585        $  1,452        $  1,206        $  1,174      $    794
          (46)              -               -               -             -
            -               -              (1)             (3)          (12)
            -               -               -               -           (11)
            -               -              (3)             (9)           (7)
            3               3               3               4             3
          542           1,455           1,205           1,166           767
         (190)              -               -          (1,646)            -
     $    352        $  1,455        $  1,205        $   (480)     $    767

      655,676         649,608         648,924         644,174       632,550

       13,091          11,691          16,108          19,206        18,005
        5,287           5,287           5,287           5,287         5,287
            -          54,687          55,960          57,325        58,620
      674,054         721,273         726,280         725,992       714,462


     $    .80        $   2.02        $   1.66        $   1.61      $   1.07
         (.28)              -               -           (2.27)            -
     $    .52        $   2.02        $   1.66        $  ( .66)     $   1.07






                                                                  Exhibit 12

                             
Computation of Ratio of Earnings to Fixed Charges
                               
Year ended December 31  (in millions)    1998*   1997    1996    1995    1994

Fixed Charges:
  Interest expense                     $  748  $  617  $  592  $  603  $  520
  Rental expense                          145     140     140     142     170
    Total fixed charges before
     capitalized interest and
     preferred stock dividend
     of subsidiary                        893     757     732     745     690
  Capitalized interest                      -       -       -       -       2
  Preferred stock dividend of
   subsidiary                              55      50       -       -       -
    Total fixed charges                $  948     807  $  732  $  745  $  692

Earnings available for fixed charges:
  Earnings**                           $  837  $2,268  $2,067  $1,980  $1,602
  Less undistributed income in
   minority owned companies               (27)    (84)    (84)    (90)    (54)
  Add fixed charges before capitalized
   interest and preferred stock
   dividend of subsidiary                 893     757     732     745     690
    Total earnings available for
     fixed charges                     $1,703  $2,941  $2,715  $2,635  $2,238

Ratio of earnings to fixed
 charges (1)(2)                          1.80    3.64    3.71    3.54    3.23


(1) The ratio of earnings to fixed charges has been computed based on the 
    Company's continuing operations by dividing total earnings available for 
fixed charges, excluding capitalized interest, by total fixed charges.  
Fixed charges consist of interest, including capitalized interest and 
preferred stock dividend requirements of subsidiaries, and one-third of 
rent expense as representative of the interest
 portion of rentals.  Debt 
has been assigned to discontinued operations based on historical levels 
assigned to the businesses when they were continuing operations, 
adjusted for subsequent paydowns.  Discontinued operations consist of 
the Company's Insurance, Other Financial Services, and Third Party 
Financing and Real Estate businesses. 

(2) The Company's ratio of earnings to fixed charges includes the effect of 
the Company's finance subsidiaries, which primarily finance Xerox 
equipment.  Financing businesses are more highly leveraged and, 
therefore, tend to operate at lower earnings to fixed charges ratio 
levels than do non-financial businesses.

 * Excluding the effects of the charges recorded in connection with the 1998 
restructuring plan, the ratio of earnings to fixed charges would be 
3.55. 

** Sum of "Income before Income Taxes, Equity Income and Minorities' 
Interests" and "Equity in Net Income of Unconsolidated Affiliates."




<PAGE>
 
Results of Operations and Financial Condition

Summary of Total Company Results

Document Processing revenues, which grew 8 percent on a pre-currency basis to
$19.4 billion in 1998, were affected by some weaker economies. Excluding Brazil
and Russia, precurrency revenues grew 10 percent. Total pre-currency revenue
growth was driven by 12 percent growth in equipment sales and 25 percent growth
in document outsourcing (excluding equipment accounted for as sales). The strong
equipment sales growth was the direct result of our investments in sales
coverage and excellent customer acceptance of our expanding portfolio of new
digital products. Revenues increased 7 percent on a pre-currency basis to $18.1
billion in 1997 and 6 percent on a pre-currency basis to $17.4 billion in 1996.

   The following table summarizes net income and diluted earnings per share
(EPS):

- -------------------------------------------------------------------
  (In millions, except per-share data)    1998       1997      1996
- -------------------------------------------------------------------
  Document Processing before
    restructuring charge                $1,692     $1,452    $1,206
  Restructuring Charge                  (1,107)         -         -
- -------------------------------------------------------------------
  Continuing operations                    585      1,452     1,206
  Discontinued operations                 (190)         -         -
- -------------------------------------------------------------------
  Net income                            $  395     $1,452    $1,206
- -------------------------------------------------------------------
  EPS
  Document Processing before
    restructuring charge                $ 2.33     $ 2.02    $ 1.66
  Restructuring charge                   (1.53)         -         -
- -------------------------------------------------------------------
  Continuing operations
                   0.80       2.02      1.66
  Discontinued operations                (0.28)         -         -
- -------------------------------------------------------------------
  Diluted EPS                           $ 0.52     $ 2.02    $ 1.66
- -------------------------------------------------------------------

Income from continuing operations increased 17 percent in 1998, excluding the
impact of a $1,107 million after-tax restructuring charge, and 20 percent in
1997.

   Diluted earnings per share from continuing operations increased 16 percent in
1998, excluding the restructuring charge, and 22 percent in 1997. Earnings per
share have been adjusted to reflect the 2-for-1 stock split to shareholders of
record on February 4, 1999.

   A quarterly analytical summary for 1998 is shown on page 28 and quarterly
results of operations for 1998 and 1997 are shown on page 62.

   Since 1995, the results of our Insurance operations have been accounted for
as discontinued operations. Discontinued operations results for 1997 and 1996
were charged to previously established reserves and did not affect reported net
income. For 1998, results include a $190 million after-tax charge in connection
with the final disposition of the insurance businesses.

              [The following data was represented by a bar chart]

                              Earnings per Share*
                                 (dollars)          
                                                     
                         96        $1.66             
                         97        $2.02             
                         98        $2.33              

              * Document processing before restructuring charge.
        
Document Processing
Pre-Currency Growth 
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 foreign currencies into U.S. dollars. We refer to
this adjusted growth as "pre-currency growth."

   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 currencies on a
revenue-weighted basis, the U.S. dollar was approximately 1 percent stronger in
1998, 8 percent stronger in 1997, and 2 percent stronger in 1996. As a result,
foreign currency translation unfavorably impacted revenue growth by
approximately 1 percentage point in 1998, 3 percentage points in 1997 and 1
percentage point in 1996.

   We do not hedge the translation effect of revenues denominated in currencies
where the local currency is the functional currency.

Revenues by Product Category
For the major product categories, the pre-currency revenue growth rates were:

- -----------------------------------------------------------------------
                                                Pre-Currency Growth
- -----------------------------------------------------------------------
                                           1998        1997        1996
- -----------------------------------------------------------------------
  Total Revenues                              8%          7%          6%
- -----------------------------------------------------------------------
  Digital products                           36          25          23
  Light-lens copiers                        (11)         (2)         (1)
  Paper and other products                    1           3          --
- -----------------------------------------------------------------------

22       XEROX CORPORATION





<PAGE>
                                                                FINANCIAL REVIEW

Consolidated Statements of Income


<TABLE>
<CAPTION>


- -----------------------------------------------------------------------------------------------------------------------------
Year ended December 31 (in millions, except per-share data)                          1998             1997               1996
- -----------------------------------------------------------------------------------------------------------------------------
<C> <S>                                                                               <C>              <C>               <C>     
REVENUES
<C> 
Sales                                                                             $10,752          $ 9,881           $  9,256

Service and rentals                                                                 7,626            7,257              7,107

Finance income                                                                      1,071            1,006              1,015

- -----------------------------------------------------------------------------------------------------------------------------
Total Revenues                                                                     19,449           18,144             17,378
- -----------------------------------------------------------------------------------------------------------------------------
COSTS AND EXPENSES

Cost of sales                                                                       5,724            5,330              5,126

Cost of service and rentals                                                         4,140            3,778              3,597

Inventory charges                                                                     113                -                  - 

Equipment financing interest                                                          570              520                513

Research and development expenses                                                   1,043            1,065              1,044

Selling, administrative and general expenses                                        5,320            5,212              5,074

Restructuring charge and asset impairments                                          1,531                -                  -

Gain on affiliates' sales of stock, net                                                 -                -                (11)

Other, net                                                                            245               98                 91
- -----------------------------------------------------------------------------------------------------------------------------
Total Costs and Expenses                                                           18,686           16,003             15,434
- -----------------------------------------------------------------------------------------------------------------------------
INCOME BEFORE INCOME TAXES, EQUITY INCOME AND MINORITIES' INTERESTS                   763            2,141              1,944
<C> 
Income taxes                                                                          207              728                700

Equity in net income of unconsolidated affiliates                                      74              127                123

Minorities' interests in earnings of subsidiaries                                      45               88                161
- -----------------------------------------------------------------------------------------------------------------------------
INCOME FROM CONTINUING OPERATIONS                                                     585            1,452              1,206

Discontinued operations                                                              (190)               -                  - 
- -----------------------------------------------------------------------------------------------------------------------------
NET INCOME                                                                        $   395          $ 1,452           $  1,206
- -----------------------------------------------------------------------------------------------------------------------------

Basic Earnings (Loss) per Share

Continuing operations                                                             $  0.82          $  2.16           $   1.78

Discontinued operations                                                             (0.29)               -                  - 
- -----------------------------------------------------------------------------------------------------------------------------
BASIC EARNINGS PER SHARE                                                          $  0.53          $  2.16           $   1.78
- -----------------------------------------------------------------------------------------------------------------------------
Diluted Earnings (Loss) per Share

Continuing operations                                                             $  0.80          $  2.02           $   1.66

Discontinued operations                                                             (0.28)               -                  -
- -----------------------------------------------------------------------------------------------------------------------------
DILUTED EARNINGS PER SHARE                                                        $  0.52          $  2.02           $   1.66
- -----------------------------------------------------------------------------------------------------------------------------
</TABLE>


The accompanying notes on pages 41 to 61 are an integral part of the
consolidated financial statements.

                                                            XEROX CORPORATION 23


<PAGE>
 
FINANCIAL REVIEW

   The digital product portfolio includes production publishing, color copying
and printing, production printing, Document Centre digital black-and-white
copiers, and network laser printers sold through indirect channels. Digital
product revenues grew 36 percent in 1998, driven by outstanding revenue growth
from our expanding Document Centre family, excellent laser printer
revenue growth, strong production publishing and color copying and printing
growth, and modest growth in production printing revenue.

   Revenues from the DocuTech family of production publishing products reflected
strong growth to $2.3 billion in 1998, up from $2.1 billion in 1997 and $1.8
billion in 1996. The 180 page-per-minute DocuTech Production Publisher, which
became available in the middle of 1997, contributed to this growth. Revenues
from color products reflected strong growth to $1.9 billion in 1998, although
growth slowed in the second half in part due to the weak economic environment in
Brazil. Color revenues were $1.5 billion in 1997 and $1.0 billion in 1996. The
DocuColor 40, our 40 page-per-minute color document production system,
introduced in April 1996, continued to contribute significantly to this growth.

   The expanding line of Document Centre digital black-and-white copiers now
includes models at speeds ranging from 20 to 65 pages per minute. Availability
of network connectivity continues to expand and the proportion of new
installations with network connectivity increased during the year. We expect the
connectivity rate will continue to increase. Document Centre revenues
represented almost 60 percent of the company's digital revenue growth.

   Our expanding family of network laser printers sold through indirect
channels experienced excellent growth in 1998 following launch of the initial
models in September 1997.

   The light-lens copier revenue decline reflects customer transition to our new
digital black-and-white products and continued price pressures. We believe the
trend over the past few years will continue and that digital product revenues
will represent an increasing share of total revenues.

   Fluctuations in paper and other products revenue growth were principally due
to swings in paper prices and OEM sales.

   For the major product categories, the revenue shares were:

- -----------------------------------------------------------------------
                                           1998        1997        1996
- -----------------------------------------------------------------------
  Digital products                           46%         36%         30%
  Light-lens copiers                         41          51          56
  Paper and other products                   13          13          14
- -----------------------------------------------------------------------

The acceleration in digital product revenue growth from 23 percent in 1996 to 25
percent in 1997 and 36 percent in 1998 resulted in 1998 digital revenues
exceeding light-lens copier revenues for the first time.

Worldwide Revenues (billions)

o United States: $10.1
o Latin America and Canada: $3.5
o Europe and Other: $5.8
   Total Xerox: $19.4
o Fuji Xerox: $6.8

[Pictured here is a world map]

Revenues by Geography
Geographically, the pre-currency revenue growth rates were:

- ---------------------------------------------------------------------
                                             Pre-Currency Growth
- ---------------------------------------------------------------------
                                        1998         1997        1996
- ---------------------------------------------------------------------
  Total Revenues                           8%           7%          6%
- ---------------------------------------------------------------------
  United States                            10           7           6
  Xerox Limited                             9           7           1
  Other Areas                               1           8          10
  Memo: Fuji Xerox                         (3)          3          11
- ---------------------------------------------------------------------

Revenues in the United States were 52 percent of total revenues in 1998 compared
with 49 percent in both 1997 and 1996. Revenues of Xerox Limited and related
companies, which operate principally in Europe, represented 28 percent of total
revenues in 1998. Other Areas, principally Latin America, Canada and China,
contributed 20 percent of total revenues in 1998.

   Revenue growth in 1998 and 1997 in both the U.S. and Xerox Limited was driven
primarily by digital products; Xerox Limited also benefited from a strengthening
economic environment in several European markets. Xerox Limited's relatively
flat revenue growth in 1996 reflected weak economic environments in a number of
major European markets. Other Areas 1998 revenue reflected a 7 percent decline
in Brazil due to the difficult economic environment. Revenues in Brazil were
$1.6 billion in 1998, $1.8 billion in 1997 and $1.6 billion in 1996. Although
our operations in Russia are relatively small, with revenue of less than $100
million, revenues


24  XEROX CORPORATION


<PAGE>
 
                                                                FINANCIAL REVIEW


declined very significantly in 1998 due to the weak economy in that country.
Growth in Canada and Mexico was strong in 1998. 1997 revenue growth reflects
good growth in Brazil and China, modest growth in Canada, and excellent growth
in Mexico.

   In the early part of 1999, the Brazilian real devalued substantially against
the U.S. dollar. Financial reporting adjustments related to the devaluation will
be recorded in shareholders' equity. Such a devaluation could adversely affect
the Brazilian economy. However, we currently are unable to determine what
effect, if any, this will have on our customers' intent or ability to purchase
our products in 1999.

   Fuji Xerox Co., Ltd. (Fuji Xerox), an unconsolidated entity jointly owned by
Xerox Limited and Fuji Photo Film Co., Ltd., develops, manufactures and
distributes document processing products in Japan and the Pacific Rim.
Approximately 90 percent of Fuji Xerox revenues are generated in Japan, with
Australia, New Zealand, Singapore, Malaysia, and Korea representing the
remaining 10 percent. Fuji Xerox conducts business in other Pacific Rim
countries through joint ventures and distributors. Xerox' exposure to economic
turmoil in Asia is mitigated by our joint ownership of Fuji Xerox. Fuji Xerox
revenues declined by 3 percent in 1998 reflecting a modest decline in Japan and
a double-digit decline in Fuji Xerox' other Asia Pacific territories due to
difficult economic conditions. Conversely, modest revenue growth in 1997
reflected good growth in the Asia Pacific countries and only modest growth in
Japan due to difficult economic conditions. Revenue growth in 1996 reflects
strong growth in Japan, driven by excellent growth in digital products sales and
good growth in the Asia Pacific countries.

Revenues by Stream

The pre-currency growth rates by type of revenue were:

- ---------------------------------------------------------------------
                                              Pre-currency growth
- ---------------------------------------------------------------------
                                        1998         1997        1996
- ---------------------------------------------------------------------
  Total revenues                           8%           7%          6%
- ---------------------------------------------------------------------
  Equipment sales                         12           14          10
  Non-equipment sales revenues             5           3            3
    Document outsourcing*                 25           35          47
    Supplies                               6           2            8
    Paper                                  3           2           (7)
    Service                                1           1           (1)
    Rentals                              (10)         (9)           -
    Finance income                         7           2            1
- ---------------------------------------------------------------------
  * Excludes equipment accounted for as equipment sales.
- ---------------------------------------------------------------------

Equipment Sales: Equipment sales in 1998 grew 12 percent despite declines in
Brazil and Russia due to their weak economies. Excluding Brazil and Russia,
equipment sales grew 17 percent. Equipment sales growth is due primarily to the
introduction of a stream of state-of-the-art digital products in 1996, 1997 and
1998. Approximately half of 1998 equipment sales was attributable to products
introduced during 1997 and 1998, including our expanding line of Document Centre
digital multifunction equipment, the DocuTech 6180 Production Publisher and the
N series of network monochrome laser printers sold through indirect channels.
Digital product equipment sales grew 46 percent in 1998, 40 percent in 1997 and
27 percent in 1996 and represented 62 percent of 1998 equipment sales, 47
percent of 1997 and 37 percent of 1996.

              [The following data was represented by a bar chart]

                            Equipment Sales Growth
                                   (percent)
                         96           10
                         97           14
                         98           12

Non-Equipment Sales: Non-equipment sales revenues from supplies, paper, service,
rentals, document outsourcing and other revenues, and income from customer
financing represented 62 percent of total revenues in 1998, 63 percent in 1997
and 65 percent in 1996. Growth in these post-sale revenues is primarily a
function of the growth in our installed population of equipment, usage levels
and pricing.

Document Outsourcing: Document Outsourcing revenues are split between Equipment
Sales and Document Outsourcing. Where document outsourcing contracts include
revenues accounted for as equipment sales, this revenue is included in Equipment
Sales on the income statement. All other document outsourcing revenues,
including service, equipment rental, supplies, paper and labor are included in
Document Outsourcing. This has the effect of diverting some revenues from
supplies, paper, service, and rental. The excellent Document Outsourcing growth
reflects the trend of customers focusing on their core businesses and
outsourcing their

                                                            XEROX CORPORATION 25


<PAGE>
 
FINANCIAL REVIEW

document processing requirements to Xerox. The growth rate for total document
outsourcing revenues is substantially higher than the growth included in
Document Outsourcing, reflecting an increase in the proportion of equipment in
outsourcing contracts accounted for as sales.

Supplies: Good supplies revenue growth in 1998 reflects excellent indirect
channels sales and strong growth in Europe. Supplies growth decelerated in 1997
due principally to the increase in document outsourcing, which includes bundled
supplies, and lower sales of OEM printer cartridges.

Paper Sales: Our strategy is to charge a spread over mill wholesale prices to
cover our costs and value added as a distributor. The increases in 1998 and 1997
result from volume increases due to expanding distribution channels partially
offset by moderating industry-wide price declines. In 1996, lower wholesale
prices were partially offset by volume increases.

Service: Service revenue growth reflects the impact of higher machine
populations resulting from higher equipment sales, partially offset by customer
preference for document outsourcing as well as competitive price pressures.

Rentals: Rental revenues declined in 1998 and 1997 and were flat in 1996 due
primarily to customers' preference for document outsourcing and the continuing
trend toward equipment sales.

Finance Income: Our strategy for financing equipment sales in the industrialized
economies is to charge a spread over our cost of borrowing and to lock in that
spread by match funding the finance receivables with borrowings of similar
maturities. In 1998, good growth in the financing of equipment sales in the U.S.
and Latin America has been partially offset by lower average interest rates. In
1997, good financing growth in the U.S., Europe and Latin America was partially
offset by lower average interest rates. In 1996, the strong growth in the
financing of equipment sales in Latin America was partially offset by the
impacts of the continuing decline in interest rates on financing contracts and
the increasing customer preference for document outsourcing rather than purchase
and finance. On average, 75 to 80 percent of customers finance purchases of
equipment through Xerox.

Cost and Expenses

              [The following data was represented by a bar chart]

                        SAG as a percentage of Revenues
                                     (percent)
                         96            29.2
                         97            28.7
                         98            27.4 

The trend in key ratios was as follows:
- -------------------------------------------------------------------
                                       1998        1997        1996
- -------------------------------------------------------------------
  Gross margin                         46.3%       46.9%       46.9%
  SAG % Revenue                        27.4        28.7        29.2
- -------------------------------------------------------------------
   The modest 1998 gross margin decline was due to the increasing proportion of
lower margin channel product sales, the growing Document Outsourcing business,
and continued competitive price pressure partially offset by manufacturing and
service productivity. Including the inventory charges resulting from the
restructuring, the 1998 gross margin was 45.8%. The 1997 total gross margin was
essentially unchanged from 1996.

   The improved ratio of selling, administrative and general expenses (SAG) to
revenue in 1998 reflected declines in general and administrative expenses due to
continuing productivity initiatives, restructuring, and expense control,
partially offset by increased sales coverage and advertising investments.
Similarly, the improvement in 1997 was due primarily to productivity initiatives
and expense controls partially offset by investments to increase worldwide sales
coverage. SAG, on a pre-currency basis, increased only 3 percent in 1998
compared with 5 percent in 1997 and 8 percent in 1996.

   Research and development (R&D) expense declined 2 percent in 1998 and
increased 3 percent in 1997 and 10 percent in 1996. The modest reduction in 1998
reflected a reprioritization of our spending to focus on areas intended to
produce significant growth, such as digital, color and solutions. We continue to
invest in technological development to maintain our premier position in the
rapidly changing document processing market with a heightened focus on
increasing the effectiveness of our R&D investment as well as time to market.
Xerox R&D is strategically coordinated with Fuji Xerox, which invested $636
million in R&D in 1998 for a combined total of $1.7 billion. We expect the 1999
R&D growth rate will exceed the revenue growth rate.

26 XEROX CORPORATION


<PAGE>
 
                                                                FINANCIAL REVIEW

   Worldwide employment increased by 1,200 in 1998 to 92,700 primarily as a
result of hiring 2,800 employees to support our fast-growing Document
Outsourcing business, 1,700 associated with the acquisition of XLConnect
Solutions, and hiring to increase sales coverage. These increases were partially
offset by 5,400 employees leaving the company under the worldwide restructuring
program.

   Other expenses, net, were $245 million in 1998, $98 million in 1997 and $91
million in 1996. The increase of $147 million for 1998 reflected increased
non-financing interest expense and goodwill amortization associated with our
June 1997 acquisition of The Rank Group's remaining interest in Xerox Limited
and our May 1998 acquisition of XLConnect Solutions; non-financing interest
expense related to an increase in working capital; and increased Year 2000
remediation spending, partially offset by reduced currency losses from balance
sheet remeasurement, primarily due to Latin American currency devaluations. The
increase of $7 million for 1997 reflected increased non-financing interest
expense associated with our June 1997 acquisition of The Rank Group's remaining
interest in Xerox Limited, increased currency losses from balance sheet
remeasurement due to currency devaluation in our Latin American operations, and
Year 2000 remediation spending, partially offset by certain non-recurring
charges in 1996. Also, we reduced debt with the proceeds from the issuance of
$650 million of mandatorily redeemable preferred securities through a subsidiary
trust in January 1997. This partially offsets the 1997 increase in non-financing
interest expense because the after-tax impact of the dividend on these
securities is included in the income statement in Minorities' Interests in
Earnings of Subsidiaries.

- --------------------------------------------------------------------------------

[Pictured here are San Francisco Bay Area high school students]

Young Authors,
New World
  
As part of our DocuWorld initiative, Xerox invited high school students in the
San Francisco Bay Area to write on "A Vision of Life in the 21st Century."
Winning poetry and essays were collected in an anthology which was published
using state-of-the-art print-on-demand technologies from Xerox. The young
authors gathered in Chicago to watch their ideas being published in a
professional-quality book. Publishers and booksellers already are using this
technology to bring out worthy books that might not otherwise get published
because of fears that demand would be too low to justify the cost. DocuWorld is
a worldwide learning initiative that offers tutorials and demonstrations of
digital printing solutions from Xerox and two dozen partners. During the last
two years, 135,000 industry professionals attended events in 50 cities,
including Cairo, Hong Kong, San Francisco and Toronto.
- --------------------------------------------------------------------------------

Income Taxes, Equity in Net Income of
Unconsolidated Affiliates, and Minorities'
Interests in Earnings of Subsidiaries
Income before income taxes and the restructuring charge was $2,407 million in
1998, $2,141 million in 1997 and $1,944 million in 1996.

   The effective tax rates, before the restructuring charge, were 31.6 percent
in 1998, 34.0 percent in 1997 and 36.0 percent in 1996. The 1998 and 1997 tax
rates benefited from increases in foreign tax credits and refunds of foreign
taxes, as well as, shifts in the mix of our worldwide profits.

   Equity in Net Income of Unconsolidated Affiliates is principally Xerox
Limited's share of Fuji Xerox income. Total equity in income declined to $74
million due principally to our share, $18 million, of a restructuring charge
recorded by Fuji Xerox; a reduction in Fuji Xerox income reflecting difficult
economic conditions in Japan and other Asia Pacific operations; adverse currency
translation due to the weakening of the Japanese yen compared with the U.S.
dollar for most of the year; and reductions in income from several smaller
investments. The 1997 increase in total equity in income reflected strong
pre-currency Fuji Xerox income growth largely offset by currency translation due
to the weakening of the Japanese yen compared with the U.S. dollar and increases
in income from several smaller investments. The Xerox Limited 50 percent share
of Fuji Xerox income was $72 million (before our $18 million share of a
restructuring charge recorded by Fuji Xerox) in 1998, $119 million in 1997 and
$116 million in 1996.



                                                            XEROX CORPORATION 27


<PAGE>
 
FINANCIAL REVIEW

   Minorities' Interests in Earnings of Subsidiaries were $45 million in 1998,
$88 million in 1997 and $161 million in 1996. The 1998 amount primarily consists
of the dividends on the mandatorily redeemable preferred securities discussed
above. The 1998 and 1997 declines reflect our acquisition of The Rank Group's
remaining interest in Xerox Limited, effective June 1997. In 1997, this decline
was partially offset by the after-tax impact of the $48 million dividend on the
mandatorily redeemable preferred securities discussed above.

Income
In 1998, Document Processing income before the restructuring charge, increased
17 percent to $1,692 million. 1997 income of $1,452 million grew 20 percent
compared with $1,206 million in 1996.

- --------------------------------------------------------------------------------

[Pictured here are children playing soccer]

Community Involvement -- Children play soccer at Vila Olimpica da Mangueira, a
combined public school, sports complex, job training program and health clinic
in Mangueira, an impoverished area of Rio de Janeiro in Brazil. The village is
largely funded by Xerox do Brasil., Ltda., Vila Olimpica, cited by President
Clinton as a sterling example of community involvement by a corporation, is
credited with giving Mangueira's public schools one of the lowest dropout rates
in Rio.

- --------------------------------------------------------------------------------

Quarterly Analytical Earnings Per Share 
The following schedule summarizes the quarterly 1998 Continuing Operations
revenues, income and Earnings per Share computations before and after the
restructuring charge.


<TABLE>
<CAPTION>
- ----------------------------------------------------------------------------------------------------------------------------------
Continuing Operations                                                           First      Second      Third     Fourth       Full
(In millions, except per-share data)                                           Quarter     Quarter    Quarter    Quarter      Year
- ----------------------------------------------------------------------------------------------------------------------------------
<S>                                                                             <C>        <C>         <C>        <C>      <C>    
Revenues                                                                        $4,304     $ 4,742     $4,607     $5,796   $19,449
Costs and expenses, excluding the restructuring charge                           3,859       4,197      4,067      4,919    17,042
Restructuring charge                                                                 -       1,644          -         -      1,644
- ----------------------------------------------------------------------------------------------------------------------------------
Income (Loss) before Income Taxes, Equity Income and Minorities' Interests      $  445     $(1,099)    $  540     $  877   $   763
- ----------------------------------------------------------------------------------------------------------------------------------
Income from continuing operations before the restructuring charge               $  301     $   395     $  381     $  615   $ 1,692
Income (Loss)                                                                   $  301     $  (712)    $  381     $  615   $   585
Diluted Earnings per Share
     Adjusted average shares outstanding                                         725.0       731.6      735.2      735.8     733.0
     Diluted Earnings per Share, excluding the restructuring charge             $ 0.42     $  0.54     $ 0.53     $ 0.84   $  2.33
     Effect of restructuring charge*                                                 -       (1.64)         -                (1.53)
     Diluted earnings per share                                                 $ 0.42     $ (1.10)    $ 0.53     $ 0.84   $  0.80
- ----------------------------------------------------------------------------------------------------------------------------------
* The restructuring charge impact is limited due to antidilutive restrictions. Additionally, the quarterly earnings per share 
  differ from the full year amounts because certain antidilutuve securities are excluded from earnings per share calculations

</TABLE>
 

Restructuring Charge
On April 7, 1998, we announced a worldwide restructuring program associated with
enhancing our competitive position and lowering our overall cost structure. In
connection with this program, we recorded a second-quarter pretax provision of
$1,644 million ($1,107 million after taxes and including our $18 million share
of a restructuring charge recorded by Fuji Xerox). The program includes the
elimination of approximately 9,000 jobs, net, worldwide, the closing and
consolidation of facilities, and the write-down of certain assets. The charges
associated with the restructuring program include $113 million of inventory
charges recorded as cost of revenues and $316 million of asset impairments.
Included in the asset impairment charge is facility fixed asset write-downs of
$156 million and other asset write-downs of $160 million. For facility fixed
assets classified as assets to be disposed of, the impairment loss recognized is
based on fair value less cost to sell, with fair value based on third-party
valuations as well as our internal estimates of existing market prices for
similar assets. The effect of suspending depreciation on assets no longer in use
for 1998 is not material. The remaining $160 million of asset impairments
includes the write-down of certain technology assets and other items impacted


28 XEROX CORPORATION



<PAGE>
 
                                                                FINANCIAL REVIEW


by the consolidation initiatives described below. Key initia-
tives of the restructuring include:

1. Consolidating 56 European customer support centers into one facility and
   implementing a shared services organization for order entry, invoicing, and
   other back-office and sales operations.
2. Streamlining manufacturing, logistics, distribution and service operations.
   This will include centralizing U.S. parts depots and outsourcing storage and
   distribution.
3. Overhauling our internal processes and associated resources, including
   closing one of four geographically-organized U.S. customer administrative
   centers.

   The reductions are primarily in administrative functions, but also impact
service, research and manufacturing.

   The following table summarizes the status of the restructuring reserve:


- ---------------------------------------------------------------------
                                                   Charges
                                          Total    Against   12/31/98
  (in millions)                         Reserve    Reserve    Balance
- ---------------------------------------------------------------------
  Severance and related costs            $1,017      $ 304      $ 713
  Asset impairment                          316        316          -
  Lease cancellation and other costs        198         28        170
  Inventory charges                         113        113          -
- ---------------------------------------------------------------------
  Total                                  $1,644      $ 761      $ 883
- ---------------------------------------------------------------------


   When fully implemented, the ongoing pre-tax savings from the restructuring
initiatives will be approximately $1 billion annually. Initially, more than half
of the savings is being reinvested to implement process and systems changes in
order to enable the restructuring, and to sustain ongoing efforts to broaden
and strengthen marketing programs and distribution channels to enhance revenue
growth. Selling, administrative and general expenses as a percentage of revenue
will move from the high 20s to the low 20s over time, driven primarily by large
reductions in overhead costs. Manufacturing and service productivity will also
improve. These benefits will be somewhat offset by lower gross margins overall
due to the increasing proportion of business conducted through indirect sales
channels and outsourcing.

   As of December 31, 1998, approximately 5,400 employees had left the company
under the restructuring program.
   
   There have been no material changes to the program since its announcement in
April 1998, and the majority of the remaining reserve will be utilized by
December 31, 1999. However, the completion of certain European initiatives will
likely be extended beyond 1999 due to local regulatory issues as they relate to
the work force.


- --------------------------------------------------------------------------------

[Pictured here is Roosevelt Thompson]

A Helping Hand 

Roosevelt Thompson, a Vietnam veteran shown here at the Vietnam Memorial in
Washington, D.C., was among the first people hired by Xerox through the Welfare
to Work Partnership. Thompson is an account associate assigned to the Document
Technology Centre at the law firm of Steptoe & Johnson in Washington. Highly
respected, Thompson has earned several promotions and has added to his
responsibilities since joining Xerox. At the end of 1998, Xerox had placed 256
people through the program and achieved a 75 percent retention rate.
- --------------------------------------------------------------------------------

              [The following data was represented by a bar chart]

                        Color Copying and Printing Revenue 
                                       (millions)
                             96          $1,000
                             97          $1,500
                             98          $1,900

Acquisition of XLConnect Solutions 
In May 1998, we acquired XLConnect Solutions, Inc. (XLConnect), an information
technology services company, and its parent company, Intelligent Electronics,
Inc. for $413 million in cash. The operating results of these companies, which
are not material, have been included in our consolidated statements of income
from the date of the acquisition. Based on the allocation of the

                                                            XEROX CORPORATION 29


<PAGE>
 
purchase price, the transaction resulted in goodwill of $395 million (including
transaction costs) which is being amortized over 25 years.

              [The following data was represented by a bar chart]

                         Document Outsourcing Revenue
                                     (millions)
                          96           $1,250
                          97           $2,000
                          98           $2,700

Share Repurchase 
In April 1998, we announced that we were reactivating our $1 billion stock
repurchase program, which was suspended in April 1997 when we acquired the
remaining financial interest in Xerox Limited. During 1998, we repurchased 3.7
million shares for $172 million. Since inception of the program we have
repurchased 20.6 million shares for $594 million.

Year 2000
The Year 2000 (Y2K) problem is the result of computer programs written in two
digits, rather than four, to define the applicable year. As a result, many
information systems are unable to properly recognize and process date-sensitive
information beyond December 31, 1999. As with all major companies, certain of
our information systems and products require remediation or replacement in order
to render these systems Year 2000 compliant. Though a majority of the
remediation and replacement work has been completed, 1999 will be used to finish
any remaining mission-critical areas and develop and deploy business contingency
plans.

   We have divided the Year 2000 project into five major sections: Information
Technology; and the non-Information Technology areas of Facilities, Vendor
Compliance, Product Compliance and Facilities Management products and services.
The general phases common to all sections are: 1) Awareness - a strategic
approach was developed to address the Year 2000 problem. 2) Assessment -
detailed plans and target dates were developed. 3) Programming - includes
hardware and software upgrades, systems replacements, vendor certification and
other associated changes. 4) Testing - includes testing and conversion of system
applications. 5) Implementation - includes compliance achievement and user
acceptance.

   The Information Technology section includes applications (software), compute
(mainframe/smaller computer environments), infrastructure (networks, servers,
and workstations), and telecommunications. The status of each section as of
December 31, 1998, is as follows:
 
   Applications - 93 percent of the mission-critical applications are Y2K
compliant. The remaining work is planned for completion by mid-1999.

   Compute - 90 percent of our mainframe/smaller computer environments have been
upgraded to be Y2K compliant with the remainder scheduled to be upgraded by
mid-1999.

   Infrastructure - 62 percent of networks, servers, and workstations have been
upgraded to be Y2K compliant with the remainder to be upgraded by mid-1999.

   Telecommunications - 71 percent of internal mission-critical components are
Y2K compliant with the remainder planned for compliance by mid-1999. To date, 84
percent of our public utility providers have provided us letters of compliance
assurance and processes are under way to obtain confirmation by the rest.

   The Facilities section, which includes electrical systems, elevators, access
control, security systems, etc., is primarily in the assessment phase. We
anticipate achieving compliance by August 31, 1999.

   We began our efforts in the Vendor Compliance area in November 1997. A
general awareness letter was sent to all external suppliers, and an assessment
survey was sent to all business-critical suppliers. Approximately 40 percent of
our suppliers were rated "low confidence" or had not responded. Given our
assessment as well as industry statistics that 23 percent of small to medium
sized companies have not started Y2K compliance activity, we have decided that
if necessary, we will acquire approximately $100 million of additional inventory
by December 31, 1999 to ensure continuity of service to our customers should our
vendors experience Y2K problems. This procedure is intended to provide a means
of managing risk; however, no assurance can be given that it will eliminate the
potential disruption caused by third party failure.

   Regarding Product Compliance, all of our products, excluding end-of-life and
a handful of engineering-related products, are Y2K compliant, or we have
developed a software/hardware

30  XEROX CORPORATION 

<PAGE>
 
                                                                FINANCIAL REVIEW

patch or have another solution in progress. We have implementation plans in
place to deploy these Y2K solutions so that all in-field Xerox products will be
made compliant by mid-1999.

   In Facilities Management, we have completed inventory and compliance
assessment and have begun action planning and remediation activities for 80
percent of our customers. Completion of remediation, on-site integrated testing
of components and full deployment is scheduled for mid-1999, while remediation
of Xerox products at these sites is being coordinated with the product
compliance area.

   Contingency Planning--Certain of our processes have in place business
resumption plans. In addition, we have established a contingency program which
requires our critical business processes to develop alternative plans should
our, or third party remediation efforts experience unforeseen difficulty.

   We are also dependent upon our customers for sales and cash flows. Y2K
interruptions in our customers' operations could result in reduced sales,
increased inventory or receivable levels and cash flow reductions. While these
events are possible, our customer base is sufficiently broad to minimize those
risks.

   In 1993, Xerox began a project to replace the majority of its legacy systems,
which in many cases date back to the 1960s. These efforts continue today. As to
remediation, we currently estimate that costs, exclusive of software and systems
that are being replaced or upgraded in the normal course of business, and
including our products and facilities, as well as legacy systems, will be $183
million of which $28 million was spent in 1997, $92 million in 1998 and we
estimate $63 million will be spent in 1999.

   We believe that the remediation of our information systems and products will
occur in a timely fashion so that the Y2K problem will not result in significant
operating problems with our operating systems, facilities and products. However,
if such remediations are not completed in a timely manner or if third party
suppliers of products or services have not completed their remediation
efforts, the Y2K problem could potentially have a material adverse impact on our
operations. Possible worst case consequences could include an interruption in
our ability to: bill and apply collections from our customers; manufacture and
deliver products to our customers; or meet our cash requirement needs.

              [The following data was represented by a bar chart]

                                  Operating Margins
                                      (percent)
                            96           11.6
                            97           12.3
                            98           13.6

- --------------------------------------------------------------------------------
Personal Banker -- 

Florisdeo Paulo Monteiro Jr. of Unibanco of Brazil displays Multi-Extrato. This
customized monthly banking statement serves as a personal banker for customers
and a one-to-one marketing tool for the bank. Multi-Extrato is produced with
data management software from Document Sciences Corp., a Xerox New Enterprises
company, and Xerox high-speed printing and finishing systems. In one attractive,
easy-to-understand booklet, Multi-Extrato provides comprehensive account
information, a performance summary of a customer's investments vs. the market,
plus information about new financial services. Unibanco was the first bank in
Brazil to use this approach. Ten other Brazilian banks have followed.
- --------------------------------------------------------------------------------

The Euro
On January 1, 1999, eleven of the fifteen member countries of the European Union
established fixed conversion rates between their existing currencies and one
common currency--the euro. The euro now trades on currency exchanges and may be
used in business transactions. Xerox has processes in place in Europe to address
the systems and business issues raised by the euro currency conversion. These
issues include among others, 1) the need to adapt computer and other business
systems and equipment to accommodate euro-denominated transactions, and 2) the
competitive impact of cross-border price transparency, which may make it more
difficult for businesses to price for local markets for the same products on a
country-by-country basis. We estimate that the euro conversion will not have a
material impact on our financial condition or results of operations.


                                                            XEROX CORPORATION 31


<PAGE>
 
FINANCIAL REVIEW

New Accounting Standards
In June 1998, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards (SFAS) No. 133, "Accounting for Derivative
Instruments and Hedging Activities." SFAS No. 133 requires companies to
recognize all derivatives as assets or liabilities measured at their fair value.
Gains or losses resulting from changes in the values of those derivatives would
be accounted for depending on the use of the derivative and whether it qualifies
for hedge accounting. We do not expect this Statement to have a material impact
on our consolidated financial statements. This Statement is effective for fiscal
years beginning after June 15, 1999. We will adopt this accounting standard
beginning January 1, 2000.

Capital Resources and Liquidity
We manage the capital structure of our non-financing operations separately from
that of our captive finance companies, which employ a more highly leveraged
capital structure typical of captive finance companies.

   Total debt, including ESOP and Discontinued Operations debt not shown
separately in our consolidated balance sheets, increased to $15,107 million at
December 31, 1998 from $12,903 million in 1997 and $12,448 million in 1996.

- ----------------------------------------------------------------------
  (In millions)                             1998       1997       1996
- ----------------------------------------------------------------------
  Total debt* as of January 1            $12,903    $12,448    $11,794
- ----------------------------------------------------------------------
  Non-Financing Businesses:
     Document Processing operations
       cash generation                       (99)    (1,026)      (678)
     Purchase of The Rank Group's
       remaining interests in Xerox
       Limited                                 -      1,534          -
     Purchase of XLConnect,
       net of cash acquired                  380          -          -
     Mandatorily redeemable
       preferred securities                    -       (637)         -
     ESOP                                    (64)       (60)       (53)
     Discontinued businesses                (381)      (541)        47
- ----------------------------------------------------------------------
  Subtotal Non-Financing                    (164)      (730)      (684)
  Financing Businesses                     1,764        760        706
  Shareholder dividends                      531        475        438
  Equity redemption and other changes         73        (50)       194
- ----------------------------------------------------------------------
  Total debt* as of December 31          $15,107    $12,903    $12,448
- ----------------------------------------------------------------------
  *  Includes discontinued operations.

   For analytical purposes, total equity includes common equity, ESOP preferred
stock, mandatorily redeemable preferred securities and minorities' interests.
Total equity decreased by $148 million in 1998 and increased by $523 million and
$535 million in 1997 and 1996, respectively.

   The following is a three-year summary of the changes in total equity:

- ----------------------------------------------------------------------
 (In millions)                              1998       1997       1996
- ----------------------------------------------------------------------
 Total equity as of January 1             $6,454     $5,931     $5,396
 Income from continuing operations,
    before restructuring charge            1,692      1,452      1,206
 Restructuring charge                     (1,107)         -          -
 Loss from Discontinued Operations          (190)         -          -
 Mandatorily redeemable preferred
    securities                                 -        637          -
 Shareholder dividends                      (531)      (475)      (438)
 Purchase of treasury stock                 (172)      (116)      (306)
 Exercise of stock options                   112         99         84
 Change in minorities' interests              (3)      (716)        88
 Translation adjustments                     (56)      (463)      (138)
 All other, net                              107        105         39
- ----------------------------------------------------------------------
 Total equity as of December 31           $6,306     $6,454     $5,931
- ----------------------------------------------------------------------

Debt related to non-financing operations grew by $439 million in 1998 and the
non-financing debt-to-capital ratio increased to 43.8 percent compared with 38.9
percent and 39.3 percent as of year-end 1997 and 1996, respectively. The $1,107
million after-tax restructuring charge announced in April was a primary factor
underlying the 4.9 point increase in 1998.

Non-Financing Operations
The following table summarizes 1998, 1997 and 1996 document processing
non-financing operations cash generation and usage:

- ----------------------------------------------------------------------
  (In millions)                             1998       1997       1996
- ----------------------------------------------------------------------
  Document Processing
    Non-Financing:
  Income                                  $1,381*    $1,217     $1,004
  Depreciation and amortization**            821        739        715
- ----------------------------------------------------------------------
  Subtotal                                $2,202     $1,956     $1,719
- ----------------------------------------------------------------------
  Additions to land, building
    and equipment                           (566)      (520)      (510)
  Cash charges against 1998
    restructuring reserve                   (332)         -          -
  Increase in inventories,
    including rental equipment            (1,031)      (517)      (422)
  Increase in accounts receivable           (540)      (188)      (180)
  All other changes, net                     366        295         71
- ----------------------------------------------------------------------
  Net Cash Generation                     $   99     $1,026     $  678
- ----------------------------------------------------------------------
  *  Before 1998 restructuring charge.
  ** Includes rental equipment depreciation of $411, $311 and $326 in 1998,
     1997 and 1996, respectively.


32  XEROX CORPORATION

<PAGE>
 
                                                                FINANCIAL REVIEW

Consolidated Balance Sheets


<TABLE>
<CAPTION>
- ------------------------------------------------------------------------------------------------------------------
December 31 (in millions)                                                                      1998           1997
- ------------------------------------------------------------------------------------------------------------------
<S>                                                                                         <C>            <C>    
Assets

Cash                                                                                        $    79        $    75
Accounts receivable, net                                                                      2,671          2,145
Finance receivables, net                                                                      5,220          4,599
Inventories                                                                                   3,269          2,792
Deferred taxes and other current assets                                                       1,236          1,155
- ------------------------------------------------------------------------------------------------------------------
Total Current Assets                                                                         12,475         10,766
Finance receivables due after one year, net                                                   9,093          7,754
Land, buildings and equipment, net                                                            2,366          2,377
Investments in affiliates, at equity                                                          1,456          1,332
Goodwill, net                                                                                 1,731          1,375
Other assets                                                                                  1,233          1,103
Investment in discontinued operations                                                         1,670          3,025
- ------------------------------------------------------------------------------------------------------------------
TOTAL ASSETS                                                                                $30,024        $27,732
- ------------------------------------------------------------------------------------------------------------------
Liabilities and Equity

Short-term debt and current portion of long-term debt                                       $ 4,104        $ 3,707
Accounts payable                                                                                948            776
Accrued compensation and benefits costs                                                         722            811
Unearned income                                                                                 210            205
Other current liabilities                                                                     2,523          2,193
- ------------------------------------------------------------------------------------------------------------------
Total Current Liabilities                                                                     8,507          7,692
Long-term debt                                                                               10,867          8,779
Postretirement medical benefits                                                               1,092          1,079
Deferred taxes and other liabilities                                                          2,711          2,469
Discontinued operations liabilities - policyholders' deposits and other                         911          1,693
Deferred ESOP benefits                                                                         (370)          (434)
Minorities' interests in equity of subsidiaries                                                 124            127
Company-obligated, mandatorily redeemable preferred securities of subsidiary
  trust holding solely subordinated debentures of the Company                                   638            637
Preferred stock                                                                                 687            705
Common shareholders' equity                                                                   4,857          4,985
- ------------------------------------------------------------------------------------------------------------------
TOTAL LIABILITIES AND EQUITY                                                                $30,024        $27,732
- ------------------------------------------------------------------------------------------------------------------
</TABLE>



Shares of common stock issued and outstanding at December 31, 1998 were (in
thousands) 657,196 and 656,787, respectively. Shares of common stock issued
and outstanding at December 31, 1997 were (in thousands) 652,482.

The accompanying notes on pages 41 to 61 are an integral part of the
consolidated financial statements.

                                                            XEROX CORPORATION 33


<PAGE>
 
FINANCIAL REVIEW

   Non-financing operations' net cash generation of $99 million in 1998 was $927
million less than in 1997. Higher year-over-year income and non-cash charges
were more than offset by restructuring payments and working capital increases.
Inventories and receivables grew by $1,571 million in 1998, or $866 million more
than in 1997. The higher level of inventory investment was driven by accelerated
digital product sales growth. Accounts receivable growth reflects strong
equipment sales in 1998 and some increase in days sales outstanding due to
temporary effects from the reorganization and consolidation of U.S. customer
administrative centers. A major initiative to improve our cash conversion cycle
has been introduced in 1999 to reduce our working capital requirements. In 1997,
non-financing operations' net cash generation totaled $1,026 million or $348
million more than in 1996. This significant improvement was largely due to
higher income, higher growth in accounts payable and accrued compensation and
benefits costs, and lower payments against restructuring reserves than in 1996.

   Discontinued non-financing businesses generated $381 million in 1998
including net proceeds from the sales of Westchester Specialty Group and Crum &
Forster, Inc., offset by debt service and other costs. In 1997, the discontinued
non-financing businesses generated $541 million reflecting proceeds from the
sales of Coregis Group, Inc., Industrial Indemnity Holdings, and The Resolution
Group partially offset by debt service and other costs.

- --------------------------------------------------------------------------------

[Pictured here is Oscar Robertson]

A Commitment to Diversity
Xerox and Oscar Robertson, the NBA Hall of Fame player and now a successful
entrepreneur, formed a strategic alliance to jointly provide printing solutions
and facilities management services. As a Minority Business Enterprise assisted
by Xerox quality and technology, Oscar Robertson Document Management Services
should provide an economic boost to the urban enterprise zone in Pleasantville,
N.J. Customers already include New Jersey's Public Service Electric & Gas
Corporation and Caesar's Casino Hotel.
- --------------------------------------------------------------------------------

Financing Businesses
Customer financing-related debt grew by $1,764 million in 1998 or $1,004 million
more than in 1997 due to equipment sales growth, currency translation effects
and a modest increase in leverage from 7.0 to 1 to 7.5 to 1. Financing debt grew
by $760 million in 1997, $54 million more than in 1996, reflecting growth in
equipment sales partially offset by currency translation.

   Debt related to discontinued third party financing and real estate
activities, which is included in financing business debt, totaled $86 million in
1998, $117 million in 1997 and $223 million in 1996. Asset sales and portfolio
run-off account for the changes in all three years.

Funding Plans for 1999
Decisions related to term funding of our non-financing businesses will remain
based on the interest rate environment, capital market conditions and our desire
to maintain ample liquidity. Our underlying strategy is to continue to maintain
adequate funding duration while balancing the normal yield curve benefit of
floating rates against the reduced volatility obtained from fixed-rate
financing.

   Customer financing-related debt is planned to increase in line with equipment
sales growth while third party financing and real estate-related debt is
expected to continue to decline. Decisions regarding the size and timing of term
funding for our financing businesses will be made based on match funding needs,
refinancing requirements and capital market conditions.

   We believe our short-term credit facilities provide an ample source of funds
to finance our day-to-day operations, and we have readily available access to
the global capital markets to satisfy medium and long-term financing needs. Our
$7 billion global revolving credit agreement with a group of banks expires in
2002. This facility is unused and available to provide back up to Xerox, Xerox
Credit Corporation (XCC) and Xerox Capital (Europe) plc (XCE) commercial paper
borrowings. Commercial paper balances supported by the global credit agreement
totaled $4.5 billion at December 31, 1998. Xerox or XCC may access the facility
up to its $7 billion limit.

34 XEROX CORPORATION


<PAGE>
 
                                                                 FINACIAL REVIEW
         
XCE has access subject to a $4 billion limit. Total drawdowns cannot exceed $7
billion. 

   At December 31, 1998, Xerox and XCE had combined U.S. shelf capacity of
$486 million and XCC had U.S. shelf capacity of $1,240 million. In addition, a
$2 billion euro-debt facility is available to Xerox, XCC and XCE, of which $993
million remained unused at December 31, 1998.

              [The following data was represented by a bar chart]
         
                          Manufacturing Productivity
         (percentage decline in per unit equipment manufacturing cost)

                               96        7.8
                               97        8.6
                               98       10.4

Risk Management
Xerox is typical of multinational corporations because it is exposed to market
risk from changes in foreign currency exchange rates and interest rates that
could affect our results of operations and financial condition.

   We have entered into certain financial instruments to manage interest rate
and foreign currency exposures. These instruments are held solely for hedging
purposes and include interest rate swap agreements, forward exchange contracts
and foreign currency swap agreements. 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
objectives.

   Currency derivatives are primarily arranged in conjunction with underlying
transactions that give rise to foreign currency-denominated payables and
receivables. For example, an option to buy foreign currency to settle the
importation of goods from foreign suppliers, or a forward exchange contract to
fix the dollar value of a foreign currency-denominated loan.

   As of December 31, 1998 and 1997 our primary foreign currency market
exposures include the Japanese yen, Brazilian real, British pound sterling,
French franc and Canadian dollar.

   In order to manage the risk of foreign currency exchange rate fluctuations,
we hedge a significant portion of all cash transactions denominated in a
currency other than the functional currency applicable to each of our legal
entities. From time to time, when cost-effective, foreign currency debt and
currency derivatives are used to hedge international equity investments.

   Consistent with the nature of the economic hedge of such foreign currency
exchange contracts, associated unrealized gains or losses would be offset by
corresponding decreases or increases in the value of the underlying asset or
liability being hedged.

   Assuming a 10 percent appreciation or depreciation in foreign currency
exchange rates as of December 31, 1998, the potential change in fair value of
our net foreign currency portfolio would approximate $32 million. The amount
permanently invested in foreign subsidiaries and affiliates, primarily Xerox
Limited, Fuji Xerox and Xerox do Brasil, and translated into dollars using the
year-end exchange rate, was $6.5 billion at December 31, 1998, net of foreign
currency denominated liabilities designated as a hedge of our net investment.
Assuming a 10 percent appreciation or depreciation of the U.S. dollar against
all currencies from the quoted foreign currency exchange rates at December 31,
1998 the unrealized loss or gain would approximate $650 million. In the early
part of 1999 the Brazilian real has devalued substantially against the U.S.
dollar. Financial reporting adjustments related to real devaluation will be
recorded in shareholders' equity. A 10 percent devaluation of the real would
reduce shareholders' equity by $230 million. Over time, such adjustments are
expected to be at least partially recovered by our Brazilian operations.

   We do not hedge foreign currency-denominated revenues of our foreign
subsidiaries since these do not represent cross-border cash flows.

   With regard to interest rate hedging, virtually all customer-financing
assets earn fixed rates of interest. Therefore, within industrialized economies,
we "lock in" an interest rate spread by arranging fixed-rate liabilities with
similar maturities as the underlying assets and fund the assets with liabilities
in the same currency. We refer to the effect of these conservative practices as
"match funding" customer financing assets. This practice effectively eliminates
the risk of a major decline in

                                                            XEROX CORPORATION 35

<PAGE>
 
FINANCIAL REVIEW

Consolidated Statements of Cash Flows


<TABLE>
<CAPTION>
- -------------------------------------------------------------------------------------------------------------------------------
Year ended December 31 (in millions)                                                           1998           1997         1996
- -------------------------------------------------------------------------------------------------------------------------------
<S>                                                                                         <C>            <C>          <C> 
CASH FLOWS FROM OPERATING ACTIVITIES
Income from continuing operations                                                           $   585        $ 1,452      $ 1,206
Adjustments required to reconcile income to cash flows from operating activities:
  Depreciation and amortization                                                                 821            739          715
  Restructuring charge and asset impairments                                                  1,531              -            -
  Inventory charges                                                                             113              -            -
  Provision for doubtful accounts                                                               301            265          259
  Provision for postretirement medical benefits, net of payments                                 33             29           38
  Cash charges against 1998 restructuring reserve                                              (332)             -            -
  Minorities' interests in earnings of subsidiaries                                              45             88          161
  Undistributed equity in income of affiliated companies                                        (27)           (84)         (84)
  Increase in inventories                                                                    (1,031)          (517)        (422)
  Increase in finance receivables                                                            (2,169)        (1,629)      (1,220)
  Increase in accounts receivable                                                              (540)          (188)        (180)
  Increase in accounts payable and accrued compensation and benefit costs                       127            250           63
  Net change in current and deferred income taxes                                              (192)           361          293
  Other, net                                                                                   (430)          (294)        (519)
- -------------------------------------------------------------------------------------------------------------------------------
Total                                                                                        (1,165)           472          310
- -------------------------------------------------------------------------------------------------------------------------------
CASH FLOWS FROM INVESTING ACTIVITIES
Cost of additions to land, buildings and equipment                                             (566)          (520)        (510)
Proceeds from sales of land, buildings and equipment                                             74             36           40
Purchase of XLConnect, net of cash acquired                                                    (380)             -            -
Purchase of additional interest in Xerox Limited                                                  -           (812)           -
Other, net                                                                                        5             45           14
- -------------------------------------------------------------------------------------------------------------------------------
Total                                                                                          (867)        (1,251)        (456)
- -------------------------------------------------------------------------------------------------------------------------------
CASH FLOWS FROM FINANCING ACTIVITIES
Net change in debt                                                                            2,468              5          990
Dividends on common and preferred stock                                                        (531)          (475)        (438)
Proceeds from sale of common stock                                                              126            140           95
Repurchase of preferred and common stock                                                       (172)          (116)        (316)
Dividends to minority shareholders                                                               (4)            (7)         (36)
Proceeds from issuance of mandatorily redeemable preferred securities                             -            637            -
- -------------------------------------------------------------------------------------------------------------------------------
Total                                                                                         1,887            184          295
- -------------------------------------------------------------------------------------------------------------------------------
Effect of exchange rate changes on cash                                                         (29)           (18)          (6)
- -------------------------------------------------------------------------------------------------------------------------------
Cash provided (used) by continuing operations                                                  (174)          (613)         143
Cash provided (used) by discontinued operations                                                 178            584         (175)
- -------------------------------------------------------------------------------------------------------------------------------
Increase (decrease) in cash                                                                       4            (29)         (32)
Cash at beginning of year                                                                        75            104          136
- -------------------------------------------------------------------------------------------------------------------------------
Cash at end of year                                                                          $   79        $    75      $   104
- -------------------------------------------------------------------------------------------------------------------------------
</TABLE>


The accompanying notes on pages 41 to 61 are an integral part of the
consolidated financial statements.


36 XEROX CORPORATION


<PAGE>
 
FINANCIAL REVIEW

interest margins during a period of rising interest rates. Conversely, this
practice effectively eliminates the opportunity to materially increase margins
when interest rates are declining.

     Pay fixed-rate and receive variable-rate swaps are typically used in place
of more expensive fixed-rate debt. Additionally, pay variable-rate and receive
fixed-rate swaps are used from time to time to transform longer-term fixed-rate
debt into variable rate obligations. The transactions performed within each of
these categories enable more cost-effective management of interest rate
exposures. The potential risk attendant to this strategy is the non-performance
of the swap counterparty. We address this risk by arranging swaps with a diverse
group of strong-credit counterparties, regularly monitoring their credit ratings
and determining the replacement cost, if any, of existing transactions.

     On an overall worldwide basis, and including the impact of our hedging
activities, weighted average interest rates for 1998, 1997 and 1996 approximated
6.1 percent, 6.2 percent and 6.9 percent, respectively.

     Many of the financial instruments we use are sensitive to changes in
interest rates. Hypothetically, interest rate changes result in gains or losses
related to the market value of our term debt and interest rate swaps due to
differences between current market interest rates and the stated interest rates
within the instrument. Applying an assumed 10 percent reduction or increase in
the yield curves at December 31, 1998, the fair value of our term debt and
interest swaps would increase or decrease by approximately $119 million.

     Our currency and interest rate hedging are typically unaffected by changes
in market conditions as forward contracts, options and swaps are normally held
to maturity consistent with our objective to lock in currency rates and interest
rate spreads on the underlying transactions.

- --------------------------------------------------------------------------------

[Pictured here is Momoe Takahashi Mehta]

Digital Artist -
Momoe Takahashi Mehta, a photographer and painter in Bangalore, India, uses the
power of Xerox digital color to make copies of her paintings, which are in turn
used for block print making.
- --------------------------------------------------------------------------------

Liquidity

Our primary sources of liquidity are cash generated from operations and
borrowings. The consolidated statements of cash flows detailing changes in our
cash balances are on page 36.

     Operating activities resulted in a net cash outflow of $1,165 million in
1998 compared with $472 million of cash generation in 1997. This year-over-year
change is largely due to strong growth in our customer financing businesses and
a temporary decrease in inventory and receivables turnover, which more than
offset higher income and non-cash charges. Conversely, 1997 operating cash
generation was $162 million greater than in 1996 as growth in customer finance
receivables was more than offset by lower working capital requirements.

     1998 investing activities resulted in net cash usage of $867 million or
$384 million less than in 1997 due to an initial $812 million payment to The
Rank Group in 1997 under our agreement to purchase The Rank Group's remaining
interests in Xerox Limited, partially offset by a net $380 million payment in
1998 related to the purchase of XLConnect. Cash used for investing activities in
1997 was $795 million more than in 1996 largely due to the 1997 payment to The
Rank Group.

     Financing activities provided net cash flows totaling $1,887 million in
1998, up substantially from $184 million in 1997. Along with the changes to cash
flows from operations and investing, 1997 financing cash flow reflects $637
million of cash generated by the issuance in January 1997 of mandatorily
redeemable preferred securities.

     Overall, continuing operations used $174 million and $613 million of cash
in 1998 and 1997, respectively, and generated $143 million in 1996.

     Discontinued operations provided $178 million and $584 million of cash in
1998 and 1997, respectively, and used $175 million in 1996.

     Year-end cash balances were $79 million in 1998, $75 million in 1997 and
$104 million in 1996, consistent with our objective to minimize investments that
do not provide added value to our shareholders.

                                                            XEROX CORPORATION 37



<PAGE>
 
FINANCIAL REVIEW

Discontinued Operations - Insurance
and Other Financial Services

The net investment in the discontinued financial services businesses, which
includes Insurance, Other Financial Services and Third Party Financing and Real
Estate, totaled $759 million at December 31, 1998 compared with $1,332 million
and $2,124 million at December 31, 1997 and 1996, respectively. The decrease in
1998 was primarily caused by the sale of the remaining Talegen Holdings, Inc.
(Talegen) companies and a reserve increase recorded in the first quarter of
1998, somewhat offset by scheduled funding of reinsurance coverage to the former
Talegen companies by Ridge Reinsurance Limited (Ridge Re) and interest for the
period on the assigned debt. A discussion of the discontinued businesses
follows.

- --------------------------------------------------------------------------------

[Pictured here is a Xerox large-format color printing advertisement]

Scaling New Heights -- 

This is an award-winning advertisement used internationally to promote Xerox
large-format color printing.
- --------------------------------------------------------------------------------

Status of Insurance
In 1995, we recorded a $1,546 million after tax charge in connection with the
disengagement activities for our five then remaining Talegen insurance companies
and three related service companies.

   In 1997, three of the insurance companies and one service company were
sold. As part of the consideration for one of the companies, The Resolution
Group, Inc. (TRG), which closed in the fourth quarter of 1997, we received a
$462 million performance-based instrument. In 1998, the remaining insurance and
service companies were sold. In the first quarter, we completed the sale of the
Westchester Specialty Group, Inc. (WSG) for $338 million in cash, less
approximately $70 million in transaction-related costs. In the third quarter, we
completed the sale of Crum & Forster Holdings, Inc. (CFI) for $680 million,
including the repayment of $115 million in debt, less approximately $75 million
in transaction-related costs. With the completion of the CFI transaction, we
have effectively completed our disengagement strategy from the Talegen
companies. In the first quarter of 1998 an additional after-tax charge of $190
million was recorded.

   Xerox Financial Services, Inc. (XFSI) continues to provide aggregate excess
of loss reinsurance coverage to certain of the former Talegen units and TRG
through Ridge Re, a wholly owned subsidiary. The coverage limits total $748
million, which is net of 15 percent coinsurance and exclusive of $234 million in
coverage which was reinsured under a retrocessional arrangement during the
fourth quarter of 1998 for a total cost to Ridge Re of $158 million. At December
31, 1998, Ridge Re had recognized the discounted value of approximately $445
million of the available coverage and it is possible that some additional
reserves could ultimately be needed, although this is not currently anticipated.

   XFSI has guaranteed to certain of the former Talegen units and TRG that Ridge
Re will meet all of its financial obligations under the Reinsurance Agreements.
Related premium payments to Ridge Re are made by XFSI and guaranteed by us. As
of December 31, 1998, there were four remaining annual premium installments of
$43 million, plus finance charges. We have also guaranteed that Ridge Re will
meet its financial obligations on $578 million of the Reinsurance Agreements and
have provided a $400 million partial guaranty of Ridge Re's $800 million letter
of credit facility. This facility is required to provide security with respect
to aggregate excess of loss reinsurance obligations under contracts with certain
of the former Talegen units and TRG.

   XFSI may also be required, under certain circumstances, to purchase over time
additional redeemable preferred shares of Ridge Re, up to a maximum of $301
million.

Net Investment in Insurance
The net investment in Insurance at December 31, 1998 totaled $513 million
compared with a balance of $1,076 million and $1,846 million at December 31,
1997 and 1996,

38  XEROX CORPORATION

<PAGE>
 
FINANCIAL REVIEW

respectively. The decrease in 1998 versus 1997 primarily reflects the sales of
WSG and CFI and the reserve increase recorded in the first quarter of 1998,
somewhat offset by contractual payments to Ridge Re for annual premium
installments and associated finance charges and interest on the assigned
insurance debt.

Other Financial Services
The net investment in Other Financial Services at December 31, 1998 was $132
million compared with $125 million and $101 million at December 31, 1997 and
1996, respectively. Debt associated with these assets totaled $50 million at
December 31, 1998, 1997 and 1996. The increase in the investment from 1997 to
1998 is primarily due to interest on the assigned debt. The increase in the
investment from 1996 to 1997 primarily reflects the effect of a transfer from
Insurance that had no effect on the total net investment in the discontinued
financial services businesses.

   On June 1, 1995, XFSI completed the sale of Xerox Financial Services Life
Insurance Company and related companies (Xerox Life). In connection with the
transaction, OakRe Life Insurance Company (OakRe), a wholly owned XFSI
subsidiary, has assumed responsibility, via Coinsurance Agreements, for existing
Single Premium Deferred Annuity (SPDA) policies issued by Xerox Life. The
Coinsurance Agreements include a provision for the assumption (at their
election) by the purchaser's companies, of all of the SPDA policies at the end
of their current rate reset periods. A Novation Agreement with an affiliate of
the new owner provides for the assumption of the liability under the Coinsurance
Agreements for any SPDA policies not so assumed.

   As a result of the Coinsurance Agreements, at December 31, 1998, OakRe
retained approximately $0.8 billion of investment portfolio assets (transferred
from Xerox Life) and liabilities related to the reinsured SPDA policies.
Interest rates on these policies are fixed and were established upon issuance of
the respective policies. Substantially all of these policies will reach their
rate reset periods through the year 2000 and will be assumed under the
Agreements as described above. Xerox Life's portfolio was designed to recognize
that policy renewals extended liability "maturities," thereby permitting
investments with average duration somewhat beyond the rate reset periods.
OakRe's practice is to selectively improve this match over time as market
conditions allow.

   In connection with the aforementioned sale, XFSI established a $500 million
letter of credit and line of credit with a group of banks to support OakRe's
coinsurance obligations. The term of this letter of credit is five years and it
is unused and available at December 31, 1998. Upon a drawing under the letter of
credit, XFSI has the option to cover the drawing in cash or to draw upon the
credit line.

- --------------------------------------------------------------------------------

[Pictured here is Ursula Burns]

Top 25 -- 
Ursula Burns, Xerox vice president for manufacturing operations, was featured in
Working Woman magazine in an article about the top 25 companies for female
executives. The copies Burns is holding were made on a Xerox 5385 departmental
copier.
- --------------------------------------------------------------------------------

Third Party Financing and Real Estate
Third Party Financing and Real Estate assets at December 31, 1998, 1997 and 1996
totaled $250 million, $298 million and $450 million, respectively. The $48
million reduction in 1998 from 1997 primarily relates to asset sales and runoff
activity that were consistent with the amounts contemplated in the formal
disposal plan. Debt associated with these assets totaled $86 million, $117
million and $223 at December 31, 1998, 1997 and 1996, respectively.

   In January and February 1999, six of our remaining eight financing leases
were sold for $127 million, consistent with the amounts contemplated in the
formal disposal plan.

                                                            XEROX CORPORATION 39



<PAGE>
 
FINANCIAL REVIEW

Consolidated Statements of Shareholders' Equity


<TABLE>
<CAPTION>
- -----------------------------------------------------------------------------------------------------------------------------------
                                                                                            Accumulated
                                                                                                  Other
                                                      Common  Common   Additional            Comprehen- Treasury  Treasury
                                                       Stock   Stock      Paid-In  Retained        sive    Stock     Stock
(In millions, except share data in thousands)         Shares  Amount      Capital  Earnings   Income(1)   Shares    Amount    Total
- -----------------------------------------------------------------------------------------------------------------------------------
<S>                 <C> <C>                          <C>        <C>        <C>       <C>          <C>                        <C>   
Balance at December 31, 1995                         650,060    $653       $1,008    $2,321       $(104)       -         -   $3,878
- -----------------------------------------------------------------------------------------------------------------------------------
Net income                                                                            1,206                                   1,206
Translation adjustments - net of minority                                          
 shareholders' interests of ($24)                                                                  (138)                       (138)
                                                                                                                              -----
   Comprehensive income                                                                                                       1,068
Purchase of treasury stock                                                                               (12,986)    $(306)    (306)
Stock option, incentive plans and other                1,192       2          (25)      (15)               4,856       122       84
Xerox Canada Inc. exchangeable stock                     205                                               2,694
Convertible securities                                   347                   10                            994        23       33
Cash dividends declared                                                            
 Common stock ($0.58 per share)                                                        (379)                                   (379)
 Preferred stock                                                                        (59)                                    (59)
Tax benefits on ESOP dividends                                                           16                                      16
Premiums from sale of put options                                              11                                                11
Tax benefits on stock options                                                  21                                                21
- -----------------------------------------------------------------------------------------------------------------------------------
Balance at December 31, 1996                         651,804     655        1,025     3,090        (242)  (4,442)     (161)   4,367
- -----------------------------------------------------------------------------------------------------------------------------------
Net income                                                                            1,452                                   1,452
Net income during stub period                                                             8                                       8
Translation adjustments - net of minority                                          
 shareholders' interests of ($44)                                                                  (463)                       (463)
                                                                                                                              -----
   Comprehensive income                                                                                                         997
Purchase of treasury stock                                                                                (3,975)     (116)    (116)
Stock option, incentive plans and other                  360                  (17)     (129)               7,296       245       99
Xerox Canada Inc. exchangeable stock                     116                                                 126
Convertible securities                                   202                    9                            995        32       41
Cash dividends declared                                                            
 Common stock ($0.64 per share)                                                        (418)                                   (418)
 Preferred stock                                                                        (57)                                    (57)
Tax benefits on ESOP dividends                                                           14                                      14
Premiums from sale of put options                                              13                                                13
Tax benefits on stock options                                                  45                                                45
- -----------------------------------------------------------------------------------------------------------------------------------
Balance at December 31, 1997                         652,482     655        1,075     3,960        (705)       -         -    4,985
- -----------------------------------------------------------------------------------------------------------------------------------
Net income                                                                              395                                     395
Net loss during stub period                                                              (6)                                     (6)
Translation adjustments - net of minority                                          
 shareholders' interests of ($1)                                                                    (56)                        (56)
                                                                                                                              -----
   Comprehensive income                                                                                                         333
Purchase of treasury stock                                                                                (3,683)     (172)    (172)
Stock option, incentive plans and other                3,899       4           69      (116)               2,364       111       68
Xerox Canada Inc. exchangeable stock                     350                                                  12
Convertible securities                                   465       1           28                            898        42       71
Cash dividends declared                                                            
 Common stock ($0.72 per share)                                                        (475)                                   (475)
 Preferred stock                                                                        (56)                                    (56)
Tax benefits on ESOP dividends                                                           10                                      10
Premiums from sale of put options                                               5                                                 5
Tax benefits on stock options                                                  88                                                88
- -----------------------------------------------------------------------------------------------------------------------------------
Balance at December 31, 1998                         657,196    $660       $1,265    $3,712      $ (761)    (409)    $ (19)  $4,857
- -----------------------------------------------------------------------------------------------------------------------------------
</TABLE>


  (1) Accumulated other comprehensive income is solely composed of cumulative
      translation adjustments.

      The accompanying notes on pages 41 to 61 are an integral part of the
      financial statements.


40 XEROX CORPORATION

<PAGE>
 
NOTES


Notes to Consolidated Financial Statements
(Dollars in millions, except per-share data and unless otherwise indicated)

1  Summary of Significant Accounting Policies 
Basis of Consolidation. The consolidated financial statements include the
accounts of Xerox Corporation and all majority-owned subsidiaries (the Company).
All significant intercompany accounts and transactions have been eliminated.
References herein to "we" or "our" refer to Xerox and consolidated subsidiaries
unless the context specifically requires otherwise.

   Xerox Limited, Xerox Holding (Nederland) BV, Xerox Investments (Bermuda)
Limited, Xerox Holdings (Bermuda) Limited and their respective subsidiaries are
referred to as Xerox Limited.

   Investments in which we have a 20 to 50 percent ownership interest are
generally accounted for on the equity method.

   Upon the sale of stock by a subsidiary, we recognize a gain or loss equal to
our proportionate share of the increase or decrease in the subsidiary's equity.
During 1996, we recognized a pre-tax net gain of $11 from such transactions.

   Fuji Xerox Co. Ltd. (Fuji Xerox), changed its reporting period from a fiscal
year ending October 20, 1996 to a fiscal year ending December 20. The results of
operations during the period between the end of the 1996 fiscal year and the
beginning of the new fiscal year (the stub period) amounted to a gain of $8.
Fuji Xerox again changed its reporting period from a fiscal year ending December
20, 1997 to a fiscal year ending December 31. The results of operations during
this stub period amounted to a loss of $6. The stub period results were recorded
directly in retained earnings to avoid reporting more than 12 months' results of
operations in one year.

Earnings per Share. Basic earnings per share are based on net income less
preferred stock dividend requirements divided by the average common shares
outstanding during the period. Diluted earnings per share assume exercise of
in-the-money stock options outstanding and full conversion of convertible debt
and convertible preferred stock into common stock at the beginning of the year
or date of issuance, unless they are antidilutive.

Use of Estimates. The preparation of financial statements in accordance with
generally accepted accounting principles requires management to make estimates
and assumptions that affect the reported amounts of assets and liabilities and
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. Actual results could differ from those estimates.

Goodwill. Goodwill represents the cost of acquired businesses in excess of the
net assets purchased and is amortized on a straight-line basis, generally over
periods ranging from 25 to 40 years. Goodwill is reported net of accumulated
amortization, and the recoverability of the carrying value is evaluated on a
periodic basis by assessing current and future levels of income and cash flows
as well as other factors. Accumulated amortization at December 31, 1998 and 1997
was $119 and $71, respectively.

Accounting Changes. Effective January 1, 1998, we adopted Statement of Financial
Accounting Standards (SFAS) No. 130, "Reporting Comprehensive Income." This
statement requires that companies disclose comprehensive income, which includes
net income, foreign currency translation adjustments, minimum pension liability
adjustments, and unrealized gains and losses on marketable securities classified
as available-for-sale. Comprehensive income and the components thereof are
included in the Consolidated Statements of Shareholders' Equity on page 40.

   Effective December 1998, we adopted SFAS No. 131, "Disclosures about Segments
of an Enterprise and Related Information." SFAS No. 131 requires us to report
segment information as it is used internally to assess performance and allocate
resources. See Note 9 on page 45.

   In June 1998, the Financial Accounting Standards Board issued SFAS No. 133,
"Accounting for Derivative Instruments and Hedging Activities." SFAS No. 133
requires companies to recognize all derivatives as assets or liabilities
measured at their fair value. Gains or losses resulting from changes in the
values of those derivatives would be accounted for depending on the use of the
derivative and whether it qualifies for

                                                          XEROX CORPORATIION  41


<PAGE>
 
NOTES

hedge accounting. We do not expect this Statement to have a material impact on
our consolidated financial statements. This Statement is effective for fiscal
years beginning after June 15, 1999. We will adopt this accounting standard
beginning January 1, 2000.

Revenue Recognition. Revenues from the sale of equipment under installment
contracts and from sales-type leases are recognized at the time of sale or at
the inception of the lease, respectively. Associated finance income is earned on
an accrual basis under an effective annual yield method. Revenues from equipment
under other leases are accounted for by the operating lease method and are
recognized over the lease term. Service revenues are derived primarily from
maintenance contracts on our equipment sold to customers and are recognized over
the term of the contracts.

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.

Inventories. Inventories are carried at the lower of average cost or market.

Buildings and Equipment. Our fixed assets are depreciated over their estimated
useful lives. Depreciation is computed using principally the straight-line
method. Significant improvements are capitalized; maintenance and repairs are
expensed. See Note 7 on page 44.

Classification of Commercial Paper and Bank Notes Payable. It is our policy to
classify as long-term debt that portion of commercial paper and notes payable
that is intended to match fund finance receivables due after one year to the
extent that we have the ability under our revolving credit agreement to
refinance such commercial paper and notes payable on a long-term basis. See Note
11 on page 49.

Foreign Currency Translation. The functional currency for most foreign
operations is the local currency. Net assets are translated at current rates of
exchange, and income and expense items are translated at the average exchange
rate for the year. The resulting translation adjustments are recorded in
accumulated other comprehensive income. The U.S. dollar is used as the
functional currency for certain subsidiaries, which conduct their business in
U.S. dollars or operate in hyperinflationary economies. A combination of current
and historical exchange rates is used in remeasuring the local currency
transactions of these subsidiaries, and the resulting exchange adjustments are
included in income. Aggregate foreign currency losses were $28, $85 and $27 in
1998, 1997 and 1996, respectively, and are included in Other, net in the
consolidated statements of income.

   Effective July 1, 1997, we changed the functional currency for our Brazilian
operation from the U.S. dollar to the Brazilian real, as the Brazilian economy
is no longer considered hyperinflationary. The effect of this change was
immaterial.

Reclassifications. Prior years' financial statements have been restated to
reflect certain reclassifications to conform with the 1998 presentation. The
impact of these changes is not material and did not affect net income.

2  Restructuring  
   On April 7, 1998, we announced a worldwide restructuring program associated
with enhancing our competitive position and lowering our overall cost structure.
In connection with this program, in the second quarter we recorded a pretax
provision of $1,644 ($1,107 after taxes and including our $18 share of a
restructuring charge recorded by Fuji Xerox). The program includes the
elimination of approximately 9,000 jobs, net, worldwide, the closing and
consolidation of facilities, and the write-down of certain assets. The charges
associated with this restructuring program include $113 of inventory charges
recorded as cost of revenues and $316 of asset impairments. Included in the
asset impairment charge is facility fixed asset write-downs of $156 and other
asset write-downs of $160. For facility fixed assets classified as


42  XEROX CORPORATION


<PAGE>
 
                                                                           NOTES

assets to be disposed of, the impairment loss recognized is based on fair value
less cost to sell, with fair value based on third-party valuations as well as
our internal estimates of existing market prices for similar assets. The effect
of suspending depreciation on assets no longer in use for 1998 is not material.
The remaining $160 of asset impairments includes the write-down of certain
technology assets and other items impacted by the consolidation initiatives
described below. Key initiatives of the restructuring include: 

1.   Consolidating 56 European customer support centers into one facility and
     implementing a shared services organization for order entry, invoicing, and
     other back-office and sales operations.

2.   Streamlining manufacturing, logistics, distribution and service operations.
     This will include centralizing U.S. parts depots and outsourcing storage
     and distribution.

3.   Overhauling our internal processes and associated resources, including
     closing one of four geographically organized U.S. customer administrative
     centers.

   The reductions are occurring primarily in administrative functions, but also
impact service, research and manufacturing.

   The following table summarizes the status of the restructuring reserve (in
millions):

- -----------------------------------------------------------------------
                                                    Charges
                                          Total     Against    12/31/98
                                        Reserve     Reserve     Balance
- -----------------------------------------------------------------------
  Severance and related costs            $1,017        $304        $713
  Asset impairment                          316         316           -
  Lease cancellation and other costs        198          28         170
  Inventory charges                         113         113           -
- -----------------------------------------------------------------------
  Total                                  $1,644        $761        $883*
- -----------------------------------------------------------------------
  AAA              

  * Of this amount, $543 is included in Other current liabilities.

   As of December 31, 1998, approximately 5,400 employees have left the Company
under the restructuring program.

   There have been no material changes to the program since its announcement in
April 1998, and the majority of the remaining reserve will be utilized by
December 31, 1999. However, the completion of certain European initiatives will
likely be extended beyond 1999 due to local regulatory issues as they relate to
the workforce.

3 Common Stock Split 
On January 25, 1999, the Board of Directors approved a two-for-one split of the
Company's common stock. The effective date of the stock split was February 23
for share-holders of record as of February 4. Shareholders' equity has been
restated to give retroactive recognition to the stock split in prior periods by
reclassifying from additional paid-in capital to common stock the par value of
the additional shares arising from the split. In addition, all references in the
financial statements to number of shares and per-share amounts have been
restated.

4 Acquisitions
In May 1998, we acquired XLConnect Solutions, Inc. (XLConnect), an information
technology services company, and its parent company, Intelligent Electronics,
Inc. for $413 in cash. The operating results of these companies, which are not
material, have been included in our consolidated statement of income from the
date of the acquisition. Based on the allocation of the purchase price, the
transaction resulted in goodwill of $395 (including transaction costs) which is
being amortized over 25 years.

   In June 1997, we acquired the remaining 20 percent of Xerox Limited from The
Rank Group Plc (Rank) in a transaction valued at (pound)940 million, or
approximately $1.5 billion. As a result of this transaction, we now own 100
percent of Xerox Limited. The transaction was funded entirely by debt consisting
of (pound)500 million of third-party debt and (pound)440 million of notes
payable issued to Rank, which will be paid in deferred installments, half paid
on June 29, 1998 and the other half by June 30, 1999. An additional payment of
up to (pound)60 million would be made in 2000 based upon achievement of certain
Xerox Limited earnings growth targets by 1999. The purchase price (including
transaction costs) was allocated such that goodwill increased by $737, minority
interest in equity of subsidiaries was reduced by approximately $720, with the
balance of $70 applied to other assets and liabilities, primarily investment in
affiliates, at equity.

                                                          XEROX CORPORATION  43


<PAGE>
 
                                                                           NOTES

5  Finance Receivables, Net 
Finance receivables result from installment sales and sales-type leases arising
from the marketing of our business equipment products. These receivables
generally mature over two to five years and are typically collateralized by a
security interest in the underlying assets. The components of finance
receivables, net at December 31, 1998, 1997 and 1996 follow:

- ----------------------------------------------------------------------
                                           1998       1997        1996
- ----------------------------------------------------------------------
  Gross receivables                     $16,918    $15,035     $13,872
  Unearned income                        (2,863)    (2,850)     (2,551)
  Unguaranteed residual values              699        557         398
  Allowance for doubtful accounts          (441)      (389)       (347)
- ----------------------------------------------------------------------
  Finance receivables, net               14,313     12,353      11,372
  Less current portion                    5,220      4,599       4,386
- ----------------------------------------------------------------------
  Amounts due after one year, net       $ 9,093    $ 7,754     $ 6,986
- ----------------------------------------------------------------------

   Contractual maturities of our gross finance receivables subsequent to
December 31, 1998 follow:

- ----------------------------------------------------------------------------
       1999         2000         2001         2002         2003   Thereafter
- ----------------------------------------------------------------------------
     $6,295       $4,570       $3,257       $1,911         $740         $145
- ----------------------------------------------------------------------------

   Experience has shown that a portion of these finance receivables will be
prepaid prior to maturity. Accordingly, the preceding schedule of contractual
maturities should not be considered a forecast of future cash collections.

   Allowances for doubtful accounts on our accounts receivable balances for the
years ended December 31, 1998, 1997 and 1996 amounted to $102, $92 and $92,
respectively.

6  Inventories 
The components of inventories at December 31, 1998, 1997 and 1996 follow:

- ----------------------------------------------------------------------
                                           1998       1997        1996
- ----------------------------------------------------------------------
  Finished goods                         $1,923     $1,549      $1,570
  Work in process                           111         97          80
  Raw materials                             464        406         322
  Equipment on operating leases, net        771        740         704
- ----------------------------------------------------------------------
  Inventories                            $3,269     $2,792      $2,676
- ----------------------------------------------------------------------

   Equipment on operating leases consists of our business equipment products
that are rented to customers and are depreciated to estimated residual value.
Depreciable lives vary from two to four years. Our business equipment operating
lease terms vary, generally from 12 to 36 months. Accumulated depreciation on
equipment on operating leases for the years ended December 31, 1998, 1997 and
1996 amounted to $1,260, $1,198 and $1,259, respectively. Scheduled minimum
future rental revenues on operating leases with original terms of one year or
longer are:

- -------------------------------------------------------------------
           1999             2000             2001        Thereafter
- -------------------------------------------------------------------
           $367             $173              $84               $46
- -------------------------------------------------------------------

   Total contingent rentals, principally usage charges in excess of minimum
allowances relating to operating leases, for the years ended December 31, 1998,
1997 and 1996 amounted to $161, $186 and $199, respectively.

7  Land, Buildings and Equipment, Net
The components of land, buildings and equipment, net at December 31, 1998, 1997
and 1996 follow:

- ----------------------------------------------------------------------
                           Estimated
                              Useful
                               Lives
                              (Years)      1998       1997        1996
- ----------------------------------------------------------------------
  Land                                   $   80     $   88      $   89
  Buildings and building
   equipment                25 to 50        973      1,012         991
  Leasehold improvements  Lease term        425        403         378
  Plant machinery            4 to 12      1,926      1,870       1,862
  Office furniture and
   equipment                 3 to 15      1,299      1,285       1,231
  Other                      3 to 20        260        190         218
  Construction in progress                  283        310         250
- ----------------------------------------------------------------------
  Subtotal                                5,246      5,158       5,019
  Less accumulated
   depreciation                           2,880      2,781       2,763
- ----------------------------------------------------------------------
  Land, buildings and
   equipment, net                        $2,366     $2,377      $2,256
- ----------------------------------------------------------------------

   We lease certain land, buildings and equipment, substantially all of which
are accounted for as operating leases. Total rent expense under operating leases
for the years ended December 31, 1998, 1997 and 1996 amounted to $436, $419 and
$421, respectively. Future minimum operating lease commitments that have
remaining non-cancelable lease terms in excess of one year at December 31, 1998
follow:

- ----------------------------------------------------------------------------
       1999         2000         2001         2002         2003   Thereafter
- ----------------------------------------------------------------------------
       $318         $258         $184         $138         $115         $396
- ----------------------------------------------------------------------------

   In certain circumstances, we sublease space not currently required in
operations. Future minimum sublease income under leases with non-cancelable
terms in excess of one year amounted to $23 at December 31, 1998.

44  XEROX CORPORATION


<PAGE>
 
                                                                           NOTES

   In 1994, we awarded a contract to Electronic Data Systems Corp. (EDS) to
operate our worldwide data processing and telecommunications network through the
year 2004. Subject to making a payment defined in the contract, effective 
July 1, 1999, Xerox has the right to terminate this agreement with six months'
notice to EDS. Minimum payments due EDS under the contract follow:

- ----------------------------------------------------------------------------
       1999         2000         2001         2002         2003         2004
- ----------------------------------------------------------------------------
       $257         $229         $217         $198         $183          $95
- ----------------------------------------------------------------------------

8  Investments in Affiliates, at Equity
Investments in corporate joint ventures and other companies in which we
generally have a 20 to 50 percent ownership interest at December 31, 1998, 1997
and 1996 follow:

- -------------------------------------------------------------------------
                                                1998      1997       1996
- -------------------------------------------------------------------------
  Fuji Xerox                                  $1,354    $1,231     $1,173
  Other investments                              102       101        109
- -------------------------------------------------------------------------
  Investments in affiliates, at equity        $1,456    $1,332     $1,282
- -------------------------------------------------------------------------

   Xerox Limited owns 50 percent of the outstanding stock of Fuji Xerox, a
corporate joint venture with Fuji Photo Film Co., Ltd. Fuji Xerox is
headquartered in Tokyo and operates in Japan and other areas of the Pacific Rim,
Australia and New Zealand, except for China. Condensed financial data of Fuji
Xerox for its last three fiscal years follow:

- -------------------------------------------------------------------------
                                                1998      1997       1996
- -------------------------------------------------------------------------
  Summary of Operations
  Revenues                                    $6,809    $7,415     $8,091
  Costs and expenses                           6,506     6,882      7,546
- -------------------------------------------------------------------------
  Income before income taxes                     303       533        545
  Income taxes                                   195       295        313
- -------------------------------------------------------------------------
  Net income                                  $  108    $  238     $  232
- -------------------------------------------------------------------------
  Balance Sheet Data
  Assets
  Current assets                              $2,760    $2,461     $3,008
  Non-current assets                           3,519     2,942      3,168
- -------------------------------------------------------------------------
  Total assets                                $6,279    $5,403     $6,176
- -------------------------------------------------------------------------
  Liabilities and Shareholders' Equity
  Current liabilities                         $2,628    $2,218     $2,546
  Long-term debt                                 101       286        427
  Other non-current liabilities                1,028       679        850
  Shareholders' equity                         2,522     2,220      2,353
- -------------------------------------------------------------------------
  Total liabilities and shareholders' equity  $6,279    $5,403     $6,176
- -------------------------------------------------------------------------

9  Segment Reporting 
In 1998, we adopted SFAS No. 131, "Disclosures about Segments of an Enterprise
and Related Information." SFAS No. 131 establishes standards for reporting
information about operating segments in annual financial statements and requires
that certain selected information about operating segments be reported in
interim financial reports. It also establishes standards for related disclosures
about products and services, and geographic areas. Operating segments are
defined as components of an enterprise about which separate financial
information is evaluated regularly by the chief operating decision maker, or
decision-making group, in deciding how to allocate resources and in assessing
performance. Our chief operating decision makers are our Chief Executive Officer
and Chief Operating Officer. SFAS No. 131 differs from the previous accounting
standard SFAS No. 14, which required companies to disclose certain financial
information about each industry segment in which they operate. Under SFAS No.
14, we described ourselves as having one segment--Document Processing. Under
the new standard, our reportable segments are as follows: Core Business, Fuji
Xerox, Paper and Media, and Other.

   The Core Business operating segment consists of the worldwide development,
manufacturing, marketing, financing and servicing of document processing
products and services. We have aggregated all Core Business operating units due
to commonality of economic characteristics, products and services, the
production process, class of customer and distribution process. This segment
also includes our corporate headquarters.

   The Fuji Xerox operating segment is composed of our corporate joint venture
with Fuji Photo Film Co., Ltd. (Fuji Photo), which operates throughout the Far
East (except China). It is managed jointly by our Chief Executive Officer and
the Chief Executive Officer of Fuji Photo.

   The Paper and Media segment operates as a distributor of print media and
supplies to our customers. The mission of Paper and Media is to charge a spread
over mill wholesale prices to cover our costs and value added as a distributor.
Although managed as a separate operating segment, our distribution of these
products is important to maintain the integrated document services solution we
offer our customers.

                                                            XEROX CORPORATION 45


<PAGE>
 
NOTES

   The Other operating segment is composed primarily of our Channels business
and Xerox New Enterprises companies. Channels distributes products primarily
through retail channels and value-added resellers. Xerox New Enterprises
comprises our investments in emerging companies with important document
processing hardware and software technologies in various stages of development.
Total assets for this segment also includes our investment in discontinued
operations. 
   The accounting policies of the operating segments are the same as those
described in the summary of significant accounting policies.


<TABLE>
<CAPTION>
- ------------------------------------------------------------------------------------------------------------------------ 
                                                                         Document Processing Segments
- ------------------------------------------------------------------------------------------------------------------------ 
                                                        Core                     Paper and
                                                    Business     Fuji Xerox          Media          Other          Total
- ------------------------------------------------------------------------------------------------------------------------ 
<S>                                                  <C>                            <C>            <C>           <C>    
 1998
 Information about profit or loss
   Revenues from external customers                  $16,037              -         $1,142         $1,199        $18,378
   Finance income                                      1,071              -              -              -          1,071
   Intercompany revenues                                (326)             -              -            326              -
                                                     ------------------------------------------------------------------- 
    Total segment revenues                            16,782              -          1,142          1,525         19,449
   Depreciation and amortization                         803              -              -             18            821
   Interest expense                                      748              -              -              -            748
   Segment profit (loss) before restructuring          2,434              -             53            (80)         2,407
   Segment profit (loss) after restructuring             929              -             50           (216)           763
   Earnings of non-consolidated affiliates(1)             19         $   72              -              1             92
 Information about assets
   Investments in non-consolidated affiliates             91          1,354              -             11          1,456
   Total assets                                       26,214          1,354             83          2,373         30,024
   Capital expenditures                                  539              -              -             27            566
- ------------------------------------------------------------------------------------------------------------------------ 
 1997
 Information about profit or loss
   Revenues from external customers                  $14,937              -         $1,117         $1,084        $17,138
   Finance income                                      1,006              -              -              -          1,006
   Intercompany revenues                                (118)             -              -            118              -
                                                     -------------------------------------------------------------------
    Total segment revenues                            15,825              -          1,117          1,202         18,144
   Depreciation and amortization                         732              -              -              7            739
   Interest expense                                      617              -              -              -            617
   Segment profit (loss)                               2,180              -             44            (83)         2,141
   Earnings of non-consolidated affiliates                 6         $  119              -              2            127
 Information about assets
   Investments in non-consolidated affiliates             91          1,231              -             10          1,332
   Total assets                                       22,913          1,231             91          3,497         27,732
   Capital expenditures                                  510              -              -             10            520
- ------------------------------------------------------------------------------------------------------------------------
 1996
 Information about profit or loss
   Revenues from external customers                  $14,067              -         $1,226         $1,070        $16,363
   Finance income                                      1,015              -              -              -          1,015
   Intercompany revenues                                 (96)             -              -             96              -
                                                     -------------------------------------------------------------------
    Total segment revenues                            14,986              -          1,226          1,166         17,378
   Depreciation and amortization                         708              -              -              7            715
   Interest expense                                      592              -              -              -            592
   Segment profit (loss)                               1,892              -             85            (33)         1,944
   Earnings of non-consolidated affiliates                 5         $  116              -              2            123
 Information about assets
   Investments in non-consolidated affiliates             94          1,173              -             15          1,282
   Total assets                                       20,689          1,173            102          4,854         26,818
   Capital expenditures                                  500              -              -             10            510
- ------------------------------------------------------------------------------------------------------------------------
</TABLE>
 

  (1) Excludes our $18 share of a restructuring charge recorded by Fuji Xerox.

46  XEROX CORPORATION

<PAGE>
 
                                                                           NOTES

   Products and services and geographic area data for our continuing operations
follow:


<TABLE>
<CAPTION>

- ------------------------------------------------------------------------------------------------------------------------
                                                                                                   Revenues
- ------------------------------------------------------------------------------------------------------------------------
                                                                                      1998           1997           1996
- ------------------------------------------------------------------------------------------------------------------------
<S>                                                                                <C>            <C>            <C>    
Information about products and services
  Digital                                                                          $ 8,960        $ 6,628        $ 5,327
  Light-lens                                                                         7,887          8,926          9,666
  Paper and Other                                                                    2,602          2,590          2,385
- ------------------------------------------------------------------------------------------------------------------------
Total                                                                              $19,449        $18,144        $17,378
- ------------------------------------------------------------------------------------------------------------------------
</TABLE>



<TABLE>
<CAPTION>
- ------------------------------------------------------------------------------------------------------------------------
                                                            Revenues                          Long-lived Assets
- ------------------------------------------------------------------------------------------------------------------------
                                         1998           1997           1996           1998           1997           1996
- ------------------------------------------------------------------------------------------------------------------------
<S>                                   <C>            <C>            <C>             <C>            <C>            <C>   
Information about Geographic Areas
United States                         $10,087        $ 9,187        $ 8,583         $2,095         $2,020         $1,881
Europe, Africa, Asia, Mideast           5,773          5,394          5,501            731            673            671
Other areas                             3,589          3,563          3,294            571            584            527
- ------------------------------------------------------------------------------------------------------------------------
Total                                 $19,449        $18,144        $17,378         $3,397         $3,277         $3,079
- ------------------------------------------------------------------------------------------------------------------------
</TABLE>


10  Discontinued Operations 
In January 1993, we announced our intent to sell or otherwise disengage from our
Insurance and Other Financial Services (IOFS) businesses. Since that time, we
have sold all but one of our insurance businesses and have disposed of a number
of other financial services businesses through sale and run-off collection
activities. At December 31, 1998, our sole remaining Insurance operation is the
Ridge Reinsurance Limited (Ridge Re) reinsurance business. Our other
discontinued businesses, consisting of Other Financial Services and Third Party
Financing and Real Estate, are primarily in asset and liability run-off. A
discussion of the status of IOFS's three segments follows.

Insurance. In the fourth quarter of 1995, we recorded a $1,546 after-tax charge
in connection with the disengagement activities for our five then remaining
Talegen Holdings, Inc. (Talegen) insurance companies and three related service
companies.

   In 1997, three of the insurance companies and one service company were sold
for an aggregate $890 in cash, the assumption of $154 of debt and, in the case
of the sale of The Resolution Group, Inc. (TRG), a $462 performance-based
instrument. We will participate in the future cash flows of TRG via the
performance-based instrument. The recovery of this instrument is dependent upon
the sufficiency of TRG's available cash flows. Based on current forecasts at
December 31, 1998, we expect to realize $462 for this instrument. However, the
ultimate realization may be greater or less than this amount.

   In 1998, the remaining insurance and service companies were sold. In the
first quarter, we completed the sale of the Westchester Specialty Group, Inc.
for $338 in cash, less approximately $70 in transaction-related costs. In the
third quarter, we completed the sale of Crum & Forster Holdings, Inc. (CFI) for
$680, including the repayment of $115 in debt, less approximately $75 in
transaction-related costs. In the first quarter of 1998, an additional after-tax
charge of $190 was recorded. With the completion of the CFI transaction, we have
effectively completed our disengagement strategy from the Talegen companies.

   The net proceeds of the above sales transactions, after transaction-related
costs were used primarily to retire debt.

   At December 31, 1998, the Insurance business consists of Ridge Re and
headquarters costs and interest expense associated with the insurance activities
of Xerox Financial Services, Inc. (XFSI), a wholly owned subsidiary.

                                                            XEROX CORPORATION 47


<PAGE>
 
NOTES   

   XFSI continues to provide aggregate excess of loss reinsurance coverage
(the Reinsurance Agreements) to certain of the former Talegen units and TRG
through Ridge Re, a wholly owned subsidiary of XFSI. The coverage limits total
$748, which is net of 15 percent coinsurance and exclusive of $234 in coverage
which was reinsured under a retrocessional arrangement during the fourth quarter
of 1998 for a total cost to Ridge Re of $158. Through December 31, 1998, Ridge
Re had recognized the discounted value of approximately $445 of the available
coverage and it is possible that some additional reserves could ultimately be
needed, although this is not currently anticipated.

   XFSI has guaranteed to certain of the former Talegen units and TRG that Ridge
Re will meet all of its financial obligations under the Reinsurance Agreements.
Related premium payments to Ridge Re are made by XFSI and guaranteed by us. As
of December 31, 1998, there were four remaining annual installments of $43, plus
finance charges. We have also guaranteed that Ridge Re will meet its financial
obligations on $578 of the Reinsurance Agreements and we have provided a $400
partial guaranty of Ridge Re's $800 letter of credit facility. This facility is
required to provide security with respect to aggregate excess of loss
reinsurance obligations under contracts with the former Talegen units and TRG.

   XFSI may also be required, under certain circumstances, to purchase, over
time, additional redeemable preferred shares of Ridge Re, up to a maximum of
$301.

Insurance Financial Information. Summarized operating results of Insurance for
the three years ended December 31, 1998 follow:

- ---------------------------------------------------------------------
                                           1998       1997       1996
- ---------------------------------------------------------------------
  Revenues                                $ 570     $1,760    $ 2,147
  Costs and expenses                        795      2,098      2,437
- ---------------------------------------------------------------------
  Loss before income taxes                 (225)      (338)      (290)
  Income tax benefits                        59        143        100
- ---------------------------------------------------------------------
  Net loss from operations(*)             $(166)    $ (195)   $  (190)
- ---------------------------------------------------------------------

  * The 1998, 1997 and 1996 operating results exclude the gains and losses
    related to sales of the Insurance subsidiaries. The results in the above
    table, including the sale-related impacts, were charged to reserves
    established for this purpose and, therefore, did not impact our earnings.
    The 1998 results exclude the first quarter 1998 after-tax charge of $190.

Other Financial Services. In 1995, we completed the sale of Xerox Financial
Services Life Insurance Company and related companies (Xerox Life). In
connection with the transaction, OakRe Life Insurance Company (OakRe), a wholly
owned XFSI subsidiary, assumed responsibility, via coinsurance agreements, for
the Single Premium Deferred Annuity (SPDA) policies issued by Xerox Life. As a
result of these coinsurance agreements, at December 31, 1998 and 1997, the
consolidated balance sheet includes approximately $0.8 billion and $1.5 billion,
respectively, of invested assets and the related reinsurance liabilities
associated with these SPDA policies. These liabilities are expected to be
substantially satisfied by the year 2000 as the policies are either terminated
by the policyholder or renewed and transferred to the buyer.

   In support of OakRe's coinsurance obligations, XFSI established a $500 letter
of credit and line of credit, expiring in 2000, with a group of banks. These
facilities are unused and available at December 31, 1998.

Third Party Financing and Real Estate. We have made substantial progress in
disengaging from the Third Party Financing and Real Estate businesses that were
discontinued in 1990. During the three years ended December 31, 1998, we
received net cash proceeds of $236 ($48 in 1998, $152 in 1997 and $36 in 1996)
from the sale of individual assets and from run-off and collection activities.
The amounts received were consistent with our estimates in the disposal plan and
were used primarily to retire debt. The remaining assets at December 31, 1998
primarily represent asset-based financing leases, many with long-duration
contractual maturities and unique tax attributes.

Total Discontinued Operations. The consolidated financial statements present the
Insurance, Other Financial Services and Third Party Financing and Real Estate
businesses as discontinued operations. Debt was assigned to discontinued
operations based on historical levels assigned to the businesses when they were
continuing operations, adjusted for subsequent paydowns. Interest expense
thereon is primarily determined based on our annual average domestic borrowing
costs. Assigned and direct interest expense for the discontinued businesses for
the years ended December 31, 1998, 1997 and 1996 was $143, $201 and $226,
respectively.

48   XEROX CORPORATION


<PAGE>
 
                                                                           NOTES

   Summarized information of discontinued operations for the three years ended
December 31, 1998 follows:

- ----------------------------------------------------------------------
                                              1998      1997      1996
- ----------------------------------------------------------------------
  Balance Sheet Data
  Assets
  Insurance
  Investment, net                           $  513    $1,076    $1,846
- ----------------------------------------------------------------------
  Other Financial Services
  Investments                                  805     1,537     1,991
  Other assets, net                            102       114       111
- ----------------------------------------------------------------------
  OFS assets                                   907     1,651     2,102
- ----------------------------------------------------------------------
  Third Party Financing and
    Real Estate
  Gross finance receivables                    252       303       401
  Unearned income and other                     (2)       (5)       49
- ----------------------------------------------------------------------
  Investment, net                              250       298       450
- ----------------------------------------------------------------------
  Investment in discontinued operations     $1,670    $3,025    $4,398
- ----------------------------------------------------------------------
  Liabilities
  OFS policyholders' deposits               $  775    $1,523    $1,998
  Other OFS liabilities                          -         3         3
  Long-term debt                               136       167       273
- ----------------------------------------------------------------------
  Discontinued operations liabilities       $  911    $1,693    $2,274
- ----------------------------------------------------------------------
  Net investment in discontinued
    operations                              $  759    $1,332    $2,124
- ----------------------------------------------------------------------

   Based on current estimates, we believe that the proceeds received from
disposal of the remaining net discontinued assets will be consistent with our
net carrying value of these businesses.

11  Debt
Short-Term Debt. Short-term borrowings data at December 31, 1998 and 1997
follow:

- ----------------------------------------------------------------------
                                          Weighted
                                           Average
                                          Interest
                                          Rates at
                                          12/31/98      1998      1997
- ----------------------------------------------------------------------
  Notes payable                              3.34%    $  536    $1,164
  Foreign commercial paper                   5.32%       384       629
- ----------------------------------------------------------------------
  Total short-term debt                                  920     1,793
  Current maturities of long-term debt                 3,184     1,914
- ----------------------------------------------------------------------
  Total                                               $4,104    $3,707
- ----------------------------------------------------------------------

     Notes payable generally represent foreign currency denominated borrowings
of non-U.S. subsidiaries.

Long-Term Debt. A summary of long-term debt by final maturity date at December
31, 1998 and 1997 follows:

- ----------------------------------------------------------------------
                                          Weighted
                                           Average
                                          Interest
                                          Rates at
                                          12/31/98      1998      1997
- ----------------------------------------------------------------------
  U.S. Operations
  Xerox Corporation (parent company)
  Guaranteed ESOP notes due 1998-2004         7.63%   $  370    $  434
  Notes due 1998                                 -         -       585
  Notes due 1999                              5.47     1,108       730
  Notes due 2000                              7.33       600       600
  Notes due 2001                              6.08       675       212
  Notes due 2002                              7.70       230       200
  Notes due 2003                              5.60     1,360       147
  Notes due 2004                              7.15       200       200
  Notes due 2006                                 -         -        25
  Notes due 2007                                 -         -        25
  Notes due 2011                                 -         -        50
  Notes due 2016                              7.20       250       250
  Convertible notes due 2018                  3.63       575         -
  Notes due 2026                                 -         -       350
  Notes due 2038                              5.07        25         -
  Other debt due 1998-2014                    6.88       137       126
  Capital lease obligations                      -         -         3
- ----------------------------------------------------------------------
  Subtotal                                             5,530     3,937
- ----------------------------------------------------------------------
  Xerox Credit Corporation
  Notes due 1998                                 -         -       795
  Notes due 1999                              6.01     1,175       300
  Notes due 2000                              5.37       536       201
  Notes due 2001                              5.17        51       126
  Notes due 2002                                 -         -       250
  Notes due 2007                                 -         -        25
  Notes due 2012                                 -         -       225
  Floating rate notes due 2048                5.09        60        60
  Other notes due 1999 and 2000                  -         -         4
- ----------------------------------------------------------------------
  Subtotal                                             1,822     1,986
- ----------------------------------------------------------------------
  Total U.S. operations                               $7,352    $5,923
- ----------------------------------------------------------------------


                                                        XEROX CORPORATION     49


<PAGE>
 
NOTES

- ----------------------------------------------------------------------
                                          Weighted
                                           Average
                                          Interest
                                          Rates at
                                          12/31/98      1998      1997
- ----------------------------------------------------------------------
  International Operations 
  Various obligations, payable in:
  Canadian dollars due 1998-2007             11.43%  $    99   $   124
  Dutch guilders due 1998-2000                5.14        37        66
  French francs due 1998-2001                 4.14         7        21
  German marks due 1998-1999                  6.37        10        51
  Pounds sterling due 1998-2003               8.75       207       206
  Swiss francs due 1998-2000                  3.59        13        35
  Italian lire due 1998-2000                  6.20       140       123
  U.S. dollars due 1998-2008                  5.66     1,013       229
  Other currencies due 1998-2003              7.56       189       207
  Capital lease obligations                   7.50         1         3
- ----------------------------------------------------------------------
  Total international operations                       1,716     1,065
- ----------------------------------------------------------------------
  Other borrowings deemed long-term                    5,119     3,872
- ----------------------------------------------------------------------
  Subtotal                                            14,187    10,860
  Less current maturities                              3,184     1,914
- ----------------------------------------------------------------------
  Total long-term debt                               $11,003   $ 8,946
- ----------------------------------------------------------------------

Consolidated Long-Term Debt Maturities. Payments due on long-term debt for the
next five years and thereafter follow:

- ----------------------------------------------------------------------------
       1999         2000         2001         2002         2003   Thereafter
- ----------------------------------------------------------------------------
     $3,184       $1,446       $1,242         $382       $1,614       $1,200
- ----------------------------------------------------------------------------

   These payments do not include amounts relating to domestic commercial paper
and foreign bank notes payable, which have been classified as long-term debt
under the caption "Other borrowings deemed long-term." These borrowings are
classified as long-term because we have the intent to refinance them on a
long-term basis and the ability to do so under our revolving credit agreement.

   Certain of our debt agreements allow us to redeem outstanding debt prior to
scheduled maturity. Outstanding debt issues with these call features are
classified in the preceding five-year maturity table in accordance with
management's current expectations. The actual decision as to early redemption
will be made at the time the early redemption option becomes exercisable and
will be based on prevailing economic and business conditions and the relative
costs of new borrowing.

Convertible Debt. In April 1998, we issued convertible subordinated debentures
for net proceeds of $575. The amount due upon maturity in April 2018 is $1,012,
resulting in an effective interest rate of 3.625 percent per annum, including
1.003 percent payable in cash semiannually beginning in October 1998. These
debentures are convertible at any time at the option of the holder into 7.808
shares of our stock per $1,000 principal amount at maturity of debentures.

Lines of Credit. We have a $7 billion revolving credit agreement with a group of
banks, which matures in 2002. This revolver is also accessible by the following
wholly owned subsidiaries: Xerox Credit Corporation (up to a $7 billion limit),
and Xerox Capital (Europe) plc (up to a $4 billion limit) with our guarantee.
Any amounts borrowed under this facility would be at rates based, at the
borrower's option, on spreads above certain reference rates such as LIBOR. This
agreement is unused and is available to back commercial paper borrowings of our
domestic operations, Xerox Capital (Europe) plc and Xerox Overseas Holdings
Ltd., which amounted to $4.5 billion at December 31, 1998. In addition, our
foreign subsidiaries had unused committed long-term lines of credit used to back
short-term indebtedness that aggregate $0.1 billion in various currencies at
prevailing interest rates.

Match Funding of Finance Receivables and Indebtedness. We employ a match funding
policy for customer financing assets and related liabilities. Under this policy,
which is more fully discussed in the accompanying Financial Review on page 35,
the interest and currency


50  XEROX CORPORATION


<PAGE>
 
                                                                           NOTES

characteristics of the indebtedness are, in most cases, matched to the interest
and currency characteristics of the finance receivables. At December 31, 1998,
these operations had approximately $14.5 billion of net finance receivables,
which will service approximately $12.0 billion of assigned short- and long-term
debt, including $0.1 billion of debt assigned to discontinued third party
financing businesses.

Guarantees. At December 31, 1998, we have guaranteed the borrowings of our ESOP
and $3,159 of indebtedness of our foreign subsidiaries.

Interest. Interest paid by us on our short- and long-term debt, including
amounts relating to debt assigned to discontinued operations, amounted to $859,
$812 and $871 for the years ended December 31, 1998, 1997 and 1996,
respectively.

Total Short- and Long-Term Debt. Our total indebtedness, excluding the direct
indebtedness of Talegen, at December 31, 1998 and 1997 is reflected in the
consolidated balance sheet captions as follows:

- ----------------------------------------------------------------------
                                                        1998      1997
- ----------------------------------------------------------------------
  Short-term debt and current portion
   of long-term debt                                 $ 4,104   $ 3,707
  Long-term debt                                      10,867     8,779
  Discontinued operations liabilities -
   policyholders' deposits and other                     136       167
- ----------------------------------------------------------------------
  Total debt                                         $15,107   $12,653
- ----------------------------------------------------------------------

   A summary of changes in consolidated indebtedness for the three years ended
December 31, 1998 follows:

- ----------------------------------------------------------------------
                                              1998      1997      1996
- ----------------------------------------------------------------------
  Increase (decrease) in
    short-term debt, net                    $  553   $  (276)  $   973
  Proceeds from long-term debt               3,464     1,807     2,998
  Principal payments on long-term debt      (1,580)   (1,632)   (2,989)
- ----------------------------------------------------------------------
  Subtotal                                   2,437      (101)      982
  Less change in debt of
    discontinued operations                    (31)     (106)       (8)
- ----------------------------------------------------------------------
  Total change in debt of
    continuing operations                  $ 2,468   $     5   $   990
- ----------------------------------------------------------------------

12  Financial Instruments
Derivative Financial Instruments. Certain financial instruments with
off-balance-sheet risk have been entered into by us to manage our interest rate
and foreign currency exposures. These instruments are held solely for hedging
purposes and include interest rate swap agreements, forward exchange contracts
and foreign currency swap agreements. We do not enter into derivative instrument
transactions for trading or other speculative purposes.

   We typically enter into simple, unleveraged derivative transactions which, by
their nature, have low credit and market risk. Our policies on the use of
derivative instruments prescribe an investment-grade counterparty credit floor
and at least quarterly monitoring of market risk on a counterparty-
by-counterparty basis. We utilize numerous counterparties to ensure that there
are no significant concentrations of credit risk with any individual
counterparty or groups of counterparties. Based upon our ongoing evaluation of
the replacement cost of our derivative transactions and counterparty
creditworthiness, we consider the risk of credit default significantly affecting
our financial position or results of operations to be remote.

   We employ the use of hedges to reduce the risks that rapidly changing market
conditions may have on the underlying transactions. Typically, our currency and
interest rate hedging activities are not affected by changes in market
conditions, as forward contracts and swaps are arranged and normally held to
maturity in order to lock in currency rates and interest rate spreads related to
underlying transactions.

   None of our hedging activities involves exchange traded instruments.

Interest Rate Swaps. We enter into interest rate swap agreements to manage
interest rate exposure. An interest rate swap is an agreement to exchange
interest rate payment streams based on a notional principal amount. We follow
settlement accounting principles for interest rate swaps whereby the net
interest rate differentials to be paid or received are recorded currently as
adjustments to interest expense.

                                                            XEROX CORPORATION 51


<PAGE>
 
NOTES

   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. Additionally, in industrialized countries customer financing
assets are funded with liabilities denominated in the same currency. We refer to
the effects of these conservative practices as "match funding" our customer
financing 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 does effectively eliminate 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.
During 1998, 17 such agreements were cancelled in connection with the early
retirement of 17 issues of medium-term notes. The transactions performed within
each of these three categories enable the cost-effective management of interest
rate exposures. During 1998, the average notional amount of an interest rate
swap agreement was $15.

   For the three years ended December 31, 1998, no pay fixed/receive variable
interest rate swap agreements were terminated prior to maturity.

   The total notional amounts of these transactions at December 31, 1998 and
1997, based on contract maturity, follow:

- --------------------------------------------------------------------------------
                                                                  1998      1997
- --------------------------------------------------------------------------------
  Commercial paper/bank borrowings                             $ 2,242   $ 1,991
  Medium-term debt                                               6,629     5,388
  Long-term debt                                                 5,128     4,313
- --------------------------------------------------------------------------------
  Total                                                        $13,999   $11,692
- --------------------------------------------------------------------------------

   The aggregate notional amounts of interest rate swaps by maturity date and 
type at December 31, 1998 and 1997 follow:


<TABLE>
<CAPTION>
- --------------------------------------------------------------------------------
                                                       2000-     2003-
                                    1998      1999      2002      2016     Total
- --------------------------------------------------------------------------------
<S>                               <C>       <C>       <C>       <C>      <C>    

1998
Pay fixed/receive variable        $    -    $1,792    $4,706    $3,050   $ 9,548
Pay variable/receive variable          -         -       603         -       603
Pay variable/receive fixed             -       450     1,320     2,078     3,848
- --------------------------------------------------------------------------------
Total                             $    -    $2,242    $6,629    $5,128   $13,999
- --------------------------------------------------------------------------------
Memo:
Interest rate paid                     -      6.36%     5.46%     4.87%     5.39%
Interest rate received                 -      5.10%     5.21%     5.29%     5.22%
- --------------------------------------------------------------------------------
1997
Pay fixed/receive variable        $1,136    $1,362    $4,817    $  354   $ 7,669
Pay variable/receive variable        320         -       203         -       523
Pay variable/receive fixed           535       450     1,007     1,508     3,500
- --------------------------------------------------------------------------------
Total                             $1,991    $1,812    $6,027    $1,862   $11,692
- --------------------------------------------------------------------------------
Memo:
Interest rate paid                  6.20%     6.88%     5.93%     6.05%     6.14%
Interest rate received              6.18%     5.72%     5.55%     6.93%     5.90%
- --------------------------------------------------------------------------------
</TABLE>



52  XEROX CORPORATION


<PAGE>
 
                                                                           NOTES

Forward Exchange Contracts. We utilize forward exchange contracts to hedge
against the potentially adverse impacts of foreign currency fluctuations on
foreign currency denominated receivables and payables; firm foreign currency
commitments; and investments in foreign operations. Firm foreign currency
commitments generally represent committed purchase orders for foreign-sourced
inventory. These contracts generally mature in six months or less. At December
31, 1998 and 1997, we had outstanding forward exchange contracts of $2,817 and
$1,977, respectively. Of the outstanding contracts at December 31, 1998, the
largest single currency represented was the British pound sterling. Contracts
denominated in British pounds sterling, U.S. dollars, Brazilian reais, French
francs and Japanese yen accounted for over 75 percent of our forward exchange
contracts. On contracts that hedge foreign currency denominated receivables and
payables, gains or losses are reported currently in income, and premiums or
discounts are amortized to income and included in Other, net in the consolidated
statements of income. Gains or losses, as well as premiums or discounts, on
contracts that hedge firm commitments are deferred and subsequently recognized
as part of the underlying transaction. At December 31, 1998, we had a net
deferred gain of $17. Gains or losses on contracts that hedge an investment in a
foreign operation are reported currently in the balance sheet as a component of
cumulative translation adjustments. The premium or discount on contracts that
hedge an investment in a foreign operation are amortized to income and included
in Other, net in the consolidated statements of income. During 1998, the average
notional amount of a forward exchange contract amounted to $17.

Foreign Currency Swap Agreements. We enter into cross-currency interest rate
swap agreements, whereby we issue foreign currency denominated debt and swap the
proceeds with a counterparty. In return, we receive and effectively denominate
the debt in local currencies. Currency swaps are utilized as hedges of the
underlying foreign currency borrowings, and exchange gains or losses are
recognized currently in Other, net in the consolidated statements of income.
During 1998, we entered into cross-currency interest rate swap agreements to
convert U.S. dollar-denominated debt ($838) to yen-denominated debt (yen 95
billion) as of December 31, 1998. This synthetic yen debt is designated as a
hedge of our investment in Fuji Xerox. Accordingly, related currency gains or
losses have been included as a component of cumulative translation adjustments.
At December 31, 1998, cross-currency interest rate swap agreements with an
aggregate notional amount of $3,143 remained outstanding.

Fair Value of Financial Instruments. The estimated fair values of our financial
instruments at December 31, 1998 and 1997 follow:

- ----------------------------------------------------------------------
                                        1998                1997
- ----------------------------------------------------------------------
                                Carrying      Fair  Carrying      Fair
                                  Amount     Value    Amount     Value
- ----------------------------------------------------------------------
  Cash                           $    79   $    79   $    75   $    75
  Accounts receivable, net         2,671     2,671     2,145     2,145
  Short-term debt                    920       920     1,793     1,793
  Long-term debt                  14,187    14,524    10,860    11,189
  Interest rate and currency
   swap agreements                     -        47         -        25
  Forward exchange contracts           -        51         -       (44)
- ----------------------------------------------------------------------

   The fair value amounts for Cash, Accounts receivable, net and Short-term debt
approximate carrying amounts due to the short maturities of these instruments.

   The fair value of Long-term debt was estimated based on quoted market prices
for these or similar issues or on the current rates offered to us for debt of
the same remaining maturities. The difference between the fair value and the
carrying value represents the theoretical net premium we would have to pay to
retire all debt at such date. We have no plans to retire significant portions of
our long-term debt prior to scheduled maturity. We are not required to determine
the fair value of our finance receivables, the match funding of which is the
source of much of our interest rate swap activity.

   The fair values for interest rate and cross-currency swap agreements and
forward exchange contracts were calculated by us based on market conditions at
year-end and supplemented with quotes from brokers. They represent amounts we
would receive (pay) to terminate/replace these contracts. We have no present
plans to terminate/replace significant portions of these contracts.

                                                            XEROX CORPORATION 53


<PAGE>
 
NOTES


13  Employee Benefit Plans 
We sponsor numerous pension and other postretirement benifit plans in our U.S.
and international operations.


<TABLE>
<CAPTION>
- ----------------------------------------------------------------------------------------------------------------------
                                                                      Pension Benefits             Other Benefits
======================================================================================================================
                                                                         1998         1997         1998         1997
- ----------------------------------------------------------------------------------------------------------------------
 Change in Benefit Obligation
<S>                                                                   <C>          <C>          <C>          <C>    
 Benefit obligation, January 1                                        $ 7,399      $ 6,441      $ 1,029      $   892
 Service cost                                                             172          167           26           25
 Interest cost                                                            916          948           72           66
 Plan participants' contributions                                          13           31            -            -
 Plan amendments                                                            -           11            -            -
 Actuarial loss                                                           157          254            8          100
 Currency exchange rate changes                                            31         (130)          (3)          (2)
 Curtailments                                                              (9)         (18)          20            -
 Special termination benefits                                              99            -            2            -
 Benefits paid                                                           (738)        (305)         (59)         (52)
- ----------------------------------------------------------------------------------------------------------------------
 Benefit obligation, December 31                                        8,040        7,399        1,095        1,029
======================================================================================================================
 Change in Plan Assets
 Fair value of plan assets, January 1                                   7,708        6,771            -            -
 Actual return on plan assets                                             872        1,293            -            -
 Employer contribution                                                     80           45           59           52
 Plan participants' contributions                                          13           31            -            -
 Currency exchange rate changes                                            23         (127)           -            -
 Benefits paid                                                           (738)        (305)         (59)         (52)
- ----------------------------------------------------------------------------------------------------------------------
 Fair value of plan assets, December 31                                 7,958        7,708            -            -
======================================================================================================================
 Funded status (including under-funded and non-funded plans)              (82)         309       (1,095)      (1,029)
 Unamortized transition assets                                            (61)         (81)           -            -
 Unrecognized prior service cost                                           28           34           (4)          (4)
 Unrecognized net actuarial (gain) loss                                   121         (217)           7          (46)
- ----------------------------------------------------------------------------------------------------------------------
 Net amount recognized                                                $     6      $    45      $(1,092)     $(1,079)
======================================================================================================================
 Amounts recognized in the consolidated balance sheets consist of:
  Prepaid benefit cost                                                $   349      $   297            -            -
  Accrued benefit liability                                              (343)        (252)     $(1,092)     $(1,079)
- ---------------------------------------------------------------------------------------------------------------------- 
 Net amount recognized                                                $     6      $    45      $(1,092)     $(1,079)
======================================================================================================================
 Under-funded or non-funded plans
  Aggregate benefit obligation                                        $   345      $   334      $ 1,095      $ 1,029
  Aggregate fair value of plan assets                                 $    35      $    68      $     -      $     -
- ----------------------------------------------------------------------------------------------------------------------
 Weighted-average assumptions as of December 31
 Discount rate                                                            7.0%         7.4%         7.0%         7.2%
 Expected return on plan assets                                           9.2          9.5
 Rate of compensation increase                                            4.2          4.4                    
- ----------------------------------------------------------------------------------------------------------------------
</TABLE>
 


54 XEROX CORPORATION

<PAGE>
 
                                                                           NOTES

<TABLE> 
<CAPTION> 
- ------------------------------------------------------------------------------------------------------------
                                                Pension Benefits                   Other Benefits
============================================================================================================
                                              1998        1997        1996     1998       1997        1996
- ------------------------------------------------------------------------------------------------------------
Components of Net Periodic Benefit Cost
<S>                                       <C>        <C>          <C>        <C>      <C>        <C> 
Defined benefit plans
Service cost                               $   172     $   167     $   164     $ 26    $    25     $    26
Interest cost                                  916         948         787       72         66          63
Expected return on plan assets              (1,010)     (1,014)       (849)       -          -           -
Recognized net actuarial (gain)/loss            10          16           8        -         (4)         (1)
Amortization of prior service cost               6           8           6        -          -           -
Recognized net transition asset                (19)        (20)        (18)       -          -           -
Recognized curtailment/settlement gain         (60)        (31)         (7)       -          -           -
- ------------------------------------------------------------------------------------------------------------
  Net periodic benefit cost                     15          74          91       98         87          88
Defined contribution plans                      32          23          17        -          -           -
- ------------------------------------------------------------------------------------------------------------
Total                                      $    47     $    97     $   108     $ 98    $    87     $    88
============================================================================================================
</TABLE>
 

   Assumed health care cost trend rates have a significant effect on the amounts
reported for the health care plans. For measurement purposes, a 7.5 percent
annual rate of increase in the per capita cost of covered health care benefits
was assumed for 1998. The rate was assumed to decrease gradually to 5.25 percent
in 2002 and thereafter.

   A one-percentage-point change in assumed health care cost trend rates would
have the following effects:

- --------------------------------------------------------------------------------
                                                         One-              One-
                                                  percentage-       percentage-
                                                        point             point
                                                     increase          decrease
================================================================================
Effect on total service and interest             
   cost components                                          4               (4)
Effect on postretirement benefit obligation                57              (54)
- --------------------------------------------------------------------------------

Employee Stock Ownership Plan (ESOP) Benefits. In 1989, we established an ESOP
and sold to it 10 million shares of Series B Convertible Preferred Stock
(Convertible Preferred) of the Company for a purchase price of $785. Each ESOP
share is convertible into six common shares of the Company. The Convertible
Preferred has a $1 par value, a guaranteed minimum value of $78.25 per share and
accrues annual dividends of $6.25 per share. The ESOP borrowed the purchase
price from a group of lenders. The ESOP debt is included in our consolidated
balance sheets because we guarantee the ESOP borrowings. A corresponding amount
classified as Deferred ESOP benefits represents our commitment to future
compensation expense related to the ESOP benefits.

   The ESOP will repay its borrowings from dividends on the Convertible
Preferred and from our contributions. The ESOP's debt service is structured such
that our annual contributions (in excess of dividends) essentially correspond to
a specified level percentage of participant compensation. As the borrowings are
repaid, the Convertible Preferred is allocated to ESOP participants and Deferred
ESOP benefits are reduced by principal payments on the borrowings. Most of our
domestic employees are eligible to participate in the ESOP.

   Information relating to the ESOP for the three years ended December 31, 1998
follows:

- ---------------------------------------------------------------------
                                         1998       1997       1996  
=====================================================================
Interest on ESOP Borrowings              $33         $38        $42
- ---------------------------------------------------------------------
Dividends declared on Convertible
  Preferred Stock                        $56         $57        $58
- ---------------------------------------------------------------------
Cash contribution to the ESOP            $41         $39        $36
- ---------------------------------------------------------------------
Compensation expense                     $44         $40        $37
=====================================================================

   We recognize ESOP costs based on the amount committed to be contributed to
the ESOP plus related trustee, finance and other charges.


                                                       
                                                        XEROX CORPORATION     55

<PAGE>
 
NOTES


14 Income Taxes
   The parent company and its domestic subsidiaries file consolidated U.S.
income tax returns. Generally, pursuant to tax allocation arrangements, domestic
subsidiaries record their tax provisions and make payments to the parent company
for taxes due or receive payments from the parent company for tax benefits
utilized.

   Income before income taxes from continuing operations for the three years
ended December 31, 1998 consists of the following:

- -----------------------------------------------------------------
                                 1998         1997         1996
=================================================================
Domestic income                  $625       $1,082       $  781
Foreign income                    138        1,059        1,163
- -----------------------------------------------------------------
Income before income taxes       $763       $2,141       $1,944
=================================================================

   Provisions for income taxes from continuing operations for the three years
ended December 31, 1998 consist of the following:

- ----------------------------------------------------------
                            1998         1997       1996
==========================================================
Federal income taxes
  Current                   $265         $253       $210 
  Deferred                  (149)          67         50
Foreign income taxes
  Current                    178          168        205
  Deferred                  (143)         158        166
State income taxes
  Current                     70           69         62
  Deferred                   (14)          13          7
- ----------------------------------------------------------
Income taxes                $207         $728       $700
==========================================================

   A reconciliation of the U.S. federal statutory income tax rate to the
effective income tax rate for continuing operations for the three years ended
December 31, 1998 follows:

- -----------------------------------------------------------------------------
                                               1998        1997        1996
=============================================================================
U.S. federal statutory income tax rate        35.0%       35.0%       35.0%
Foreign earnings and dividends
  taxed at different rates                    (7.3)       (3.2)         .5
Goodwill amortization                           .7          .3          .3
Tax-exempt income                             (2.3)        (.8)        (.5)
State taxes                                    4.7         2.5         2.3
Change in valuation allowance for
  deferred tax assets                            -           -        (1.0)
Other                                         (3.7)         .2         (.6)
- -----------------------------------------------------------------------------
Effective income tax rate                     27.1%       34.0%       36.0%
=============================================================================

   The 1998 effective tax rate of 27.1 percent is 6.9 percentage points lower
than 1997. Excluding the 1998 worldwide restructuring program, the 1998
effective tax rate is 31.6 percent, which is 2.4 percentage points lower than
1997. This lower 1998 rate is primarily attributable to an increase in foreign
tax credits, refund of foreign taxes and mix of profits from our worldwide
operations.

   The 1997 effective tax rate of 34.0 percent is 2.0 percentage points lower
than 1996. This lower 1997 rate is primarily attributable to an increase in
foreign tax credits, refund of foreign taxes and mix of profits from our
worldwide operations.

   On a consolidated basis, including the effects of discontinued operations, we
paid a total of $217, $241 and $252 in income taxes to federal, foreign and
state income-taxing authorities in 1998, 1997 and 1996, respectively.

   Total income tax expense (benefit) for the three years ended December 31,
1998 was allocated as follows:

- -------------------------------------------------------------
                                    1998      1997      1996
=============================================================
Income taxes on income
   from continuing operations      $ 207     $ 728     $ 700
Tax benefit included in
   minorities' interests(*)          (20)      (19)        -
Discontinued operations              (54)     (166)      (84)
Common shareholders' equity(**)     (140)      (57)      (15)
- -------------------------------------------------------------
Total                              $  (7)    $ 486     $ 601
=============================================================

(*)  Benefit relates to preferred securities as more fully described in Note 16
     on page 58.

(**) For dividends paid on shares held by the ESOP; cumulative translation
     adjustments and tax benefit on nonqualified stock options.
================================================================================

   Deferred income taxes have not been provided on the undistributed earnings of
foreign subsidiaries and other foreign investments carried at equity. The amount
of such earnings included in consolidated retained earnings at December 31, 1998
was approximately $4.7 billion. These earnings have been substantially
reinvested, and we do not plan to initiate any action that would precipitate the
payment of income taxes thereon. It is not practicable to estimate the amount of
additional tax that might be payable on the foreign earnings.




56    XEROX CORPORATION

<PAGE>
 
   The tax effects of temporary differences that give rise to significant
portions of the deferred taxes at December 31, 1998 and 1997 follow:

- --------------------------------------------------------------------
                                             1998             1997
====================================================================
Tax effect of future tax deductions
  Depreciation                            $   443           $  294
  Postretirement medical benefits             419              406
  Restructuring reserves                      329               22
  Other operating reserves                    277              299
  Deferred intercompany profit                 76               60
  Allowance for doubtful accounts              93               95
  Deferred compensation                       165              151
  Tax credit carryforwards                    104              125
  Research and development                    564              256
  Other                                       116              133
- --------------------------------------------------------------------
Total                                     $ 2,586           $1,841
====================================================================
Tax effect of future taxable income
  Installment sales and leases            $(1,407)         $(1,282) 
  Leveraged leases                            (23)             (21) 
  Deferred income                            (630)            (353) 
  Other                                      (264)            (192) 
- --------------------------------------------------------------------
Total                                     $(2,324)         $(1,848) 
====================================================================

   The above amounts are classified as current or long-term in the consolidated
balance sheets in accordance with the asset or liability to which they relate.
Current deferred tax assets at December 31, 1998 and 1997 amounted to $551 and
$516, respectively.

   We conclude that it is more likely than not that the deferred tax assets will
be realized in the ordinary course of operations based on scheduling of deferred
tax liabilities and income from operating activities.

   At December 31, 1998, we have tax credit carryforwards for federal income tax
purposes of $2 available to offset future federal income taxes through 2002 and
$104 available to offset future federal income taxes indefinitely. We also have
net operating loss carryforwards for income tax purposes of $80 which are
available to offset future taxable income through 2005 and $90 available to
offset future taxable income indefinitely.


15  Litigation 

On March 10, 1994, a lawsuit was filed in the United States District Court for
the District of Kansas by two independent service organizations (ISOs) in Kansas
City and St. Louis and their parent company. Subsequently, a single corporate
entity, CSU, L.L.C. ("CSU") was substituted for the three affiliated companies.
CSU claimed damages predominately resulting from the Company's alleged refusal
to sell parts for high volume copiers and printers to CSU prior to 1994. The
Company's policies and practices with respect to the sale of parts to ISOs were
at issue in an antitrust class action in Texas, which was settled by the Company
during 1994. Claims for individual lost profits of ISOs who were not named
parties, such as CSU, were not included in that class action. The Company
asserted counterclaims against CSU alleging patent and copyright infringement
relating to the copying of diagnostic software and service manuals. On April 8,
1997, the District Court granted partial summary judgment in favor of the
Company on CSU's antitrust claims, ruling that the Company's unilateral refusal
to sell or license its patented parts cannot give rise to antitrust liability.
On January 8, 1999, the Court dismissed with prejudice all of CSU's antitrust
claims. CSU has preserved for appeal only its claims that Xerox unlawfully
refused to sell critical parts (including patented parts), to sell manuals and
to license patented and copyrighted software and its claim that the Company's
refusal to sell non-critical parts was unlawful because it was in conjunction
with an allegedly unlawful refusal to sell critical parts. The District Court
also granted summary judgment in favor of the Company on its patent infringement
claim, leaving open with respect to patent infringement only the issues of
willfulness and the amount of damages, and granted partial summary judgment in
favor of the Company with respect to some of its claims of copyright
infringement. A judgment in the amount of $1.0 was entered in favor of the
Company and against CSU on the copyright infringement counterclaim. Pursuant to
a final judgment entered by the Court on January 11, 1999 CSU was granted leave
to appeal the antitrust claims and copyright counterclaims without entry of
final judgment on the patent claims.

                                                        XEROX CORPORATION     57

<PAGE>
 
NOTES



   On April 11, 1996, an action was commenced by Accuscan Corp. (Accuscan), in
the United States District Court for the Southern District of New York, against
the Company seeking unspecified damages for infringement of a patent of Accuscan
which expired in 1993. The suit, as amended, was directed to facsimile and
certain other products containing scanning functions and sought damages for
sales between 1990 and 1993. On April 1, 1998, the jury entered a verdict in
favor of Accuscan for $40. However, on September 14, 1998, the Court granted the
Company's motion for a new trial on damages. The Company is also seeking to
appeal the issue of liability and believes that the liability verdict should be
set aside.

   On December 18, 1998, three former employees of Crum & Forster Holdings, Inc.
(a former subsidiary of ours) ("C&F") filed a lawsuit in the United States
District Court for the District of New Jersey claiming wrongful termination of
their participation in the Xerox Corporation Employee Stock Ownership Plan
("ESOP"). Xerox, the ESOP, C&F and the company that acquired C&F are named
defendants. Plaintiffs purport to bring this action on behalf of themselves and
a class of approximately 10,000 persons who were employed by C&F (or one of its
insurance subsidiaries which also participated in the ESOP) from July 1, 1989
through December 31, 1993. Plaintiffs assert violations of the Employee
Retirement Income Security Act, breach of contract, conversion, unjust
enrichment and fraudulent misrepresentation. They are seeking approximately $250
in damages.

   The foregoing action is related to an action previously filed in the United
States District Court for the Western District of Texas. The Texas plaintiffs
did not specify their damages, but they are seeking certification of a similar
class of former ESOP participants. Plaintiffs' motion for class certification
and our motion to dismiss the Texas action are still pending.

 
  We deny any wrongdoing and we intend to vigorously defend both the Texas and
New Jersey actions.


16  Preferred Securities
We have 22 million authorized shares of cumulative preferred stock, $1 par
value. Outstanding preferred stock at December 31, 1998 and 1997 follows (shares
in thousands):

- ------------------------------------------------------------------------
                                      1998                 1997
- ------------------------------------------------------------------------
                                Shares  Amount        Shares   Amount 
========================================================================
  Convertible
    Preferred Stock             8,785      $687       9,013       $705
========================================================================

Convertible Preferred Stock. As more fully described in Note 13 on page 55, we
sold, for $785, 10 million shares of our Series B Convertible Preferred Stock
(ESOP shares) in 1989 in connection with the establishment of our ESOP. As
employees with vested ESOP shares leave the Company, these shares are redeemed
by us. We have the option to settle such redemptions with either shares of
common stock or cash.

Preferred Stock Purchase Rights. We have a shareholder rights plan designed to
deter coercive or unfair takeover tactics and to prevent a person or persons
from gaining control of us without offering a fair price to all shareholders.

   Under the terms of the plan, one-half of one preferred stock purchase right
(Right) accompanies each share of outstanding common stock (giving effect to the
two-for-one stock split in February 1999). Each full Right entitles the holder
to purchase from us one three-hundredth of a new series of preferred stock at an
exercise price of $250.

   Within the time limits and under the circumstances specified in the plan, the
Rights entitle the holder to acquire either our common stock, the surviving
company in a business combination, or the purchaser of our assets, having a
value of two times the exercise price.

   The Rights may be redeemed prior to becoming exercisable by action of the
Board of Directors at a redemption price of $.01 per Right. The Rights expire in
April 2007.

   The Rights are non-voting and, until they become exercisable, have no
dilutive effect on the earnings per share or book value per share of our common
stock.

Deferred Preferred Stock. In October 1996, a subsidiary of ours issued 2 million
deferred preferred shares for Canadian (Cdn.) $50 million. The U.S. dollar value
was $37 and is included in Minorities' interests in equity of subsidiaries in



58      XEROX CORPORATION


<PAGE>
 
                                                                           NOTES



the consolidated balance sheet. These shares are mandatorily redeemable on
February 28, 2006 for Cdn. $90 million. The difference between the redemption
amount and the proceeds from the issue is being amortized, through the
redemption date, to minorities' interests in earnings of subsidiaries in the
consolidated statements of income. We have guaranteed the redemption value.

Company-obligated, mandatorily redeemable preferred securities of subsidiary
trust holding solely subordinated debentures of the Company. On January 29,
1997, a trust sponsored and wholly owned by the Company issued $650 aggregate
liquidation amount preferred securities (the "Original Preferred Securities") to
investors and 20,103 shares of common securities to the Company, the proceeds of
which were invested by the trust in $670.1 aggregate principal amount of the
Company's newly issued 8 percent Junior Subordinated Debentures due 2027 ("the
Original Debentures"). On June 13, 1997, pursuant to a registration statement
filed by the Company and the trust with the Securities and Exchange Commission,
Original Preferred Securities with an aggregate liquidation preference amount of
$644.2 and Original Debentures with a principal amount of $644.2 were exchanged
for a like amount of preferred securities (together with the Original Preferred
Securities, the "Preferred Securities") and 8 percent Junior Subordinated
Debentures due 2027 (together with the Original Debentures, the "Debentures")
which were registered under the Securities Act of 1933. The Debentures represent
all of the assets of the trust. The proceeds from the issuance of the Original
Debentures were used by the Company for general corporate purposes. The
Debentures and related income statement effects are eliminated in the Company's
consolidated financial statements.

   The Preferred Securities accrue and pay cash distributions semi-annually at a
rate of 8 percent per annum of the stated liquidation amount of $1,000 per
Preferred Security. The Company has guaranteed (the "Guarantee"), on a
subordinated basis, distributions and other payments due on the Preferred
Securities. The Guarantee and the Company's obligations under the Debentures and
in the indenture pursuant to which the Debentures were issued and the Company's
obligations under the Amended and Restated Declaration of Trust governing the
trust, taken together, provide a full and unconditional guarantee of amounts due
on the Preferred Securities.

   The Preferred Securities are mandatorily redeemable upon the maturity of the
Debentures on February 1, 2027, or earlier to the extent of any redemption by
the Company of any Debentures. The redemption price in either such case will be
$1,000 per share plus accrued and unpaid distributions to the date fixed for
redemption.

17  Common Stock
We have 1.05 billion authorized shares of common stock, $1 par value. At
December 31, 1998 and 1997, 45.3 and 41.5 million shares, respectively, were
reserved for issuance under our incentive compensation plans. In addition, at
December 31, 1998, 13.2 million common shares were reserved for the conversion
of $628 of convertible debt and 52.7 million common shares were reserved for
conversion of ESOP-related Convertible Preferred Stock.

Treasury Stock. The Board of Directors has authorized us to repurchase up to $1
billion of our common stock. The stock will be repurchased from time to time on
the open market depending on market conditions. During 1998 and 1997, we
repurchased 3.7 and 4.0 million shares for $172 and $116, respectively. Since
inception of the program we have repurchased 20.6 million shares for $594.
Common shares issued for stock option exercises, conversion of convertible
securities and other exchanges were partially satisfied by reissuances of
treasury shares.

Put Options. In connection with the share repurchase program, during 1998, 1997
and 1996, we sold 1.0 million, 8.0 million and 5.6 million put options,
respectively, that entitle the holder to sell one share of our common stock to
us at a specified price. These put options are exercisable only at maturity and
can be settled in cash at our option. The put options had original maturities
ranging from six months to two years.

   At December 31, 1998, 1.0 million put options remain outstanding with a
strike price of $47.93 per share.



                                                       XEROX CORPORATION      59

<PAGE>
 
NOTES



Stock Option and Long-Term Incentive Plans. We have a long-term incentive plan
whereby eligible employees may be granted nonqualified stock options and
performance unit rights. Subject to vesting and other requirements, performance
unit rights are typically paid in our common stock, beginning with the 1998
awards and are typically paid in cash for units awarded prior to 1998. The value
of each performance unit was typically based upon the level of return on assets
during the year in which granted. Performance units ratably vest in the three
years after the year awarded.

   Stock options and rights are settled with newly issued or treasury shares of
our common stock. Stock options granted prior to December 31, 1995 normally vest
in two years and normally expire five years from the date of grant. Stock
options granted subsequent to December 31, 1995 vest in three years and
generally will expire eight years from the date of grant. The exercise price of
the options is equal to the market value of our common stock on the effective
date of grant.

   At December 31, 1998 and 1997, 6.4 and 8.5 million shares, respectively, were
available for grant of options or rights. The following table provides
information relating to the status of, and changes in, options granted:

<TABLE> 
<CAPTION> 
- ------------------------------------------------------------------------------------------------
Employee Stock Options                 1998                 1997                   1996
- ------------------------------------------------------------------------------------------------
                                          Average                Average                Average
                                Stock      Option      Stock      Option      Stock      Option
(Options in thousands)        Options       Price    Options       Price    Options       Price
================================================================================================
<S>                          <C>         <C>        <C>          <C>        <C>        <C> 
Outstanding at January 1       27,134     $    26     22,206     $    19     21,588     $    17
Granted                         8,980          47     12,201          34      7,376          22
Cancelled                        (199)         37       (300)         24       (730)         19
Exercised                      (5,571)         20     (6,973)         17     (5,878)         16
Surrendered for SARs                -           -          -           -       (150)          8
Outstanding at December 31     30,344          33     27,134          26     22,206          19
- ------------------------------------------------------------------------------------------------
Exercisable at end of year      9,622                  8,850                  8,888  
================================================================================================
<CAPTION> 
  Options outstanding and exercisable at December 31, 1998 are as follows:
- ------------------------------------------------------------------------------------------------------------------------------
Thousands except per share data                     Options Outstanding                              Options Exercisable
==============================================================================================================================
                                                             Weighted                                
 Range of                                  Number   Average Remaining   Weighted Average          Number    Weighted Average 
 Exercise Prices                      Outstanding    Contractual Life     Exercise Price     Exercisable      Exercise Price
- ------------------------------------------------------------------------------------------------------------------------------
<S>                                       <C>                   <C>             <C>             <C>              <C> 
 $13.18 to $19.63                          4,972                 1.75            $ 17.94           4,972           $   17.94
  19.77 to  28.91                          4,939                 4.88              22.09           2,806               22.10
  30.97 to  44.16                         16,477                 6.31              37.06           1,844               31.96
  46.88 to  54.86                          3,956                 6.98              49.64               -                   -
- ------------------------------------------------------------------------------------------------------------------------------
 $13.18 to $54.86                         30,344                 5.42            $ 33.13           9,622           $   21.84
- ------------------------------------------------------------------------------------------------------------------------------
</TABLE>
 


60      XEROX CORPORATION


<PAGE>
 
                                                                           NOTES



We do not recognize compensation expense relating to employee stock options
because the exercise price of the option equals the fair value of the stock on
the effective date of grant. If we had determined the compensation based on the
value as determined by the modified Black-Scholes option pricing model, in
accordance with SFAS No. 123, the pro forma net income and earnings per share
would be as follows:

- -----------------------------------------------------------------------------
                                              1998         1997         1996
=============================================================================
Net income - as reported                     $ 395       $1,452       $1,206
Net income - pro forma                         350        1,429        1,189
Basic earnings per share - as reported        0.53         2.16         1.78
Basic earnings per share - pro forma          0.46         2.12         1.75
Diluted earnings per share - as reported      0.52         2.02         1.66
Diluted earnings per share - pro forma        0.45         1.99         1.64
- -----------------------------------------------------------------------------

   The effects of applying SFAS No. 123 in this pro forma disclosure are not
necessarily indicative of future amounts.

   As reflected in the pro forma amounts in the table above, the fair value of
each option granted in 1998, 1997 and 1996 was $13.31, $9.03 and $5.25,
respectively. The fair value of each option granted was estimated on the date of
grant using the following weighted average assumptions:

- ------------------------------------------------------------
                              1998        1997        1996
============================================================
Risk-free interest rate        5.2%        6.1%        5.7%
Expected life in years         5.3         5.0         5.5
Expected volatility           24.9%       23.5%       22.0%
Expected dividend yield        1.4%        1.9%        2.6%
============================================================

18  Earnings per Share
A reconciliation of the numerators and denominators of the basic and diluted EPS
calculation follows:

<TABLE> 
<CAPTION> 
- ----------------------------------------------------------------------------------------------------------------------------------
                                                    1998                           1997                           1996
- ----------------------------------------------------------------------------------------------------------------------------------
                                        Income     Shares       Per   Income      Shares      Per    Income      Shares      Per
                                       (Numer-    (Denom-     Share  (Numer-     (Denom-    Share   (Numer-     (Denom-    Share
(Shares in thousands)                    ator)    inator)    Amount    ator)     inator)   Amount     ator)     inator)   Amount
==================================================================================================================================
<S>                                     <C>       <C>      <C>       <C>        <C>        <C>      <C>       <C>        <C> 
Basic EPS                              
 Income from continuing operations       $585                         $1,452                         $1,206              
 Accrued dividends on preferred stock     (46)                           (44)                           (44)             
Basic EPS                                 539     658,956     $0.82    1,408     653,371    $2.16     1,162     654,388    $1.78
==================================================================================================================================
Diluted EPS                                                                                                              
 Stock options and other incentives                 9,811                          7,929                         10,642  
 ESOP Adjustment, net of tax                                              44      54,686                 40      55,962  
 Convertible debt, net of tax               3       5,287                  3       5,287                  3       5,287  
Diluted EPS                              $542     674,054     $0.80   $1,455     721,273    $2.02    $1,205     726,279    $1.66
==================================================================================================================================
  Note: Recalculation of per share amounts may be off by $0.01 in certain instances due to rounding.
- ----------------------------------------------------------------------------------------------------------------------------------
</TABLE>
 



                                                       -------------------------
                                                       XEROX CORPORATION      61
                                                       -------------------------

<PAGE>
 
NOTES


Quarterly Results of Operations
(Unaudited)

<TABLE> 
<CAPTION> 
- -----------------------------------------------------------------------------------------------------------------------------
                                                                          First       Second     Third    Fourth        Full
 In millions, except per share data                                     Quarter      Quarter   Quarter   Quarter        Year
=============================================================================================================================
 1998
<S>                                                                   <C>          <C>         <C>       <C>       <C> 
 Revenues                                                              $  4,304     $  4,742    $4,607    $5,796    $ 19,449
 Costs and Expenses                                                       3,859        5,841     4,067     4,919      18,686
- -----------------------------------------------------------------------------------------------------------------------------
 Income (Loss) before Income Taxes, Equity Income and
   Minorities' Interests                                                    445       (1,099)      540       877         763
 Income Taxes                                                               147         (385)      173       272         207
 Equity in Net Income of Unconsolidated Affiliates                           14           12        28        20          74
 Minorities' Interests in Earnings of Subsidiaries                           11           10        14        10          45
- -----------------------------------------------------------------------------------------------------------------------------
 Income (Loss) from Continuing Operations                                   301         (712)      381       615         585
 Discontinued Operations                                                   (190)           -         -         -        (190)
- -----------------------------------------------------------------------------------------------------------------------------
 Net Income (Loss)(1)                                                    $  111       $ (712)   $  381    $  615     $   395
=============================================================================================================================
 Basic Earnings (Loss) per Share
   Continuing Operations                                                 $ 0.44      $ (1.10)   $ 0.56    $ 0.92     $  0.82
   Discontinued Operations                                                (0.29)          -          -         -       (0.29)
- -----------------------------------------------------------------------------------------------------------------------------
 Basic Earnings per Share                                                $ 0.15      $ (1.10)   $ 0.56    $ 0.92     $  0.53
=============================================================================================================================
 Diluted Earnings (Loss) per Share(2)
   Continuing Operations                                                 $ 0.42      $ (1.10)   $ 0.53    $ 0.84      $ 0.80
   Discontinued Operations                                                (0.26)          -          -         -       (0.28)
- -----------------------------------------------------------------------------------------------------------------------------
 Diluted Earnings per Share(2)                                           $ 0.16      $ (1.10)   $ 0.53    $ 0.84     $  0.52
=============================================================================================================================

 1997
 Revenues                                                              $  4,017     $  4,351    $4,371    $5,405    $ 18,144
 Costs and Expenses                                                       3,589        3,854     3,921     4,639      16,003
- -----------------------------------------------------------------------------------------------------------------------------
 Income before Income Taxes, Equity Income and Minorities' Interests        428          497       450       766       2,141
 Income Taxes                                                               150          175       153       250         728
 Equity in Net Income of Unconsolidated Affiliates                           22           46        37        22         127
 Minorities' Interests in Earnings of Subsidiaries                           30           31        14        13          88
- -----------------------------------------------------------------------------------------------------------------------------
 Income from Continuing Operations                                          270          337       320       525       1,452
 Discontinued Operations                                                      -            -         -         -           - 
- -----------------------------------------------------------------------------------------------------------------------------
 Net Income                                                              $  270       $  337    $  320    $  525     $ 1,452
============================================================================================================================= 
 Basic Earnings per Share
   Continuing Operations                                                 $ 0.40       $ 0.50    $ 0.47    $ 0.79     $  2.16
   Discontinued Operations                                                    -          -           -         -           -
- -----------------------------------------------------------------------------------------------------------------------------
 Basic Earnings per Share                                                $ 0.40       $ 0.50    $ 0.47    $ 0.79     $  2.16
============================================================================================================================= 
 Diluted Earnings per Share(3)                                                                                          
   Continuing Operations                                                 $ 0.37       $ 0.47    $ 0.44    $ 0.73     $  2.02
   Discontinued Operations                                                    -          -           -         -           -
- -----------------------------------------------------------------------------------------------------------------------------
 Diluted Earnings per Share(3)                                           $ 0.37       $ 0.47    $ 0.44    $ 0.73     $  2.02
============================================================================================================================= 
</TABLE>
 
(1) 1998 second quarter includes a restructuring charge of $1,644 ($1,107 after
    taxes and including our $18 share of a restructuring charge recorded by Fuji
    Xerox).
(2) 1998 quarterly diluted earnings per share differ from the full year amount
    because certain antidilutive securities are excluded from the earnings per
    share calculations.
(3) 1997 quarterly diluted earnings per share differ from the full year amount
    by $.01 due to rounding.


 62  XEROX CORPORATION

<PAGE>
 
Reports of Management and Independent Auditors

Report of Management

Xerox Corporation management is responsible for the integrity and objectivity of
the financial data presented in this annual report. The consolidated financial
statements were prepared in conformity with generally accepted accounting
principles and include amounts based on management's best estimates and
judgments.

   The Company maintains an internal control structure designed to provide
reasonable assurance that assets are safeguarded against loss or unauthorized
use and that financial records are adequate and can be relied upon to produce
financial statements in accordance with generally accepted accounting
principles. This structure includes the hiring and training of qualified people,
written accounting and control policies and procedures, clearly drawn lines of
accountability and delegations of authority. In a business ethics policy that is
communicated annually to all employees, the Company has established its intent
to adhere to the highest standards of ethical conduct in all of its business
activities.

   The Company monitors its internal control structure with direct management
reviews and a comprehensive program of internal audits. In addition, KPMG LLP,
independent auditors, have audited the consolidated financial statements and
have reviewed the internal control structure to the extent they considered
necessary to support their report, which follows.

   The Audit Committee of the Board of Directors, which is composed solely of
outside directors, meets regularly with the independent auditors, the internal
auditors and representatives of management to review audits, financial 
reporting and internal control matters, as well as the nature and extent of the
audit effort. The Audit Committee also recommends the engagement of independent
auditors, subject to shareholder approval. The independent auditors and internal
auditors have free access to the Audit Committee.


/s/ Paul A. Allaire                     /s/ Barry D. Romeril 

Paul A. Allaire                         Barry D. Romeril 
Chairman of the Board and               Executive Vice President and
Chief Executive Officer                 Chief Financial Officer




Report of Independent Auditors
To the Board of Directors and Shareholders of
Xerox Corporation:

We have audited the consolidated balance sheets of Xerox Corporation and
consolidated subsidiaries as of December 31, 1998 and 1997, and the related
consolidated statements of income, cash flows and shareholders' equity for each
of the years in the three-year period ended December 31, 1998. These
consolidated financial statements are the responsibility of the Company's
management. Our responsibility is to express an opinion on these consolidated
financial statements based on our audits.

   We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the consolidated financial statements are
free of material misstatement. An audit includes examining, on a test basis,
evidence supporting the amounts and disclosures in the consolidated financial
statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
consolidated financial statement presentation. We believe that our audits
provide a reasonable basis for our opinion.

   In our opinion, the consolidated financial statements appearing on pages 23,
33, 36 and 40-61 present fairly, in all material respects, the financial
position of Xerox Corporation and consolidated subsidiaries as of December 31,
1998 and 1997, and the results of their operations and their cash flows for each
of the years in the three-year period ended December 31, 1998, in conformity
with generally accepted accounting principles.


/s/ KPMG LLP

KPMG LLP
Stamford, Connecticut
January 25, 1999



                                                           XEROX CORPORATION  63

<PAGE>


NOTES
 
Eleven Years in Review

<TABLE> 
<CAPTION> 
- -----------------------------------------------------------------------------------------------------------------------------------
  (Dollars in millions, except per-share data)                                        1998         1997         1996         1995
=================================================================================================================================== 
<S>                                                                                   <C>         <C>           <C>          <C> 
 Per-Share Data

  Earnings (loss) from continuing operations

   Basic                                                                           $  0.82      $  2.16      $  1.78      $  1.73
   Diluted                                                                            0.80         2.02         1.66         1.61
  Dividends declared                                                                  0.72         0.64         0.58         0.50
=================================================================================================================================== 

 Operations

  Revenues                                                                        $ 19,449     $ 18,144     $ 17,378     $ 16,588
  Research and development expenses                                                  1,043        1,065        1,044          949
  Income (loss) from continuing operations                                             585        1,452        1,206        1,174
  Net income (loss)                                                                    395        1,452        1,206         (472)
=================================================================================================================================== 

 Financial Position

  Accounts and finance receivables, net                                           $ 16,984     $ 14,498     $ 13,394     $ 12,389
  Inventories                                                                        3,269        2,792        2,676        2,656
  Land, buildings and equipment, net                                                 2,366        2,377        2,256        2,105
  Investment in discontinued operations                                              1,670        3,025        4,398        4,810
  Total assets                                                                      30,024       27,732       26,818       26,008
  Consolidated capitalization
   Short-term debt                                                                   4,104        3,707        3,536        3,274
   Long-term debt                                                                   11,003        8,946        8,697        8,148
   Total debt                                                                       15,107       12,653       12,233       11,422
   Deferred ESOP benefits                                                             (370)        (434)        (494)        (547)
   Minorities' interests in equity of subsidiaries                                     124          127          843          755
   Company-obligated, mandatorily redeemable
     preferred securities of subsidiary trust holding
     solely subordinated debentures of the Company                                     638          637            -            -
   Preferred stock                                                                     687          705          721          763
   Common shareholders' equity                                                       4,857        4,985        4,367        3,878
   Total capitalization                                                             21,043       18,673       17,670       16,271
=================================================================================================================================== 

 Selected Data and Ratios

  Common shareholders of record at year-end                                         52,048       54,689       55,908       54,262
  Book value per common share (1)                                                  $  7.35      $  7.59      $  6.71      $  5.92
  Year-end common stock market price                                               $ 59.00      $ 36.94      $ 26.31      $ 22.84
  Employees at year-end                                                             92,700       91,500       86,700       85,900
  Working capital                                                                  $ 3,968      $ 3,074      $ 2,948      $ 2,843
  Current ratio                                                                        1.5          1.4          1.4          1.4
  Additions to land, buildings and equipment                                       $   566      $   520      $   510      $   438
  Depreciation on land, buildings and equipment                                    $   362      $   400      $   372      $   376
=================================================================================================================================== 
</TABLE>
 
  (*) Data that conform with the 1998 basis of presentation were not available. 

  (1) Book value per common share is computed by dividing common shareholders'
      equity by outstanding common shares plus common shares reserved for the
      conversion of the Xerox Canada Inc. Exchangeable Class B Stock.

 64  XEROX CORPORATION


<PAGE>
 

<TABLE> 
- -----------------------------------------------------------------------------------------------  
     1994          1993          1992          1991          1990          1989          1988
=============================================================================================== 
<S>             <C>             <C>             <C>         <C>           <C>           <C> 
  $  1.14     $   (0.42)      $  0.87       $  0.63       $  0.91       $  0.74       $  0.19
     1.07         (0.42)         0.77          0.62          0.87          0.73          0.19
     0.50          0.50          0.50          0.50          0.50          0.50          0.50
=============================================================================================== 

$  15,084     $  14,229     $  14,298     $  13,438     $  13,210     $  12,095     $  11,354
      895           883           922           890           848           809           794
      794          (193)          562           436           599           488           148
      794          (126)       (1,020)          454           243           704           388
=============================================================================================== 

$  11,759     $  10,565     $  10,250       $ 8,952       $ 8,016       $ 7,272       $ 6,109
    2,294         2,162         2,257         2,091         2,148         2,413         2,558
    2,108         2,219         2,150         1,950         1,851         1,781         1,803
    7,904         8,841         8,652         9,164         9,695           (*)           (*)
   27,278        26,999        25,792        24,342        24,116           (*)           (*)

    3,159         2,698         2,533         2,038         1,828         1,482         1,174
    7,355         7,386         8,105         7,825         8,726         9,247         6,675
   10,514        10,084        10,638         9,863        10,554        10,729         7,849
     (596)         (641)         (681)         (720)         (756)         (785)            - 
    1,021           844           885           818           832           715           806

        -             -             -             -             -             -             -
      832         1,066         1,072         1,078         1,081         1,081           296
    4,177         3,972         3,875         5,140         5,051         5,035         5,371
   15,948        15,325        15,789        16,179        16,762        16,775        14,322
=============================================================================================== 

   56,414        65,820        68,877        71,213        74,994        78,876        84,864
  $  6.48       $  6.28       $  6.70       $  9.07       $  8.96       $  8.93       $  8.71
  $ 16.50       $ 14.69       $ 13.21       $ 11.42       $  5.92       $  9.54       $  9.73
   87,600        97,000        99,300       100,900        99,000        99,000       100,000
  $ 2,411       $ 2,357       $ 2,578       $ 2,282       $ 2,537           (*)           (*)
      1.4           1.4           1.5           1.5           1.6           (*)           (*)
  $   389       $   470       $   582       $   467       $   405       $   390       $   418
  $   446       $   437       $   418       $   397       $   372       $   370       $   369
=============================================================================================== 

- -----------------------------------------------------------------------------------------------  
</TABLE>
 

                                                           XEROX CORPORATION  65

<PAGE>
 
Where to Find Us

Xerox Corporation                     Developing Markets Operations  
800 Long Ridge Road                   800 Long Ridge Road            
P.O. Box 1600                         P.O. Box 1600                  
Stamford, CT 06904                    Stamford, CT 06904             
203 968-3000                          203 968-3000                   
                                                                     
Industry Solutions Operations         Xerox Europe                   
800 Long Ridge Road                   Parkway, Marlow                
P.O. Box 1600                         Buckinghamshire Sl7 1YL        
Stamford, CT 06904                    England                        
203 968-3000                          44 1628-890000                 
                                                                     
General Markets Operations            Fuji Xerox Co., Ltd.           
800 Long Ridge Road                   2-17-22 Akasaka                
P.O. Box 1600                         Minato-ku, Tokyo 107           
Stamford, CT 06904                    Japan                          
203 968-3000                          81 3 3585-3211                  

Products and Services
www.xerox.com or by phone:
 .  800 ASK-XEROX (800 275-9376) for any product or service

 .  800 TEAM-XRX (800 832-6979) for any small office or 
   home office product

 .  800 34-XEROX (800 349-3769) for networked products 
   sold through resellers


Additional Information
The Xerox Foundation and Community
Involvement Program: 203 968-3333

Xerox diversity programs and 
EEO-1 reports: 203 968-3144

Environmental, Health and 
Safety Progress Report: 800 828-6571

Questions from Students and Educators: 
800 594-5015 or 716 423-4828
E-mail:  Nancy_Dempsey@mc.xerox.com

Auditors
KPMG LLP
Certified Public Accountants
Stamford Square
3001 Summer Street
Stamford, CT 06905
203 356-9800

Consecutive Dividends Paid to Shareholders

  On January 25, 1999, the Company's Board of Directors approved a two-for-one
split of the Company's common stock. Additionally, the Board declared an 11
percent increase in the quarterly common stock dividend to $.20 per share
effective April 1, 1999. Xerox has declared dividends to its shareholders for
69 consecutive years and has paid consecutive quarterly dividends since 1948.

  At its February 1, 1999 meeting, the Company's Board of Directors declared the
regular quarterly $1.5625 per share dividend on the Company's preferred stock.
The Series B Convertible Preferred stock was issued in July 1989 in connection
with the formation of a Xerox Employee Stock Ownership Plan.

  Both the common and preferred stock dividends are payable April 1 to
shareholders of record March 5.

Xerox Common Stock Prices and Dividends
- --------------------------------------------------------------------------------
New York Stock Exchange                     First   Second    Third   Fourth
Composite Prices                           Quarter  Quarter  Quarter  Quarter
- --------------------------------------------------------------------------------
1998                       High             $53.38   $57.50   $58.25   $60.81
                           Low               33.09    45.16    39.00    40.91
                           Dividends Paid      .16      .18      .18      .18
- --------------------------------------------------------------------------------
1997                       High             $31.63   $39.69   $42.56   $44.00
                           Low               25.75    27.38    36.34    34.00
                           Dividends Paid      .15      .16      .16      .16
- --------------------------------------------------------------------------------

    During 1998, Xerox common stock reached an all-time high of $60.81 on
December 29 and closed at $59.00 on December 31.

Stock Listed and Traded

Xerox common stock (XRX) is listed on the New York Stock Exchange and the
Chicago Stock Exchange. It is also traded on the Boston, Cincinnati, Pacific
Coast, Philadelphia, London and Switzerland exchanges.

Copyright (C) Xerox Corporation 1998. All rights reserved. XEROX(R), The
Document Company(R) and the stylized X are trademarks of XEROX CORPORATION, as
are Book In Time(R), DigiPath, DocuColor(R), DocuImage, Document Centre,
DocuPrint(R), DocuShare(R), DocuTech(R), Eureka, TextBridge(R), ScanSoft,
WorkCentre(R), and Xerox Connect.

Xerox Corporation

Our paper is Potlatch, Northwest Gloss. The text contains 50 percent recycled
fibers with 20 percent post-consumer  fiber content.


68  XEROX CORPORATION




                                                                  EXHIBIT 21

Subsidiaries of Xerox Corporation

The following companies are subsidiaries of Xerox Corporation as of February 
1, 1999.  The names of a number of other subsidiaries have been omitted as 
they would not, if considered in the aggregate as a single subsidiary, 
constitute a significant subsidiary:

Name of Subsidiary                               Incorporated In

1247461 Ontario Inc.                             Ontario
AMTX,  Inc.                                      Delaware
Bradley Company                                  Ohio
Carmel Valley, Inc.                              Delaware
ChannelBind Corporation                          Delaware
Chrystal Software, Inc.                          Delaware
Copiadores Nacionales, S.A.                      Peru
Copicentro N.V.                                  Netherlands Antilles 
Copicentros, S.A.                                Venezuela
Delphax Systems, Inc.                            Delaware
Docucentro S.A.                                  Colombia
Document Sciences Corporation                    Delaware
dpiX, Inc.                                       Delaware
FairCopy Services Inc.                           Canada
InConcert, Inc.                                  Delaware
Institute for Research on Learning               Delaware
Intelligent Electronics, Inc.                    Pennsylvania
E-C Computer Technical Services, Inc.            Texas
Intellinet, Ltd.                                 Pennsylvania
R C K Computers, Inc.                            Texas
RNTS, Inc.                                       Colorado
Xerox Connect, Inc.                              Pennsylvania
InXight Software, Inc.                           Delaware
Jeremiad Co.                                     Delaware
Leeroit S.A.                                     Ecuador
LiveWorks, Inc.                                  Delaware
Low-Complexity Manufacturing Group, Inc.         Delaware
Pacific Services and Development Corporation     Delaware
 
Inversiones San Simon, S.A.                      Venezuela
Estacionamiento Bajada III, C.A.                 Venezuela
Panama Services and Development Corporation      Panama
PixelCraft, Inc.                                 Delaware
Proyectos Inverdoco, C.A.                        Venezuela
Securities Information Center, Inc.              Delaware
SCC Burton Corporation                           Delaware
Servicios Xerograficos del Peru S.A.             Peru
79861 Ontario Inc.                               Ontario
Terabank Systems, Inc.                           Delaware
The Xerox Foundation                             Delaware
Uppercase, Inc.                                  Delaware
Via Xerox Relocation Company, Inc.               New York 
XDI, Inc.                                        Delaware 
XEG Business Services, Inc.                      Delaware 
Xerox Antilliana N.V.                            Netherlands Antilles 
Xerox Antilliana (Aruba) N.V.                    Aruba 
Xerox Antilliana (St. Maarten) N.V.              Netherlands Antilles 
Xerox Argentina, I.C.S.A.                        Argentina 



Name of Subsidiary                               Incorporated In

Xerox Canada Capital Ltd.                        Ontario 
Xerox Canada Inc.                                Ontario  
832666 Ontario Inc.                              Ontario  
832667 Ontario Inc.                              Ontario  
973859 Ontario Inc.                              Ontario  
1192990 Ontario Inc.                             Ontario  
Xerox (Barbados) SRL                             Barbados  
Xerox Capital de Mexico, S.A. de C.V.            Mexico  
Xerox Canada Acceptance Inc.                     Canada  
Xerox Canada Facilities Management Ltd.          Ontario  
Xerox Canada Finance Inc.                        Ontario  
Xerox Canada Ltd.                                Canada  
DS Holdings, Inc.                                Canada  
Xerox Canada Manufacturing & Research Inc.       Ontario  
Xerox Capital, LLC                               Turks & Caicos Islands  
Xerox Capital Trust I                            Delaware  
Xerox de Chile S.A.                              Chile  
Xerox China Investments (Bermuda) Limited        Bermuda  
Xerox (China) Limited                            China  
Xerox Engineering Copy Systems Suzhou Co. 
   Limited                                       China  
Xerox Shanghai Limited                           China  
Xerox de Colombia S.A.                           Colombia  
Xerox ColorgrafX Systems, Inc.                   California  
Xerox de Costa Rica, S.A.                        Costa Rica  
Xerox Dominicana, C. por A.                      Dominican Republic  
Xerox del Ecuador, S.A.                          Ecuador  
Xerox de El Salvador, S.A. de C.V.               El Salvador  
Xerox Financial Services, Inc.                   Delaware  
OakRe Life Insurance Company                     Missouri  
LKN-1, Inc.                                      Illinois  
Ridge Reinsurance Limited                        Bermuda  
Talegen Holdings, Inc.                           Delaware  
VRN Inc.                                         Delaware  
Xerox Credit Corporation                         Delaware  
MultiLease, Ltd.                                 Delaware  
XCC/AFG, Inc.                                    Delaware   
XCC Holdings, Inc.                               Delaware  
XCC Investment Corporation                       Delaware  
XFS Merchant Partner, Inc.                       Delaware  
Xerox Foreign Sales Corporation                  Barbados  
Xerox Funding Corporation                        Delaware  
Xerox de Guatemala, S.A.                         Guatemala  
Xerox d'Haiti, S.A.                              Haiti  
Xerox de Honduras, S.A.                          Honduras  
Xerox Imaging Systems, Inc.                      Delaware  
ScanSoft, Inc.                                   Delaware  
Formmat Limited                                  United Kingdom  
Xerox Imaging Systems UK Limited                 United Kingdom  
Xerox International Joint Marketing, Inc.        Delaware  
Xerox International Partners                     California 
Xerox International Realty Corporation           Delaware  
Xerox Canada Realty Inc.                         Ontario  
Xerox Investments (Nederland) BV                 Netherlands  
Xerox Holdings (Ireland) Limited                 Ireland  
Xerox (Europe) Limited                           Ireland
Cantaloupe Limited                               Ireland


Name of Subsidiary                               Incorporated In

Oriel Star Limited                               Ireland
Pirrip Limited                                   Ireland
Toblersong Limited                               Ireland
Topspeed Limited                                 Ireland
Xerox XF Holdings (Ireland) Limited              Ireland
Xerox UK Holdings Limited                        United Kingdom
Triton Business Finance Limited                  United Kingdom
Xerox Business Equipment Limited                 United Kingdom
Xerox Computer Services Limited                  United Kingdom
Xerox Mailing Systems Limited                    United Kingdom
Xerox Engineering Systems Europe Limited         United Kingdom
Xerox Research (UK) Limited                      United Kingdom
Xerox Trading Enterprises Limited                United Kingdom
Xerox Overseas Holdings Limited                  United Kingdom
Xerox Capital (Europe) plc                       United Kingdom  
XRO Limited                                      United Kingdom
Nemo (AKS) Limited                               United Kingdom
XRI Limited                                      United Kingdom
RRXH Limited                                     United Kingdom  
RRXO Limited                                     United Kingdom
RRXIL Limited                                    United Kingdom  
Xerox Holding (Nederland) B.V.                   Netherlands
Xerox Limited                                    Hong Kong  
Xerox Manufacturing (Nederland) B.V.             Netherlands  
Tefea B.V.                                       Netherlands  
Xerox Holdings (Bermuda) Limited                 Bermuda 
Xerox Investments (Bermuda) Limited              Bermuda
Xerox Limited                                    United Kingdom  
City Paper Limited                               United Kingdom  
Continua Limited *                               United Kingdom  
Fuji Xerox Co., Ltd. *                           Japan  
Aichi Xerox Co., Ltd. **                         Japan 
Aichi-Higashi Xerox Co., Ltd. **                 Japan  
Akita Xerox Co., Ltd. ***                        Japan  
Assist V Co., Ltd. **                            Japan  
Chiba Xerox Co., Ltd. **                         Japan  
Fuji Xerox Asia Pacific Pte Ltd. *               Singapore
College Hill Properties Limited *                New Zealand
Fuji Xerox Australia Pty. Limited *              Australia
Fuji Xerox Finance Limited *                     Australia
Fuji Xerox Finance Limited *                     New Zealand
Fuji Xerox (Myanmar) Limited *                   Bermuda
Fuji  Xerox New Zealand Limited *                New Zealand
Fuji Xerox (Sales) Pty. Limited *                Australia
Fuji Xerox Singapore Pte Ltd. *                  Singapore
Philipine Fuji Xerox Corporation ***             Philippines  
Taiwan Fuji Xerox Corporation ***                Taiwan  
Taiwan Fuji Xerox System Service Corporation *** Taiwan  
Thai Fuji Xerox Co., Ltd. ***                    Thailand  
Fuji System Brain Co. Ltd. **                    Japan  
Fuji Xerox Career Net Co., Ltd. *                Japan
Fuji Xerox Distribution Co., Ltd. *              Japan
Fuji Xerox Engineering Co., Ltd. *               Japan
Fuji Xerox Far East Limited *                    Hong Kong
Fuji Xerox General Business Co., Ltd. *          Japan
Fuji Xerox Information Systems Co., Ltd. *       Japan 
Fuji Xerox Learning Institute Inc. *             Japan


Name of Subsidiary                               Incorporated In

Fuji Xerox Office Supply Co., Ltd. *             Japan
Fuji Xerox System Service Co., Ltd. *            Japan
Fukui Xerox Co. Ltd. ***                         Japan  
Fukuoka Xerox Co., Ltd. **                       Japan  
Fukushima Xerox Co., Ltd. **                     Japan  
FX Global, Inc. *                                Delaware
FX Palo Alto Laboratory, Inc. *                  Delaware
Gifu Xerox Co., Ltd. *                           Japan
Gunma Xerox Co., Ltd. **                         Japan  
Hiroshima Xerox Co., Ltd. **                     Japan  
Hokkaido Xerox Co., Ltd. **                      Japan  
Hokuriku Xerox Co., Ltd. **                      Japan  
Hyogo Xerox Co., Ltd. **                         Japan  
Ibaraki Xerox Co., Ltd. *                        Japan
Iwate Xerox Co., Ltd. *                          Japan
Japan Image Communications Co., Ltd. ***         Japan  
Kagoshima Xerox Co., Ltd. **                     Japan  
Kanagawa Xerox Co., Ltd. **                      Japan  
Kita Kyushu Xerox Co., Ltd. **                   Japan  
K-O-A Co., Ltd. ***                              Japan  
Korea Xerox Company Limited **                   S. Korea
Korea Xerox Information System Co., Ltd. **      S. Korea  
Kumamoto Xerox Co., Ltd. **                      Japan 
Kyoto Xerox Co., Ltd. **                         Japan  
MCM Asia Pacific Co., Ltd. ***                   Japan
M-I-C Co., Ltd. ***                              Japan  
Mie Xerox Co., Ltd. **                           Japan  
Miyagi Network Inc. ***                          Japan  
Miyagi Xerox Co., Ltd. **                        Japan  
Nagano Xerox Co., Ltd. **                        Japan  
Nagasaki Xerox Co., Ltd. **                      Japan  
Nara Xerox Co., Ltd. *                           Japan
Niigata Xerox Co., Ltd. **                       Japan  
NTT Learning Systems Corp. ***                   Japan  
Okayama Xerox Co., Ltd. **                       Japan  
Oita Xerox Co. Ltd. ***                          Japan  
Okinawa Xerox Co. Ltd. ***                       Japan 
Osaka Xerox Co., Ltd. **                         Japan  
Protex Co. Ltd. **                               Japan  
Saitama Xerox Co., Ltd. **                       Japan  
Shikoku Xerox Co., Ltd. **                       Japan  
Shizuoka Xerox Co., Ltd. **                      Japan  
SOAR Co., Ltd. ***                               Japan  
Sogetsu Art Planning Co., Ltd. ***               Japan   
Suzuka Fuji Xerox Co., Ltd. *                    Japan
Tama Xerox Co., Ltd. **                          Japan  
Technol Co. Ltd. ***                             Japan  
Tochigi Xerox Co., Ltd. **                       Japan  
Tokyo Xerox Co., Ltd. **                         Japan  
Yamaguchi Xerox Co., Ltd. *                      Japan
Wakayama Xerox Co. Ltd. ***                      Japan  
Xerox High-Technology Company of Shenzhen 
   Ltd. **                                       China
Xoo GraphiX Co., Ltd. **                         Japan  
Yamagata Xerox Co., Ltd. ***                     Japan  
GS Xerox Electronics **                          S. Korea  
Mitcheldean Enterprise Workshops Limited         United Kingdom


Name of Subsidiary                               Incorporated In

Modi Xerox Limited ****                          India  
Modi Xerox Financial Services Limited ****       India  
Multilingual Technology Limited ****             United Kingdom  
MX Software Services Limited                     India  
NV Xerox Credit S.A.                             Belgium
NV Xerox Management Services S.A.                Belgium
N.V. Xerox S.A.                                  Belgium
The Limited Liability Company Xerox (Ukraine) 
   Limited                                       Ukraine 
The Xerox (UK) Trust                             United Kingdom
Westbourne Limited                               United Kingdom
Xerox AB                                         Sweden
Xerox AG                                         Switzerland
Xerox Office Supplies AG                         Switzerland
Xerox A/S                                        Denmark
Xerox AS                                         Norway
Xerox Austria GmbH                               Austria
Xerox Business Services GmbH                     Austria
Xerox Leasing GmbH                               Austria
Xerox Beograd d.o.o.                             Yugoslavia
Xerox Bulgaria                                   Bulgaria
Xerox Buro Araciari Ticaret ve Servis A.S.       Turkey
Xerox Channels Limited                           United Kingdom
Xerox (C.I.S.)                                   Russia
Xerox Credit AB                                  Sweden
XEROX CZECH Republic s r.o.                      Czech Republic
Xerox Direct Nord GmbH                           Germany
Xerox Direct Ost GmbH                            Germany
Xerox Direct Rheinland GmbH                      Germany
Xerox Direct Rhein-Main GmbH                     Germany
Xerox Direct Sud GmbH                            Germany
Xerox Direct Sud-West GmbH                       Germany
Xerox Direct Westfalen GmbH                      Germany
Xerox Espana-The Document Company, S.A.U.        Spain
Xerox Renting S.A.U.                             Spain
Xerox Exports Limited                            United Kingdom
Xerox Fabricacion S.A.U.                         Spain
Xerox Finance AG                                 Switzerland
Xerox Finance (Nederland) BV                     Netherlands
Xerox de Financiacion S.A.U., E.F.C.             Spain
Xerox GmbH                                       Germany
Xerox Dienstleistungsgesellschaft GmbH           Germany
Xerox Leasing Deutschland GmbH                   Germany
Xerox Service GmbH                               Germany
Xerox Reprographische Services GmbH              Germany
Xerox Hellas AEE                                 Greece
Xerox (Hong Kong) Limited                        Hong Kong
Xerox Industry Development (Shanghai) Co., Ltd.  China
Xerox Hungary Trading Company Ltd.               Hungary
Xerox (Ireland) Limited                          Ireland  
Xerox Kenya Limited                              Kenya
Xerox Leasing (Europe) Limited                   United Kingdom
Xerox (Nederland) BV                             Netherlands
"Veco" Beheer Onroerend Goed BV                  Netherlands
Xerox Document Supplies BV                       Netherlands
Xerox Rentalease BV                              Netherlands
Xerox Services BV                                Netherland


Name of Subsidiary                               Incorporated In

Xerox (Nigeria) Limited                          Nigeria  
Xerox Office Supplies S.A.U.                     Spain
Xerox Office Supplies GmbH                       Austria
Xerox Oy                                         Finland
Asunto Oy Kristiinanvalli                        Finland  
Xerox Pensions Limited                           United Kingdom
Xerox Polska Sp.zo.o                             Poland
Xerox Portugal Equipamentos de Escritorio, 
   Limitada                                      Portugal
CREDITEX - Aluguer de Equipamentos S.A.          Portugal
Xerox Professional Services Limited              United Kingdom
Xerox (Romania) Echipmante Si Servich S.A.       Romania
Xerox (Romania) SRL                              Romania
Xerox Slovenia d.o.o.                            Slovenia
Xerox South Africa (Proprietary) Limited         South Africa 
University Document Management Services 
   (Proprietary) Limited                         South Africa
Xerox S.p.A.                                     Italy
Xerox Noleggi S.p.A.                             Italy
Xerox - THE DOCUMENT COMPANY S.A.                France
Network Services SA                              France
Office de Transformation Papetiere S.N.C.        France
Xerobail S.A.                                    France 
Xerbail Gestion (SNC)                            France
Xerox Business Services Sarl                     France
Xerox Document Services SNC                      France
Xerox Uganda Limited                             Uganda
Xerox (UK) Limited                               United Kingdom
Bessemer Trust Limited                           United Kingdom
Inserco Manufacturing Limited                    United Kingdom
Xerox Finance Limited                            United Kingdom
Xerox Finance (Ireland) Limited                  United Kingdom
Xerox Office Supplies Limited                    United Kingdom
Xerox (R & S) Limited                            United Kingdom
Xexco Trading Limited                            United Kingdom
Xerox West Africa Limited                        United Kingdom  
Xerox (Jamaica) Limited                          Jamaica  
Xerox Latinamerican Holdings, Inc.               Delaware
Xerox Mexicana, S.A. de C.V.                     Mexico
Xerox Middle East Investments (Bermuda) Limited  Bermuda 
Bessemer Insurance Limited                       Bermuda  
Investissements Xerographiques Marocains S.A.    Morocco 
Reprographics Egypt Limited                      Egypt 
Xerox Egypt S.A.E.                               Egypt  
Xerox Finance Leasing S.A.E.                     Egypt  
Xerox Equipment Limited                          Bermuda  
Xerox Maroc S.A.                                 Morocco  
Xerox Products Limited                           Bermuda  
Xerox de Nicaragua, S.A.                         Nicaragua  
Xerox de Panama, S.A.                            Panama
Xerox del Paraguay SRL                           Paraguay
Xerox Participacoes Ltda.                        Brazil
Xerox do Brasil Ltda.                            Brazil
Astor Administracao de Bens e Participacoes      Brazil  
Centro de Desenvolvimiento de Sistemas Vitoria 
   S.A.                                          Brazil
J.D.R. Vitoria Equipamentos S.A.                 Brazil


Name of Subsidiary                               Incorporated In

Xerox Comercio e Industria Ltda                  Brazil
Xerox del Peru, S.A.                             Peru 
Xerox Real Estate Services, Inc.                 New York
Xerox Realty Corporation                         Delaware
Xerox Realty Corp. (California)                  California
XRC Realty Corp. West                            California
Xerox Servicios Tecnicos, C.A.                   Venezuela
Xerox Technologies Limited                       Ireland
Xerox Trinidad Limited                           Trinidad  
Xerox Uruguay S.A.                               Uruguay
Xerox Zona Libre, S.A.                           Panama
XESystems, Inc.                                  Delaware  
XE Holdings, Inc.                                Delaware
Xerox Engineering Systems AG                     Switzerland
Xerox Engineering Systems Espanola SA            Spain
Xerox Engineering Systems SpA                    Italy
Xerox Engineering Systems N.V.                   Belgium
Xerox Engineering Systems S.A.                   France
Xerox Engineering Systems GmbH                   Germany
Xerox Engineering Systems B.V.                   Netherlands
XESystems Canada Inc.                            Ontario
XESystems UK Limited                             United Kingdom
Xerox Engineering Systems Limited                United Kingdom
Xtended Memory Systems                           California


*    Indicates only 50% is owned, directly or indirectly, by Xerox 
Corporation.

**   Indicates 50% or more is owned, directly or indirectly, by Fuji Xerox 
Co., Ltd.

***  Indicates less than 50% is owned, directly or indirectly, by Fuji Xerox 
Co., Ltd.

**** Indicates less than 50% is owned by Xerox Corporation.






                                                                  EXHIBIT 23

Consent of Independent Auditors



To the Board of Directors and Shareholders of Xerox Corporation


We consent to the incorporation by reference in the Registration Statements 
of Xerox Corporation on Form S-3 (Nos. 333-34333, 333-59355 and 333-73173) 
of our reports dated January 25, 1999 relating to the consolidated balance 
sheets of Xerox Corporation and subsidiaries as of December 31, 1998 and 
1997, and the related consolidated statements of income, cash flows, and 
shareholders' equity and related financial statement schedule for each of 
the years in the three-year period ended December 31, 1998, which reports 
appear in or are incorporated by reference in the 1998 Annual Report on Form 
10-K of Xerox Corporation.


                                            KPMG LLP

Stamford, Connecticut
March 22, 1999







<TABLE> <S> <C>



<ARTICLE> 5
<LEGEND>
THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM XEROX
CORPORATION'S DECEMBER 31, 1998 FINANCIAL STATEMENTS AND IS QUALIFIED IN
ITS ENTIRETY BY REFERENCE TO SUCH FINANCIAL STATEMENTS.
</LEGEND>
<MULTIPLIER> 1,000,000
       
<S>                             <C>
<PERIOD-TYPE>                   YEAR
<FISCAL-YEAR-END>                          DEC-31-1998
<PERIOD-END>                               DEC-31-1998
<CASH>                                              79
<SECURITIES>                                         0
<RECEIVABLES>                                   17,527
<ALLOWANCES>                                       543
<INVENTORY>                                      3,269
<CURRENT-ASSETS>                                12,475
<PP&E>                                           5,246
<DEPRECIATION>                                   2,880
<TOTAL-ASSETS>                                  30,024
<CURRENT-LIABILITIES>                            8,507
<BONDS>                                         15,107
<PREFERRED-MANDATORY>                              638
<PREFERRED>                                        687
<COMMON>                                           660
<OTHER-SE>                                       4,197
<TOTAL-LIABILITY-AND-EQUITY>                    30,024
<SALES>                                         10,752
<TOTAL-REVENUES>                                19,449
<CGS>                                            5,724
<TOTAL-COSTS>                                   10,547
<OTHER-EXPENSES>                                 8,139
<LOSS-PROVISION>                                   301
<INTEREST-EXPENSE>                                 748
<INCOME-PRETAX>                                    763
<INCOME-TAX>                                       207
<INCOME-CONTINUING>                                585
<DISCONTINUED>                                    (190)
<EXTRAORDINARY>                                      0
<CHANGES>                                            0
<NET-INCOME>                                       395
<EPS-PRIMARY>                                     0.53
<EPS-DILUTED>                                     0.52
        



</TABLE>