Canadian National Railway Company
Annual Report 2002

Plain-text annual report

2002 Annual Report 2 0 0 2 A n n u a l R e p o r t The long haul Another year of challenge put our company to the test. It was a test of our model and our mettle, a test we believe we passed. In 2002, CN delivered strong results in the face of a severe drought affecting one of our markets, and economic uncertainty. We remain confident as the challenge continues. CN is on a long haul, with a solid trip plan, a powerful engine and a worthy destina- tion: delivering performance that endures. Contents 2 The destination 4 The trip plan 6 The engine 10 Message from E. Hunter Harrison 12 Financial summary 14 The road to delivering value 16 Performance and productivity, just in time 18 Fewer cars, smoother pipeline, lower costs 20 From between the white lines to the main line 22 CN at a glance 24 Message from David McLean 25 Pulling together for a brighter future 28 Glossary of terms 29 Financial Section (U.S. GAAP) 73 Financial Section (Canadian GAAP) 118 The CN Pension Plan and the CN 1935 Pension Plan 127 President’s Awards for Excellence 128 Board of Directors 130 Executive Officers of the Company 131 Shareholder and investor information Except where otherwise indicated, all financial infor- mation reflected in this docu- ment is expressed in Canadian dollars and determined on the basis of United States generally accepted accounting principles (U.S. GAAP). Canadian National Railway Company 1 Per formance that endures At CN, our destination is an objective Profitable top-line growth. This is what shareholders want, along in an always-challenging economic and competitive landscape: growth. with something equally important: financial durability. At CN, this is a Long-term, sustainable, profitable top-line growth. critical element of shareholder value. We have worked to build an enter- Delivering profitable top-line growth is firmly connected to the prise that is capable of generating revenue growth, steadily increasing ability to create real value for customers. Customer value is determined profitability, strong cash flow and return on investment. by each one’s individual requirements, but at its core is a meaningful Performance that endures. It is a destination at which one never contribution to efficiency, productivity and competitiveness. At CN, we truly arrives – there are always new challenges – but in 2002, CN know that when we contribute in a significant way to a customer’s demonstrated that it is well on its way to achieving its objectives. business success, we have formed a strong platform for expanding the relationship. 2 Canadian National Railway Company The destination Canadian National Railway Company 3 The trip plan 4 Canadian National Railway Company Pursuing grow th one carload at a time Railroads have historically minerals, petroleum and chemicals, and forest products – as well as done a very good job of providing reliable transportation solutions to intermodal. Merchandise businesses, sometimes called carload shippers, bulk shippers – primarily grain and coal and other products that move on are where we have the clearest competitive advantage, both against unit trains. CN is a well-established bulk carrier, with a number of strong, trucks and other rail carriers. long-term customer relationships. But in bulk commodities shipping, With its precision, velocity and reliability, the CN service plan is per- there is little to differentiate between railroads, leaving less room for fectly suited to the merchandise shipper. Our strategy – our trip plan – market share gains. is to pursue carload business by emphasizing transportation solutions CN has a unique franchise, less dependent upon bulk commodities rather than transactions. The level of service reliability we provide gives than other major North American railroads. Our strengths align well with us a greater opportunity to help customers reduce their transportation service-sensitive businesses like merchandise – automotive, metals and costs, enabling us to help them succeed. Canadian National Railway Company 5 What drives CN Two things drive this company: our unique service On-time performance is of little use if the shipment arrives dam- plan and the talented, dedicated people who make it work. aged. So CN is accelerating the process of renewing and upgrading its With the CN service plan, we have succeeded in creating a uniquely fleet, purchasing equipment like state-of-the-art refrigerated rail cars efficient, reliable transportation solution that’s more economical than for grocery shippers, new boxcars for paper shippers and an increased trucks and capable of delivering more value than traditional rail carriers. number of centerbeam flatcars for our forest product customers. We are continually working to perfect the service plan’s industry- Ease of doing business is another important service quality issue. leading performance – striving to improve upon 90 per cent-plus reliabil- CN is investing to make it simpler to get service schedules and rates, ity while at the same time increasing speed. CN is always concentrating simpler to order equipment and manage shipments, and simpler to on further enhancing service quality in ways that go beyond speed manage and pay invoices. or reliability, such as providing better quality equipment and simplifying customer processes. 6 Canadian National Railway Company The engine Canadian National Railway Company 7 Creating a culture of dif ference-makers Every CN employee has develop and present proactive, value-adding solutions that support CN’s an opportunity to have a positive impact on improved service quality for growth strategy. customers. Across the entire organization, CN has launched employee CN changed its sales compensation structure in 1999 to support the development and training programs aimed at improving skills and right behaviors – with a commission-like bonus formula that rewards enhancing individual performance. high achievers and creates incentives to grow, not just maintain, revenues Sales has been a particular emphasis. Over the past several years, each year. Meanwhile, CN is pursuing an aggressive, ongoing sales CN has been systematically transforming and expanding its sales strategy aimed at uncovering ways to reach new customers who can force, adding more highly qualified professionals to drive a fundamen- benefit from rail – going beyond traditional rail channels that focus only tal shift away from the traditional “order-taker” approach to rail on large nationwide accounts to expand coverage and increase the transportation sales and marketing. An intensified focus on training number of opportunities to grow revenue. is designed to improve CN sales professionals’ ability to identify, 8 Canadian National Railway Company A groundbreaking new partnership w ith labor CN is a different In contrast with other major Class 1 railroad mileage- and rule-based kind of railroad, always looking for new and innovative ways to lead and wage systems, these agreements are based on an hourly wage. CN excel. Nowhere is this more in evidence than at CN’s U.S. operations. benefits from enhanced productivity and unprecedented flexibility with This is where we worked together with the Brotherhood of Locomotive the elimination of outdated work rules and mileage caps. In addition to Engineers (BLE) and with the United Transportation Union (UTU) at excellent compensation, employees benefit from better work and home-life the former Wisconsin Central division and with the BLE in the former balance as well as job security provisions. Illinois Central territory to forge truly game-changing labor agreements in 2002. The new contracts are better for CN, better for employees and, by strengthening our ability to improve service quality, ultimately are better for shippers. Dear shareholders: CN delivered growth and generated record free cash flow and solid earnings in spite of external factors that negatively affected revenues and increased costs. CN performed well this year – more important, we have a great team and a good, solid franchise that put us in an excellent position for the long haul. 10 A year of continued challenge The year 2002 proved to be challeng- the business, there are times when the best means to deliver value is ing, with an increasingly tough market environment characterized by a through share repurchases. severe drought that decimated the Canadian wheat harvest, the ongoing We decided that 2002 was just such a time. In the fourth quarter, decline of Canada’s CN-served metallurgical coal mines and continued the CN Board authorized a share repurchase program of up to 13.0 mil- uncertainty in the North American economy. lion shares over the course of one year beginning on October 25, 2002. All in all, 2002 was a test of CN’s character, resiliency and strength, The buyback potentially represents 6.5 per cent of shares outstanding. a test I feel we passed. In fact, I believe we can be proud of what we We have proven our ability to make and successfully integrate accomplished. acquisitions that bring real benefit to this company and its investors. The Illinois Central integration proceeded so smoothly that the STB discontin- Rising to the challenge Our 2002 financial performance was solid ued its formal oversight process of the merger after two years, three in the face of adversity. We grew revenues, driven mainly by the years ahead of schedule. The Wisconsin Central integration is nearly com- Wisconsin Central acquisition, but also by the strength of our merchan- plete, following the same step-by-step approach designed to maintain dise franchise, which offset significantly weaker grain revenues. At the safety at the highest level and avoid any disruption or compromise of same time, through aggressive cost control measures, we mitigated customer service. major cost pressures. We were able to deliver an adjusted operating ratio of 69.4 per cent in 2002 compared to the 68.5 per cent adjusted A solid model that is working The most encouraging aspect of our figure in 2001. A key achievement was CN's record free cash flow of 2002 performance was our ability to deliver good overall performance in $513 million, building on the $443 million generated in 2001. spite of an enormous revenue hit in our grain business unit. While the revenues gained in our Wisconsin Central acquisition helped offset the Tough measures In the fourth quarter of 2002, we recorded charges impact, a major factor in CN’s 2002 performance was the success of for workforce reductions and for U.S. personal injury and other claims. our growth strategy in merchandise businesses focused on selling the We made the difficult decision to make a permanent workforce reduction benefits of premium-quality rail service. of 1,146 employees. This move reflects a hard reality: we must aggres- Our merchandise businesses are steadily gaining market share, sively control our costs in order to remain competitive, especially in growing much faster than the industry. We’re achieving these share gains today’s economic environment. across many segments: automotive, fuel oil, aluminum, liquified petro- We have a responsibility to operate as efficiently as we possibly can leum gas, lumber and newsprint. And the sales strategy we created in without compromising safety. But it doesn’t make a decision like this any 1999 to pursue smaller customers is clearly working. easier. My hope is to get this company to the point where these kinds of Railroading is a tough business, but not necessarily a complicated cuts aren’t necessary – to grow the business to the point where we’re one. Success is all about staying focused on the basics: one, providing adding people, rather than subtracting them. This is our goal. good service – doing what you say you’ll do, every time. Two, managing Delivering value for CN investors We are determined to continue to three things without getting anyone hurt. And five, developing your create shareholder value in every way we can. With our strong balance people. The first three things we’re now doing at a high level, and the sheet and free cash flow, we are fortunate to be able to do this in a fourth is something we’re always working on. My biggest focus is on number of ways. While we always seek avenues to build the strength of the fifth: people. your costs. Three, focusing on asset utilization. Four, doing the first Canadian National Railway Company 11 Financial summary ($ in millions, except per share data, or unless otherwise indicated) 2002 (1) 2001 (1) 2000 (1) Financial results Revenues Operating income Net income Diluted earnings per share Dividend per share Net capital expenditures Financial position Total assets Long-term debt, including current portion and convertible preferred securities Shareholders’ equity Financial ratios (%) Operating ratio Debt to total capitalization $÷6,110 $÷5,652 $÷5,428 1,469 800 3.97 0.86 938 1,682 1,040 5.23 0.78 941 1,648 937 4.67 0.70 958 21,738 21,223 17,314 5,577 8,369 6,293 7,488 4,665 6,598 76.0 40.0 70.2 45.7 69.6 41.4 (1) 2001 includes Wisconsin Central Transportation Corporation from October 9, 2001. In addition, the Company’s financial results for 2002, 2001 and 2000 include items impacting their comparability as discussed in the Company’s Management’s Discussion and Analysis on pages 31 and 35. Employees (average for the year) 2000 2001 (1) 2002 Adjusted earnings per share (dollars) (2) 2000 2001 (1) 2002 Adjusted operating ratio (percentage) (3) 2000 2001 (1) 2002 (1) The 2001 figures include Wisconsin Central Transportation Corporation from October 9, 2001. (2) Based on 2002, 2001 and 2000 adjusted net income, as discussed in the Company’s Management’s Discussion and Analysis on pages 31 and 35. (3) Excludes a 2002 charge of $281 million to increase the Company’s provision for U.S. personal injury and other claims, and workforce reduction charges of $120 million and $98 million in 2002 and 2001, respectively, as discussed in the Company’s Management’s Discussion and Analysis on pages 31 and 35. 12 Canadian National Railway Company 22,457 22,668 23,190 4.39 4.92 5.22 69.6 68.5 69.4 All across this organization, CN people are realizing that they It’s a long haul As one of the leaders of this company and throughout each can play a significant role in the success of this company. I’m par- my management career, I’ve always been struck by the pressure we get ticularly proud of the labor agreements we reached in 2002 with the to produce short-term results. Don’t misunderstand me; this isn’t a bad Brotherhood of Locomotive Engineers (BLE) and the United Transporta- thing – it imposes discipline on management and supports full account- tion Union (UTU) at our former Wisconsin Central division and with the ability. But if you get too caught up in short-term performance, it can BLE in our former IC territories. These ground-breaking contracts free make it tougher to pursue strategies critical to long-term success. Under CN from outdated work rules and compensation structures while giving my leadership, the CN management team will continue to balance the engineers, conductors and brakemen excellent wages, job security and need to protect and build your long-term investment with the desire for more time with their families. strong year-over-year results. We’re slowly transforming the culture of this great company. Are As bulk commodities continue to struggle in 2003, we will aggres- we there yet? No. Will we ever completely get there? Probably not, sively continue to build our service-sensitive businesses to maintain because it’s a continuous process of improvement. We can always get revenue growth while we closely watch expenses. We are on a long haul, better. That’s what a passion for performance is all about. making steady progress up the steep grade of a tough economy. When the track levels off, as we know it will, we’ll be poised to accelerate to A strong team This company’s management team is one of the most new levels of performance. Thank you for coming along. outstanding groups of individuals I’ve ever seen assembled in my 38 years of railroading. James Foote and Claude Mongeau are two of our Yours sincerely, standouts. James is one of the top marketing people in the business. He’s been in this industry his whole career and has been involved in nearly every aspect of running a railroad, holding positions in law, finance, operations and now marketing, his current position. He’s done a great job leading the growth in our merchandise businesses. Claude Mongeau (signed) is among the best and brightest business minds in Canada. At only 41, E. Hunter Harrison Claude is a pillar of our financial discipline and a key architect of our President and Chief Executive Officer strategic agenda. James and Claude are just two of many – too many to list here – who have played an integral role in our success. This is a solid team, and I’m proud to have this opportunity to lead them. As you know, Paul Tellier announced in December 2002 his decision to accept the position of President and Chief Executive Officer of Bombardier Inc. I don’t have to tell you what Paul has meant to this organization. I congratulate him and thank him for his dedication, lead- ership and vision. We worked very closely together during the time I have been with the company to set CN’s current strategic direction. That direction won’t change under my leadership. Canadian National Railway Company 13 Creating w in-w in relationships CN has delivered growth in difficult other major railroads, with experience and an operating approach that times by meeting the needs of shippers with a superior rail product, translate to a strong competitive position. the scheduled railroad. The degree of precision and reliability of our service plan provides Our growth strategy centers upon continuing to leverage this supe- an opportunity to help certain customers reduce spending on transporta- rior product to deliver value for service-sensitive carload customers, tion while capturing a higher percentage of it for CN. Our sales strategy many of whom use trucks for a large proportion of their transportation is focused on helping customers see that we can reduce total logistics needs. The carload market is much bigger than the unit train market, costs without sacrificing performance. There are three principal ways concentrated mostly in the merchandise business sector. CN has a sig- CN’s superior rail service enables us to deliver cost savings for customers nificantly higher proportion of merchandise freight in its portfolio than without having to reduce our rates: The road to delivering value 14 Canadian National Railway Company Reducing customer-owned inventory Better service reliability means Mov ing traf f ic from truck to rail It’s a fact that most rail rates are lower inventory requirements – less capital in goods-in-transit; reduced lower than truck, but many companies pay the higher freight costs to need for safety stock or express trucking costs to ensure uninterrupted gain the high degree of reliability trucks traditionally offer. Once rail processes; lower warehousing and storage costs. reliability and trust are established, many shippers discover that rail meets their needs at significantly lower cost. Reducing customer-owned f leets We know from our own experience Considerable potential exists for truly win-win business relation- that better service reliability means smaller rail car fleet requirements – ships. Shippers realize reduced transportation, inventory, equipment which reduces depreciation and interest expense; lowers leasing costs; and back office costs, while CN gains higher-yield business, more reduces maintenance costs; and decreases overall ownership risk. We can volume and closer customer collaboration that forms a strong base deliver the same benefits to customers who own significant rail car fleets. for further growth. Canadian National Railway Company 15 Reducing inventory is increasingly critical in most manufacturing processes, and a well-managed transportation chain is the principal success factor. Led by automotive producers, more and more manufacturers are moving to just-in-time manage- ment of inputs, which demands precision not typically found in rail transportation. Those who do use rail often maintain substantial backup inventory on-site to ensure that an adequate supply of products is available for their customers. Already a major transportation supplier to auto- motive manufacturers, CN is supporting customers in other industries using scheduled rail service to bring value through smoother logistics. Paper manufacturers and printers are highly focused on inventory reduction, representing a sig- nificant opportunity for CN and shippers of paper products. Our approach here is to provide a highly reliable transportation product that renders the need for a large safety stock obsolete. If necessary, we offer integrated services that include the use of warehousing to hold some buffer stock or serve non-rail served facilities. As we demonstrate relia- bility, we’re well positioned to take on more traffic. 16 Canadian National Railway Company Performance and productivity, just in time (cid:1) With its velocity, precision and reliability, CN’s scheduled rail service affords maga- zine and newspaper printers the ability to run just-in-time operations more cost effectively – eliminating or reducing the need to maintain “safety stock,” a backup inventory of paper supply to ensure uninterrupted production. Canadian National Railway Company 17 18 Canadian National Railway Company Reducing private rail car fleets is an attractive way to improve productivity of the supply chain while significantly reducing costs for industries that depend on their own equipment to transport mate- rials and products to and from their plants. The enhanced speed and dependability of CN’s scheduled network can have an immediate impact on helping customers reduce their fleets. We’ve proven it for ourselves – from 1998 to 2002, CN reduced its active rail car fleet by almost 25,000 cars, or more than 28 per cent, as a direct result of the precision and control afforded by the service plan. Chemical manufacturers maintain extremely complex transportation pipelines, typically with multiple inputs flowing directly from rail cars into the plants. Their cars serve literally as warehouses on wheels. Most manufacturers in this industry make a huge investment in rail cars in order to maintain large fleets partly to offset variables in rail transportation. With 90 per cent-plus reliability that removes the variables, CN can help reduce that investment. Canadian National Railway Company 19 Fewer cars, smoother pipeline, lower costs (cid:2) Manufacturers of consumer goods such as these plastic milk containers typically maintain large private rail car fleets in order to manage extremely complex trans- portation pipelines for raw materials. CN’s service plan enables dramatic fleet reduction – we’ve proven it in our own operations. Now we’re proving it in our customers’ operations. Moving shipments from truck to rail has an immediate impact on transportation costs. Trucking normally commands a premium based on reliability, speed and simplicity. Traditionally, the complexity of the carload business has been a major barrier to rail penetration. CN is working to change that. In recent years, we have captured a significant amount of traffic from trucks in key intercontinental corridors through continuous transit time reduction and ongoing investment in new equipment. Our strategy in merchandise is to identify areas currently handled by trucks that are natural for railroads. Rail transportation isn’t as well suited for shippers with 24–48-hour transit windows, but there are vast numbers of small- to medium-sized shippers who use trucks exclusively because they are simply not accustomed to utilizing rail. For instance, shippers of rolled steel and aluminum ingots supplying the automotive industry are increasingly discovering the benefits – fewer weight restrictions and greater load efficiency at two to three truckloads per car – of precision scheduled rail service. Increasingly, they are becoming CN customers. 20 Canadian National Railway Company From between the white lines to the main line (cid:1) Many suppliers of aluminum ingots used in the automotive industry have traditionally relied upon truck transportation to ship product. CN’s high-quality service is encouraging suppliers to take advantage of the greater load efficiency and fewer weight restrictions of rail. Canadian National Railway Company 21 CN at a glance Statistical summary Route miles (includes Canada and the U.S.) Carloads (thousands) Gross ton miles (millions) Revenue ton miles (millions) Rail employees (average for the year) Diesel fuel consumed (liters in millions) Diesel fuel consumed (U.S. gallons in millions) Average fuel price per liter (dollars) Average fuel price per U.S. gallon (dollars) * Includes Wisconsin Central Transportation Corporation from October 9, 2001. 2002 data Freight revenues Petroleum and chemicals (millions) $1,102 Revenue ton miles Petroleum and chemicals Metals and minerals Forest products Coal Grain and fertilizers Intermodal Automotive 521 Metals and minerals Forest products 1,323 326 986 1,052 591 Coal Grain and fertilizers Intermodal Automotive 2002 17,821 4,164 309,295 159,876 23,190 1,420 375 2001* 17,986 3,821 293,857 153,095 22,668 1,328 351 2000 15,532 3,796 288,150 149,557 22,457 1,292 341 ÷«$÷÷÷0.32 ÷«$÷÷÷1.20 ÷«$÷÷÷0.36 ÷«$÷÷÷1.35 ÷«$÷÷÷0.33 ÷«$÷÷÷1.24 Freight revenue per revenue ton mile (millions) 30,006 13,505 Metals and minerals 33,551 Forest products Petroleum and chemicals 14,503 35,773 29,257 3,281 Coal Grain and fertilizers Intermodal Automotive (cents) 3.67 3.86 3.94 2.25 2.76 3.60 18.01 Freight revenues 2002 percentage data Revenue – traffic mix Per cent 10% 19% 18% 9% 17% 22% 5% 19% Petroleum and chemicals ÷9% Metals and minerals 22% Forest products ÷5% Coal 17% Grain and fertilizers 18% Intermodal 10% Automotive 24% 19% 57% 57% U.S. domestic and transborder 19% Overseas 24% Canadian domestic Petroleum and chemicals Metals and minerals Forest products Petroleum and chemicals comprise a wide range of commodities, including chemicals, sulfur, plastics, petroleum and gas products. Most of CN’s petroleum and chemicals shipments originate in the Gulf of Mexico, in Alberta and in eastern Canada, and are destined for customers in Canada, the United States and over- seas export. CN’s metals and minerals business consists primarily of nonferrous base metals, steel, equipment and parts. Exclusive access to major mines and smelters throughout North America makes CN a leader in the trans- portation of copper, lead, zinc concentrates, refined metals and aluminum. CN is the largest carrier of forest products in North America. The prod- uct lines for this business unit include various types of lumber, panels, wood chips, woodpulp, printing paper, liner- board and newsprint. In Canada, CN enjoys superior access to the major fiber-producing regions. In the United States, CN is strategically located to serve both the northern and southern U.S. corridors with interline capabili- ties to other Class 1 railroads. CN derives revenue from seven business units – a balanced mix of goods moving over a network of approximately 18,000 route miles of track spanning North America. CN is the only rail network on the continent to con- nect three coasts – the Pacific, the Atlantic and the Gulf of Mexico. We believe the balance of our business mix positions us well to weather eco- nomic downturns and maximizes our potential to grow revenue by competing with trucks. 22 Canadian National Railway Company CN CN-CSXI CN-BNSF CN-NS KCS TM TFM CN-UP CN-CP Coal Grain and fertilizers Intermodal Automotive CN moves both Canadian and U.S. thermal coal. Canadian thermal coal is delivered to power utilities primar- ily in eastern Canada. U.S. thermal coal is transported from mines in southern Illinois or from western U.S. mines via interchange with other rail- roads to utilities in the U.S. Midwest. CN’s grain and fertilizer business transports commodities grown in western Canada and the U.S. Midwest. The majority of grain and grain products carried by CN are for export. In the United States, CN handles grain grown in Illinois and Iowa for export, as well as to domestic processing facilities and feed markets. CN also serves pro- ducers of potash, ammonium nitrate, urea and other fertilizers. CN’s intermodal business consists of two product segments. The first segment, domestic, is responsible for consumer products and manufac- tured goods, operating through both retail and wholesale channels. The second, the international seg- ment, handles import and export container traffic, serving the ports of Vancouver, Montreal, Halifax, Mobile and New Orleans. CN is a leading carrier of automotive products originating in southwestern Ontario and Michigan. This business unit moves both finished vehicles and parts within the United States, Canada and Mexico. CN also serves shippers of import vehicles via the ports of Halifax and Vancouver, and through interchange with other railroads. 23 Dear Fellow Shareholders: The past year has been one of challenge and change at CN. Economic challenges and drought in the grain producing areas served by CN caused our management to work even harder to produce good results. The departure of Paul Tellier in December The challenges of corporate governance issues throughout corporate America highlighted our good governance practices, which have been a priority for our company since our Initial Public Offering. CN has always been a leader in good corporate governance. We have from our inception had a separate non-executive chair as well as independent and financially literate members forming our audit commit- tee. Our Board meets regularly without management, which illustrates the strength and independence of our Board. Investor Relations magazine awarded CN its top corporate governance award. CN has also received the Korn/Ferry-Revue Commerce award for the best corporate governance confirmed our resilience and our succession practices in Quebec. planning. We welcome Hunter Harrison as We will always strive to maintain these high standards – it is part of our proud tradition, ensuring we will always be accountable to those our new President and Chief Executive who invest in our company. Officer with great enthusiasm. 24 Canadian National Railway Company CN directors have made substantial personal investments in our company, clearly an illustration of the close alignment of the interests of the Board of Directors with those of our shareholders. After 10 years as President and Chief Executive Officer of CN, Paul Tellier has chosen to pursue new challenges at Bombardier Inc. We are grateful to Paul for his inspired leadership and especially for leaving the company ready for his successor with a strong balance sheet and a clear sense of direction. We are all committed to continue the path of excellence Paul established, and our new President and Chief Executive Officer, Hunter Harrison, North America’s Railroader of the Year in 2001, is well equipped to take CN to the next level. The Board is very optimistic that with the depth of leadership at CN, we can and intend to maintain our position as North America’s most efficient and profitable railroad. To our dedicated employees at CN, we are grateful for your contin- ued commitment to excellence; to my fellow Board members, I am very appreciative of your conscientious attention to maintaining the high standards you have set; and finally to our shareholders, we will always appreciate and respect your investment by our commitment to delivering solid shareholder value. Sincerely, (signed) David McLean, O.B.C. LL.D. Chairman of the Board Pulling together… Canadian National Railway Company 25 for a brighter future Safety above all; lifelong learning; community support; and commitment Business starting in 2003. The chair is part of a new program in logistics, to action. These are the values that form the bedrock of CN’s community transportation and supply chain management at one of Canada’s investment philosophy. Our goal is simple: we seek, through our premier centers of study in the transportation field. resources, our talents and our time, to help make our communities better places to live and work. The CN Transportation and Logistics Management Fund, University CN’s corporate citizenship philosophy, called “Pulling Together,” is of Wisconsin-Superior – In 2002, CN made a significant contribution focused on four areas: community safety, transportation education, to help develop programs and fund scholarships at the school in the community response and United Way/Centraide – areas carefully chosen transportation management field of study. The fund will provide income so our efforts have the best chance to make a difference. to support research projects, scholarships for students majoring in Because we know North America’s prosperity is closely linked to transportation management who maintain high academic standards and its transportation infrastructure, we support study and research in trans- program development such as the purchase of specialized simulation portation, encouraging young people to get involved in the field and software. help shape the future. We focus our support on creating and helping to sustain centers of excellence in transportation education and policy The CN Intermodal Transportation Chair, Université de Montréal – by providing funds for university chairs, scholarships and postgraduate The CN chair, created in 2002, continues a long relationship between fellowships. A few notable examples of our support in 2002: CN and one of Canada’s most prestigious institutions of higher learning. Sustainable Transport, Logistics and Supply Chain Management portation, addressing a range of topics, from the transport of goods to The chair will devote itself primarily to research on intermodal trans- Chair, University of Manitoba – A major donation from CN helped to government transportation policies. create this chair, to be held at the university’s I.H. Asper School of 26 Canadian National Railway Company Canadian National Railway Company 27 Glossary of Terms Average length of haul – The average distance in miles one ton is carried. Computed by dividing total ton-miles by tons of freight. Rolling stock – Transportation equipment on wheels, especially locomotives and freight cars. Carload – A one-car shipment of freight from one consignor to one consignee. Route miles – The miles of right-of-way operated by a railroad. In multiple track territories only one track counts as route miles. Car velocity – Car velocity is an average speed calculation, expressed in miles per day, of the car movements from time of release at one location to arrival at the destination. Scheduled railroad – Running a scheduled railroad is a disciplined process that handles individual car movements according to a specific plan where possible and that manages expectations to meet agreed upon customer commitments. Class 1 railroad – As determined by the U.S. Surface Transportation Board, a railroad with annual operating revenues that exceed the threshold indexed to a base of U.S.$250 million in 1991 dollars. Siding – A track auxiliary to the main track for meeting or passing trains, or a track for industrial purposes. Gross ton miles – The weight of railway cars and contents behind the locomotives expressed in tons multiplied by the distance in miles from the originating location to the destination on the railroad. Through train – A train operated between two or more major concentration or distribution points. Intermodal service – In railroad transportation, the movement of trailers or containers on railroad freight cars. Linehaul – The movement of trains between terminals and stations on the main or branch lines of the road, exclusive of switching movements. Main track – A track extending through and between stations upon which trains are operated. Operating ratio – The ratio of operating expenses to operating revenues. Regional railroad – As defined by the Association of American Railroads, a regional railroad is one that operates at least 350 miles of track and/or has annual revenues of at least U.S.$40 million but less than the Class 1 threshold indexed to a base of U.S.$250 million in 1991 dollars. Revenue ton mile – The movement of a ton of freight over one mile for revenue. Right-of-way – A strip of land of various widths upon which a rail track is built. Trip plan – A trip plan is a detailed chain of train handling events describing how a car(s) can be handled from the shipper’s door to the consignee’s door. Trip plans are expressed in hours and are tailored for each specific customer location. Unit train – A train with a fixed, coupled consist of cars operated con- tinuously in shuttle service under load from origin and delivered intact at destination and returning usually for reloading at the same origin. Waybill – The document covering a shipment and showing the forward- ing and receiving stations, the name of consignor and consignee, the car initials and number, the routing, the description and weight of the com- modity, instructions for special services, the rate, total charges, advances and waybill reference for previous services, and the amount prepaid. Yard – A system of tracks within defined limits, designed for switching services. Yard dwell – Yard dwell is the average duration, expressed in hours, that cars spend in a specific operating terminal. 28 Canadian National Railway Company Financial Section (U.S. GA AP) Contents Canadian National Railway Company Selected Railroad Statistics 30 31 Management’s Discussion and Analysis 49 Management Report Auditors’ Report 49 Consolidated Statement of Income 50 Consolidated Statement of Comprehensive Income 51 Consolidated Balance Sheet 52 Consolidated Statement of Changes in Shareholders’ Equity 53 Consolidated Statement of Cash Flows 54 Notes to Consolidated Financial Statements 55 58 58 59 59 60 60 60 61 62 63 63 65 66 66 66 67 67 68 68 70 71 72 72 1 Summary of significant accounting policies 2 Accounting changes 3 Acquisition of Wisconsin Central Transportation Corporation 4 Accounts receivable 5 Properties 6 Other assets and deferred charges 7 Credit facilities 8 Accounts payable and accrued charges 9 Other liabilities and deferred credits 10 Long-term debt 11 Capital stock and convertible preferred securities 12 Stock plans 13 Pensions 14 Workforce reduction charges 15 Interest expense 16 Other income 17 Income taxes 18 Segmented information 19 Earnings per share 20 Major commitments and contingencies 21 Financial instruments 22 Other comprehensive income (loss) 23 Quarterly financial data – unaudited 24 Comparative figures U.S. GAAP Canadian National Railway Company 29 Selected Railroad Statistics Year ended December 31, 2002 2001(1) 2000 Rail operations Freight revenues ($ millions) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Gross ton miles (millions) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Revenue ton miles (RTM) (millions) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Route miles (includes Canada and the U.S.) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Operating expenses per RTM (cents) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Adjusted operating expenses per RTM (cents) (2) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Freight revenue per RTM (cents) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Carloads (thousands) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Freight revenue per carload ($) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Diesel fuel consumed (liters in millions) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Average fuel price ($/liter) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Revenue ton miles per liter of fuel consumed . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Gross ton miles per liter of fuel consumed . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Diesel fuel consumed (U.S. gallons in millions) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Average fuel price ($/U.S. gallon). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Revenue ton miles per U.S. gallon of fuel consumed . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Gross ton miles per U.S. gallon of fuel consumed . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Locomotive bad order ratio (%) (3) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Freight car bad order ratio (%) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Productivity Adjusted operating ratio (%) (2). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Freight revenue per route mile ($ thousands) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Revenue ton miles per route mile (thousands) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Freight revenue per average number of employees ($ thousands) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Revenue ton miles per average number of employees (thousands) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Employees Number at end of period. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Average number during period. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Labor and fringe benefits expense per RTM (cents) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Adjusted labor and fringe benefits expense per RTM (cents) (4) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Injury frequency rate per 200,000 person hours . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Accident rate per million train miles . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (1) Includes Wisconsin Central Transportation Corporation from October 9, 2001. (2) Excludes a 2002 charge of $281 million to increase the Company’s provision for U.S. personal injury and other claims, and workforce reduction charges of $120 million and $98 million in 2002 and 2001, respectively, as discussed in the Company’s Management’s Discussion and Analysis on pages 31 and 35. (3) In 2002, the Company expanded its measure of bad order locomotives to include all those not available for service, including on-line failures. The comparative figures have been restated accordingly. (4) Excludes workforce reduction charges recorded in 2002 and 2001. 5,901 309,295 159,876 17,821 2.90 2.65 3.69 4,164 1,417 1,420 0.32 113 218 375 1.20 426 825 7.0 6.0 69.4 331 8,971 254 6,894 22,114 23,190 1.15 1.07 3.0 2.0 5,457 293,857 153,095 17,986 2.59 2.53 3.56 3,821 1,428 1,328 0.36 115 221 351 1.35 436 837 7.1 5.7 68.5 303 8,512 241 6,754 22,868 22,668 1.06 1.00 4.4 2.0 5,236 288,150 149,557 15,532 2.53 2.53 3.50 3,796 1,379 1,292 0.33 116 223 341 1.24 439 845 7.0 5.1 69.6 337 9,629 233 6,660 21,378 22,457 0.98 0.98 5.5 2.1 30 Canadian National Railway Company U.S. GAAP Management ’s Discussion and Analysis Management’s discussion and analysis (MD&A) relates to the financial condition and results of operations of Canadian National Railway Company (CN) together with its wholly owned subsidiaries, including Grand Trunk Corporation (GTC), Illinois Central Corporation (IC) and Wisconsin Central Transportation Corporation (WC), the latter from October 9, 2001. As used herein, the word “Company” means, as the context requires, CN and its subsidiaries. CN’s common shares are listed on the Toronto and New York stock exchanges. Except where otherwise indicated, all financial information reflected herein is expressed in Canadian dollars and determined on the basis of United States generally accepted account- ing principles (U.S. GAAP). This MD&A should be read in conjunction with the Company’s Consolidated Financial Statements and notes thereto. Financial results 2002 compared to 2001 On October 9, 2001, the Company completed its acquisition of WC and began a phased integration of the companies’ operations. Accordingly, in the following discussion, the Company’s results include the results of operations of WC, which were fully integrated into those of the Company in 2002. The Company recorded consolidated net income of $800 million ($4.07 per basic share) for the year ended December 31, 2002 compared to $1,040 million ($5.41 per basic share) for the year ended December 31, 2001. Diluted earnings per share were $3.97 for the current year compared to $5.23 in 2001. Operating income was $1,469 million for 2002 compared to $1,682 million in 2001. The years ended December 31, 2002 and 2001 included items impacting the comparability of the results of operations. Included in 2002 is a fourth quarter charge of $281 million, or $173 million after tax, to increase the Company’s provision for U.S. personal injury and other claims, and a charge for workforce reductions of $120 million, or $79 million after tax. In 2001, the Company recorded a deferred income tax recovery of $122 million resulting from the enactment of lower corporate tax rates in Canada, a charge for workforce reductions of $98 million, or $62 mil- lion after tax, a charge to write down the Company’s net investment in 360networks Inc. of $99 million, or $71 million after tax and a gain of $101 million, or $73 million after tax related to the sale of the Company’s 50 percent interest in the Detroit River Tunnel Company (DRT). Excluding the effects of the items discussed in the preceding para- graph, adjusted consolidated net income(1) was $1,052 million ($5.35 per basic share or $5.22 per diluted share) in 2002 compared to $978 million ($5.09 per basic share or $4.92 per diluted share) in 2001, an increase of $74 million, or 8%. Adjusted operating income,(1) which excludes the 2002 charge to increase the Company’s provision for U.S. personal injury and other claims and the 2002 and 2001 workforce reduction charges, increased by $90 million, or 5%, to $1,870 million. The adjusted operating ratio was 69.4% in 2002 compared to 68.5% in 2001, a 0.9-point increase. (1) The Company’s results of operations include items affecting the comparability of results. Management believes adjusted consolidated net income and the resulting adjusted performance measures for such items as operating income, operating ratio, per share data and other statistical measures are useful measures of performance that facilitate period-to-period comparisons. These adjusted measures do not have any standardized meaning prescribed by GAAP and are not necessarily comparable to similar measures presented by other companies, and therefore, should not be considered in isolation. Revenues Revenues for the year ended December 31, 2002 totaled $6,110 million compared to $5,652 million in 2001. The increase of $458 million, or 8%, was mainly due to the inclusion of a full year of revenues attributable to the operations of WC in 2002. In addition, revenue gains were made in petroleum and chemicals, automotive, intermodal and forest products. These overall increases in revenues were partly offset by continued weakness in Canadian grain, coal, and metals and minerals. Revenue ton miles increased by 4% relative to 2001 and freight revenue per revenue ton mile increased by 4%. Year ended December 31, 2002 2001 2002 2001 2002 2001 Petroleum and chemicals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,102 521 Metals and minerals. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Forest products . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Coal . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Grain and fertilizers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Intermodal . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Automotive . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,323 326 986 1,052 591 Other items* . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $6,110 209 * Principally non-freight revenues derived from third parties. Revenues Revenue ton miles In millions Freight revenue per revenue ton mile In cents $÷«923 458 1,088 338 1,161 969 520 195 30,006 13,505 33,551 14,503 35,773 29,257 3,281 – 25,243 10,777 29,639 15,566 42,728 26,257 2,885 – $5,652 159,876 153,095 3.67 3.86 3.94 2.25 2.76 3.60 18.01 – 3.69 3.66 4.25 3.67 2.17 2.72 3.69 18.02 – 3.56 U.S. GAAP Canadian National Railway Company 31 Management ’s Discussion and Analysis Petroleum and chemicals Revenues for the year ended December 31, 2002 increased by $179 mil- lion, or 19%, over 2001. Growth was mainly due to the inclusion of a full year of revenues attributable to the operations of WC in 2002, strong sulfur traffic to the United States and offshore markets and market share gains in various sectors. The revenue per revenue ton mile remained rela- tively unchanged for the year as the effect of the weaker Canadian dollar was offset by an increase in the average length of haul for non-WC traffic. Forest products Revenues for the year ended December 31, 2002 increased by $235 mil- lion, or 22%, over 2001. Growth was mainly due to the inclusion of a full year of revenues attributable to the operations of WC in 2002, a strong North American housing market and improving pulp and paper markets. Also contributing to growth in the second half of the year were strong lumber shipments from CN’s western lumber producers. The increase in revenue per revenue ton mile of 7% was mainly due to the effect of the weaker Canadian dollar and the inclusion of shorter haul WC traffic. In thousands 0 0 6 Petroleum and chemicals Forest products Percentage of revenues Carloads* In thousands Percentage of revenues Carloads* 5 8 4 4 9 4 2 1 5 9 1 5 7 8 5 46% 54% 54% Petroleum and plastics 46% Chemicals 98 99 00 01 02 12% 31% 28% 29% 31% Lumber 29% Fibers 28% Paper 12% Panels 9 7 4 1 8 4 6 8 4 1 0 5 98 99 00 01 02 *Includes WC from October 9, 2001 *Includes WC from October 9, 2001 Metals and minerals Revenues for the year ended December 31, 2002 increased by $63 mil- lion, or 14%, over 2001. The increase was mainly due to the inclusion of a full year of revenues attributable to the operations of WC in 2002, market share gains in the non-ferrous segment, particularly aluminum, and strong construction materials traffic. Partly offsetting these gains were the effects of weak steel markets in the first half of the year, one-time gains in 2001 and reduced traffic in specific segments due to ongoing customer strikes. Revenue per revenue ton mile decreased by 9% over 2001 mainly due to an increase in longer haul traffic and the inclusion of certain lower rated WC traffic. Coal Revenues for the year ended December 31, 2002 decreased by $12 mil- lion, or 4%, from 2001. The decrease was mainly attributable to weak Canadian coal exports to offshore markets and reduced demand from power utilities in the first half of the year. The revenue per revenue ton mile increase of 4% was mainly due to a decrease in longer haul traffic. Metals and minerals Coal Percentage of revenues Carloads* In thousands Percentage of revenues Carloads* In thousands 8 8 3 3 7 2 6 6 2 6 5 2 7 8 2 31% 69% 14% 86% 4 3 5 8 5 5 8 2 5 7 1 5 9 9 4 69% Metals 31% Minerals 98 99 00 01 02 86% Coal 14% Petroleum coke 98 99 00 01 02 *Includes WC from October 9, 2001 *Includes WC from October 9, 2001 32 Canadian National Railway Company U.S. GAAP Management ’s Discussion and Analysis Grain and fertilizers Revenues for the year ended December 31, 2002 decreased by $175 mil- lion, or 15%, from 2001. The decrease reflects a significant deterioration in the Canadian grain crop, a decline in U.S. originated traffic and the loss of a potash move. Revenue per revenue ton mile increased by 1% mainly as a result of an increase in regulated grain rates. Automotive Revenues for the year ended December 31, 2002 increased by $71 mil- lion, or 14%, over 2001. The increase reflects strong motor vehicle pro- duction in both Canada and the United States. Revenue per revenue ton mile remained relatively unchanged for the year as the effect of the weaker Canadian dollar was offset by an increase in the average length of haul. Grain and fertilizers Automotive Percentage of revenues Carloads* In thousands Percentage of revenues Carloads* In thousands 7 3 5 2 4 5 7 6 5 0 9 5 5 3 5 13% 14% 26% 22% 25% 6 2 3 0 1 3 4 0 3 8 1 3 7 5 2 17% 83% 26% Oil seeds 25% Food grain 22% Feed grain 14% Potash 13% Fertilizers 98 99 00 01 02 83% Finished vehicles 17% Auto parts 98 99 00 01 02 *Includes WC from October 9, 2001 *Includes WC from October 9, 2001 Intermodal Revenues for the year ended December 31, 2002 increased by $83 mil- lion, or 9%, over 2001. Growth in the international segment was driven by market share gains by steamship lines served by CN. The domestic segment benefited from growing North American markets, particularly in Canada. Revenue per revenue ton mile decreased by 2%, mainly due to a higher average fuel surcharge in 2001 and an increase in the average length of haul. Intermodal Percentage of revenues Carloads* In thousands 7 3 2 , 1 1 2 1 , 1 3 0 1 , 1 4 9 9 8 1 9 43% 57% 57% Domestic 43% International 98 99 00 01 02 *Includes WC from October 9, 2001 U.S. GAAP Canadian National Railway Company 33 Management ’s Discussion and Analysis Operating expenses Operating expenses amounted to $4,641 million in 2002 compared to $3,970 million in 2001. The increase was mainly due to the inclusion of a full year of expenses attributable to the operations of WC in 2002, higher Casualty and other expenses resulting primarily from the 2002 charge to increase the Company’s provision for U.S. personal injury and other claims, and increased expenses for labor and fringe benefits that included a higher workforce reduction charge in 2002 compared to 2001. These increases were partly offset by lower fuel costs. Operating expenses, excluding the 2002 charge for U.S. personal injury and other claims and the 2002 and 2001 workforce reduction charges, amounted to $4,240 million, an increase of $368 million, or 10%, from 2001.(1) Dollars in millions Year ended December 31, 2002 2001 Labor and fringe benefits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,837 778 Purchased services and material . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Depreciation and amortization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Fuel . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Equipment rents . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 584 459 346 Casualty and other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $4,641 637 Amount % of revenue 30.1% 12.7% 9.6% 7.5% 5.7% 10.4% % of revenue 28.7% 12.2% 9.4% 8.6% 5.5% 5.8% Amount $1,624 692 532 484 309 329 $3,970 Labor and fringe benefits: Labor and fringe benefit expenses in 2002 increased by $213 million, or 13%, as compared to 2001. The increase was mainly due to the inclusion of a full year of expenses attributable to the operations of WC in 2002, a higher workforce reduction charge in 2002, wage increases, and higher benefit expenses, including health and welfare, particularly in the U.S. These increases were partly offset by the effects of a reduced workforce in 2002. In 2002, the Company announced 1,146 job reductions across all corporate and operating functions in a renewed drive to improve produc- tivity and recorded a workforce reduction charge of $120 million. Reductions relating to this and the 2001 workforce reduction charge were 388 in 2001, 433 in 2002, with the remainder to be completed by the end of 2003. The charges included payments for severance, early retirement incentives and bridging to early retirement, to be made to affected employees. Purchased services and material: These costs increased by $86 million, or 12%, in 2002 as compared to 2001. The increase was mainly due to the inclusion of a full year of expenses attributable to the operations of WC in 2002 and higher expenses for professional services and joint facil- ities. These increases were partly offset by reduced expenses for crew transportation and lodging in 2002. Depreciation and amortization: Depreciation and amortization expense in 2002 increased by $52 million, or 10%, as compared to 2001. The increase was mainly due to the inclusion of a full year of expenses attrib- utable to the operations of WC in 2002 and the impact of net capital additions in the current year. Fuel: Fuel expense in 2002 decreased by $25 million, or 5%, as compared to 2001. The decrease was primarily due to a lower average price of fuel, partially offset by the inclusion of a full year of expenses attributable to the operations of WC in 2002. Equipment rents: These expenses increased by $37 million, or 12%, in 2002 as compared to 2001. The increase was mainly due to the inclusion of a full year of expenses attributable to the operations of WC in 2002 and lower car hire income, partly offset by reduced expenses for long- term operating leases. Casualty and other: These expenses increased by $308 million, or 94%, in 2002 as compared to 2001. The increase was mainly due to higher expenses for personal injury and other claims which included a fourth quarter 2002 charge of $281 million to increase the provision for U.S. personal injury and other claims, and higher derailment related expenses. Partly offsetting these increases were lower expenses related to environ- mental matters and bad debts. 34 Canadian National Railway Company U.S. GAAP Management ’s Discussion and Analysis Other Interest expense: Interest expense increased by $34 million to $361 mil- lion for the year ended December 31, 2002 as compared to 2001. The increase was mainly due to the financing related to the acquisition of WC and the inclusion of a full year of WC expenses in 2002. Partly offset- ting these increases was lower interest expense as a result of the conver- sion of the convertible preferred securities in July 2002 and the maturity of certain notes in 2001. Other income: In 2002, the Company recorded other income of $76 mil- lion compared to $65 million in 2001. The increase was mainly due to the inclusion of a full year of equity in earnings of English Welsh and Scottish Railway (EWS) in 2002 partly offset by lower gains on disposal of properties. Included in 2001 was a charge of $99 million to write down the Company’s net investment in 360networks Inc. and a gain of $101 million related to the sale of the Company’s 50 percent interest in DRT. Income tax expense: The Company recorded income tax expense of $384 million for the year ended December 31, 2002 compared to $380 million in 2001. The effective tax rate for the year ended December 31, 2002 was 32.4% compared to 35.4% in 2001, excluding the 2001 deferred income tax recovery of $122 million resulting from the enactment of lower corporate tax rates in Canada. The decrease in 2002 was primarily due to lower income tax rates in Canada. 2001 compared to 2000 The Company recorded consolidated net income of $1,040 million ($5.41 per basic share) for the year ended December 31, 2001 compared to $937 million ($4.81 per basic share) for the year ended December 31, 2000. Diluted earnings per share were $5.23 for 2001 compared to $4.67 in 2000. The results for 2001 include net income of $17 million related to the acquisition of WC. Operating income was $1,682 million for 2001 compared to $1,648 million in 2000. This represents an increase of $34 million, or 2%. The years ended December 31, 2001 and 2000 included items impacting the comparability of the results of operations. Included in 2001 is a deferred income tax recovery of $122 million resulting from the enactment of lower corporate tax rates in Canada, a charge for work- force reductions of $98 million, or $62 million after tax, a charge to write down the Company’s net investment in 360networks Inc. of $99 million, or $71 million after tax and a gain of $101 million, or $73 million after tax related to the sale of the Company’s 50 percent interest in DRT. In 2000, the Company recorded a gain of $84 million, or $58 million after tax related to the exchange of its minority equity investments in certain joint venture companies for 11.4 million shares of 360networks Inc. Excluding the effects of the items discussed in the preceding para- graph, adjusted consolidated net income(1) was $978 million ($5.09 per basic share or $4.92 per diluted share) in 2001 compared to $879 million ($4.51 per basic share or $4.39 per diluted share) in 2000. Adjusted operating income,(1) which excludes the 2001 charge for workforce reduc- tions, increased by $132 million, or 8%, to $1,780 million. The adjusted operating ratio, which excludes the 2001 charge for workforce reductions, improved to 68.5% in 2001 from 69.6% in 2000, a 1.1-point betterment. Revenues Revenues for the year ended December 31, 2001 totaled $5,652 million compared to $5,428 million in 2000. The increase of $224 million, or 4%, was mainly attributable to the inclusion of $129 million of WC revenues and to gains in metals and minerals, intermodal, forest products and grain and fertilizers. This was partially offset by lower automotive rev- enues. Revenue ton miles and freight revenue per revenue ton mile each increased by 2% as compared to 2000. Year ended December 31, 2001 2000 2001 2000 2001 2000 Revenues Revenue ton miles In millions Freight revenue per revenue ton mile In cents Petroleum and chemicals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $÷«923 458 Metals and minerals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Forest products . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Coal. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Grain and fertilizers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Intermodal . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Automotive . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other items* . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,088 338 1,161 969 520 195 $÷«894 392 1,008 328 1,136 919 559 192 25,243 10,777 29,639 15,566 42,728 26,257 2,885 – 24,858 9,207 28,741 15,734 42,396 25,456 3,165 – Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $5,652 $5,428 153,095 149,557 3.66 4.25 3.67 2.17 2.72 3.69 18.02 – 3.56 3.60 4.26 3.51 2.08 2.68 3.61 17.66 – 3.50 * Principally non-freight revenues derived from third parties. U.S. GAAP Canadian National Railway Company 35 Management ’s Discussion and Analysis Petroleum and chemicals Revenues for the year ended December 31, 2001 increased by $29 mil- lion, or 3%, over 2000 of which $22 million resulted from the inclusion of WC revenues. Excluding WC, growth in 2001 was driven by market share gains and plant expansions in the petroleum products sector, increased salt traffic, mainly in the early part of the year, and the weaker Canadian dollar. Significant weakness in sulfur demand partially offset these increases. The revenue per revenue ton mile increase of 2% for 2001 was mainly attributable to the effect of the weaker Canadian dollar. Metals and minerals Revenues for the year ended December 31, 2001 increased by $66 mil- lion, or 17%, over 2000 of which $22 million resulted from the inclusion of WC revenues. Excluding WC, growth in 2001 was driven by strong Canadian aluminum exports to the United States in line with weaker U.S. production, increased levels of equipment traffic, market share gains in steel, ores and concentrates, and increased stone and rock shipments to the United States. Significant weakness in the steel markets partially offset overall growth. Revenue per revenue ton mile was essentially flat year over year. Forest products Revenues for the year ended December 31, 2001 increased by $80 mil- lion, or 8%, over 2000 of which $55 million resulted from the inclusion of WC revenues. Excluding WC, growth was driven by market share gains in the panels segment and the effect of the weaker Canadian dollar. These gains were partially offset by weakness in the pulp and paper markets due, in part, to a significant reduction in U.S. paper consumption. The increase in revenue per revenue ton mile of 5% was mainly due to the effect of the weaker Canadian dollar and the inclusion of shorter haul WC traffic. Coal Revenues for the year ended December 31, 2001 increased by $10 mil- lion, or 3%, over 2000 of which $7 million resulted from the inclusion of WC revenues. Excluding WC, strong demand for thermal coal in 2001 was partially offset by reduced shipments of metallurgical coal due to the closure of some Canadian mines in 2000. The revenue per revenue ton mile increase of 4% was mainly due to an increase in rates tied to commodity prices and the effect of the weaker Canadian dollar. Grain and fertilizers Revenues for the year ended December 31, 2001 increased by $25 mil- lion, or 2%, over 2000 of which $15 million resulted from the inclusion of WC revenues. Excluding WC, growth was mainly driven by higher wheat shipments to the United States, increased market share of U.S. corn and soybean traffic and higher exports of canola through Vancouver. The 1% increase in revenue per revenue ton mile was mainly due to a shift to shorter haul traffic and the effect of the weaker Canadian dollar, partially offset by the introduction of the Canadian grain revenue cap in August 2000. Intermodal Revenues for the year ended December 31, 2001 increased by $50 mil- lion, or 5%, over 2000 of which $7 million resulted from the inclusion of WC revenues. Excluding WC, growth was driven by market share gains in the international segment and from new service offerings in the domestic segment. Weaker economic conditions in the second half of 2001 led to slower growth. Revenue per revenue ton mile increased by 2% due to rate increases and the effect of the weaker Canadian dollar, partially offset by a shift to longer haul traffic. Automotive Revenues for the year ended December 31, 2001 decreased by $39 mil- lion, or 7%, from 2000. The revenue decline resulted from weakness in North American vehicle production in 2001 and from one-time gains obtained in 2000 due, in part, to competitors’ service problems. The decline was partially offset by the effect of the weaker Canadian dollar. The increase in revenue per revenue ton mile of 2% was mainly due to the weaker Canadian dollar partially offset by an increase in the average length of haul. 36 Canadian National Railway Company U.S. GAAP Management ’s Discussion and Analysis Operating expenses Operating expenses amounted to $3,970 million in 2001 compared to $3,780 million in 2000. The increase in 2001 was mainly due to the inclusion of $86 million of WC expenses, higher labor and fringe benefit expenses that included a charge for workforce reductions of $98 million, higher fuel costs, and increased expenses for equipment rents. Partially offsetting these increases were lower expenses for purchased services and material. Operating expenses, excluding the workforce reduction charge, amounted to $3,872 million, an increase of $92 million, or 2%, from 2000.(1) Dollars in millions Year ended December 31, 2001 2000 Labor and fringe benefits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Purchased services and material . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Depreciation and amortization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Fuel . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Equipment rents . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Casualty and other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Amount $1,624 692 532 484 309 329 $3,970 % of revenue 28.7% 12.2% 9.4% 8.6% 5.5% 5.8% % of revenue 27.1% 13.8% 9.7% 8.2% 5.2% 5.6% Amount $1,472 746 525 446 285 306 $3,780 Labor and fringe benefits: Labor and fringe benefit expenses in 2001 increased by $152 million, or 10%, as compared to 2000. The increase was mainly attributable to the workforce reduction charge, the inclusion of WC labor expense of $40 million, wage increases and the impact of the weaker Canadian dollar on U.S. denominated expenses. This was par- tially offset by lower pension and other benefit related expenses. The Company recorded a workforce reduction charge of $98 million in the second quarter of 2001 for the reduction of 690 positions (388 occurred in 2001 and the remainder was completed by the end of 2002). The charge included payments for severance, early retirement incentives and bridging to early retirement, to be made to affected employees. Purchased services and material: These expenses decreased by $54 mil- lion, or 7%, in 2001 as compared to 2000. The decrease was mainly due to one-time consulting and professional fees related to a proposed com- bination in 2000, lower contracted services and higher recoveries in 2001 from work performed for third parties. This was partially offset by higher equipment repair and maintenance expenses and $12 million resulting from the inclusion of WC expenses. Depreciation and amortization: Depreciation and amortization expense in 2001 increased by $7 million, or 1%, as compared to 2000. The effect of revised depreciation rates for certain assets mostly offset the increases related to net capital additions and the inclusion of WC depre- ciation of $10 million. Fuel: Fuel expense in 2001 increased by $38 million, or 9%, as compared to 2000, primarily due to an increase in the average cost of fuel and the inclusion of $10 million of WC fuel expense. Equipment rents: These expenses increased by $24 million, or 8%, in 2001 as compared to 2000. The increase was mainly attributable to lower lease and offline car hire income and the inclusion of $6 million of WC equipment rents. This was partially offset by lower private car mileage payments. Casualty and other: These expenses increased by $23 million, or 8%, in 2001 as compared to 2000. The increase resulted from higher expenses for occupational disease claims and environmental matters, higher provincial capital taxes and the inclusion of $8 million of WC expenses. This was partially offset by lower expenses for damaged equipment and merchandise claims and provincial sales tax recoveries in 2001. Other Interest expense: Interest expense increased by $16 million to $327 mil- lion for the year ended December 31, 2001 as compared to 2000. The increase was mainly due to the financing related to the acquisition of WC, the inclusion of $4 million of WC interest expense, and the impact of the weaker Canadian dollar on U.S. denominated interest costs. This was, in part, offset by the refinancing of a portion of matured debt at lower rates. Other income: In 2001, the Company recorded other income of $65 mil- lion compared to $136 million in 2000. Included in 2001 is a charge of $99 million to write down the Company’s net investment in 360networks Inc., a gain of $101 million related to the sale of the Company’s 50 per- cent interest in DRT and $11 million of WC other income. The comparative 2000 period included an $84 million gain related to the 360networks Inc. transaction. U.S. GAAP Canadian National Railway Company 37 Management ’s Discussion and Analysis Income tax expense: The Company recorded an income tax expense of $380 million for the year ended December 31, 2001 compared to $536 million in 2000. The decrease in income tax expense was mainly due to a $122 million deferred income tax recovery recorded in 2001 resulting from the enactment of lower corporate tax rates in Canada. Excluding this item, the effective tax rate for the year ended December 31, 2001 decreased to 35.4% from 36.4% in 2000 due mainly to lower tax rates in 2001. The Company anticipates that capital expenditures for 2003 will remain at approximately the same level as 2002. This will include funds required for ongoing renewal of the basic plant and other acquisitions and investments required to improve the Company’s operating efficiency and customer service. As at December 31, 2002, the Company had commitments to acquire railroad ties, rail, freight cars and locomotives at an aggregate cost of $183 million. Liquidity and capital resources The Company’s principal source of liquidity is cash generated from oper- ations. The Company also has the ability to fund liquidity requirements through its revolving credit facility, the issuance of debt and/or equity, and the sale of a portion of its accounts receivable through its Accounts receivable securitization program. In addition, from time to time, the Company’s liquidity requirements can be supplemented by the disposal of surplus properties and the monetization of assets. Operating activities: Cash provided from operating activities was $1,612 million for the year ended December 31, 2002 compared to $1,621 million for 2001. Cash generated in 2002 was partially consumed by payments for interest, workforce reductions and personal injury and other claims of $398 million, $177 million and $156 million, respectively, compared to $322 million, $169 million and $149 million, respectively in 2001. Pension contributions and payments for income taxes were $92 million and $65 million, respectively, compared to $69 million and $63 million, respectively in 2001. The Company increased the level of accounts receivable sold under its Accounts receivable securitization pro- gram by $5 million in 2002 and $133 million in 2001. Payments in 2003 for workforce reductions are expected to be $168 million while pension contributions are expected to be approximately $92 million. Investing activities: Cash used by investing activities in 2002 amounted to $924 million compared to $2,173 million in 2001. The Company’s investing activities in 2002 included aggregate net proceeds of $69 mil- lion from the sale of its investments in Tranz Rail Holdings Limited and Australian Transport Network Limited, and $28 million from the sale of IC Terminal Holdings Company. Investing activities in 2001 included $1,278 million related to the acquisition of WC as at October 9, 2001 and net proceeds of $112 million from the sale of DRT. Net capital expenditures for the year ended December 31, 2002 amounted to $938 million, including $76 million related to WC, a decrease of $3 million over 2001. Net capital expenditures included expenditures for roadway renewal, rolling stock, and other capacity and productivity improvements. Dividends: During 2002, the Company paid dividends totaling $170 mil- lion to its shareholders at the quarterly rate of $0.215 per share. Free cash flow The Company generated $513 million of free cash flow for the year ended December 31, 2002, compared to $443 million for the same 2001 period, excluding $1,278 million related to the 2001 acquisition of WC. The Company defines free cash flow as cash provided from operating activities, excluding increases in the level of accounts receivable sold under the securitization program ($5 million in 2002, $133 million in 2001), less capital expenditures, other investing activities and dividends paid. Financing activities: Cash used by financing activities totaled $546 mil- lion for the year ended December 31, 2002 compared to cash generated of $740 million in 2001. In 2002, issuances and repayments of long-term debt related principally to the Company’s commercial paper and revolv- ing credit facilities. In 2001, the Company issued debt securities in two series, U.S.$400 million (Cdn$629 million) 6.375% Notes due 2011 and U.S.$200 million (Cdn$314 million) 7.375% Debentures due 2031, related to the acquisition of WC. In 2002, $203 million was used to repurchase common shares under the share repurchase program. In 2001, the Company also had a share repurchase program, under which it did not repurchase any common shares. During 2002, the Company recorded $114 million in capital lease obligations ($91 million in 2001) related to new equipment and the exercise of purchase options on existing equipment. The Company has access to various financing arrangements: Revolving credit facilities In December 2002, the Company entered into a U.S.$1,000 million three- year revolving credit facility and concurrently terminated its previous revolving credit facilities before their scheduled maturity in March 2003. The credit facility provides for borrowings at various interest rates, plus applicable margins, and contains customary financial covenants. Throughout the year, the Company was in compliance with all financial covenants contained in its outstanding revolving credit agreements. The Company’s borrowings of U.S.$172 million (Cdn$273 million) outstanding 38 Canadian National Railway Company U.S. GAAP Management ’s Discussion and Analysis at December 31, 2001 were entirely repaid in the first quarter of 2002. At December 31, 2002, the Company had borrowings under its revolving credit facility of U.S.$90 million (Cdn$142 million) at an average interest rate of 1.77%. Outstanding letters of credit under the previous facilities were transferred into the current facility. As at December 31, 2002, letters of credit under the revolving credit facility amounted to $295 million. Commercial paper The Company has a commercial paper program, which is backed by a portion of its revolving credit facility, enabling it to issue commercial paper up to a maximum aggregate principal amount of $600 million, or the U.S. dollar equivalent. Commercial paper debt is due within one year but has been classified as long-term debt, reflecting the Company’s intent and contractual ability to refinance the short-term borrowing through subsequent issuances of commercial paper or drawing down on the long-term revolving credit facility. As at December 31, 2002, the Company had outstanding commercial paper of U.S.$136 million (Cdn$214 million) compared to U.S.$213 million (Cdn$339 million) as at December 31, 2001. Shelf registration statement At December 31, 2002, the Company had U.S.$400 million remaining for issuance under its shelf registration statement, which expires in August 2003. Contractual obligations and commercial commitments Accounts receivable securitization program The sale of a portion of the Company’s accounts receivable is conducted under a securitization program, which has a $350 million maximum limit and will expire in June 2003. The program is subject to customary credit rating and reporting requirements. In the event the program is terminated before its scheduled maturity, the Company expects to have sufficient liquidity remaining in its revolving credit facility to meet its payment obligations. The Company intends to renew or replace the program upon expiration. At December 31, 2002, pursuant to the agreement, $173 mil- lion and U.S.$113 million (Cdn$177 million) had been sold on a limited recourse basis, an increase of $5 million from the level of accounts receivable sold at December 31, 2001. The Receivables Purchase Agreement provides for customary indem- nification provisions, which survive for a period of two years following the final purchase of any receivable, three years from the final collection date or until statute barred, in the case of taxes. As at December 31, 2002, the Company has not recorded a liability associated with these indemnifications, for which there is no monetary limitation, as the Company does not expect to make any payments pertaining to the indemnifications of this program. Although there is no monetary limita- tion with respect to these indemnifications, the Company would not expect the amount to exceed the maximum limit under the program. In the normal course of business, the Company incurs contractual obligations and commercial commitments. The following tables set forth material obligations and commitments as of December 31, 2002: Contractual obligations Total In millions Debentures and notes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $4,167 1,424 Capital leases and other(a) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Long-term debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,591 Operating leases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total obligations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $6,745 1,154 Commercial commitments In millions Standby letters of credit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other commercial commitments(b). . . . . . . . . . . . . . . . . . . . . . . . . . . . Total commitments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total $403 183 $586 2003 $394 180 574 212 $786 2003 $401 112 $513 2004 $419 141 560 188 $748 2004 $÷1 71 $72 2005 $158 444 602 167 $769 2006 $394 46 440 139 $579 2007 $÷79 90 169 120 $289 2008 and thereafter $2,723 523 3,246 328 $3,574 2005 2006 2007 2008 and thereafter $– – $– $1 – $1 $– – $– $– – $– (a) Excludes $498 million of imputed interest on capital leases at rates ranging from approximately 3.0% to 14.6%. (b) Includes commitments for railroad ties, rail, freight cars and locomotives. For 2003 and the foreseeable future, the Company expects cash flow from operations and from its various sources of financing to be sufficient to meet its debt repayments and future obligations, and to fund anticipated capital expenditures. U.S. GAAP Canadian National Railway Company 39 Management ’s Discussion and Analysis Guarantees Share repurchase program Guarantee of residual values of operating leases The Company has guaranteed a portion of the residual values of certain of its assets under operating leases with expiry dates between 2004 and 2012, for the benefit of the lessor. If the fair value of the assets, at the end of their respective lease term, is less than the fair value, as estimated at the inception of the lease, then the Company must, under certain con- ditions, compensate the lessor for the shortfall. The maximum exposure in respect of these guarantees is $63 million. As at December 31, 2002, the Company has not recorded a liability associated with these guaran- tees, as the Company does not expect to make any payments pertaining to the guarantees of these leases. Standby letters of credit The Company, including certain of its subsidiaries, has granted irrevocable standby letters of credit, issued by highly rated banks, to third parties to indemnify them in the event the Company does not perform its contrac- tual obligations. As at December 31, 2002, the maximum potential liability under these letters of credit was $403 million of which $334 million was for workers’ compensation and other employee benefits and $69 million was for equipment under leases and other. As at December 31, 2002, the Company has not recorded a liability with respect to these guarantees, as the Company does not expect to make any payments in excess of what is recorded on the Company’s financial statements for the aforementioned items. The standby letters of credit mature at various dates between 2003 and 2007. Indemnifications CN Pension Plan and CN 1935 Pension Plan The Company has indemnified and held harmless the current trustee and the former trustee of the Canadian National Railways Pension Trust Funds, and the respective officers, directors, employees and agents of such trustees, from any and all taxes, claims, liabilities, damages, costs and expenses arising out of the performance of their obligations under the relevant trust agreements and trust deeds, including in respect of their reliance on authorized instructions of the Company or for failing to act in the absence of authorized instructions. These indemnifications sur- vive the termination of such agreements or trust deeds. As at December 31, 2002, the Company has not recorded a liability associated with these indemnifications, as the Company does not expect to make any payments pertaining to these indemnifications. On October 22, 2002, the Board of Directors of the Company approved a share repurchase program which allows for the repurchase of up to 13.0 million common shares between October 25, 2002 and October 24, 2003 pursuant to a normal course issuer bid, at prevailing market prices. As at December 31, 2002, $203 million was used to repurchase 3.0 million common shares at an average price of $67.68 per share. Termination of conversion rights of 5.25% convertible preferred securities (“Securities”) On May 6, 2002, the Company met the conditions required to terminate the Securities holders’ right to convert their Securities into common shares of the Company, and set the conversion termination date as July 3, 2002. The conditions were met when the Company’s common share price exceeded 120% of the conversion price of U.S.$38.48 per share for a specified period, and all accrued interest on the Securities had been paid. On July 3, 2002, Securities that had not been previously surrendered for conversion were deemed converted, resulting in the issuance of 6.0 million common shares of the Company. Acquisition of Wisconsin Central Transportation Corporation On October 9, 2001, the Company completed its acquisition of WC for an acquisition cost of $1,301 million (U.S.$833 million) and began a phased integration of the companies’ operations. The Company accounted for the merger using the purchase method of accounting as required by the Financial Accounting Standards Board’s (FASB) Statement of Financial Accounting Standards (SFAS) No. 141 “Business Combinations.” As such, the Company’s consolidated financial statements include the assets, liabilities and results of operations of WC as of October 9, 2001, the date of acquisition. The Company had esti- mated, on a preliminary basis, the fair values of the assets and liabilities acquired based on currently available information. In 2002, the Company finalized the allocation of the purchase price and adjusted the prelimi- nary fair values of the assets and liabilities acquired as follows: Current assets decreased by $10 million, Properties increased by $141 million, Other assets and deferred charges decreased by $98 million, Current lia- bilities increased by $10 million, Deferred income taxes increased by $16 million and Other liabilities and deferred credits increased by $3 million. The increase in Properties and decrease in Other assets and deferred charges was mainly due to the final valuation of the Company’s foreign equity investment. The remaining adjustments resulted from additional information obtained for conditions and circumstances that existed at the time of acquisition. 40 Canadian National Railway Company U.S. GAAP Management ’s Discussion and Analysis The following table outlines the final fair values of WC’s assets and liabilities acquired: In millions Current assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Properties . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other assets and deferred charges . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total assets acquired . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Current liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Deferred income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other liabilities and deferred credits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Long-term debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total liabilities assumed . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net assets acquired . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $÷«165 2,576 335 3,076 363 759 181 «472 1,775 $1,301 Recent accounting pronouncements In January 2003, the FASB issued FASB Interpretation (FIN) No. 46, “Consolidation of Variable Interest Entities.” FIN No. 46 requires that an enterprise holding other than a voting interest in a Variable Interest Entity (VIE) could, subject to certain conditions, be required to consoli- date the VIE if the enterprise will absorb a majority of the VIE’s expected losses and/or receive a majority of its expected residual returns. This interpretation is effective for newly created entities after January 31, 2003. For pre-existing VIEs, the provisions of the interpretation are effec- tive for periods beginning after June 15, 2003. The Company does not expect FIN No. 46 to have a material impact on its financial statements. In November 2002, the FASB issued FIN No. 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others,” which requires that a guarantor disclose and recognize in its financial statements its obliga- tions relating to guarantees that it has issued. Liability recognition is required at the inception of the guarantee, whether or not payment is probable. The disclosure requirements are effective for periods ending after December 15, 2002, and have been reflected in the notes to the Company’s 2002 consolidated financial statements. The recognition and measurement provisions are effective for guarantees issued or modified after December 31, 2002. The Company will apply the recognition and measurement provisions of FIN No. 45 on a prospective basis and, as such, does not expect it to have an initial material impact on its financial statements upon adoption. In July 2002, the FASB issued SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities,” which requires that a liability for costs associated with an exit or disposal activity be recognized when the liability is incurred. SFAS No. 146 also establishes that the liability should be initially measured at fair value and subsequently adjusted for changes in estimated cash flows. SFAS No. 146 is to be applied to exit or disposal activities initiated after December 31, 2002. The Company will apply SFAS No. 146 on a prospective basis and, as such, does not expect it to have an initial material impact on its financial statements upon adoption. In August 2001, the FASB issued SFAS No. 143, “Accounting for Asset Retirement Obligations,” which requires an entity to record the fair value of an asset retirement obligation as a liability in the period in which it incurs a legal obligation associated with the retirement of tangible long- lived assets. As a result of the issuance of SFAS No. 143, the Company is reviewing the accounting policy of its asset replacement program. A change in this policy will be treated as a change in accounting principle with a cumulative effect adjustment being recorded in the first quarter of 2003. This statement is effective for the Company’s fiscal year begin- ning January 1, 2003. The Company is currently evaluating the impact of this statement on its financial statements. Critical accounting policies The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of revenues and expenses during the period, the reported amounts of assets and liabilities, and the disclosure of contingent assets and liabilities at the date of the financial statements. On an ongoing basis, management reviews its estimates, including those related to personal injury and other claims, environmental matters, depreciation lives, pensions and other post- retirement benefits, and income taxes, based upon currently available information. Actual results could differ from these estimates. The follow- ing accounting policies require management’s more significant judg- ments and estimates in the preparation of the Company’s consolidated financial statements and as such, are considered to be critical. The fol- lowing information should be read in conjunction with the Company’s Consolidated Financial Statements and notes thereto. Management has discussed the development and selection of the Company’s critical accounting estimates with the Audit, Finance and Risk Committee of the Company’s Board of Directors and the Audit, Finance and Risk Committee has reviewed the Company’s related disclosures herein. U.S. GAAP Canadian National Railway Company 41 Management ’s Discussion and Analysis Personal injury and other claims In the normal course of its operations, the Company becomes involved in various legal actions, including claims relating to personal injuries, occupational disease and damage to property. In Canada, employee injuries are governed by the workers’ compen- sation legislation in each province whereby employees may be awarded either a lump sum or future stream of payments depending on the nature and severity of the injury. Accordingly, the Company accounts for costs related to employee work-related injuries based on actuarially developed estimates of the ultimate cost associated with such injuries, including compensation, health care and administration costs. For all other legal actions, the Company maintains, and regularly updates on a case-by-case basis, provisions for such items when the expected loss is both probable and can be reasonably estimated based on currently available information. Assumptions used in estimating the ultimate costs for Canadian employee injury claims consider, among others, the discount rate, the rate of inflation, wage increases and health care costs. The Company periodically reviews its assumptions to reflect currently available infor- mation. Over the past three years, the Company has changed certain of these assumptions, which have not had a material effect on its results of operations. For all other legal claims in Canada, estimates are based on case history, trends and judgment. In the United States, employee work-related injuries, including occu- pational disease claims, are compensated according to the provisions of the Federal Employers’ Liability Act (FELA) and represent a major expense for the railroad industry. The FELA system, which requires either the finding of fault through the U.S. jury system or individual settlements, has contributed to the significant increase in the Company’s personal injury expense in recent years. In view of the Company’s growing pres- ence in the United States and the increase in the number of occupational disease claims over the past few years, an actuarial study was conducted in 2002, and in the fourth quarter of 2002 the Company changed its methodology for estimating its liability for U.S. personal injury and other claims, including occupational disease claims and claims for property damage, from a case-by-case approach to an actuarial-based approach. Consequently, and as discussed in Note 2 to the Consolidated Financial Statements, the Company recorded a charge of $281 million ($173 mil- lion after tax) to increase its provision for these claims. Under the actuarial-based approach, the Company accrues the cost for the expected personal injury and property damage claims and existing occupational disease claims, based on actuarial estimates of their ultimate cost. The Company is unable to estimate the total cost for unasserted occupational disease claims. However, a liability for unasserted occupa- tional disease claims is accrued to the extent they are probable and can be reasonably estimated. Under the case-by-case approach, the Company was accruing the cost for claims as incidents were reported based on currently available information. In addition, the Company did not record a liability for unasserted claims, as such amounts could not be reasonably estimated under the case-by-case approach. For the U.S. personal injury and other claims liability, historical claim data is used to formulate assumptions relating to the expected number of claims and average cost per claim (severity) for each year. Changes in any one of these assumptions could materially affect Casualty and other expense as reported in the Company’s results of operations. For example, a 5% change in the number of claims or severity would have the effect of changing the provision by approximately $25 million and the annual expense by approximately $5 million. The Company’s expenses for personal injury and other claims, net of recoveries, and including the above-mentioned charge, were $393 million in 2002 ($78 million in 2001 and $60 million in 2000) and payments for such items were $156 million in 2002 ($149 million in 2001 and $111 million in 2000). As at December 31, 2002, the Company had aggregate reserves for personal injury and other claims of $664 million ($430 million at December 31, 2001). Environmental matters Regulatory compliance A risk of environmental liability is inherent in railroad and related trans- portation operations; real estate ownership, operation or control; and other commercial activities of the Company with respect to both current and past operations. As a result, the Company incurs significant compliance and capital costs, on an ongoing basis, associated with environmental regulatory compliance and clean-up requirements in its railroad opera- tions and relating to its past and present ownership, operation or control of real property. Environmental expenditures that relate to current opera- tions are expensed unless they relate to an improvement to the property. Expenditures that relate to an existing condition caused by past operations and which are not expected to contribute to current or future operations are expensed. Known existing environmental concerns The ultimate cost of known contaminated sites cannot be definitely established, and the estimated environmental liability for any given site may vary depending on the nature and extent of the contamination, the available clean-up technique, the Company’s share of the costs and evolving regulatory standards governing environmental liability. As a result, liabilities are recorded based on the results of a four-phase envi- ronmental assessment conducted on a site-by-site basis. A liability is initially recorded at the completion of the second phase and adjusted, if necessary, upon completion of the third and/or fourth phase depending on the facts, as they become known. 42 Canadian National Railway Company U.S. GAAP Management ’s Discussion and Analysis The initial phase entails an overview of the pertinent site and includes obtaining and reviewing historical data. At the end of the second phase, the presence or absence of contamination is confirmed for those sites identified as a concern in the initial phase. Upon completion of phase three, the extent of the contamination is determined and if necessary, options are developed to monitor, contain or remediate the contamination. In the final phase, the remediation or containment program is put in operation. Cost scenarios are established by external consultants based on extent of contamination and expected costs for remedial efforts. The Company uses these scenarios to estimate the costs related to a particular site. At December 31, 2002, most of the Company’s properties not acquired through recent acquisitions are approaching phase four and therefore costs related to such sites may change based on information as it becomes available. For properties acquired through recent acquisitions, the Company obtained assessments from both external and internal consul- tants and a liability has been accrued based on such assessments. These estimates may change based on information as it becomes available. Unknown existing environmental concerns The Company’s ongoing efforts to identify potential environmental con- cerns that may be associated with its properties may lead to future envi- ronmental investigations, which may result in the identification of additional environmental costs and liabilities. The magnitude of such additional liabilities and costs cannot be reasonably estimated due to: (i) (ii) the lack of specific technical information available with respect to many sites; the absence of any government authority, third-party orders, or claims with respect to particular sites; (iii) the potential for new or changed laws and regulations and for development of new remediation technologies and uncertainty regarding the timing of the work with respect to particular sites; (iv) the ability to recover costs from any third parties with respect to particular sites; and as such, costs related to future remediation will be accrued in the year they become known. Future occurrences In the operation of a railroad, it is possible that derailments, explosions or other accidents may occur that could cause harm to human health or to the environment. As a result, the Company may incur costs in the future, which may be material, to address any such harm, including costs relating to the performance of clean-ups, natural resource damages and compensatory or punitive damages relating to harm to individuals or property. The Company’s expenses relating to environmental matters, net of recoveries, have not been significant in the past three years. Payments for such items were $16 million in 2002 ($14 million in 2001 and $11 million in 2000). As at December 31, 2002, the Company had aggregate accruals for environmental costs of $106 million ($112 million at December 31, 2001). The Company anticipates that the majority of the liability will be paid out over the next five years. Depreciation lives Railroad properties are carried at cost less accumulated depreciation including asset impairment write-downs. The Company follows the group method of depreciation and, as such, depreciates the cost of railroad properties, less net salvage value, on a straight-line basis over their estimated useful lives. In addition, under the group method of depreciation, the cost of railroad properties, less net salvage value, retired or disposed of in the normal course of business, is charged to accumulated depreciation. Assessing the reasonableness of the estimated useful lives of proper- ties requires judgment and is based on currently available information, including periodic depreciation studies conducted by the Company. The Company’s U.S. properties are subject to comprehensive depreciation studies conducted by external consultants as required by the Surface Transportation Board (STB). Depreciation studies for Canadian properties are not required by regulation and are therefore conducted internally. Studies are performed on specific asset groups on a periodic basis. The studies consider, among others, the analysis of historical retirement data using recognized life analysis techniques, and the forecasting of asset life characteristics. Changes in circumstances, such as technological advances, changes to the Company’s business strategy, changes in the Company’s capital strategy or changes in regulations can result in the actual useful lives differing from the Company’s estimates. A change in the remaining useful life of a group of assets, or their estimated net salvage, will affect the depreciation rate used to amortize the group of assets and thus affect depreciation expense as reported in the Company’s results of operations. A change of one year in the com- posite useful life of the Company’s fixed asset base would impact annual depreciation expense by approximately $12 million. Depreciation studies are a means of ensuring that the assumptions used to estimate the useful lives of particular asset groups are still valid and where they are not, they serve as the basis to establish the new depreciation rates to be used on a prospective basis. In 2001, the Company conducted a comprehensive study for its Canadian properties, which revealed that estimated depreciable lives for certain asset types had increased, and therefore those asset lives were extended prospectively. As a result, depreciation expense was reduced by $44 million for the year ended December 31, 2001. The study conducted in 2000 for the Company’s U.S. properties did not have an impact on depreciation expense. U.S. GAAP Canadian National Railway Company 43 Management ’s Discussion and Analysis In 2002, the Company recorded total depreciation and amortization expense of $591 million ($538 million in 2001 and $533 million in 2000). At December 31, 2002, the Company had Properties of $19,681 million, net of accumulated depreciation of $9,159 million ($19,145 million in 2001, net of accumulated depreciation of $9,006 million). Pensions and other post-retirement benefits The Company accounts for pension and other post-retirement benefits as required by SFAS No. 87, “Employers’ Accounting for Pensions,” and SFAS No. 106, “Employers’ Accounting for Post-retirement Benefits Other Than Pensions,” respectively. Under these accounting standards, assumptions are made regarding the valuation of benefit obligations and performance of plan assets. Deferred recognition of differences between actual results and those assumed is a guiding principle of these standards. This approach allows for a gradual recognition of changes in benefit obligations and plan performance over the expected average remaining service life of the employee group covered by the plans. The following description pertain- ing to pensions relate generally to the Company’s main pension plan, the CN Pension Plan. The Company’s other pension plans are not significant. For pensions, an actuarial valuation is required at least on a triennial basis. However, for the last 15 years, the Company has conducted an annual actuarial valuation to account for pensions, which uses manage- ment assumptions for the discount rate, the expected long-term rate of return on plan assets and the rate of compensation increase. The Canadian plans have a measurement date of December 31 whereas the U.S. plans have a measurement date of September 30. For pensions and other post-retirement benefits, assumptions are required for, among others, the discount rate, the expected long-term rate of return on plan assets, the rate of compensation increase, health care cost trend rates, mortality rates, employee early retirements, terminations or disability. Changes in these assumptions result in actuarial gains or losses which in accordance with SFAS No. 87 and SFAS No. 106, the Company has elected to amortize over the expected average remaining service life of the employee group covered by the plans only to the extent that the unrecognized net actuarial gains and losses are in excess of 10% of the greater of the beginning of year balances of the projected benefit obliga- tion or market-related value of plan assets. The future effect on the Company’s results of operations is dependent on economic conditions, employee demographics, mortality rates and investment performance. The Company sets its discount rate assumption annually to reflect the rates available on high-quality, fixed-income debt instruments with a duration of approximately 11 years, which is expected to match the timing and amount of expected benefit payments. High quality debt instruments are corporate bonds with a rating of AA or better. A discount rate of 6.5%, based on bond yields prevailing at December 31, 2002, was considered appropriate by the Company and is supported by reports issued by third party advisors. A one-percentage-point change in the discount rate would not cause a material change in the Company’s net periodic benefit cost. To develop its expected long-term rate of return assumption used in the calculation of net periodic benefit cost applicable to the market- related value of assets, the Company considers both its past experience and future estimates of long-term investment returns and the expected composition of the plans’ assets. The Company has elected to use a market-related value of assets, whereby realized and unrealized capital gains and losses are recognized over a period of five years, while invest- ment and dividend income are recognized immediately. The Company follows a disciplined investment strategy, which limits investments in international companies and prohibits investments in speculative type assets and as such, the Company does not anticipate the expected average rate of return on plan assets to fluctuate materially when com- pared to major capital market indices. During the last ten years ended December 31, 2002, the CN Pension Plan earned an annual average rate of return of 9.6%. The actual and market-related value rates of return on plan assets for the last five years were as follows: Rates of return 2002 2001 Actual . . . . . . . . . . . . . . . . . . . . . . . . Market-related value . . . . . . . . . «(0.3)% 7.4«% (1.4)% 10.2«% 2000 10.5% 13.7% 1999 15.0% 13.8% 1998 12.6% 10.4% For that same period, the Company used a long-term rate of return assumption on the market-related value of plan assets not exceeding 9% to compute net periodic benefit cost. However, given the recent perfor- mance of its plan assets and the equity markets in North America, the Company will, effective for 2003, reduce the expected long-term rate of return on plan assets from 9% to 8% to reflect management’s current view of long-term investment returns. The effect of this change in man- agement’s assumption will be to increase net periodic benefit cost in 2003 by approximately $50 million. Based on the fair value of the assets held as at December 31, 2002, the plan assets are comprised of 1% in cash and short-term investments, 40% in bonds and mortgages, 50% in Canadian and foreign equities and 9% in real estate and oil and gas assets. The long-term asset allocation percentages are not expected to differ materially from the current composition. The rate of compensation increase of 4% is another significant assumption in the actuarial model for pension accounting and is deter- mined by the Company based upon its long-term plans for such increases. For other post-retirement benefits, the Company reviews external data 44 Canadian National Railway Company U.S. GAAP Management ’s Discussion and Analysis and its own historical trends for health care costs to determine the health care cost trend rates. For measurement purposes, the projected health care cost trend rate was 18% in the current year, and it is assumed that the rate will decrease gradually to 8% in 2012 and remain at that level thereafter. A one-percentage-point change in either the rate of compensation increase or the health care cost trend rate would not cause a material change to the Company’s net periodic benefit cost for both pensions and other post-retirement benefits. The latest actuarial valuation of the CN Pension Plan was conducted as at December 31, 2001 and indicated a funding excess. Based on the Pension Plan’s current position, the Company’s contributions are expected to be approximately $75 million in each of 2003, 2004 and 2005. The assumptions discussed above are not expected to have a significant impact on the cash funding requirements of the pension plan in 2003. For pensions, the Company recorded consolidated net periodic bene- fit income of $20 million and $13 million in 2002 and 2001, respectively, and net periodic benefit cost of $6 million in 2000. Consolidated net periodic benefit cost for other post-retirement benefits was $45 million, $35 million, and $25 million in 2002, 2001, and 2000, respectively. At December 31, 2002, the Company’s accrued benefit cost for post-retire- ment benefits other than pensions was $284 million ($258 million at December 31, 2001). In addition, at December 31, 2002, the Company’s consolidated pension benefit obligation and accumulated post-retirement benefit obligation were $11,243 million and $444 million, respectively ($11,156 million and $309 million at December 31, 2001). Income taxes The Company follows the asset and liability method of accounting for income taxes. Under the asset and liability method, the change in the net deferred income tax asset or liability is included in the computation of net income. Deferred income tax assets and liabilities are measured using enacted income tax rates expected to apply to taxable income in the years in which temporary differences are expected to be recovered or settled. As a result, a projection of taxable income is required for those years, as well as an assumption of the ultimate recovery/settlement period for temporary differences. The projection of future taxable income is based on management’s best estimate and may vary from actual tax- able income. On an annual basis, the Company assesses its need to establish a valuation allowance for its deferred income tax assets, and if it is deemed more likely than not that its deferred income tax assets will not be realized based on its taxable income projections, a valuation allowance is recorded. As at December 31, 2002, the Company expects that its deferred income tax assets will be recovered from future taxable income and therefore, has not set up a valuation allowance. In addition, Canadian and U.S. tax rules and regulations are subject to interpretation and require judgment by the Company that may be challenged by the taxation authorities. The Company believes that its provisions for income taxes are adequate pertaining to any assessments from the taxation authorities. The Company’s deferred income tax asset is mainly composed of temporary differences related to accruals for workforce reductions, per- sonal injury and other claims, environmental, and other post-retirement benefits, and losses and tax credit carryforwards. The majority of these accruals will be paid out over the next five years. The Company’s deferred income tax liability is mainly composed of temporary differences related to properties, including purchase accounting adjustments. Estimating the ultimate settlement period, given that depreciation rates in effect are based on information as it develops, requires judgment and management’s best estimates. The reversal of timing differences is expected at future-enacted income tax rates which could change due to fiscal budget changes and/or changes in income tax laws. As a result, a change in the timing and the income tax rate at which the components will reverse, could materially affect deferred income tax expense as recorded in the Company’s results of operations. A one-percentage-point change in the Company’s reported effective income tax rate would have the effect of changing the income tax expense by $12 million in 2002. In 2001, the Company recorded a reduction of $90 million to its net deferred income tax liability resulting from the enactment of lower cor- porate tax rates in Canada. As a result, for the year ended December 31, 2001, a deferred income tax recovery of $122 million was recorded in the Consolidated statement of income and a deferred income tax expense of $32 million was recorded in Other comprehensive income. For the year ended December 31, 2002, the Company recorded total income tax expense of $384 million ($380 million in 2001 and $536 mil- lion in 2000) of which $272 million was for deferred income taxes ($295 million in 2001 and $312 million in 2000). The Company’s net deferred income tax liability at December 31, 2002 was $4,704 million ($4,438 million at December 31, 2001). Business risks Certain information included in this report may be “forward-looking statements” within the meaning of the United States Private Securities Litigation Reform Act of 1995. Such forward-looking statements are not guarantees of future performance and involve known and unknown risks, uncertainties and other factors which may cause the outlook, the actual results or performance of the Company or the rail industry to be materially different from any future results or performance implied by such statements. Such factors include the factors set forth below as well as other risks detailed from time to time in reports filed by the Company with securities regulators in Canada and the United States. U.S. GAAP Canadian National Railway Company 45 Management ’s Discussion and Analysis Competition The Company faces significant competition from a variety of carriers, including Canadian Pacific Railway Company which operates the other major rail system in Canada, serving most of the same industrial and population centers as the Company, long distance trucking companies and, in certain markets, major U.S. railroads and other Canadian and U.S. railroads. Competition is generally based on the quality and reliability of services provided, price, and the condition and suitability of carriers’ equipment. Competition is particularly intense in eastern Canada where an extensive highway network and population centers, located relatively close to one another, have encouraged significant competition from trucking companies. In addition, much of the freight carried by the Company consists of commodity goods that are available from other sources in competitive markets. Factors affecting the competitive position of suppliers of these commodities, including exchange rates, could mate- rially adversely affect the demand for goods supplied by the sources served by the Company and, therefore, the Company’s volumes, revenues and profit margins. To a greater degree than other rail carriers, the Company’s subsidiary, Illinois Central Railroad Company (ICRR), is vulnerable to barge competi- tion because its main routes are parallel to the Mississippi River system. The use of barges for some commodities, particularly coal and grain, often represents a lower cost mode of transportation. Barge competition and barge rates are affected by navigational interruptions from ice, floods and droughts, which can cause widely fluctuating barge rates. The ability of ICRR to maintain its market share of the available freight has tradition- ally been affected by the navigational conditions on the river. In recent years, there has been significant consolidation of rail systems in the United States. The resulting larger rail systems are able to offer seamless services in larger market areas and effectively compete with the Company in certain markets. There can be no assurance that the Company will be able to compete effectively against current and future competitors in the railroad industry and that further consolidation within the railroad industry will not adversely affect the Company’s competitive position. No assurance can be given that competitive pressures will not lead to reduced revenues, profit margins or both. Environmental matters The Company’s operations are subject to federal, provincial, state, munic- ipal and local regulations under environmental laws and regulations concerning, among other things, emissions into the air; discharges into waters; the generation, handling, storage, transportation, treatment and disposal of waste, hazardous substances and other materials; decommis- sioning of underground and aboveground storage tanks; and soil and groundwater contamination. A risk of environmental liability is inherent in railroad and related transportation operations; real estate ownership, operation or control; and other commercial activities of the Company with respect to both current and past operations. As a result, the Company incurs significant compliance and capital costs, on an ongoing basis, associated with environmental regulatory compliance and clean-up requirements in its railroad operations and relating to its past and present ownership, operation or control of real property. While the Company believes that it has identified the costs likely to be incurred in the next several years, based on known information, for environmental matters, the Company’s ongoing efforts to identify poten- tial environmental concerns that may be associated with its properties may lead to future environmental investigations, which may result in the identification of additional environmental costs and liabilities. In the operation of a railroad, it is possible that derailments, explo- sions or other accidents may occur that could cause harm to human health or to the environment. As a result, the Company may incur costs in the future, which may be material, to address any such harm, including costs relating to the performance of clean-ups, natural resource damages and compensatory or punitive damages relating to harm to individuals or property. The ultimate cost of known contaminated sites cannot be definitely established, and the estimated environmental liability for any given site may vary depending on the nature and extent of the contamination, the available clean-up technique, the Company’s share of the costs and evolving regulatory standards governing environmental liability. Also, additional contaminated sites yet unknown may be discovered or future operations may result in accidental releases. For these reasons, there can be no assurance that material liabilities or costs related to environmental matters will not be incurred in the future, or will not have a material adverse effect on the Company’s financial position or results of opera- tions in a particular quarter or fiscal year, or that the Company’s liquidity will not be adversely impacted by such environmental liabilities or costs. Personal injury and other claims In the normal course of its operations, the Company becomes involved in various legal actions, including claims relating to personal injuries, occupational disease and damage to property. The Company maintains provisions for such items, which it considers to be adequate for all of its outstanding or pending claims. The final outcome with respect to actions outstanding or pending at December 31, 2002, or with respect to future claims, cannot be predicted with certainty, and therefore there can be no assurance that their resolution will not have a material adverse effect on the Company’s financial position or results of operations in a particular quarter or fiscal year. 46 Canadian National Railway Company U.S. GAAP Management ’s Discussion and Analysis Labor negotiations Canadian workforce As of January 2003, the Company has labor agreements with bargaining groups representing substantially its entire Canadian unionized work- force. These agreements are generally effective until December 31, 2003. U.S. workforce The general approach to labor negotiations by U.S. Class 1 railroads is to bargain on a collective national basis. Grand Trunk Western (GTW), Duluth, Winnipeg and Pacific (DWP), ICRR, CCP Holdings, Inc. (CCP) and just recently WC, have bargained on a local basis rather than holding national, industry wide negotiations because it results in agreements that better address both the employees’ concerns and preferences, and the railways’ actual operating environment. However, local negotiations may not generate federal intervention in a strike or lockout situation, since a dispute may be localized. The Company believes the potential mutual benefits of local bargaining outweigh the risks. As of January 2003, the Company has in place agreements with bargaining units representing the entire unionized workforce at ICRR, GTW, DWP, and CCP, and 65% of the unionized workforce at WC. These agreements have various moratorium provisions, ranging from the end of 2001 to the end of 2005, which preserve the status quo in respect of given areas during the terms of such moratoriums. Several of these agreements are currently under renegotiation and several will open for negotiation in 2003. Negotiations are ongoing with the bargaining units with which the Company does not have agreements or settlements. Until new agreements are reached or until settlements are ratified, the terms and conditions of previous agreements continue to apply. Although the Company does not anticipate work action related to these negotiations while they are ongoing, there can be no assurance that their resolution will not have a material adverse effect on the Company’s financial position or results of operations. Regulation The Company’s rail operations in Canada are subject to regulation as to (i) rate setting and network rationalization by the Canadian Transportation Agency (the Agency) under the Canada Transportation Act (Canada) (the CTA), and (ii) safety by the federal Minister of Transport under the Railway Safety Act (Canada) and certain other statutes. The Company’s U.S. rail operations are subject to regulation by the Surface Transportation Board (STB) (the successor to the Interstate Commerce Commission) and the Federal Railroad Administration. In addition, the Company is subject to a variety of health, safety, security, labor, environmental and other reg- ulations, all of which can affect its competitive position and profitability. The CTA Review Panel, which was appointed by the federal govern- ment to carry out a comprehensive review of the Canadian transportation legislation, issued its report to the Minister of Transport at the end of June 2001. The report was released to the public on July 18, 2001 and contains numerous recommendations for legislative changes, which, if adopted, would affect all modes of transportation, including rail. Concurrently, the Minister of Transport launched a transportation blue- print consultation process, which could eventually lead to new legislation affecting rail and other transportation industries. No assurance can be given that any decisions by the federal government pursuant to the report’s recommendations or in connection with the blueprint consulta- tion process will not materially adversely affect the Company’s financial position or results of operations. Financial instruments Although the Company conducts its business and receives revenues primarily in Canadian dollars, a growing portion of its revenues, expenses, assets and debt are denominated in U.S. dollars. Thus, the Company’s results are affected by fluctuations in the exchange rate between these currencies. Changes in the exchange rate between the Canadian dollar and other currencies (including the U.S. dollar) make the goods transported by the Company more or less competitive in the world marketplace and thereby affect the Company’s revenues and expenses. The Company has limited involvement with derivative financial instruments and does not use them for trading purposes. Collateral or other security to support financial instruments subject to credit risk is usually not obtained. However, the credit standing of counterparties or their guarantors is regularly monitored, and losses due to counterparty non-performance are not anticipated. To mitigate the effects of fuel price changes on its operating margins and overall profitability, the Company has a systematic hedging program which calls for regularly entering into swap positions on crude and heat- ing oil to cover a target percentage of future fuel consumption up to two years in advance. At December 31, 2002, the Company has hedged approximately 47% of the estimated 2003 fuel consumption and 25% of the estimated 2004 fuel consumption. This represents approximately 263 million U.S. gallons at an average price of U.S.$0.5865 per U.S. gallon. Realized gains and losses from the Company’s fuel hedging activities were a $3 million gain, a $6 million loss and a $49 million gain for the years ended December 31, 2002, 2001 and 2000, respectively. At December 31, 2002, Accumulated other comprehensive income included an unrealized gain of $30 million, $20 million after tax ($38 million unrealized loss, $25 million after tax at December 31, 2001), of which $29 million relates to derivative instruments that will mature within the next year. U.S. GAAP Canadian National Railway Company 47 Management ’s Discussion and Analysis General indemnifications In the normal course of business, the Company has provided indemnifica- tions, customary for the type of transaction or for the railway business, in various agreements with third parties, including indemnification provi- sions where the Company would be required to indemnify third parties and others. Indemnifications are found in various types of contracts with third parties which include, but are not limited to, (a) contracts granting the Company the right to use or enter upon property owned by third par- ties such as leases, easements, trackage rights and sidetrack agreements; (b) contracts granting rights to others to use the Company’s property, such as leases, licenses and easements; (c) contracts for the sale of assets; (d) contracts for the acquisition of services; (e) financing agreements; (f) trust indentures or fiscal agency agreements or similar agreements relating to debt or equity securities of the Company and engagement agreements with financial advisors; (g) transfer agent and registrar agreements in respect of the Company’s securities; and (h) trust agree- ments establishing trust funds to secure the payment to certain officers and senior employees of special retirement compensation arrangements or plans. To the extent of any actual claims under these agreements, the Company maintains provisions for such items, which it considers to be adequate. Due to the nature of the indemnification clauses, the maximum exposure for future payments may be material, however cannot be determined with certainty. Other risks In any given year, the Company, like other railroads, is susceptible to changes in the economic conditions of the industries and geographic areas that produce and consume the freight it transports or the supplies it requires to operate. In addition, many of the goods and commodities carried by the Company experience cyclicality in the demand for them. However, many of the bulk commodities the Company transports move offshore and are impacted more by global economic conditions than North American economic cycles. The Company’s results of operations can be expected to reflect this cyclicality because of the significant fixed costs inherent in railroad operations. Global as well as North American economic conditions, including trade barriers on certain commodities, may interfere with the free circulation of goods across Canada and the United States. Potential terrorist actions can have a direct or indirect impact on the U.S. transportation infrastructure, including railway infrastructure, and interfere with the free flow of trade across the two countries. International conflicts can also have an impact on the Company’s markets. The Company’s revenues in 2001 were affected by widespread recessionary conditions. Although growth rebounded strongly in early 2002, there continues to be ongoing concern about the sustainability of the recovery due to uncertain consumer and business confidence. While economic growth is expected to continue in 2003, the Company remains cautious about business prospects. Should a major economic slowdown or recession occur in North America or other key markets, or should major industrial restructuring take place, the volume of rail shipments carried by the Company is likely to be affected. In addition to the inherent risks of the business cycle, the Company is occasionally susceptible to severe weather conditions. For example, in the first quarter of 1998, a severe ice storm hit eastern Canada, which disrupted operations and service for the railroad as well as for CN cus- tomers. More recently, severe drought conditions in western Canada sig- nificantly reduced bulk commodity revenues, principally grain. There continues to be widespread concerns about the impact of crop condi- tions on grain supplies in the near term. Generally accepted accounting principles require the use of historical cost as the basis of reporting in financial statements. As a result, the cumulative effect of inflation, which has significantly increased asset replacement costs for capital-intensive companies such as CN, is not reflected in operating expenses. Depreciation charges on an inflation- adjusted basis, assuming that all operating assets are replaced at current price levels, would be substantially greater than historically reported amounts. Selected quarterly financial data Selected quarterly financial data for the eight most recently completed quarters ending December 31, 2002 is disclosed in Note 23 to the Company’s 2002 Consolidated Financial Statements. Disclosure controls and procedures The Company’s Chief Executive Officer and its Chief Financial Officer, after evaluating the effectiveness of the Company’s “disclosure controls and procedures” (as defined in Exchange Act Rules 13a-14(c) and 15-d-14(c)) as of January 21, 2003 (the “Evaluation Date”) within the 90-day period leading to and ending on the filing date of this annual report, have concluded that the Company’s disclosure controls and procedures were adequate and effective and designed to ensure that material information relating to the Company and its consolidated subsidiaries would have been made known to them. Subsequent to the Evaluation Date, there were no significant changes in the Company’s internal controls or, to their knowledge, in other factors that could significantly affect the Company’s disclosure controls and procedures. 48 Canadian National Railway Company U.S. GAAP Management Report Auditors ’ Report The accompanying consolidated financial statements of Canadian National Railway Company and all information in this annual report are the responsibility of management and have been approved by the Board of Directors. The financial statements have been prepared by management in conformity with generally accepted accounting principles in the United States. These statements include some amounts that are based on best estimates and judgments. Financial information used elsewhere in the annual report is consistent with that in the financial statements. Management of the Company, in furtherance of the integrity and objectivity of data in the financial statements, has developed and main- tains a system of internal accounting controls and supports an extensive program of internal audits. Management believes that this system of internal accounting controls provides reasonable assurance that financial records are reliable and form a proper basis for preparation of financial statements, and that assets are properly accounted for and safeguarded. The Board of Directors carries out its responsibility for the financial statements in this report principally through its Audit, Finance and Risk Committee, consisting solely of outside directors. The Audit, Finance and Risk Committee reviews the Company’s consolidated financial statements and annual report and recommends their approval by the Board of Directors. Also, the Audit, Finance and Risk Committee meets regularly with the Chief, Internal Audit, and with the shareholders’ auditors. These consolidated financial statements have been audited by KPMG LLP, who have been appointed as the sole auditors of the Company by the shareholders. To the Board of Directors of Canadian National Railway Company We have audited the consolidated balance sheets of Canadian National Railway Company as at December 31, 2002 and 2001 and the consolidated statements of income, comprehensive income, changes in shareholders’ equity and cash flows for each of the years in the three-year period ended December 31, 2002. These financial statements are the responsi- bility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with Canadian and United States generally accepted auditing standards. Those standards require that we plan and perform an audit to obtain reasonable assurance whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. In our opinion, these consolidated financial statements present fairly, in all material respects, the financial position of the Company as at December 31, 2002 and 2001, and the results of its operations and its cash flows for each of the years in the three-year period ended December 31, 2002, in accordance with generally accepted accounting principles in the United States. On January 20, 2003, we reported separately to the shareholders of the Company on consolidated financial statements for the same period, prepared in accordance with Canadian generally accepted accounting principles. (signed) Claude Mongeau Executive Vice-President and Chief Financial Officer January 21, 2003 (signed) KPMG LLP Chartered Accountants Montreal, Canada January 20, 2003 (signed) Serge Pharand Vice-President and Corporate Comptroller January 21, 2003 U.S. GAAP Canadian National Railway Company 49 Consolidated Statement of Income In millions, except per share data Year ended December 31, 2002 2001 2000 Revenues Petroleum and chemicals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $÷«1,102 521 Metals and minerals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,323 Forest products. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 326 Coal. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 986 Grain and fertilizers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,052 Intermodal . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 591 Automotive . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 209 Other items . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Operating expenses Labor and fringe benefits (Note 14) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Purchased services and material . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Depreciation and amortization (Note 2) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Fuel . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Equipment rents. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Casualty and other (Note 2). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total operating expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Operating income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Interest expense (Note 15) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other income (Note 16) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Income before income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Income tax expense (Note 17) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net income. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Basic earnings per share (Note 19). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Diluted earnings per share (Note 19) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,110 1,837 778 584 459 346 637 4,641 1,469 (361) 76 1,184 (384) $÷«800 $÷4.07 $÷3.97 $÷«923 458 1,088 338 1,161 969 520 195 5,652 1,624 692 532 484 309 329 3,970 1,682 (327) 65 1,420 (380) $1,040 $÷5.41 $÷5.23 $÷«894 392 1,008 328 1,136 919 559 192 5,428 1,472 746 525 446 285 306 3,780 1,648 (311) 136 1,473 (536) $÷«937 $÷4.81 $÷4.67 See accompanying notes to consolidated financial statements. 50 Canadian National Railway Company U.S. GAAP Consolidated Statement of Comprehensive Income In millions Year ended December 31, 2002 2001 2000 Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $800 $1,040 $÷«937 Other comprehensive income (loss) (Note 22) : Unrealized foreign exchange gain (loss) on translation of U.S. dollar denominated long-term debt designated as a hedge of the net investment in U.S. subsidiaries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Unrealized foreign exchange gain (loss) on translation of the net investment in foreign operations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Unrealized holding gain (loss) on investment in 360networks Inc. (Note 6) . . . . . . . . . . . . . . . . . . . . . . . . . . . . Unrealized holding gain (loss) on fuel derivative instruments (Note 21) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Minimum pension liability adjustment (Note 13) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other comprehensive income (loss) before income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Income tax expense on other comprehensive income (loss) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other comprehensive income (loss) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51 (40) – 68 (20) 59 (20) 39 (202) 308 (129) (38) (17) (78) (15) (93) (91) 191 129 – – 229 (72) 157 Comprehensive income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $839 $«««947 $1,094 See accompanying notes to consolidated financial statements. U.S. GAAP Canadian National Railway Company 51 Consolidated Balance Sheet In millions Assets Current assets: December 31, 2002 2001 Cash and cash equivalents . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Accounts receivable (Note 4) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Material and supplies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Deferred income taxes (Note 17) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Properties (Note 5). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other assets and deferred charges (Note 6) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $÷«÷««25 722 127 122 196 1,192 19,681 865 $÷«÷««53 645 133 153 180 1,164 19,145 914 Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $21,738 $21,223 Liabilities and shareholders’ equity Current liabilities: Accounts payable and accrued charges (Note 8) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Current portion of long-term debt (Note 10) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $÷1,487 574 73 $÷1,374 163 132 Deferred income taxes (Note 17) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other liabilities and deferred credits (Note 9) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Long-term debt (Note 10) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Convertible preferred securities (Note 11) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Shareholders’ equity: Common shares (Note 11) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Accumulated other comprehensive income (Note 22) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,134 4,826 1,406 5,003 – 4,785 97 3,487 8,369 1,669 4,591 1,345 5,764 366 4,442 58 2,988 7,488 Total liabilities and shareholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $21,738 $21,223 On behalf of the Board: David G.A. McLean Director E. Hunter Harrison Director See accompanying notes to consolidated financial statements. 52 Canadian National Railway Company U.S. GAAP Consolidated Statement of Changes in Shareholders ’ Equity In millions Issued and outstanding common shares Balances December 31, 1999 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Stock options exercised and employee share plans (Note 11, 12) Share repurchase program (Note 11) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other comprehensive income (Note 22) . . . . . . . . . . . . . . . . . . . . . . . . . . Dividends ($0.70 per share) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Balances December 31, 2000 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Stock options exercised (Note 11, 12). . . . . . . . . . . . . . . . . . . . . . . . . . . . Other comprehensive loss (Note 22) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Dividends ($0.78 per share) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Balances December 31, 2001 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Stock options exercised (Note 11, 12). . . . . . . . . . . . . . . . . . . . . . . . . . . . Conversion of convertible preferred securities (Note 11) . . . . . . . . . Share repurchase program (Note 11) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other comprehensive income (Note 22) . . . . . . . . . . . . . . . . . . . . . . . . . . Dividends ($0.86 per share) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 202.4 – 1.2 (13.0) – – 190.6 – 2.1 – – 192.7 – 1.8 6.0 (3.0) – – Accumulated other comprehensive income (loss) $÷÷«(6) – – – 157 – 151 – – (93) – 58 – – – – 39 – Common shares $«4,597 – 47 (295) – – 4,349 – 93 – – 4,442 – 75 340 (72) – – Retained earnings $«1,531 937 – (234) – (136) 2,098 1,040 – – (150) 2,988 800 – – (131) – (170) Total shareholders’ equity $«6,122 937 47 (529) 157 (136) 6,598 1,040 93 (93) (150) 7,488 800 75 340 (203) 39 (170) Balances December 31, 2002 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 197.5 $4,785 $«««97 $3,487 $8,369 See accompanying notes to consolidated financial statements. U.S. GAAP U.S. GAAP Canadian National Railway Company Canadian National Railway Company 53 53 Consolidated Statement of Cash Flows In millions Operating activities Year ended December 31, 2002 2001 2000 Net income. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Adjustments to reconcile net income to net cash provided from operating activities: $÷÷800 $«1,040 $÷««937 Depreciation and amortization (Note 18) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Deferred income taxes (Note 17) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Charge to increase U.S. personal injury and other claims liability (Note 2). . . . . . . . . . . . . . . . . . . . . . . . . Workforce reduction charges (Note 14) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Equity in earnings of English Welsh and Scottish Railway (Note 16) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Gain on sale of investments (Note 16) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Write-down of investment (Note 16). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other changes in: Accounts receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Material and supplies. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Accounts payable and accrued charges . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other net current assets and liabilities. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 591 272 281 120 (33) – – (80) – (154) (18) (167) 538 295 – 98 (8) (101) 99 199 11 (385) (27) (138) 533 312 – – – (84) – 80 6 (157) (36) (85) Cash provided from operating activities. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,612 1,621 1,506 Investing activities Net additions to properties (Note 18) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Acquisition of Wisconsin Central Transportation Corporation (Note 3) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cash used by investing activities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Dividends paid. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Financing activities Issuance of long-term debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Reduction of long-term debt. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Issuance of common shares (Note 11). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Repurchase of common shares (Note 11). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cash provided from (used by) financing activities. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net increase (decrease) in cash and cash equivalents. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cash and cash equivalents, beginning of year. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (938) – 14 (924) (170) 3,146 (3,558) 69 (203) (546) (28) 53 (941) (1,278) 46 (2,173) (150) 4,015 (3,336) 61 – 740 38 15 (958) – (23) (981) (136) 860 (1,038) 28 (529) (679) (290) 305 Cash and cash equivalents, end of year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $««««««25 $««««««53 $÷÷««15 Supplemental cash flow information Payments for: Interest (Note 15) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Workforce reductions (Note 9) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Personal injury and other claims (Note 20). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Pensions (Note 13) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Income taxes (Note 17) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $÷÷398 177 156 92 65 $÷÷322 169 149 69 63 $÷÷315 189 111 59 101 See accompanying notes to consolidated financial statements. 54 Canadian National Railway Company U.S. GAAP Notes to Consolidated Financial Statements Canadian National Railway Company (CN or the Company), directly and through its subsidiaries, is engaged in the rail transportation business. CN spans Canada and mid-America, from the Atlantic and Pacific oceans to the Gulf of Mexico, serving the ports of Vancouver, Prince Rupert, B.C., Montreal, Halifax, New Orleans and Mobile, Alabama, and the key cities of Toronto, Buffalo, Chicago, Detroit, Duluth, Minnesota/Superior, Wisconsin, Green Bay, Wisconsin, Minneapolis/St. Paul, Memphis, St. Louis and Jackson, Mississippi, with connections to all points in North America. CN’s revenues are derived from the movement of a diversified and balanced portfolio of goods, including petroleum and chemicals, grain and fertilizers, coal, metals and minerals, forest products, intermodal and automotive. 1 Summary of significant accounting policies These consolidated financial statements are expressed in Canadian dol- lars, except where otherwise indicated, and have been prepared in accor- dance with accounting principles generally accepted in the United States (U.S. GAAP). The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of revenues and expenses during the period, the reported amounts of assets and lia- bilities, and the disclosure of contingent assets and liabilities at the date of the financial statements. On an ongoing basis, management reviews its estimates, including those related to personal injury and other claims, environmental matters, depreciation lives, pensions and other post-retire- ment benefits, and income taxes, based upon currently available informa- tion. Actual results could differ from these estimates. A. Principles of consolidation These consolidated financial statements include the accounts of all sub- sidiaries, including Wisconsin Central Transportation Corporation (WC) for which the Company acquired control and consolidated effective October 9, 2001. The Company’s investments in which it has significant influence are accounted for using the equity method and all other investments are accounted for using the cost method. B. Revenues Freight revenues are recognized on services performed by the Company, based on the percentage of completed service method. Costs associated with movements are recognized as the service is performed. C. Foreign exchange All of the Company’s United States (U.S.) operations are self-sustaining foreign entities with the U.S. dollar as their functional currency. The Company also has an equity investment in an international affiliate based in the United Kingdom with the British pound as its functional cur- rency. Accordingly, the U.S. operations’ assets and liabilities and the Company’s foreign equity investment are translated into Canadian dol- lars at the rate in effect at the balance sheet date and the revenues and expenses are translated at average exchange rates during the year. All adjustments resulting from the translation of the foreign operations are recorded in Other comprehensive income (Note 22). The Company has designated all U.S. dollar denominated long-term debt of the parent company as a foreign exchange hedge of its net investment in U.S. subsidiaries. Accordingly, unrealized foreign exchange gains and losses, from the dates of designation, on the translation of the U.S. dollar denominated long-term debt are also included in Other com- prehensive income. D. Cash and cash equivalents Cash and cash equivalents include highly liquid investments purchased three months or less from maturity and are stated at cost, which approx- imates market value. E. Accounts receivable Accounts receivable are recorded at cost net of the provision for doubtful accounts that is based on expected collectibility. Any gains or losses on the sale of accounts receivable are calculated by comparing the carrying amount of the accounts receivable sold to the total of the cash proceeds on sale and the fair value of the retained interest in such receivables on the date of transfer. Fair values are determined on a discounted cash flow basis. Costs related to the sale of accounts receivable are recog- nized in earnings in the period incurred. F. Material and supplies Inventory is valued at weighted-average cost for ties, rails, fuel and new materials in stores, and at estimated utility or sales value for usable secondhand, obsolete and scrap materials. G. Properties Railroad properties are carried at cost less accumulated depreciation including asset impairment write-downs. Labor, materials and other costs associated with the installation of rail, ties, ballast and other track improvements are capitalized to the extent they meet the Company’s minimum threshold for capitalization. Included in property additions are the costs of developing computer software for internal use. Maintenance costs are expensed as incurred. U.S. GAAP Canadian National Railway Company 55 Notes to Consolidated Financial Statements 1 Summary of significant accounting policies (continued) The cost of railroad properties, less net salvage value, retired or dis- posed of in the normal course of business is charged to accumulated depreciation, in accordance with the group method of depreciation. The Company reviews the carrying amounts of properties held and used whenever events or changes in circumstances indicate that such carrying amounts may not be recoverable based on future undiscounted cash flows. Assets that are deemed impaired as a result of such review are recorded at the lower of carrying amount or fair value. Assets held for sale are measured at the lower of their carrying amount or fair value, less cost to sell. Losses resulting from significant line sales are recog- nized when the asset meets the criteria for classification as held for sale whereas losses resulting from abandonment are recognized when the asset ceases to be used. Gains are recognized when they are realized. H. Depreciation The cost of properties, net of asset impairment write-downs, is depreci- ated on a straight-line basis over their estimated useful lives as follows: Asset class Annual rate Track and roadway . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2% Rolling stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3% Buildings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6% Other. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4% The Company follows the group method of depreciation and as such conducts comprehensive depreciation studies on a periodic basis to assess the reasonableness of the lives of properties based upon current information and historical activities. Changes in estimated useful lives are accounted for prospectively. I. Pensions Pension costs are determined using actuarial methods. Net periodic benefit cost is charged to operations and includes: (i) the cost of pension benefits provided in exchange for employees’ services rendered during the year, (ii) the interest cost of pension obligations, (iii) the amortization of the initial net transition obligation on a straight- line basis over the expected average remaining service life of the employee group covered by the plans, (iv) the amortization of prior service costs and amendments over the expected average remaining service life of the employee group covered by the plans, (v) the expected long-term return on pension fund assets, and (vi) the amortization of cumulative unrecognized net actuarial gains and losses in excess of 10% of the greater of the beginning of year bal- ances of the projected benefit obligation or market-related value of plan assets over the expected average remaining service life of the employee group covered by the plans. The pension plans are funded through contributions determined in accordance with the projected unit credit actuarial cost method. J. Post-retirement benefits other than pensions The Company accrues the cost of post-retirement benefits other than pen- sions using actuarial methods. These benefits, which are funded by the Company as they become due, include life insurance programs, medical benefits, supplemental pension allowances and free rail travel benefits. The Company amortizes the cumulative unrecognized net actuarial gains and losses in excess of 10% of the projected benefit obligation at the beginning of the year, over the expected average remaining service life of the employee group covered by the plans. K. Derivative financial instruments The Company uses derivative financial instruments in the management of its fuel exposure, and may use them from time to time, in the manage- ment of its interest rate and foreign currency exposures. Derivative instruments are recorded on the balance sheet at fair value and the changes in fair value are recorded in earnings or Other comprehensive income depending on the nature and effectiveness of the hedge transac- tion. Income and expense related to hedged derivative financial instru- ments are recorded in the same category as that generated by the underlying asset or liability. L. Personal injury claims In Canada, the Company accounts for costs related to employee work- related injuries based on actuarially developed estimates of the ultimate cost associated with such injuries, including compensation, health care and administration costs. In the U.S., the Company accrues the cost for the expected personal injury claims and existing occupational disease claims, based on actuarial estimates of their ultimate cost. A liability for unasserted occupational disease claims is also accrued to the extent they are probable and can be reasonably estimated. M. Environmental expenditures Environmental expenditures that relate to current operations are expensed unless they relate to an improvement to the property. Expenditures that relate to an existing condition caused by past operations and which are not expected to contribute to current or future operations are expensed. Liabilities are recorded when environmental assessments and/or remedial efforts are likely, and when the costs, based on a specific plan of action in terms of the technology to be used and the extent of the corrective action required, can be reasonably estimated. 56 Canadian National Railway Company U.S. GAAP Notes to Consolidated Financial Statements N. Income taxes The Company follows the asset and liability method of accounting for income taxes. Under the asset and liability method, the change in the net deferred tax asset or liability is included in the computation of net income. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which temporary differences are expected to be recovered or settled. O. Stock-based compensation The Company accounts for stock-based compensation in accordance with Accounting Principles Board Opinion (APB) 25, “Accounting for Stock Issued to Employees,” and related interpretations. Accordingly, compen- sation cost is recorded for the Company’s performance-based stock option awards and no compensation cost is recorded for the Company’s conventional stock option awards. If compensation cost had been deter- mined based upon fair values at the date of grant for awards under all plans, consistent with the methods of Statement of Financial Accounting Standards (SFAS) No. 123, “Accounting for Stock-Based Compensation,” the Company’s pro forma net income and earnings per share would have been as follows: Year ended December 31, 2002 2001 Net income, as reported (in millions) . . . . . . . . . . . . . . . . . . . $«800 Add (deduct) compensation cost, net of applicable taxes, determined under: Intrinsic value method for performance-based awards (APB 25) . . . . . . . . . . . . 9 Fair value method for all awards (SFAS No. 123). . . . . . . . . . . . . . . . . . . . . . . . . . . Pro forma net income (in millions) . . . . . . . . . . . . . . . . . . . . . $«764 (45) Basic earnings per share, as reported . . . . . . . . . . . . . . . . . . $4.07 Basic earnings per share, pro forma . . . . . . . . . . . . . . . . . . . . $3.88 Diluted earnings per share, as reported . . . . . . . . . . . . . . . . $3.97 Diluted earnings per share, pro forma . . . . . . . . . . . . . . . . . . $3.80 2000 $«937 3 (23) $1,040 19 (28) $1,031 $«917 $÷5.41 $÷5.37 $÷5.23 $÷5.19 $4.81 $4.70 $4.67 $4.58 These pro forma amounts include compensation cost as calculated using the Black-Scholes option-pricing model with the following assumptions: Year ended December 31, 2002 2001 2000 Expected option life (years) . . . . . . . . . . . . . . . . . . . . . . . . . . . Risk-free interest rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Expected stock price volatility. . . . . . . . . . . . . . . . . . . . . . . . . Average dividend per share . . . . . . . . . . . . . . . . . . . . . . . . . . . 7.0 5.79% 30% $0.86 7.0 5.36% 30% $0.78 7.0 5.38% 30% $0.70 Year ended December 31, 2002 2001 2000 Weighted average fair value of options granted. . . . . . . $30.98 $13.79 $12.54 P. Recent accounting pronouncements In January 2003, the Financial Accounting Standards Board (FASB) issued FASB Interpretation (FIN) No. 46, “Consolidation of Variable Interest Entities.” FIN No. 46 requires that an enterprise holding other than a voting interest in a Variable Interest Entity (VIE) could, subject to certain conditions, be required to consolidate the VIE if the enterprise will absorb a majority of the VIE’s expected losses and/or receive a majority of its expected residual returns. This interpretation is effective for newly created entities after January 31, 2003. For pre-existing VIEs, the provisions of the interpretation are effective for periods beginning after June 15, 2003. The Company does not expect FIN No. 46 to have a material impact on its financial statements. In November 2002, the FASB issued FIN No. 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others,” which requires that a guarantor disclose and recognize in its financial statements its obligations relating to guarantees that it has issued. Liability recognition is required at the inception of the guarantee, whether or not payment is probable. The dis- closure requirements are effective for periods ending after December 15, 2002, and have been reflected in the Notes to Consolidated Financial Statements. The recognition and measurement provisions are effective for guarantees issued or modified after December 31, 2002. The Company will apply the recognition and measurement provisions of FIN No. 45 on a prospective basis and, as such, does not expect it to have an initial material impact on its financial statements upon adoption. In July 2002, the FASB issued SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities,” which requires that a liability for costs associated with an exit or disposal activity be recognized when the liability is incurred. SFAS No. 146 also establishes that the liability should be initially measured at fair value and subsequently adjusted for changes in estimated cash flows. SFAS No. 146 is to be applied to exit or disposal activities initiated after December 31, 2002. The Company will apply SFAS No. 146 on a prospective basis and, as such, does not expect it to have an initial material impact on its financial statements upon adoption. In August 2001, the FASB issued SFAS No. 143, “Accounting for Asset Retirement Obligations,” which requires an entity to record the fair value of an asset retirement obligation as a liability in the period in which it incurs a legal obligation associated with the retirement of tangible long-lived assets. As a result of the issuance of SFAS No. 143, the Company is reviewing the accounting policy of its asset replacement program. A change in this policy will be treated as a change in account- ing principle with a cumulative effect adjustment being recorded in the first quarter of 2003. The statement is effective for the Company’s fiscal year beginning January 1, 2003. The Company is currently evaluating the impact of this statement on its financial statements. U.S. GAAP Canadian National Railway Company 57 Notes to Consolidated Financial Statements 2 Accounting changes 2002 U.S. personal injury and other claims In the fourth quarter of 2002, the Company changed its methodology for estimating its liability for U.S. personal injury and other claims, including occupational disease claims and claims for property damage, from a case-by-case approach to an actuarial-based approach. Consequently, the Company recorded a charge of $281 million ($173 million after tax) to increase its provision for these claims. Under the actuarial-based approach, the Company accrues the cost for the expected personal injury and property damage claims and existing occupational disease claims, based on actuarial estimates of their ultimate cost. The Company is unable to estimate the total cost for unasserted occupational disease claims. However, a liability for unasserted occupa- tional disease claims is accrued to the extent they are probable and can be reasonably estimated. Under the case-by-case approach, a liability was recorded only when the expected loss was both probable and reasonably estimable based on currently available information. In addition, the Company did not record a liability for unasserted claims, as such amounts could not be reasonably estimated under the case-by-case approach. The Company’s U.S. personal injury and other claims expense, including the above-mentioned charge, was $362 million in 2002. Had the Company continued to apply the case-by-case approach to its U.S. personal injury and other claims liability, recognizing the effects of the actual claims experience for existing and new claims in the fourth quarter, these expenses would have been approximately $135 million in 2002. 2001 Depreciation In 2001, the Company conducted a comprehensive depreciation study for its Canadian properties to assess the reasonableness of the deprecia- ble lives of properties based on current and historical information. The study revealed that estimated depreciable lives for certain asset types had increased, and therefore, those asset lives were extended prospec- tively. As a result, depreciation and amortization expense was reduced by $44 million ($28 million after tax) in 2001. Derivative financial instruments On January 1, 2001, the Company adopted SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities,” as amended by SFAS No. 138 “Accounting for Certain Derivative Instruments and Certain Hedging Activities.” These statements require that all derivative instru- ments be recorded on the balance sheet at their fair value. Changes in fair value of derivatives are recorded each period in current earnings or Other comprehensive income, depending on whether or not a derivative is designated as part of a hedge transaction and, if so, the type of hedge transaction. The initial adoption of these statements on January 1, 2001 resulted in the recognition of an unrealized loss of $17 million ($11 million after tax) in Other comprehensive income. Of that amount, $8 million ($5 million after tax) was recognized in earnings during 2001. The adop- tion of these statements did not have a material impact on net income for 2001 since prior to its adoption, the Company had already deferred and amortized gains and losses in its results of operations. Income and expense related to the hedged derivative financial instruments were recorded in the same category as that generated by the underlying asset or liability. 3 Acquisition of Wisconsin Central Transportation Corporation On January 29, 2001, the Company, through an indirect wholly owned subsidiary, and WC entered into a merger agreement (the Merger) pro- viding for the acquisition of all of the shares of WC by the Company for an acquisition cost of $1,301 million (U.S.$833 million). The Merger was approved by the shareholders of WC at a special meeting held on April 4, 2001. On September 7, 2001, the U.S. Surface Transportation Board ren- dered a decision, unanimously approving the Company’s acquisition of WC. On October 9, 2001, the Company completed its acquisition of WC and began a phased integration of the companies’ operations. The acqui- sition was financed by debt and cash on hand. The Company accounted for the Merger using the purchase method of accounting as required by SFAS No. 141 “Business Combinations.” As such, the Company’s consolidated financial statements include the assets, liabilities and results of operations of WC as of October 9, 2001, the date of acquisition. The Company had estimated, on a preliminary basis, the fair values of the assets and liabilities acquired based on currently available information. In 2002, the Company finalized the 58 Canadian National Railway Company U.S. GAAP Notes to Consolidated Financial Statements allocation of the purchase price and adjusted the preliminary fair values of the assets and liabilities acquired as follows: Current assets decreased by $10 million, Properties increased by $141 million, Other assets and deferred charges decreased by $98 million, Current liabilities increased by $10 million, Deferred income taxes increased by $16 million and Other liabilities and deferred credits increased by $3 million. The increase in Properties and decrease in Other assets and deferred charges was mainly due to the final valuation of the Company’s foreign equity investment. The remaining adjustments resulted from additional information obtained for conditions and circumstances that existed at the time of acquisition. The following table outlines the final fair values of WC’s assets and liabilities acquired: In millions Current assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $÷«165 2,576 Properties . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other assets and deferred charges. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total assets acquired . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Current liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Deferred income taxes. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other liabilities and deferred credits. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Long-term debt. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 335 3,076 363 759 181 472 Total liabilities assumed . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net assets acquired . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,301 1,775 If the Company had acquired WC on January 1, 2000, based on the historical amounts reported by WC, net of the difference between the Company’s cost to acquire WC and its net assets, revenues, net income, basic and diluted earnings per share would have been $6,090 million, $1,090 million, $5.67 per basic share and $5.48 per diluted share, respectively for the year ended December 31, 2001 and $5,961 million, $971 million, $4.98 per basic share and $4.84 per diluted share, respec- tively for 2000. These pro forma figures do not reflect synergies, and accordingly, do not account for any potential increases in operating income, any estimated cost savings or facilities consolidation. 4 Accounts receivable In millions Freight December 31, 2002 2001 Trade. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $321 150 Accrued . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Non-freight. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Provision for doubtful accounts. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 310 781 (59) $309 119 298 726 (81) $722 $645 The Company has a five-year revolving agreement, expiring in June 2003, to sell eligible freight trade receivables up to a maximum of $350 million of receivables outstanding at any point in time. The Company intends to renew or replace the program upon expiration. At December 31, 2002, pursuant to the agreement, $173 million and U.S.$113 million (Cdn$177 million) had been sold on a limited recourse basis compared to $168 million and U.S.$113 million (Cdn$179 million) at December 31, 2001. Recourse is limited to 10% of receivables sold and consists of additional freight trade receivables that have been recorded in Other current assets. The Company has retained the responsibility for servicing, administering and collecting freight trade receivables sold. Other income included $9 million in 2002 and $10 million in each of 2001 and 2000 for costs related to the agreement, which fluctuate with changes in prevailing interest rates. No servicing asset or liability has been recorded since the costs of servicing are compensated by the benefits of the agreement. The Receivables Purchase Agreement provides for customary indem- nification provisions, which survive for a period of two years following the final purchase of any receivable, three years from the final collection date or until statute barred, in the case of taxes. As at December 31, 2002, the Company has not recorded a liability associated with these indemni- fications, for which there is no monetary limitation, as the Company does not expect to make any payments pertaining to the indemnifications of this program. 5 Properties In millions December 31, 2002 Cost Accumulated depreciation Track, roadway and land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $22,048 4,057 Rolling stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Buildings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,819 916 $28,840 Capital leases included in rolling stock . . . . . . . . . . . . . . . . . . . $÷1,351 $6,265 1,506 880 508 $9,159 $÷«233 Net $15,783 2,551 939 408 $19,681 $÷1,118 December 31, 2001 Accumulated depreciation $6,230 1,456 826 494 $9,006 $÷«209 Cost $21,582 3,913 1,715 941 $28,151 $÷1,249 Net $15,352 2,457 889 447 $19,145 $÷1,040 U.S. GAAP Canadian National Railway Company 59 Notes to Consolidated Financial Statements 6 Other assets and deferred charges In millions December 31, 2002 Investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $380 353 Prepaid benefit cost (Note 13). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Deferred receivables . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Unamortized debt issue costs. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 88 41 3 2001 $496 251 108 54 5 securities” whereby the investment was carried at market value on the balance sheet and the change in the value of the investment was recorded in Other comprehensive income as an unrealized holding gain. As a result of the write-down, the Company eliminated all marked-to- market adjustments related to its investment in 360networks Inc., previ- ously recorded in Other comprehensive income. $865 $914 7 Credit facilities Investments As at December 31, 2002, the Company had $368 million ($478 million at December 31, 2001) of investments accounted for under the equity method and $12 million ($18 million at December 31, 2001) of invest- ments accounted for under the cost method. Investment in Tranz Rail Holdings Limited (Tranz Rail) and Australian Transport Network Limited (ATN) In 2002, the Company sold its interests in Tranz Rail and ATN for aggre- gate net proceeds of $69 million, which approximated the carrying value of the investments. Prior to the sale, the Company had accounted for these investments as “available for sale” in accordance with the FASB’s Emerging Issues Task Force (EITF) 87-11, “Allocation of Purchase Price to Assets to be Sold.” Investment in English Welsh and Scottish Railway (EWS) Through its acquisition of WC in 2001, the Company acquired 40.9% of EWS, a company which provides most of the rail freight services in Great Britain, operates freight trains through the English Channel tunnel and carries mail for the Royal Mail. The final fair value of the investment at the date of acquisition was determined based on the discounted cash flow method and a multiple of EWS earnings. The Company accounts for its investment in EWS using the equity method. At December 31, 2002, the excess of the Company’s share of the book value of EWS’ net assets over the carrying value of the investment is being depreciated over the life of its assets and is not significant. Investment in 360networks Inc. In June 2001, the Company recorded a charge of $99 million, $71 million after tax, to write down 100% of its net investment in 360networks Inc. and subsequently sold all of its shares. In 2000, the Company had recorded a gain of $84 million, $58 million after tax, related to the exchange of its minority equity investments in certain joint venture companies for 11.4 million shares of 360networks Inc. Prior to the write-down, the Company accounted for its investment in 360networks Inc. in accordance with SFAS No. 115, “Accounting for Certain Investments in Debt and Equity Securities.” The shares held were classified as “available-for-sale In December 2002, the Company entered into a U.S.$1,000 million three- year revolving credit facility and concurrently terminated its previous revolving credit facilities before their scheduled maturity in March 2003. The credit facility provides for borrowings at various interest rates, including the Canadian prime rate, bankers’ acceptance rates, the U.S. federal funds effective rate and the London Interbank Offer Rate, plus applicable margins. The credit facility agreement contains customary financial covenants, based on U.S. GAAP, including limitations on debt as a percentage of total capitalization and maintenance of tangible net worth above pre-defined levels. Throughout the year, the Company was in compliance with all financial covenants contained in its outstanding revolving credit agreements. The Company’s commercial paper program is backed by a portion of its revolving credit facility. As at December 31, 2002, the Company had outstanding commercial paper of U.S.$136 mil- lion (Cdn$214 million) compared to U.S.$213 million (Cdn$339 million) as at December 31, 2001. The Company’s borrowings of U.S.$172 million (Cdn$273 million) outstanding at December 31, 2001 were entirely repaid in the first quarter of 2002. At December 31, 2002, the Company had borrowings under its revolving credit facility of U.S.$90 million (Cdn$142 million) at an average interest rate of 1.77%. Outstanding letters of credit under the previous facilities were transferred into the current facility. As at December 31, 2002, letters of credit under the revolving credit facility amounted to $295 million. 8 Accounts payable and accrued charges In millions December 31, 2002 2001 Trade payables . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $÷«436 251 Income and other taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Payroll-related accruals. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Workforce reduction provisions. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Personal injury and other claims (Note 20) . . . . . . . . . . . . . . . . . . . . . . . . Accrued charges. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Accrued interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Accrued operating leases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 235 168 136 113 104 18 26 $÷«385 236 218 151 51 131 141 19 42 $1,487 $1,374 60 Canadian National Railway Company U.S. GAAP 2001 $309 (26) (25) $258 2000 $15 8 1 1 $25 Notes to Consolidated Financial Statements 9 Other liabilities and deferred credits (ii) Funded status In millions December 31, 2002 2001 In millions December 31, 2002 Personal injury and other claims, net of current portion (Note 20) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $÷«528 Workforce reduction provisions, net of current portion (A) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Accrual for post-retirement benefits other than pensions (B) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Environmental reserve, net of current portion. . . . . . . . . . . . . . . . . . . . . . Deferred credits and other. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 253 284 81 260 $÷«379 Unfunded benefit obligation at end of year . . . . . . . . . . . . . . . . . . . . . . . . . . $444 (122) Unrecognized net actuarial loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 340 258 73 295 Unrecognized prior service cost. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (38) Accrued benefit cost for post-retirement benefits other than pensions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $284 (iii) Components of net periodic benefit cost $1,406 $1,345 In millions Year ended December 31, 2002 2001 A. Workforce reduction provisions (Note 14) The workforce reduction provisions, which cover employees in both Canada and the United States, are mainly comprised of payments related to severance, early retirement incentives and bridging to early retire- ment, the majority of which will be disbursed within the next three years. Payments have reduced the provisions by $177 million for the year ended December 31, 2002 ($169 million for the year ended December 31, 2001). As at December 31, 2002, the aggregate provisions, including the current portion, amounted to $421 million ($491 million as at December 31, 2001). B. Post-retirement benefits other than pensions (i) Change in benefit obligation In millions Year ended December 31, 2002 Benefit obligation at beginning of year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $309 18 Amendments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Actuarial loss. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Interest cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Service cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Foreign currency changes. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Transfer from other plans. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 101 23 13 (1) – 2001 $242 25 20 19 11 6 5 Benefits paid . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Benefit obligation at end of year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $444 (19) (19) $309 Interest cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Service cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Amortization of prior service cost . . . . . . . . . . . . . . . . . . . . . . . Recognized net actuarial loss . . . . . . . . . . . . . . . . . . . . . . . . . . . Net periodic benefit cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $23 13 5 4 $45 $19 11 3 2 $35 (iv) Weighted-average assumptions December 31, 2002 2001 2000 Discount rate. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6.65% Rate of compensation increase . . . . . . . . . . . . . . . . . . . . . . . . 4.00% 6.97% 4.00% 6.95% 4.25% For measurement purposes, increases in the per capita cost of cov- ered health care benefits were assumed to be 17% for 2003 and 18% for 2002. It is assumed that the rate will decrease gradually to 8% in 2012 and remain at that level thereafter. A one-percentage-point change in the health care cost trend rate would not cause a material change in the Company’s net periodic benefit cost nor the post-retirement benefit obligation. U.S. GAAP Canadian National Railway Company 61 Notes to Consolidated Financial Statements 10 Long-term debt In millions Debentures and notes: (A) Canadian National series: Currency in which payable Maturity December 31, 2002 2001 6.63% 10-year notes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . May 15, 2003 7.00% 10-year notes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Mar. 15, 2004 6.45% Puttable Reset Securities (PURS) (B) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . July 15, 2006 6.38% 10-year notes (C) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Oct. 15, 2011 6.80% 20-year notes (C) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . July 15, 2018 7.63% 30-year debentures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . May 15, 2023 6.90% 30-year notes (C) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . July 15, 2028 7.38% 30-year debentures (C) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Oct. 15, 2031 Illinois Central series: 6.75% 10-year notes. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . May 15, 2003 7.75% 10-year notes. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . May 1, 2005 6.98% 12-year notes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . July 12, 2007 6.63% 10-year notes. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . June 9, 2008 5.00% 99-year income debentures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Dec. 1, 2056 7.70% 100-year debentures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Sep. 15, 2096 Wisconsin Central series: 6.63% 10-year notes. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . April 15, 2008 Total debentures and notes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other: Revolving credit facilities (Note 7) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Commercial paper (D) (Note 7) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Capital lease obligations, amounts owing under equipment agreements and other (E) . . . . . . . . . . . . . . . . . . . . Total other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Subtotal . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Less: Current portion of long-term debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net unamortized discount . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . U.S.$ U.S.$ U.S.$ U.S.$ U.S.$ U.S.$ U.S.$ U.S.$ U.S.$ U.S.$ U.S.$ U.S.$ U.S.$ U.S.$ U.S.$ U.S.$ U.S.$ Various $÷«236 $÷«239 419 394 631 315 236 749 315 158 158 79 32 12 197 236 4,167 142 214 1,068 1,424 5,591 574 14 588 422 398 636 318 239 755 318 159 159 80 32 12 199 239 4,205 273 339 1,125 1,737 5,942 163 15 178 $5,003 $5,764 A. The Company’s debentures and notes are unsecured. B. The PURS contain imbedded simultaneous put and call options at par. At the time of issuance, the Company sold the option to call the securities on July 15, 2006 (the reset date). If the call option is exercised, the imbedded put option is automatically triggered, resulting in the redemp- tion of the original PURS. The call option holder will then have the right to remarket the securities at a new coupon rate for an additional 30-year term ending July 15, 2036. The new coupon rate will be determined according to a pre-set mechanism based on market conditions then prevailing. If the call option is not exercised, the put option is deemed to have been exer- cised, resulting in the redemption of the PURS on July 15, 2006. C. These debt securities are redeemable, in whole or in part, at the option of the Company, at any time, at the greater of par and a formula price based on interest rates prevailing at the time of redemption. D. The Company has a commercial paper program, which is backed by a portion of its revolving credit facility, enabling it to issue commercial paper up to a maximum aggregate principal amount of $600 million, or the U.S. dollar equivalent. Commercial paper debt is due within one year but has been classified as long-term debt, reflecting the Company’s intent and contractual ability to refinance the short-term borrowing through subsequent issuances of commercial paper or drawing down on the revolving credit facility. Interest rates on commercial paper at December 31, 2002 range from approximately 1.4% to 1.7%. 62 Canadian National Railway Company U.S. GAAP Notes to Consolidated Financial Statements E. Interest rates for the capital leases range from approximately 3.0% to 14.6% with maturity dates in the years 2003 through 2025. The imputed interest on these leases amounted to $498 million as at December 31, 2002, and $545 million as at December 31, 2001. The equipment agreements are payable by monthly or semi-annual installments over various periods to 2007 at interest rates ranging from 6.0% to 6.7%. As at December 31, 2002, the principal amount repayable was $14 million ($19 million as at December 31, 2001). The capital leases, equipment agreements, and other obligations are secured by properties with a net carrying amount of $1,136 million as at December 31, 2002 and $1,108 million as at December 31, 2001. During 2002, the Company recorded $114 million in assets it acquired through the exercise of purchase options on existing leases and leases for new equipment ($91 million in 2001). An equivalent amount was recorded in debt. F. Long-term debt maturities, including repurchase arrangements and capital lease repayments on debt outstanding as at December 31, 2002 but excluding repayments of commercial paper and revolving credit facil- ity of $214 million and $142 million, respectively, for the next five years and thereafter, are as follows: Year 2003. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2004. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2005. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2006. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2007. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2008 and thereafter . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . In millions $÷«574 560 246 438 164 3,239 G. The aggregate amount of debt payable in U.S. currency as at December 31, 2002 is U.S.$3,164 million (Cdn$4,987 million) and U.S.$3,334 million (Cdn$5,302 million) as at December 31, 2001. C. Convertible preferred securities (“Securities”) On May 6, 2002, the Company met the conditions required to terminate the Securities holders’ right to convert their Securities into common shares of the Company, and set the conversion termination date as July 3, 2002. The conditions were met when the Company’s common share price exceeded 120% of the conversion price of U.S.$38.48 per share for a specified period, and all accrued interest on the Securities had been paid. On July 3, 2002, Securities that had not been previously surrendered for conversion were deemed converted, resulting in the issuance of 6.0 million common shares of the Company. In 1999, the Company had issued 4.6 million 5.25% Securities due on June 30, 2029, at U.S.$50 per Security. These Securities were subordi- nated securities convertible into common shares of CN at the option of the holder at an original conversion price of U.S.$38.48 per common share, representing an original conversion rate of 1.2995 common shares for each Security. D. Share repurchase programs On October 22, 2002, the Board of Directors of the Company approved a share repurchase program which allows for the repurchase of up to 13.0 million common shares between October 25, 2002 and October 24, 2003 pursuant to a normal course issuer bid, at prevailing market prices. As at December 31, 2002, $203 million was used to repurchase 3.0 million common shares at an average price of $67.68 per share. In 2001, the Board of Directors of the Company approved a share repurchase program under which the Company did not repurchase any common shares. In 2000, $529 million was used to repurchase 13.0 million common shares, the maximum allowed under the program, pursuant to a normal course issuer bid at an average price of $40.70 per share. 12 Stock plans 11 Capital stock and convertible preferred securities The Company has various stock-based incentive plans for eligible employ- ees. A description of the Company’s major plans is provided below: A. Authorized capital stock The authorized capital stock of the Company is as follows: • Unlimited number of Common Shares, without par value • Unlimited number of Class A Preferred Shares, without par value issuable in series • Unlimited number of Class B Preferred Shares, without par value issuable in series B. Issued and outstanding common shares During 2002, the Company issued 7.8 million shares of which 1.8 million shares (2.1 million shares in 2001 and 1.2 million shares in 2000) was related to stock options exercised and 6.0 million shares was related to the conversion of the Company’s convertible preferred securities. The total number of common shares issued and outstanding was 197.5 mil- lion as at December 31, 2002. A. Employee share plan The Company has an Employee Share Investment Plan (ESIP) giving eligi- ble employees the opportunity to subscribe for up to 6% of their gross salaries to purchase shares of the Company’s common stock on the open market and to have the Company invest, on the employees’ behalf, a further 35% of the amount invested by the employees. Participation at December 31, 2002 was 8,911 employees (9,432 at December 31, 2001). The total number of ESIP shares purchased on behalf of employees, including the Company’s contributions, was 497,459 in 2002, 516,726 in 2001 and 637,531 in 2000, resulting in a pre-tax charge to income of $9 million, $8 million and $6 million for the years ended December 31, 2002, 2001 and 2000, respectively. U.S. GAAP Canadian National Railway Company 63 Notes to Consolidated Financial Statements 12 Stock plans (continued) B. Mid-term incentive share unit plan The Company has a share unit plan, which was approved by the Board of Directors in 2001, for designated senior management employees entitling them to receive payout on June 30, 2004 of a combination of common stock of the Company, as to fifty percent, and cash value, as to the remaining fifty percent. The share units vest conditionally upon the attainment of targets relating to the Company’s share price during the six-month period ending June 30, 2004. At December 31, 2002, the total number of share units outstanding was 419,900, representing a potential maximum compensa- tion cost of $42 million. Due to the nature of the vesting conditions, no compensation cost was recorded for 2002 and 2001. At December 31, 2002, an additional 45,100 share units remained authorized for future issuances under this plan. C. Stock options The Company has stock option plans for eligible employees to acquire common shares of the Company upon vesting at a price equal to the market value of the common shares at the date of granting. The options are exercisable during a period not exceeding 10 years. The right to exercise options generally accrues over a period of four years of continu- ous employment. Options are not generally exercisable during the first 12 months after the date of grant. At December 31, 2002, an additional 2.6 million common shares remained authorized for future issuances under these plans. Options issued by the Company include conventional options, which vest over a period of time, and performance options, which vest upon the attainment of Company targets relating to the operating ratio and unlev- ered return on investment. The total conventional and performance options outstanding at December 31, 2002 were 9.1 million and 2.0 mil- lion, respectively. Changes in the Company’s stock options are as follows: Number of options In millions Weighted-average exercise price Outstanding at December 31, 1999 (1) . . . . . . . . . . . . . . . . . . . . . Granted . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Canceled . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Exercised . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Outstanding at December 31, 2000 (1) . . . . . . . . . . . . . . . . . . . . . Conversion of WC options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Granted . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Canceled . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Exercised . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Outstanding at December 31, 2001 (1) (2) . . . . . . . . . . . . . . . . . . . Granted . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Canceled . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8.3 2.2 (0.4) (1.2) 8.9 1.0 2.4 (0.3) (2.1) 9.9 3.2 (0.2) Exercised . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Outstanding at December 31, 2002 (1) (2) . . . . . . . . . . . . . . . . . . . 11.1 (1.8) $«34.88 $«35.33 $«36.23 $«22.19 $«34.95 $«58.63 $«50.65 $«46.01 $«30.43 $«43.62 $«76.78 $«56.98 $«39.16 $53.50 (1) Includes IC converted stock options translated to Canadian dollars using the foreign exchange rate in effect at the balance sheet date. (2) Includes WC converted stock options translated to Canadian dollars using the foreign exchange rate in effect at the balance sheet date. Stock options outstanding and exercisable as at December 31, 2002 were as follows: Range of exercise prices $13.50–$23.72 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $25.18–$35.01 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $35.70–$49.45 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $50.02–$69.77 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $70.04 and above . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Balance at December 31, 2002 (1) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Options outstanding Options exercisable Number of options In millions 0.1 2.1 3.2 2.5 3.2 11.1 Weighted- average years to expiration Weighted- average exercise price 3 6 6 8 9 7 $«17.23 $«33.59 $«44.69 $«51.43 $«77.59 $53.50 Number of options In millions 0.1 1.2 2.7 0.8 0.1 4.9 Weighted- average exercise price $«17.23 $«32.48 $«44.56 $«52.93 $«97.09 $44.01 (1) Includes IC and WC converted stock options translated to Canadian dollars using the foreign exchange rate in effect at the balance sheet date. 64 Canadian National Railway Company U.S. GAAP Notes to Consolidated Financial Statements D. Stock-based compensation cost Compensation cost for performance-based stock option awards under these plans is determined by the options’ intrinsic value in accordance with APB 25, “Accounting for Stock Issued to Employees,” and related interpretations. Compensation cost recognized for stock-based awards was $9 million, $19 million and $3 million in 2002, 2001 and 2000, respectively. Disclosures required under the fair value measurement and recognition method prescribed by SFAS No. 123, “Accounting for Stock- Based Compensation,” are presented in Note 1 – Summary of significant accounting policies. 13 Pensions The Company has retirement benefit plans under which substantially all of its employees are entitled to benefits at retirement age, generally based on compensation and length of service and/or contributions. The tables that follow pertain to all such plans. However, the following descriptions relate solely to the Company’s main pension plan, the CN Pension Plan (the Pension Plan). The Company’s other pension plans are not significant. Description of plan The Pension Plan is a contributory defined benefit pension plan that covers the majority of CN employees. It provides for pensions based mainly on years of service and final average pensionable earnings and is generally applicable from the first day of employment. Indexation of pen- sions is provided after retirement through a gain (loss) sharing mechanism, subject to guaranteed minimum increases. An independent trust company is the Trustee of the Canadian National Railways Pension Trust Funds (CN Pension Trust Funds). As Trustee, the trust company performs certain duties, which include holding legal title to the assets of the CN Pension Trust Funds and ensuring that the Company, as Administrator, complies with the provisions of the Pension Plan and the related legislation. Funding policy Employee contributions to the Pension Plan are determined by the plan rules. Company contributions are in accordance with the requirements of the Government of Canada legislation, The Pension Benefits Standards Act, 1985, and are determined by actuarial valuations conducted at least on a triennial basis. These valuations are made in accordance with leg- islative requirements and with the recommendations of the Canadian Institute of Actuaries for the valuation of pension plans. The latest actuarial valuation of the Pension Plan was conducted as at December 31, 2001 and indicated a funding excess. Based on the Pension Plan’s current position, the Company’s contributions are expected to be approximately $75 million in each of 2003, 2004 and 2005. Description of fund assets The assets of the Pension Plan are accounted for separately in the CN Pension Trust Funds and consist of cash and short-term investments, bonds, mortgages, Canadian and foreign equities, real estate, and oil and gas assets. Based on the fair value of the assets held at December 31, 2002, the plan assets are comprised of 1% in cash and short-term invest- ments, 40% in bonds and mortgages, 50% in Canadian and foreign equi- ties and 9% in real estate and oil and gas assets. (a) Change in benefit obligation In millions Year ended December 31, 2002 2001 Benefit obligation at beginning of year . . . . . . . . . . . . . . . . . . . . . . . . . . $11,156 714 Interest cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $10,855 701 Actuarial (gain) loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Service cost. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Plan participants’ contributions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Foreign currency changes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (92) 99 61 (1) 94 92 73 6 Benefit payments and transfers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Benefit obligation at end of year. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $11,243 (694) (665) $11,156 (b) Change in plan assets In millions Year ended December 31, 2002 2001 Fair value of plan assets at beginning of year . . . . . . . . . . . . . . . . . . . . $11,763 92 Employer contributions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Plan participants’ contributions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Foreign currency changes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Actual return on plan assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 61 (1) (39) Benefit payments and transfers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Fair value of plan assets at end of year . . . . . . . . . . . . . . . . . . . . . . . . . . $11,182 (694) $12,455 69 73 6 (175) (665) $11,763 (c) Funded status In millions December 31, 2002 2001 Excess (deficiency) of fair value of plan assets over benefit obligation at end of year (1) . . . . . . . . . . . . . . . . . . . . . . . . . . $«(61) 282 Unrecognized net actuarial (gain) loss (1). . . . . . . . . . . . . . . . . . . . . . . . . . . . . Unrecognized net transition obligation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19 Unrecognized prior service cost. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net amount recognized. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $353 113 (1) Subject to future reduction for gain sharing under the terms of the plan. (d) Amount recognized in the Consolidated Balance Sheet In millions December 31, 2002 Prepaid benefit cost (Note 6) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $353 – Accrued benefit cost. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Additional minimum pension liability . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Intangible asset . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (38) 1 Accumulated other comprehensive income (Note 22) . . . . . . . . . . . . . . . . Net amount recognized. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $353 37 $«607 (537) 39 133 $«242 2001 $251 (9) (18) 1 17 $242 U.S. GAAP Canadian National Railway Company 65 Notes to Consolidated Financial Statements 13 Pensions (continued) 14 Workforce reduction charges (e) Components of net periodic benefit cost In millions Year ended December 31, 2002 Interest cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $«714 99 Service cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Amortization of net transition obligation. . . . . . . . . . . . . . . Amortization of prior service cost . . . . . . . . . . . . . . . . . . . . . . Expected return on plan assets. . . . . . . . . . . . . . . . . . . . . . . . . 20 20 (874) Recognized net actuarial loss . . . . . . . . . . . . . . . . . . . . . . . . . . Net periodic benefit cost (income) . . . . . . . . . . . . . . . . . . . . . $÷(20) 1 2001 $«701 92 20 20 (846) – 2000 $«690 70 19 19 (792) – $÷(13) $÷÷«6 In 2002, the Company announced 1,146 job reductions, in a renewed drive to improve productivity in all its corporate and operating functions, and recorded a charge of $120 million, $79 million after tax. In 2001, a charge of $98 million, $62 million after tax, was recorded for the reduc- tion of 690 positions. Reductions relating to these charges were 388 in 2001, 433 in 2002, with the remainder to be completed by the end of 2003. The charges included payments for severance, early retirement incentives and bridging to early retirement, to be made to affected employees. (f) Weighted-average assumptions December 31, 2002 2001 2000 Discount rate. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6.50% Rate of compensation increase . . . . . . . . . . . . . . . . . . . . . . . . 4.00% Expected return on plan assets for year ending December 31 . . . . . . . . . . . . . . . . . . . . . . . . . . 9.00% 6.50% 4.00% 6.50% 4.25% 9.00% 9.00% 15 Interest expense In millions Year ended December 31, Interest on long-term debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cash interest payments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2002 $361 – $361 $398 2001 $329 (2) $327 $322 2000 $322 (11) $311 $315 Effective January 1, 2003, the Company will reduce the expected long-term rate of return on plan assets from 9% to 8% to reflect man- agement’s current view of long-term investment returns. The effect of this change in management’s assumption will be to increase net periodic benefit cost in 2003 by approximately $50 million. As at December 31, 2002, one of the Company’s pension plans had an accumulated benefit obligation of $112 million ($106 million at December 31, 2001) in excess of the fair value of the plan assets of $77 million ($79 million at December 31, 2001) which gave rise to an additional minimum pension liability. The projected benefit obligation was $116 million at December 31, 2002 ($110 million at December 31, 2001). The Company has indemnified and held harmless the current trustee and the former trustee of the Canadian National Railways Pension Trust Funds, and the respective officers, directors, employees and agents of such trustees, from any and all taxes, claims, liabilities, damages, costs and expenses arising out of the performance of their obligations under the relevant trust agreements and trust deeds, including in respect of their reliance on authorized instructions of the Company or for failing to act in the absence of authorized instructions. These indemnifications survive the termination of such agreements or trust deeds. As at December 31, 2002, the Company has not recorded a liability associated with these indemnifications, as the Company does not expect to make any payments pertaining to these indemnifications. 16 Other income In millions Year ended December 31, 2002 Gain on disposal of properties . . . . . . . . . . . . . . . . . . . . . . . . . . $«41 2001 $«53 2000 $÷57 Equity in earnings of English Welsh and Scottish Railway (Note 6). . . . . . . . . . . . . . . . . . . . . . . . Investment income. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Foreign exchange gain . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Gain on sale of interest in Detroit River Tunnel Company (A) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Write-down of investment in 360networks Inc. (Note 6). . . . . . . . . . . . . . . . . . . . . . . . . Gain on exchange of investment (Note 6) . . . . . . . . . . . . . . . Net real estate costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33 18 12 – – – (15) (13) $«76 8 22 7 101 (99) – (20) (7) – 10 10 – – 84 (22) (3) $«65 $136 A. In March 2001, the Company completed the sale of its 50 percent interest in the Detroit River Tunnel Company (DRT) for proceeds of $112 million and recorded a gain of $101 million, $73 million after tax. The DRT is a 1.6 mile rail-only tunnel crossing the Canada-U.S. border between Detroit and Windsor, Ontario. 66 Canadian National Railway Company U.S. GAAP Notes to Consolidated Financial Statements 17 Income taxes The Company’s consolidated effective income tax rate differs from the statutory Federal tax rate. The reconciliation of income tax expense is as follows: In millions Year ended December 31, 2002 2001 2000 Federal tax rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26.1% 28.1% 29.1% The Company expects to realize its deferred income tax assets from the generation of future taxable income, as the related payments are made and losses and tax credit carryforwards are utilized. The Company recognized tax credits of $9 million in 2002 for research and development expenditures ($35 million in 2001 for investment tax credits) not previously recognized, which reduced the cost of properties. Income tax expense at the statutory Federal tax rate. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $÷(309) $÷(399) $÷(429) 18 Segmented information Income tax (expense) recovery resulting from: Provincial and other taxes . . . . . . . . . . . . . . . . . . . . . . . . . (140) (178) (180) Deferred income tax adjustment due to rate reductions . . . . . . . . . . . . . . . . . . . . . . . . . . U.S. tax rate differential. . . . . . . . . . . . . . . . . . . . . . . . . . . . Gain on disposals and dividends . . . . . . . . . . . . . . . . . . . Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . – (1) 6 60 122 3 18 54 – 9 18 46 Income tax expense. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $÷(384) $÷(380) $÷(536) Income before income taxes Canada . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,101 83 U.S. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,153 $1,172 267 301 $1,184 $1,420 $1,473 Current income taxes Canada . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $÷(130) 18 U.S. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $÷÷(99) $÷(153) 14 (71) The Company operates in one business segment with operations and assets in Canada and the United States. Information on geographic areas In millions Revenues: Year ended December 31, 2002 2001 2000 Canadian rail . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . U.S. rail . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Operating income: Canadian rail . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . U.S. rail . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $3,726 2,384 $6,110 $3,675 1,977 $5,652 $3,650 1,778 $5,428 $1,163 $1,181 $1,199 306 501 449 $1,469 $1,682 $1,648 $÷(112) $÷÷(85) $÷(224) Net income: Canadian rail . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $÷«719 $÷«844 $÷«695 U.S. rail . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 81 196 242 Deferred income taxes Canada . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $÷(221) (51) U.S. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $÷(173) $÷(290) (122) (22) Cash payments for income taxes . . . . . . . . . . . . . . . . . . . . . . $÷÷«65 $÷÷«63 $÷«101 Canadian rail (A). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . U.S. rail . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $÷(272) $÷(295) $÷(312) Depreciation and amortization: Significant components of deferred income tax assets and liabilities are as follows: In millions December 31, 2002 2001 Canadian rail (C) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . U.S. rail . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Capital expenditures: (B) $÷«800 $1,040 $÷«937 $÷«343 $÷«309 $÷«336 248 229 197 $÷«591 $÷«538 $÷«533 $÷«717 $÷«723 $÷«802 335 274 310 $1,052 $÷«997 $1,112 Deferred income tax assets Workforce reduction provisions. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $÷«144 276 Accruals and other reserves . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Post-retirement benefits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Losses and tax credit carryforwards . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 99 69 588 $÷«178 182 85 53 498 Deferred income tax liabilities Properties and other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,292 4,936 In millions Identifiable assets: December 31, 2002 2001 Canadian rail . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $÷9,688 12,050 U.S. rail (D) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $÷9,036 12,187 $21,738 $21,223 Total net deferred income tax liability . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net current deferred income tax asset . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,704 122 4,438 153 (A) Includes $7 million (2001: $6 million, 2000: $8 million) of depreciation and amortization of properties related to other business activities. (B) Represents additions to properties that include non-cash capital expenditures financed Net long-term deferred income tax liability $4,826 $4,591 through capital lease arrangements. Net deferred income tax liability Canada . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,285 3,419 U.S. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,050 3,388 $4,704 $4,438 (C) Includes $4 million (2001: $5 million, 2000: $9 million) of additions to properties related to other business activities. (D) Includes equity holdings in foreign investments held by the Company’s U.S. subsidiaries. U.S. GAAP Canadian National Railway Company 67 Notes to Consolidated Financial Statements 19 Earnings per share Year ended December 31, 2002 Basic earnings per share . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $4.07 Diluted earnings per share . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $3.97 2001 $5.41 $5.23 2000 $4.81 $4.67 The following table provides a reconciliation between basic and diluted earnings per share: In millions Year ended December 31, 2002 2001 Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $800 $1,040 Income impact on assumed conversion of preferred securities (Note 11) . . . . . . . . . . . . . . . . . . . . 6 12 $806 $1,052 Weighted-average shares outstanding . . . . . . . . . . . . . . . . . 196.7 6.1 Effect of dilutive securities and stock options . . . . . . . . . . Weighted-average diluted shares outstanding. . . . . . . . . . 202.8 192.1 8.9 201.0 2000 $937 11 $948 195.0 7.8 202.8 At December 31, 2002, 3.2 million stock options at a weighted- average exercise price of $77.56 were not included in the calculation of diluted earnings per share since their inclusion would have had an anti-dilutive impact. 20 Major commitments and contingencies A. Leases The Company has lease commitments for locomotives, freight cars and intermodal equipment, many of which provide the option to purchase the leased items at fixed values during or at the end of the lease term. As at December 31, 2002, the Company’s commitments under operating and capital leases are $1,154 million and $1,407 million, respectively. Annual net minimum payments in each of the next five years and there- after, are as follows: Year In millions Operating Capital 2003 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $÷«212 $÷«168 2004 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2005 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2006 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2007 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2008 and thereafter . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 188 167 139 120 328 153 111 68 123 784 $1,154 1,407 Less: imputed interest on capital leases at rates ranging from approximately 3.0% to 14.6%. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 498 Present value of minimum lease payments at current rate included in debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $÷«909 Rent expense for operating leases was $269 million, $258 million and $219 million for the years ended December 31, 2002, 2001 and 2000, respectively. Contingent rentals and sublease rentals were not significant. The Company has guaranteed a portion of the residual values of certain of its assets under operating leases with expiry dates between 2004 and 2012, for the benefit of the lessor. If the fair value of the assets, at the end of their respective lease term, is less than the fair value, as estimated at the inception of the lease, then the Company must, under certain conditions, compensate the lessor for the shortfall. The maximum exposure in respect of these guarantees is $63 million. As at December 31, 2002, the Company has not recorded a liability associated with these guarantees, as the Company does not expect to make any payments pertaining to the guarantees of these leases. B. Other commitments As at December 31, 2002, the Company had commitments to acquire railroad ties, rail, freight cars and locomotives at an aggregate cost of $183 million. Furthermore, as at December 31, 2002, the Company had entered into agreements with fuel suppliers to purchase approximately 38% of its anticipated 2003 volume and 8% of its anticipated 2004 vol- ume at market prices prevailing on the date of the purchase. C. Contingencies In the normal course of its operations, the Company becomes involved in various legal actions, including claims relating to personal injuries, occu- pational disease and damage to property. In Canada, employee injuries are governed by the workers’ compen- sation legislation in each province whereby employees may be awarded either a lump sum or future stream of payments depending on the nature and severity of the injury. Accordingly, the Company accounts for costs related to employee work-related injuries based on actuarially developed estimates of the ultimate cost associated with such injuries, including compensation, health care and administration costs. For all other legal actions, the Company maintains, and regularly updates on a case-by-case basis, provisions for such items when the expected loss is both probable and can be reasonably estimated based on currently available information. In the United States, employee work-related injuries, including occu- pational disease claims, are compensated according to the provisions of the Federal Employers’ Liability Act (FELA) and represent a major expense for the railroad industry. The FELA system, which requires either the finding of fault through the U.S. jury system or individual settle- ments, has contributed to the significant increase in the Company’s per- sonal injury expense in recent years. In view of the Company’s growing presence in the United States and the increase in the number of occupa- tional disease claims over the past few years, an actuarial study was conducted in 2002, and in the fourth quarter of 2002 the Company changed its methodology for estimating its liability for U.S. personal injury and other claims, including occupational disease claims and claims for property damage, from a case-by-case approach to an actuarial-based approach. Consequently, and as discussed in Note 2, the Company recorded a charge of $281 million ($173 million after tax) to increase its provision for these claims. 68 Canadian National Railway Company U.S. GAAP Notes to Consolidated Financial Statements Under the actuarial-based approach, the Company accrues the cost for the expected personal injury and property damage claims and existing occupational disease claims, based on actuarial estimates of their ultimate cost. The Company is unable to estimate the total cost for unasserted occupational disease claims. However, a liability for unasserted occupa- tional disease claims is accrued to the extent they are probable and can be reasonably estimated. Under the case-by-case approach, the Company was accruing the cost for claims as incidents were reported based on currently available information. In addition, the Company did not record a liability for unasserted claims, as such amounts could not be reasonably estimated under the case-by-case approach. The Company’s expenses for personal injury and other claims, net of recoveries, and including the above-mentioned charge, were $393 million in 2002, ($78 million in 2001 and $60 million in 2000) and payments for such items were $156 million in 2002 ($149 million in 2001 and $111 million in 2000). As at December 31, 2002, the Company had aggregate reserves for personal injury and other claims of $664 million ($430 mil- lion at December 31, 2001). Although the Company considers such provisions to be adequate for all its outstanding and pending claims, the final outcome with respect to actions outstanding or pending at December 31, 2002, or with respect to future claims, cannot be predicted with certainty, and therefore there can be no assurance that their resolution will not have a material adverse effect on the Company’s financial position or results of operations in a particular quarter or fiscal year. D. Environmental matters The Company’s operations are subject to federal, provincial, state, munic- ipal and local regulations under environmental laws and regulations con- cerning, among other things, emissions into the air; discharges into waters; the generation, handling, storage, transportation, treatment and disposal of waste, hazardous substances, and other materials; decommis- sioning of underground and aboveground storage tanks; and soil and groundwater contamination. A risk of environmental liability is inherent in railroad and related transportation operations; real estate ownership, operation or control; and other commercial activities of the Company with respect to both current and past operations. As a result, the Company incurs significant compliance and capital costs, on an ongoing basis, associated with environmental regulatory compliance and clean-up requirements in its railroad operations and relating to its past and pre- sent ownership, operation or control of real property. While the Company believes that it has identified the costs likely to be incurred in the next several years, based on known information, for environmental matters, the Company’s ongoing efforts to identify poten- tial environmental concerns that may be associated with its properties may lead to future environmental investigations, which may result in the identification of additional environmental costs and liabilities. The magnitude of such additional liabilities and the costs of complying with environmental laws and containing or remediating contamination cannot be reasonably estimated due to: (i) (ii) the lack of specific technical information available with respect to many sites; the absence of any government authority, third-party orders, or claims with respect to particular sites; (iii) the potential for new or changed laws and regulations and for development of new remediation technologies and uncertainty regarding the timing of the work with respect to particular sites; (iv) the ability to recover costs from any third parties with respect to particular sites; and therefore, the likelihood of any such costs being incurred or whether such costs would be material to the Company cannot be determined at this time. There can thus be no assurance that material liabilities or costs related to environmental matters will not be incurred in the future, or will not have a material adverse effect on the Company’s financial position or results of operations in a particular quarter or fiscal year, or that the Company’s liquidity will not be adversely impacted by such environmental liabilities or costs. Although the effect on operating results and liquidity cannot be reasonably estimated, management believes, based on current information, that environmental matters will not have a material adverse effect on the Company’s financial condition or competitive position. Costs related to any future remediation will be accrued in the year in which they become known. As at December 31, 2002, the Company had aggregate accruals for environmental costs of $106 million ($112 million as at December 31, 2001). During 2002, payments of $16 million were applied to the provision for environmental costs compared to $14 million in 2001 and $11 million in 2000. The Company anticipates that the majority of the liability at December 31, 2002 will be paid out over the next five years. In addition, related environmental capital expenditures were $19 mil- lion in both 2002 and 2001 and $20 million in 2000. The Company expects to incur capital expenditures relating to environmental matters of approxi- mately $20 million in each of 2003 and 2004 and $17 million in 2005. E. Standby letters of credit The Company, including certain of its subsidiaries, has granted irrevoca- ble standby letters of credit, issued by highly rated banks, to third parties to indemnify them in the event the Company does not perform its con- tractual obligations. As at December 31, 2002, the maximum potential liability under these letters of credit was $403 million of which $334 mil- lion was for workers’ compensation and other employee benefits and $69 million was for equipment under leases and other. U.S. GAAP Canadian National Railway Company 69 Notes to Consolidated Financial Statements 20 Major commitments and contingencies (continued) As at December 31, 2002, the Company has not recorded a liability with respect to these guarantees, as the Company does not expect to make any payments in excess of what is recorded on the Company’s financial statements for the aforementioned items. The standby letters of credit mature at various dates between 2003 and 2007. F. General indemnifications In the normal course of business, the Company has provided indemnifi- cations, customary for the type of transaction or for the railway business, in various agreements with third parties, including indemnification provi- sions where the Company would be required to indemnify third parties and others. Indemnifications are found in various types of contracts with third parties which include, but are not limited to, (a) contracts granting the Company the right to use or enter upon property owned by third parties such as leases, easements, trackage rights and sidetrack agree- ments; (b) contracts granting rights to others to use the Company’s property, such as leases, licenses and easements; (c) contracts for the sale of assets; (d) contracts for the acquisition of services; (e) financing agreements; (f) trust indentures or fiscal agency agreements or similar agreements relating to debt or equity securities of the Company and engagement agreements with financial advisors; (g) transfer agent and registrar agreements in respect of the Company’s securities; and (h) trust agreements establishing trust funds to secure the payment to certain officers and senior employees of special retirement compensation arrangements or plans. To the extent of any actual claims under these agreements, the Company maintains provisions for such items, which it considers to be adequate. Due to the nature of the indemnification clauses, the maximum exposure for future payment cannot be deter- mined with certainty, however, may be material. 21 Financial instruments A. Risk management The Company has limited involvement with derivative financial instru- ments in the management of its fuel, foreign currency and interest rate exposures, and does not use them for trading purposes. (i) Credit risk In the normal course of business, the Company monitors the financial con- dition of its customers and reviews the credit history of each new customer. The Company is exposed to credit risk in the event of non-perfor- mance by counterparties to its derivative financial instruments. Although collateral or other security to support financial instruments subject to credit risk is usually not obtained, counterparties are of high credit qual- ity and their credit standing or that of their guarantor is regularly moni- tored. As a result, losses due to counterparty non-performance are not anticipated. The total risk associated with the Company’s counterparties was immaterial at December 31, 2002. The Company believes there are no significant concentrations of credit risk. (ii) Fuel To mitigate the effects of fuel price changes on its operating margins and overall profitability, the Company has a systematic hedging program which calls for regularly entering into swap positions on crude and heat- ing oil to cover a target percentage of future fuel consumption up to two years in advance. The changes in the fair value of the swap positions are highly correlated to changes in the price of fuel and therefore, these fuel hedges are being accounted for as cash flow hedges, whereby the effec- tive portion of the cumulative change in the market value of the deriva- tive instruments has been recorded in Accumulated other comprehensive income. The amounts in Accumulated other comprehensive income will be reclassified into income upon the ultimate consumption of the hedged fuel. To the extent that the cumulative change in the fair value of the swap positions does not offset the cumulative change in the price of fuel, the ineffective portion of the hedge will be recognized into income immediately. In the event that the fuel hedge is discontinued and the forecasted purchase of fuel is not expected to occur, the amount in Accumulated other comprehensive income would be reclassified into income immediately. Realized gains and losses from the Company’s fuel hedging activi- ties were a $3 million gain, a $6 million loss and a $49 million gain for the years ended December 31, 2002, 2001 and 2000, respectively. At December 31, 2002, the Company has hedged approximately 47% of the estimated 2003 fuel consumption and 25% of the estimated 2004 fuel consumption. This represents approximately 263 million U.S. gallons at an average price of U.S.$0.5865 per U.S. gallon. At December 31, 2002, Accumulated other comprehensive income included an unrealized gain of $30 million, $20 million after tax ($38 mil- lion unrealized loss, $25 million after tax at December 31, 2001), of which $29 million relates to derivative instruments that will mature within the next year. The Company did not recognize any material gains or losses in 2002 and 2001 due to hedge ineffectiveness as the Company’s derivative instruments have been highly effective in hedging the changes in cash flows associated with forecasted purchases of diesel fuel. (iii) Foreign currency Although the Company conducts its business and receives revenues pri- marily in Canadian dollars, a growing portion of its revenues, expenses, assets and debt are denominated in U.S. dollars. Thus, the Company’s results are affected by fluctuations in the exchange rate between these currencies. Changes in the exchange rate between the Canadian dollar and other currencies (including the U.S. dollar) make the goods trans- ported by the Company more or less competitive in the world market- place and thereby affect the Company’s revenues and expenses. For the purpose of minimizing volatility of earnings resulting from the conversion of U.S. dollar denominated long-term debt into the Canadian dollar, the Company has designated all U.S. dollar denominated long-term debt of the parent company as a foreign exchange hedge of 70 Canadian National Railway Company U.S. GAAP Notes to Consolidated Financial Statements its net investment in U.S. subsidiaries. As a result, from the dates of des- ignation, unrealized foreign exchange gains and losses on the translation of the Company’s U.S. dollar denominated long-term debt are recorded in Accumulated other comprehensive income. The following table presents the carrying amounts and estimated fair values of the Company’s financial instruments as at December 31, 2002 and 2001 for which the carrying values on the Consolidated Balance Sheet are different from their fair values: (iv) Interest rates From time to time, the Company enters into interest rate swap trans- actions for the purpose of minimizing the volatility in the fair value of certain fixed-interest long-term debt. In 2002 and 2001, the Company did not enter into any interest rate swap transactions. (v) Other The Company does not currently have any derivative instruments not designated as hedging instruments. B. Fair value of financial instruments Generally accepted accounting principles define the fair value of a finan- cial instrument as the amount at which the instrument could be exchanged in a current transaction between willing parties. The Company uses the following methods and assumptions to estimate the fair value of each class of financial instruments for which the carrying amounts are included in the Consolidated Balance Sheet under the following captions: (i) Cash and cash equivalents, Accounts receivable, Accounts payable and accrued charges, and Other current liabilities: The carrying amounts approximate fair value because of the short matu- rity of these instruments. (ii) Other assets and deferred charges: Investments: The Company has various debt and equity investments for which the carrying value approximates the fair value, with the exception of a cost investment for which the fair value was estimated based on the Company’s proportionate share of its net assets. (iii) Long-term debt: The fair value of the Company’s long-term debt is estimated based on the quoted market prices for the same or similar debt instruments, as well as discounted cash flows using current interest rates for debt with similar terms, company rating, and remaining maturity. (iv) Convertible preferred securities: In 2001, the fair value of the Company’s convertible preferred securities was estimated based on the quoted market price. In millions December 31, 2002 December 31, 2001 Carrying amount Fair value Carrying amount Fair value Financial assets Investments . . . . . . . . . . . . . . . . . . . . . . . . . . $÷«380 Financial liabilities Long-term debt (including current portion). . . . . . . . . $5,577 Convertible preferred securities . . . . . . . $÷«÷÷– $÷÷440 $÷«496 $÷÷551 $5,738 $÷«÷÷– $5,927 $÷«366 $5,986 $÷«479 22 Other comprehensive income (loss) A. Components of Other comprehensive income (loss) and the related tax effects are as follows: In millions Unrealized foreign exchange gain on translation of U.S. dollar denominated long-term debt designated as a hedge of the net investment in U.S. subsidiaries . . . . . . . Unrealized foreign exchange loss on translation of the net investment in foreign operations . . . . . . . . . . . . . . . . . . . . . . . . . . . Unrealized holding gain on fuel derivative instruments (Note 21). . . . . . . . . . . . . . . . Minimum pension liability adjustment (Note 13) . . . . . . . . . . . . . . . . . . . . . . . . . . . Other comprehensive income . . . . . . . . . . . . . . . . . . . . . . In millions Year ended December 31, 2002 Before Income tax (expense) recovery tax amount Net of tax amount $«51 $(17) $«34 (40) 68 (20) $«59 13 (23) 7 $(20) (27) 45 (13) $«39 Year ended December 31, 2001 Before tax amount Income tax (expense) recovery Net of tax amount Unrealized foreign exchange loss on translation of U.S. dollar denominated long-term debt designated as a hedge of the net investment in U.S. subsidiaries . . . . . . . . . . Unrealized foreign exchange gain on translation of the net investment in foreign operations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Unrealized holding loss on investment in 360networks Inc. (Note 6). . . . . . . . . . . . . . . . . . . . . . . . . Unrealized holding loss on fuel derivative instruments (Note 21) . . . . . . . . . . . . . . . . . . Minimum pension liability adjustment (Note 13) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Deferred income tax (DIT) rate enactment . . . . . . . . . . . . $(202) $÷«71 $(131) 308 (129) (38) (17) – (108) 200 35 13 6 (32) (94) (25) (11) (32) Other comprehensive loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . $÷(78) $÷(15) $÷(93) U.S. GAAP Canadian National Railway Company 71 Notes to Consolidated Financial Statements 22 Other comprehensive income (loss) (continued) In millions Year ended December 31, 2000 Before tax amount Income tax (expense) recovery Net of tax amount Unrealized foreign exchange loss on translation of U.S. dollar denominated long-term debt designated as a hedge of the net investment in U.S. subsidiaries . . . . . . . . . . Unrealized foreign exchange gain on translation of the net investment in U.S. subsidiaries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Unrealized holding gain on investment in 360networks Inc. (Note 6). . . . . . . . . . . . . . . . . . . . . . . . . Other comprehensive income. . . . . . . . . . . . . . . . . . . . . . . . . $«(91) $÷«34 $÷(57) 191 129 $229 (71) (35) 120 94 $÷(72) $«157 B. Changes in the balances of each classification within Accumulated other comprehensive income (loss) are as follows: In millions Foreign exchange – Net investment in foreign operations Foreign exchange – U.S. $ debt Holding gain (loss) on 360networks Inc. investment Holding gain (loss) on fuel derivative instruments Minimum pension liability adjustment Accumulated other comprehensive income (loss) DIT rate enactment Balance at January 1, 2000 . . . . . . . . . . . . . . . . . . . . . $«÷(33) Period change . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Balance at December 31, 2000 . . . . . . . . . . . . . . . . . Period change . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Balance at December 31, 2001 . . . . . . . . . . . . . . . . . Period change . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (57) (90) (131) (221) 34 Balance at December 31, 2002 . . . . . . . . . . . . . . . . . $(187) 23 Quarterly financial data – unaudited In millions, except per share data $÷27 120 147 200 347 (27) $320 $÷«– 94 94 (94) – – $÷«– $÷«– – – (25) (25) 45 $«20 $÷«– – – (11) (11) (13) $(24) $÷«– – – (32) (32) – $(32) $÷«(6) 157 151 (93) 58 39 $÷97 Revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Operating income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,509 $÷«406 $÷«230 $1,551 $÷«490 $÷«280 $1,503 $÷«484 $÷«268 $1,547 $÷«÷89 $÷«÷22 $1,398 $÷«385 $÷«275 $1,392 $÷«346 $÷«217 2002 2001 First Second Third Fourth (1) First Second Third $1,325 $÷«430 $÷«252 Fourth $1,537 $÷«521 $÷«296 Basic earnings per share. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $÷1.19 $÷1.44 $÷1.34 $÷0.11 $÷1.44 $÷1.13 $÷1.31 $÷1.54 Diluted earnings per share . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $÷1.15 $÷1.39 $÷1.32 $÷0.11 $÷1.39 $÷1.10 $÷1.27 $÷1.48 Dividend declared per share . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $0.215 $0.215 $0.215 $0.215 $0.195 $0.195 $0.195 $0.195 (1) In the fourth quarter of 2002, the Company recorded a charge of $281 million ($173 million after tax) to increase its liability for U.S. personal injury and other claims and a charge for workforce reductions of $120 million ($79 million after tax). 24 Comparative figures Certain figures, previously reported for 2001 and 2000, have been reclassified to conform with the basis of presentation adopted in the current year. 72 Canadian National Railway Company U.S. GAAP Financial Section (Canadian GA AP) Contents Canadian National Railway Company The CN Pension Plan and the CN 1935 Pension Plan 74 Management’s Discussion and Analysis 93 Management Report Auditors’ Report 93 Consolidated Statement of Income 94 Consolidated Balance Sheet 95 Consolidated Statement of Changes in 96 Shareholders’ Equity Consolidated Statement of Cash Flows 97 118 119 120 120 121 122 123 General Review Trustee’s Report Actuary’s Report Auditors’ Report Consolidated Statement of Net Assets at Market Value Consolidated Statement of Changes in Net Assets at Market Value Notes to Consolidated Financial Statements Notes to Consolidated Financial Statements 98 100 102 102 103 103 103 104 104 105 106 106 108 109 109 109 109 110 110 111 113 114 117 117 1 Summary of significant accounting policies 2 Accounting changes 3 Acquisition of Wisconsin Central Transportation Corporation 4 Accounts receivable 5 Properties 6 Other assets and deferred charges 7 Credit facilities 8 Accounts payable and accrued charges 9 Other liabilities and deferred credits 10 Long-term debt 11 Capital stock and convertible preferred securities 12 Stock plans 13 Pensions 14 Workforce reduction charges 15 Interest expense 16 Other income 17 Income taxes 18 Segmented information 19 Earnings per share 20 Major commitments and contingencies 21 Financial instruments 22 Reconciliation of Canadian and United States generally accepted accounting principles 23 Quarterly financial data – unaudited 24 Comparative figures Canadian GAAP Canadian National Railway Company 73 Management ’s Discussion and Analysis Management’s discussion and analysis (MD&A) relates to the financial condition and results of operations of Canadian National Railway Company (CN) together with its wholly owned subsidiaries, including Grand Trunk Corporation (GTC), Illinois Central Corporation (IC) and Wisconsin Central Transportation Corporation (WC), the latter from October 9, 2001. As used herein, the word “Company” means, as the context requires, CN and its subsidiaries. CN’s common shares are listed on the Toronto and New York stock exchanges. Except where otherwise indi- cated, all financial information reflected herein is expressed in Canadian dollars and determined on the basis of Canadian generally accepted accounting principles (Canadian GAAP). This MD&A should be read in conjunction with the Company’s Consolidated Financial Statements and notes thereto. Financial results 2002 compared to 2001 On October 9, 2001, the Company completed its acquisition of WC and began a phased integration of the companies’ operations. Accordingly, in the following discussion, the Company’s results include the results of operations of WC, which were fully integrated into those of the Company in 2002. The Company recorded consolidated net income of $571 million ($2.87 per basic share) for the year ended December 31, 2002 compared to $727 million ($3.72 per basic share) for the year ended December 31, 2001. Diluted earnings per share were $2.82 for the current year com- pared to $3.62 in 2001. Operating income was $1,116 million for 2002 compared to $1,366 million in 2001. The years ended December 31, 2002 and 2001 included items impacting the comparability of the results of operations. Included in 2002 is a fourth quarter charge of $281 million, or $173 million after tax, to increase the Company’s provision for U.S. personal injury and other claims, and a charge for workforce reductions of $120 million, or $79 million after tax. In 2001, the Company recorded a charge for workforce reduc- tions of $98 million, or $62 million after tax, a charge to write down the Company’s net investment in 360networks Inc. of $99 million, or $77 mil- lion after tax and a gain of $101 million, or $82 million after tax related to the sale of the Company’s 50 percent interest in the Detroit River Tunnel Company (DRT). Excluding the effects of the items discussed in the preceding para- graph, adjusted consolidated net income(1) was $823 million ($4.15 per basic share or $4.07 per diluted share) in 2002 compared to $784 million ($4.02 per basic share or $3.90 per diluted share) in 2001, an increase of $39 million, or 5%. Adjusted operating income,(1) which excludes the 2002 charge to increase the Company’s provision for U.S. personal injury and other claims and the 2002 and 2001 workforce reduction charges, increased by $53 million, or 4%, to $1,517 million. The adjusted operating ratio was 75.2% in 2002 compared to 74.1% in 2001, a 1.1-point increase. (1) The Company’s results of operations include items affecting the comparability of results. Management believes adjusted consolidated net income and the resulting adjusted performance measures for such items as operating income, operating ratio, per share data and other statistical measures are useful measures of performance that facilitate period-to-period comparisons. These adjusted measures do not have any standardized meaning prescribed by GAAP and are not necessarily comparable to similar measures presented by other companies, and therefore, should not be considered in isolation. Revenues Revenues for the year ended December 31, 2002 totaled $6,110 million compared to $5,652 million in 2001. The increase of $458 million, or 8%, was mainly due to the inclusion of a full year of revenues attributable to the operations of WC in 2002. In addition, revenue gains were made in petroleum and chemicals, automotive, intermodal and forest products. These overall increases in revenues were partly offset by continued weakness in Canadian grain, coal, and metals and minerals. Revenue ton miles increased by 4% relative to 2001 and freight revenue per revenue ton mile increased by 4%. Year ended December 31, 2002 2001 2002 2001 2002 2001 Petroleum and chemicals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,102 521 Metals and minerals. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Forest products . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Coal . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Grain and fertilizers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Intermodal . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Automotive . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,323 326 986 1,052 591 Other items * . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $6,110 209 * Principally non-freight revenues derived from third parties. Revenues Revenue ton miles In millions Freight revenue per revenue ton mile In cents $÷«923 458 1,088 338 1,161 969 520 195 30,006 13,505 33,551 14,503 35,773 29,257 3,281 – 25,243 10,777 29,639 15,566 42,728 26,257 2,885 – $5,652 159,876 153,095 3.67 3.86 3.94 2.25 2.76 3.60 18.01 – 3.69 3.66 4.25 3.67 2.17 2.72 3.69 18.02 – 3.56 74 Canadian National Railway Company Canadian GAAP Management ’s Discussion and Analysis Petroleum and chemicals Revenues for the year ended December 31, 2002 increased by $179 mil- lion, or 19%, over 2001. Growth was mainly due to the inclusion of a full year of revenues attributable to the operations of WC in 2002, strong sulfur traffic to the United States and offshore markets and market share gains in various sectors. The revenue per revenue ton mile remained rela- tively unchanged for the year as the effect of the weaker Canadian dollar was offset by an increase in the average length of haul for non-WC traffic. Forest products Revenues for the year ended December 31, 2002 increased by $235 mil- lion, or 22%, over 2001. Growth was mainly due to the inclusion of a full year of revenues attributable to the operations of WC in 2002, a strong North American housing market and improving pulp and paper markets. Also contributing to growth in the second half of the year were strong lumber shipments from CN’s western lumber producers. The increase in revenue per revenue ton mile of 7% was mainly due to the effect of the weaker Canadian dollar and the inclusion of shorter haul WC traffic. In thousands 0 0 6 Petroleum and chemicals Forest products Percentage of revenues Carloads* In thousands Percentage of revenues Carloads* 5 8 4 4 9 4 2 1 5 9 1 5 7 8 5 46% 54% 54% Petroleum and plastics 46% Chemicals 98 99 00 01 02 12% 31% 28% 29% 31% Lumber 29% Fibers 28% Paper 12% Panels 9 7 4 1 8 4 6 8 4 1 0 5 98 99 00 01 02 *Includes WC from October 9, 2001 *Includes WC from October 9, 2001 Metals and minerals Revenues for the year ended December 31, 2002 increased by $63 mil- lion, or 14%, over 2001. The increase was mainly due to the inclusion of a full year of revenues attributable to the operations of WC in 2002, market share gains in the non-ferrous segment, particularly aluminum, and strong construction materials traffic. Partly offsetting these gains were the effects of weak steel markets in the first half of the year, one-time gains in 2001 and reduced traffic in specific segments due to ongoing customer strikes. Revenue per revenue ton mile decreased by 9% over 2001 mainly due to an increase in longer haul traffic and the inclusion of certain lower rated WC traffic. Coal Revenues for the year ended December 31, 2002 decreased by $12 mil- lion, or 4%, from 2001. The decrease was mainly attributable to weak Canadian coal exports to offshore markets and reduced demand from power utilities in the first half of the year. The revenue per revenue ton mile increase of 4% was mainly due to a decrease in longer haul traffic. Metals and minerals Coal Percentage of revenues Carloads* In thousands Percentage of revenues Carloads* In thousands 8 8 3 3 7 2 6 6 2 6 5 2 7 8 2 31% 69% 14% 86% 4 3 5 8 5 5 8 2 5 7 1 5 9 9 4 69% Metals 31% Minerals 98 99 00 01 02 86% Coal 14% Petroleum coke 98 99 00 01 02 *Includes WC from October 9, 2001 *Includes WC from October 9, 2001 Canadian GAAP Canadian National Railway Company 75 Management ’s Discussion and Analysis Grain and fertilizers Revenues for the year ended December 31, 2002 decreased by $175 mil- lion, or 15%, from 2001. The decrease reflects a significant deterioration in the Canadian grain crop, a decline in U.S. originated traffic and the loss of a potash move. Revenue per revenue ton mile increased by 1% mainly as a result of an increase in regulated grain rates. Automotive Revenues for the year ended December 31, 2002 increased by $71 mil- lion, or 14%, over 2001. The increase reflects strong motor vehicle pro- duction in both Canada and the United States. Revenue per revenue ton mile remained relatively unchanged for the year as the effect of the weaker Canadian dollar was offset by an increase in the average length of haul. Grain and fertilizers Automotive Percentage of revenues Carloads* In thousands Percentage of revenues Carloads* In thousands 7 3 5 2 4 5 7 6 5 0 9 5 5 3 5 13% 14% 26% 22% 25% 6 2 3 0 1 3 4 0 3 8 1 3 7 5 2 17% 83% 26% Oil seeds 25% Food grain 22% Feed grain 14% Potash 13% Fertilizers 98 99 00 01 02 83% Finished vehicles 17% Auto parts 98 99 00 01 02 *Includes WC from October 9, 2001 *Includes WC from October 9, 2001 Intermodal Revenues for the year ended December 31, 2002 increased by $83 mil- lion, or 9%, over 2001. Growth in the international segment was driven by market share gains by steamship lines served by CN. The domestic segment benefited from growing North American markets, particularly in Canada. Revenue per revenue ton mile decreased by 2%, mainly due to a higher average fuel surcharge in 2001 and an increase in the average length of haul. Intermodal Percentage of revenues Carloads* In thousands 7 3 2 , 1 1 2 1 , 1 3 0 1 , 1 4 9 9 8 1 9 43% 57% 57% Domestic 43% International 98 99 00 01 02 *Includes WC from October 9, 2001 76 Canadian National Railway Company Canadian GAAP Management ’s Discussion and Analysis Operating expenses Operating expenses amounted to $4,994 million in 2002 compared to $4,286 million in 2001. The increase was mainly due to the inclusion of a full year of expenses attributable to the operations of WC in 2002, higher Casualty and other expenses resulting primarily from the 2002 charge to increase the Company’s provision for U.S. personal injury and other claims, and increased expenses for labor and fringe benefits that included a higher workforce reduction charge in 2002 compared to 2001. These increases were partly offset by lower fuel costs. Operating expenses, excluding the 2002 charge for U.S. personal injury and other claims and the 2002 and 2001 workforce reduction charges, amounted to $4,593 million, an increase of $405 million, or 10%, from 2001.(1) Dollars in millions Year ended December 31, 2002 2001 Labor and fringe benefits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2,051 908 Purchased services and material . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Depreciation and amortization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Fuel . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Equipment rents . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 499 459 353 Casualty and other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $4,994 724 Amount % of revenue 33.6% 14.9% 8.1% 7.5% 5.8% 11.8% % of revenue 32.0% 14.4% 8.2% 8.6% 5.5% 7.1% Amount $1,810 811 463 485 314 403 $4,286 Labor and fringe benefits: Labor and fringe benefit expenses in 2002 increased by $241 million, or 13%, as compared to 2001. The increase was mainly due to the inclusion of a full year of expenses attributable to the operations of WC in 2002, a higher workforce reduction charge in 2002, wage increases, and higher benefit expenses, including health and welfare, particularly in the U.S. These increases were partly offset by the effects of a reduced workforce in 2002. In 2002, the Company announced 1,146 job reductions across all corporate and operating functions in a renewed drive to improve produc- tivity and recorded a workforce reduction charge of $120 million. Reductions relating to this and the 2001 workforce reduction charge were 388 in 2001, 433 in 2002, with the remainder to be completed by the end of 2003. The charges included payments for severance, early retirement incentives and bridging to early retirement, to be made to affected employees. Purchased services and material: These costs increased by $97 million, or 12%, in 2002 as compared to 2001. The increase was mainly due to the inclusion of a full year of expenses attributable to the operations of WC in 2002 and higher expenses for professional services and joint facil- ities. These increases were partly offset by reduced expenses for crew transportation and lodging in 2002. Depreciation and amortization: Depreciation and amortization expense in 2002 increased by $36 million, or 8%, as compared to 2001. The increase was mainly due to the inclusion of a full year of expenses attrib- utable to the operations of WC in 2002 and the impact of net capital additions in the current year. Fuel: Fuel expense in 2002 decreased by $26 million, or 5%, as compared to 2001. The decrease was primarily due to a lower average price of fuel, partially offset by the inclusion of a full year of expenses attributable to the operations of WC in 2002. Equipment rents: These expenses increased by $39 million, or 12%, in 2002 as compared to 2001. The increase was mainly due to the inclusion of a full year of expenses attributable to the operations of WC in 2002 and lower car hire income, partly offset by reduced expenses for long- term operating leases. Casualty and other: These expenses increased by $321 million, or 80%, in 2002 as compared to 2001. The increase was mainly due to higher expenses for personal injury and other claims which included a fourth quarter 2002 charge of $281 million to increase the provision for U.S. personal injury and other claims, and higher derailment related expenses. Partly offsetting these increases were lower expenses related to environ- mental matters and bad debts. Canadian GAAP Canadian National Railway Company 77 Management ’s Discussion and Analysis Other Interest expense: Interest expense increased by $41 million to $353 mil- lion for the year ended December 31, 2002 as compared to 2001. The increase was mainly due to the financing related to the acquisition of WC and the inclusion of a full year of WC expenses in 2002. Partly offset- ting these increases was the maturity of certain notes in 2001. Other income: In 2002, the Company recorded other income of $76 mil- lion compared to $65 million in 2001. The increase was mainly due to the inclusion of a full year of equity in earnings of English Welsh and Scottish Railway (EWS) in 2002 partly offset by lower gains on disposal of properties. Included in 2001 was a charge of $99 million to write down the Company’s net investment in 360networks Inc. and a gain of $101 million related to the sale of the Company’s 50 percent interest in DRT. Income tax expense: The Company recorded income tax expense of $268 million for the year ended December 31, 2002 compared to $392 million in 2001. The effective tax rate for the year ended December 31, 2002 decreased to 31.9% from 35.0% in 2001, due mainly to lower income tax rates in Canada. 2001 compared to 2000 The Company recorded consolidated net income of $727 million ($3.72 per basic share) for the year ended December 31, 2001 compared to $774 million ($3.91 per basic share) for the year ended December 31, 2000. Diluted earnings per share were $3.62 for 2001 compared to $3.82 in 2000. The results for 2001 include net income of $11 million related to the acquisition of WC. Operating income was $1,366 million for 2001 compared to $1,385 million in 2000. This represents a decrease of $19 million, or 1%. The years ended December 31, 2001 and 2000 included items impacting the comparability of the results of operations. Included in 2001 is a charge for workforce reductions of $98 million, or $62 million after tax, a charge to write down the Company’s net investment in 360networks Inc. of $99 million, or $77 million after tax and a gain of $101 million, or $82 million after tax related to the sale of the Company’s 50 percent interest in DRT. In 2000, the Company recorded a gain of $84 million, or $58 million after tax related to the exchange of its minority equity investments in certain joint venture companies for 11.4 million shares of 360networks Inc. Excluding the effects of the items discussed in the preceding para- graph, adjusted consolidated net income (1) was $784 million ($4.02 per basic share or $3.90 per diluted share) in 2001 compared to $716 million ($3.61 per basic share or $3.54 per diluted share) in 2000. Adjusted operating income,(1) which excludes the 2001 charge for workforce reduc- tions, increased by $79 million, or 6%, to $1,464 million. The adjusted operating ratio, which excludes the 2001 charge for workforce reduc- tions, improved to 74.1% in 2001 from 74.6% in 2000, a half-point bet- terment. Revenues Revenues for the year ended December 31, 2001 totaled $5,652 million compared to $5,446 million in 2000. The increase of $206 million, or 4%, was mainly attributable to the inclusion of $129 million of WC revenues and to gains in metals and minerals, intermodal, forest products and grain and fertilizers. This was partially offset by lower automotive rev- enues. Revenue ton miles and freight revenue per revenue ton mile each increased by 2% as compared to 2000. Year ended December 31, 2001 2000 2001 2000 2001 2000 Revenues Revenue ton miles In millions Freight revenue per revenue ton mile In cents Petroleum and chemicals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Metals and minerals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Forest products . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Coal. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Grain and fertilizers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Intermodal . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Automotive . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other items *. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $÷923 458 1,088 338 1,161 969 520 195 $÷«894 392 1,008 328 1,136 919 559 210 25,243 10,777 29,639 15,566 42,728 26,257 2,885 – 24,858 9,207 28,741 15,734 42,396 25,456 3,165 – Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $5,652 $5,446 153,095 149,557 3.66 4.25 3.67 2.17 2.72 3.69 18.02 – 3.56 3.60 4.26 3.51 2.08 2.68 3.61 17.66 – 3.50 * Principally non-freight revenues derived from third parties. 78 Canadian National Railway Company Canadian GAAP Management ’s Discussion and Analysis Petroleum and chemicals Revenues for the year ended December 31, 2001 increased by $29 mil- lion, or 3%, over 2000 of which $22 million resulted from the inclusion of WC revenues. Excluding WC, growth in 2001 was driven by market share gains and plant expansions in the petroleum products sector, increased salt traffic, mainly in the early part of the year, and the weaker Canadian dollar. Significant weakness in sulfur demand partially offset these increases. The revenue per revenue ton mile increase of 2% for 2001 was mainly attributable to the effect of the weaker Canadian dollar. Metals and minerals Revenues for the year ended December 31, 2001 increased by $66 mil- lion, or 17%, over 2000 of which $22 million resulted from the inclusion of WC revenues. Excluding WC, growth in 2001 was driven by strong Canadian aluminum exports to the United States in line with weaker U.S. production, increased levels of equipment traffic, market share gains in steel, ores and concentrates, and increased stone and rock shipments to the United States. Significant weakness in the steel markets partially offset overall growth. Revenue per revenue ton mile was essentially flat year over year. Forest products Revenues for the year ended December 31, 2001 increased by $80 mil- lion, or 8%, over 2000 of which $55 million resulted from the inclusion of WC revenues. Excluding WC, growth was driven by market share gains in the panels segment and the effect of the weaker Canadian dollar. These gains were partially offset by weakness in the pulp and paper markets due, in part, to a significant reduction in U.S. paper consumption. The increase in revenue per revenue ton mile of 5% was mainly due to the effect of the weaker Canadian dollar and the inclusion of shorter haul WC traffic. Coal Revenues for the year ended December 31, 2001 increased by $10 mil- lion, or 3%, over 2000 of which $7 million resulted from the inclusion of WC revenues. Excluding WC, strong demand for thermal coal in 2001 was partially offset by reduced shipments of metallurgical coal due to the closure of some Canadian mines in 2000. The revenue per revenue ton mile increase of 4% was mainly due to an increase in rates tied to commodity prices and the effect of the weaker Canadian dollar. Grain and fertilizers Revenues for the year ended December 31, 2001 increased by $25 mil- lion, or 2%, over 2000 of which $15 million resulted from the inclusion of WC revenues. Excluding WC, growth was mainly driven by higher wheat shipments to the United States, increased market share of U.S. corn and soybean traffic and higher exports of canola through Vancouver. The 1% increase in revenue per revenue ton mile was mainly due to a shift to shorter haul traffic and the effect of the weaker Canadian dollar, partially offset by the introduction of the Canadian grain revenue cap in August 2000. Intermodal Revenues for the year ended December 31, 2001 increased by $50 mil- lion, or 5%, over 2000 of which $7 million resulted from the inclusion of WC revenues. Excluding WC, growth was driven by market share gains in the international segment and from new service offerings in the domestic segment. Weaker economic conditions in the second half of 2001 led to slower growth. Revenue per revenue ton mile increased by 2% due to rate increases and the effect of the weaker Canadian dollar, partially offset by a shift to longer haul traffic. Automotive Revenues for the year ended December 31, 2001 decreased by $39 mil- lion, or 7%, from 2000. The revenue decline resulted from weakness in North American vehicle production in 2001 and from one-time gains obtained in 2000 due, in part, to competitors’ service problems. The decline was partially offset by the effect of the weaker Canadian dollar. The increase in revenue per revenue ton mile of 2% was mainly due to the weaker Canadian dollar partially offset by an increase in the average length of haul. Canadian GAAP Canadian National Railway Company 79 Management ’s Discussion and Analysis Operating expenses Operating expenses amounted to $4,286 million in 2001 compared to $4,061 million in 2000. The increase in 2001 was mainly due to the inclusion of $95 million of WC expenses, higher labor and fringe benefit expenses that included a charge for workforce reductions of $98 million, increased depreciation and amortization expense, higher fuel costs, and increased expenses for equipment rents and casualty and other. Partially offsetting these increases were lower expenses for purchased services and material. Operating expenses, excluding the workforce reduction charge, amounted to $4,188 million, an increase of $127 million, or 3%, from 2000.(1) Dollars in millions Year ended December 31, 2001 2000 Labor and fringe benefits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Purchased services and material . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Depreciation and amortization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Fuel . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Equipment rents . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Casualty and other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Amount $1,810 811 463 485 314 403 $4,286 % of revenue 32.0% 14.4% 8.2% 8.6% 5.5% 7.1% % of revenue 30.7% 15.8% 7.6% 8.3% 5.3% 6.9% Amount $1,674 858 412 450 291 376 $4,061 Labor and fringe benefits: Labor and fringe benefit expenses in 2001 increased by $136 million, or 8%, as compared to 2000. The increase was mainly attributable to the workforce reduction charge, the inclusion of WC labor expense of $46 million, wage increases and the impact of the weaker Canadian dollar on U.S. denominated expenses. This was partially offset by lower pension and other benefit related expenses. The Company recorded a workforce reduction charge of $98 million in the second quarter of 2001 for the reduction of 690 positions (388 occurred in 2001 and the remainder was completed by the end of 2002). The charge included payments for severance, early retirement incentives and bridging to early retirement, to be made to affected employees. Purchased services and material: These expenses decreased by $47 mil- lion, or 5%, in 2001 as compared to 2000. The decrease was mainly due to one-time consulting and professional fees related to a proposed com- bination in 2000, lower contracted services and higher recoveries in 2001 from work performed for third parties. This was partially offset by higher equipment repair and maintenance expenses and $15 million resulting from the inclusion of WC expenses. Depreciation and amortization: Depreciation and amortization expense in 2001 increased by $51 million, or 12%, as compared to 2000. The increase was mainly due to net capital additions and the inclusion of WC depreciation of $10 million. Fuel: Fuel expense in 2001 increased by $35 million, or 8%, as compared to 2000, primarily due to an increase in the average cost of fuel and the inclusion of $10 million of WC fuel expense. Equipment rents: These expenses increased by $23 million, or 8%, in 2001 as compared to 2000. The increase was mainly attributable to lower lease and offline car hire income and the inclusion of $6 million of WC equipment rents. This was partially offset by lower private car mileage payments. Casualty and other: These expenses increased by $27 million, or 7%, in 2001 as compared to 2000. The increase resulted from higher expenses for occupational disease claims and environmental matters, higher provincial capital taxes and the inclusion of $8 million of WC expenses. This was partially offset by lower expenses for damaged equipment and merchandise claims and provincial sales tax recoveries in 2001. 80 Canadian National Railway Company Canadian GAAP Management ’s Discussion and Analysis Other Interest expense: Interest expense increased by $17 million to $312 mil- lion for the year ended December 31, 2001 as compared to 2000. The increase was mainly due to the financing related to the acquisition of WC, the inclusion of $4 million of WC interest expense, and the impact of the weaker Canadian dollar on U.S. denominated interest costs. This was, in part, offset by the refinancing of a portion of matured debt at lower rates. Other income: In 2001, the Company recorded other income of $65 mil- lion compared to $126 million in 2000. Included in 2001 is a charge of $99 million to write down the Company’s net investment in 360networks Inc., a gain of $101 million related to the sale of the Company’s 50 per- cent interest in DRT and $11 million of WC other income. The comparative 2000 period included an $84 million gain related to the 360networks Inc. transaction. Income tax expense: The Company recorded an income tax expense of $392 million for the year ended December 31, 2001 compared to $442 million in 2000. The effective tax rate for the year ended December 31, 2001 decreased to 35.0% from 36.3% in 2000 due mainly to lower tax rates in 2001. Liquidity and capital resources Investing activities: Cash used by investing activities in 2002 amounted to $476 million compared to $1,764 million in 2001. The Company’s investing activities in 2002 included aggregate net proceeds of $69 mil- lion from the sale of its investments in Tranz Rail Holdings Limited and Australian Transport Network Limited, and $28 million from the sale of IC Terminal Holdings Company. Investing activities in 2001 included $1,278 million related to the acquisition of WC as at October 9, 2001 and net proceeds of $112 million from the sale of DRT. Net capital expen- ditures for the year ended December 31, 2002 amounted to $571 million, including $27 million related to WC, a decrease of $34 million over 2001. Net capital expenditures included expenditures for roadway renewal, rolling stock, and other capacity and productivity improvements. The Company anticipates that capital expenditures for 2003 will remain at approximately the same level as 2002. This will include funds required for ongoing renewal of the basic plant and other acquisitions and investments required to improve the Company’s operating efficiency and customer service. As at December 31, 2002, the Company had commitments to acquire railroad ties, rail, freight cars and locomotives at an aggregate cost of $183 million. Dividends: During 2002, the Company paid dividends totaling $179 mil- lion to its shareholders at the quarterly rate of $0.215 per share on the common shares and 5.25% per year on the convertible preferred securities. The Company’s principal source of liquidity is cash generated from oper- ations. The Company also has the ability to fund liquidity requirements through its revolving credit facility, the issuance of debt and/or equity, and the sale of a portion of its accounts receivable through its Accounts receivable securitization program. In addition, from time to time, the Company’s liquidity requirements can be supplemented by the disposal of surplus properties and the monetization of assets. Operating activities: Cash provided from operating activities was $1,173 million for the year ended December 31, 2002 compared to $1,232 mil- lion for 2001. Cash generated in 2002 was partially consumed by payments for interest, workforce reductions and personal injury and other claims of $390 million, $177 million and $156 million, respectively, compared to $307 million, $169 million and $149 million, respectively in 2001. Pension contributions and payments for income taxes were $92 million and $65 million, respectively, compared to $69 million and $63 million, respectively in 2001. The Company increased the level of accounts receiv- able sold under its Accounts receivable securitization program by $5 mil- lion in 2002 and $133 million in 2001. Payments in 2003 for workforce reductions are expected to be $168 million while pension contributions are expected to be approximately $92 million. Free cash flow The Company generated $513 million of free cash flow for the year ended December 31, 2002, compared to $439 million for the same 2001 period, excluding $1,278 million related to the 2001 acquisition of WC. The Company defines free cash flow as cash provided from operating activities, excluding increases in the level of accounts receivable sold under the securitization program ($5 million in 2002, $133 million in 2001), less capital expenditures, other investing activities and dividends paid. Financing activities: Cash used by financing activities totaled $546 mil- lion for the year ended December 31, 2002 compared to cash generated of $740 million in 2001. In 2002, issuances and repayments of long-term debt related principally to the Company’s commercial paper and revolv- ing credit facilities. In 2001, the Company issued debt securities in two series, U.S.$400 million (Cdn$629 million) 6.375% Notes due 2011 and U.S.$200 million (Cdn$314 million) 7.375% Debentures due 2031, related to the acquisition of WC. In 2002, $203 million was used to repurchase common shares under the share repurchase program. In 2001, the Company also had a share repurchase program, under which it did not repurchase any common shares. Canadian GAAP Canadian National Railway Company 81 Management ’s Discussion and Analysis During 2002, the Company recorded $114 million in capital lease obligations ($91 million in 2001) related to new equipment and the exercise of purchase options on existing equipment. The Company has access to various financing arrangements: Shelf registration statement At December 31, 2002, the Company had U.S.$400 million remaining for issuance under its shelf registration statement, which expires in August 2003. Accounts receivable securitization program The sale of a portion of the Company’s accounts receivable is conducted under a securitization program, which has a $350 million maximum limit and will expire in June 2003. The program is subject to customary credit rating and reporting requirements. In the event the program is terminated before its scheduled maturity, the Company expects to have sufficient liquidity remaining in its revolving credit facility to meet its payment obligations. The Company intends to renew or replace the program upon expiration. At December 31, 2002, pursuant to the agreement, $173 mil- lion and U.S.$113 million (Cdn$177 million) had been sold on a limited recourse basis, an increase of $5 million from the level of accounts receivable sold at December 31, 2001. The Receivables Purchase Agreement provides for customary indem- nification provisions, which survive for a period of two years following the final purchase of any receivable, three years from the final collection date or until statute barred, in the case of taxes. As at December 31, 2002, the Company has not recorded a liability associated with these indemni- fications, for which there is no monetary limitation, as the Company does not expect to make any payments pertaining to the indemnifications of this program. Although there is no monetary limitation with respect to these indemnifications, the Company would not expect the amount to exceed the maximum limit under the program. Revolving credit facilities In December 2002, the Company entered into a U.S.$1,000 million three- year revolving credit facility and concurrently terminated its previous revolving credit facilities before their scheduled maturity in March 2003. The credit facility provides for borrowings at various interest rates, plus applicable margins, and contains customary financial covenants. Throughout the year, the Company was in compliance with all financial covenants contained in its outstanding revolving credit agreements. The Company’s borrowings of U.S.$172 million (Cdn$273 million) outstanding at December 31, 2001 were entirely repaid in the first quarter of 2002. At December 31, 2002, the Company had borrowings under its revolving credit facility of U.S.$90 million (Cdn$142 million) at an average interest rate of 1.77%. Outstanding letters of credit under the previous facilities were transferred into the current facility. As at December 31, 2002, letters of credit under the revolving credit facility amounted to $295 million. Commercial paper The Company has a commercial paper program, which is backed by a portion of its revolving credit facility, enabling it to issue commercial paper up to a maximum aggregate principal amount of $600 million, or the U.S. dollar equivalent. Commercial paper debt is due within one year but has been classified as long-term debt, reflecting the Company’s intent and contractual ability to refinance the short-term borrowing through subsequent issuances of commercial paper or drawing down on the long-term revolving credit facility. As at December 31, 2002, the Company had outstanding commercial paper of U.S.$136 million (Cdn$214 million) compared to U.S.$213 million (Cdn$339 million) as at December 31, 2001. 82 Canadian National Railway Company Canadian GAAP Management ’s Discussion and Analysis Contractual obligations and commercial commitments In the normal course of business, the Company incurs contractual obligations and commercial commitments. The following tables set forth material obligations and commitments as of December 31, 2002: Contractual obligations Total In millions Debentures and notes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $4,167 1,424 Capital leases and other(a) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Long-term debt. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,591 Operating leases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total obligations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $6,745 1,154 Commercial commitments In millions Standby letters of credit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other commercial commitments(b). . . . . . . . . . . . . . . . . . . . . . . . . . . . Total commitments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total $403 183 $586 2003 $394 180 574 212 $786 2003 $401 112 $513 2004 $419 141 560 188 $748 2004 $÷1 71 $72 2005 $158 444 602 167 $769 2006 $394 46 440 139 $579 2007 $÷79 90 169 120 $289 2008 and thereafter $2,723 523 3,246 328 $3,574 2005 2006 2007 2008 and thereafter $– – $– $1 – $1 $– – $– $– – $– (a) Excludes $498 million of imputed interest on capital leases at rates ranging from approximately 3.0% to 14.6%. (b) Includes commitments for railroad ties, rail, freight cars and locomotives. For 2003 and the foreseeable future, the Company expects cash flow from operations and from its various sources of financing to be sufficient to meet its debt repayments and future obligations, and to fund anticipated capital expenditures. Guarantees Guarantee of residual values of operating leases The Company has guaranteed a portion of the residual values of certain of its assets under operating leases with expiry dates between 2004 and 2012, for the benefit of the lessor. If the fair value of the assets, at the end of their respective lease term, is less than the fair value, as estimated at the inception of the lease, then the Company must, under certain con- ditions, compensate the lessor for the shortfall. The maximum exposure in respect of these guarantees is $63 million. As at December 31, 2002, the Company has not recorded a liability associated with these guarantees, as the Company does not expect to make any payments pertaining to the guarantees of these leases. Standby letters of credit The Company, including certain of its subsidiaries, has granted irrevocable standby letters of credit, issued by highly rated banks, to third parties to indemnify them in the event the Company does not perform its contractual obligations. As at December 31, 2002, the maximum potential liability under these letters of credit was $403 million of which $334 million was for workers’ compensation and other employee benefits and $69 million was for equipment under leases and other. As at December 31, 2002, the Company has not recorded a liability with respect to these guarantees, as the Company does not expect to make any payments in excess of what is recorded on the Company’s financial statements for the aforementioned items. The standby letters of credit mature at various dates between 2003 and 2007. Indemnifications CN Pension Plan and CN 1935 Pension Plan The Company has indemnified and held harmless the current trustee and the former trustee of the Canadian National Railways Pension Trust Funds, and the respective officers, directors, employees and agents of such trustees, from any and all taxes, claims, liabilities, damages, costs and expenses arising out of the performance of their obligations under the relevant trust agreements and trust deeds, including in respect of their reliance on authorized instructions of the Company or for failing to act in the absence of authorized instructions. These indemnifications survive the termination of such agreements or trust deeds. As at December 31, 2002, the Company has not recorded a liability associated with these indem- nifications, as the Company does not expect to make any payments pertaining to these indemnifications. Canadian GAAP Canadian National Railway Company 83 Management ’s Discussion and Analysis Share repurchase program On October 22, 2002, the Board of Directors of the Company approved a share repurchase program which allows for the repurchase of up to 13.0 million common shares between October 25, 2002 and October 24, 2003 pursuant to a normal course issuer bid, at prevailing market prices. As at December 31, 2002, $203 million was used to repurchase 3.0 mil- lion common shares at an average price of $67.68 per share. Termination of conversion rights of 5.25% convertible preferred securities (“Securities”) On May 6, 2002, the Company met the conditions required to terminate the Securities holders’ right to convert their Securities into common shares of the Company, and set the conversion termination date as July 3, 2002. The conditions were met when the Company’s common share price exceeded 120% of the conversion price of U.S.$38.48 per share for a specified period, and all accrued interest on the Securities had been paid. On July 3, 2002, Securities that had not been previously surren- dered for conversion were deemed converted, resulting in the issuance of 6.0 million common shares of the Company. Acquisition of Wisconsin Central Transportation Corporation On October 9, 2001, the Company completed its acquisition of WC for an acquisition cost of $1,301 million (U.S.$833 million) and began a phased integration of the companies’ operations. The Company accounted for the merger using the purchase method of accounting as required by the Canadian Institute of Chartered Accountants (CICA) Handbook Section 1581 “Business Combinations.” As such, the Company’s consolidated financial statements include the assets, liabilities and results of operations of WC as of October 9, 2001, the date of acquisition. The Company had estimated, on a preliminary basis, the fair values of the assets and liabilities acquired based on cur- rently available information. In 2002, the Company finalized the allocation of the purchase price and adjusted the preliminary fair values of the assets and liabilities acquired as follows: Current assets decreased by $10 million, Properties increased by $141 million, Other assets and deferred charges decreased by $98 million, Current liabilities increased by $10 million, Deferred income taxes increased by $16 million and Other liabilities and deferred credits increased by $3 million. The increase in Properties and decrease in Other assets and deferred charges was mainly due to the final valuation of the Company’s foreign equity invest- ment. The remaining adjustments resulted from additional information obtained for conditions and circumstances that existed at the time of acquisition. The following table outlines the final fair values of WC’s assets and liabilities acquired: In millions Current assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Properties . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other assets and deferred charges . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total assets acquired . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Current liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Deferred income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other liabilities and deferred credits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Long-term debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total liabilities assumed . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net assets acquired . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $÷«165 2,576 335 3,076 363 «759 181 «472 1,775 $1,301 Recent accounting pronouncements In December 2002, the CICA issued Handbook Section 3063 “Impairment of Long-Lived Assets.” Section 3063 provides accounting guidance for the determination of a long-lived asset impairment as well as recognition, measurement and disclosure of the impairment. This section is effective for the Company’s fiscal year beginning January 1, 2004. The Company does not expect Section 3063 to have an initial material impact on its financial statements upon adoption. Also in December 2002, the CICA issued Handbook Section 3475 “Disposal of Long-Lived Assets and Discontinued Operations.” Section 3475 provides accounting guidance for long-lived assets to be disposed of other than by sale, long-lived assets to be disposed of by sale and presentation and disclosure for discontinued operations. This section is effective for disposal activities initiated by the Company on or after May 1, 2003. The Company does not expect Section 3475 to have an initial material impact on its financial statements upon adoption. 84 Canadian National Railway Company Canadian GAAP Management ’s Discussion and Analysis Critical accounting policies The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of revenues and expenses during the period, the reported amounts of assets and liabili- ties, and the disclosure of contingent assets and liabilities at the date of the financial statements. On an ongoing basis, management reviews its estimates, including those related to personal injury and other claims, environmental matters, depreciation lives, pensions and other post-retire- ment benefits, and income taxes, based upon currently available informa- tion. Actual results could differ from these estimates. The following accounting policies require management’s more significant judgments and estimates in the preparation of the Company’s consolidated financial statements and as such, are considered to be critical. The following infor- mation should be read in conjunction with the Company’s Consolidated Financial Statements and notes thereto. Management has discussed the development and selection of the Company’s critical accounting estimates with the Audit, Finance and Risk Committee of the Company’s Board of Directors and the Audit, Finance and Risk Committee has reviewed the Company’s related disclosures herein. Personal injury and other claims In the normal course of its operations, the Company becomes involved in various legal actions, including claims relating to personal injuries, occupational disease and damage to property. In Canada, employee injuries are governed by the workers’ compen- sation legislation in each province whereby employees may be awarded either a lump sum or future stream of payments depending on the nature and severity of the injury. Accordingly, the Company accounts for costs related to employee work-related injuries based on actuarially developed estimates of the ultimate cost associated with such injuries, including compensation, health care and administration costs. For all other legal actions, the Company maintains, and regularly updates on a case-by-case basis, provisions for such items when the expected loss is both probable and can be reasonably estimated based on currently available information. Assumptions used in estimating the ultimate costs for Canadian employee injury claims consider, among others, the discount rate, the rate of inflation, wage increases and health care costs. The Company periodically reviews its assumptions to reflect currently available infor- mation. Over the past three years, the Company has changed certain of these assumptions, which have not had a material effect on its results of operations. For all other legal claims in Canada, estimates are based on case history, trends and judgment. In the United States, employee work-related injuries, including occu- pational disease claims, are compensated according to the provisions of the Federal Employers’ Liability Act (FELA) and represent a major expense for the railroad industry. The FELA system, which requires either the finding of fault through the U.S. jury system or individual settlements, has contributed to the significant increase in the Company’s personal injury expense in recent years. In view of the Company’s growing pres- ence in the United States and the increase in the number of occupational disease claims over the past few years, an actuarial study was conducted in 2002, and in the fourth quarter of 2002 the Company changed its methodology for estimating its liability for U.S. personal injury and other claims, including occupational disease claims and claims for property damage, from a case-by-case approach to an actuarial-based approach. Consequently, and as discussed in Note 2 to the Consolidated Financial Statements, the Company recorded a charge of $281 million ($173 million after tax) to increase its provision for these claims. Under the actuarial-based approach, the Company accrues the cost for the expected personal injury and property damage claims and existing occupational disease claims, based on actuarial estimates of their ultimate cost. The Company is unable to estimate the total cost for unasserted occupational disease claims. However, a liability for unasserted occupational disease claims is accrued to the extent they are probable and can be reasonably estimated. Under the case-by-case approach, the Company was accruing the cost for claims as incidents were reported based on currently available information. In addition, the Company did not record a liability for unasserted claims, as such amounts could not be reasonably estimated under the case-by-case approach. For the U.S. personal injury and other claims liability, historical claim data is used to formulate assumptions relating to the expected number of claims and average cost per claim (severity) for each year. Changes in any one of these assumptions could materially affect Casualty and other expense as reported in the Company’s results of operations. For example, a 5% change in the number of claims or severity would have the effect of changing the provision by approximately $25 million and the annual expense by approximately $5 million. The Company’s expenses for personal injury and other claims, net of recoveries, and including the above-mentioned charge, were $393 million in 2002 ($78 million in 2001 and $60 million in 2000) and payments for such items were $156 million in 2002 ($149 million in 2001 and $111 million in 2000). As at December 31, 2002, the Company had aggregate reserves for personal injury and other claims of $664 million ($430 million at December 31, 2001). Canadian GAAP Canadian National Railway Company 85 Management ’s Discussion and Analysis Environmental matters Regulatory compliance A risk of environmental liability is inherent in railroad and related trans- portation operations; real estate ownership, operation or control; and other commercial activities of the Company with respect to both current and past operations. As a result, the Company incurs significant compliance and capital costs, on an ongoing basis, associated with environmental regulatory compliance and clean-up requirements in its railroad opera- tions and relating to its past and present ownership, operation or control of real property. Environmental expenditures that relate to current opera- tions are expensed unless they relate to an improvement to the property. Expenditures that relate to an existing condition caused by past operations and which are not expected to contribute to current or future operations are expensed. Known existing environmental concerns The ultimate cost of known contaminated sites cannot be definitely established, and the estimated environmental liability for any given site may vary depending on the nature and extent of the contamination, the available clean-up technique, the Company’s share of the costs and evolving regulatory standards governing environmental liability. As a result, liabilities are recorded based on the results of a four-phase envi- ronmental assessment conducted on a site-by-site basis. A liability is initially recorded at the completion of the second phase and adjusted, if necessary, upon completion of the third and/or fourth phase depending on the facts, as they become known. The initial phase entails an overview of the pertinent site and includes obtaining and reviewing historical data. At the end of the second phase, the presence or absence of contamination is confirmed for those sites identified as a concern in the initial phase. Upon completion of phase three, the extent of the contamination is determined and if necessary, options are developed to monitor, contain or remediate the contamina- tion. In the final phase, the remediation or containment program is put in operation. Cost scenarios are established by external consultants based on extent of contamination and expected costs for remedial efforts. The Company uses these scenarios to estimate the costs related to a particular site. At December 31, 2002, most of the Company’s properties not acquired through recent acquisitions are approaching phase four and therefore costs related to such sites may change based on information as it becomes available. For properties acquired through recent acquisi- tions, the Company obtained assessments from both external and internal consultants and a liability has been accrued based on such assessments. These estimates may change based on information as it becomes available. Unknown existing environmental concerns The Company’s ongoing efforts to identify potential environmental con- cerns that may be associated with its properties may lead to future envi- ronmental investigations, which may result in the identification of additional environmental costs and liabilities. The magnitude of such additional liabilities and costs cannot be reasonably estimated due to: (i) (ii) the lack of specific technical information available with respect to many sites; the absence of any government authority, third-party orders, or claims with respect to particular sites; (iii) the potential for new or changed laws and regulations and for development of new remediation technologies and uncertainty regarding the timing of the work with respect to particular sites; (iv) the ability to recover costs from any third parties with respect to particular sites; and as such, costs related to future remediation will be accrued in the year they become known. Future occurrences In the operation of a railroad, it is possible that derailments, explosions or other accidents may occur that could cause harm to human health or to the environment. As a result, the Company may incur costs in the future, which may be material, to address any such harm, including costs relating to the performance of clean-ups, natural resource damages and compensatory or punitive damages relating to harm to individuals or property. The Company’s expenses relating to environmental matters, net of recoveries, have not been significant in the past three years. Payments for such items were $16 million in 2002 ($14 million in 2001 and $11 million in 2000). As at December 31, 2002, the Company had aggre- gate accruals for environmental costs of $106 million ($112 million at December 31, 2001). The Company anticipates that the majority of the liability will be paid out over the next five years. 86 Canadian National Railway Company Canadian GAAP Management ’s Discussion and Analysis Depreciation lives Railroad properties are carried at cost less accumulated depreciation including asset impairment write-downs. The Company follows the group method of depreciation and, as such, depreciates the cost of railroad properties, less net salvage value, on a straight-line basis over their estimated useful lives. In addition, under the group method of deprecia- tion, the cost of railroad properties, less net salvage value, retired or disposed of in the normal course of business, is charged to accumulated depreciation. Assessing the reasonableness of the estimated useful lives of proper- ties requires judgment and is based on currently available information, including periodic depreciation studies conducted by the Company. The Company’s U.S. properties are subject to comprehensive depreciation studies conducted by external consultants as required by the Surface Transportation Board (STB). Depreciation studies for Canadian properties are not required by regulation and are therefore conducted internally. Studies are performed on specific asset groups on a periodic basis. The studies consider, among others, the analysis of historical retirement data using recognized life analysis techniques, and the forecasting of asset life characteristics. Changes in circumstances, such as technological advances, changes to the Company’s business strategy, changes in the Company’s capital strategy or changes in regulations can result in the actual useful lives differing from the Company’s estimates. A change in the remaining useful life of a group of assets, or their estimated net salvage, will affect the depreciation rate used to amortize the group of assets and thus affect depreciation expense as reported in the Company’s results of operations. A change of one year in the com- posite useful life of the Company’s fixed asset base would impact annual depreciation expense by approximately $12 million. Depreciation studies are a means of ensuring that the assumptions used to estimate the useful lives of particular asset groups are still valid and where they are not, they serve as the basis to establish the new depreciation rates to be used on a prospective basis. In 2001, the Company conducted a comprehensive study for its Canadian properties, which did not have an impact on depreciation expense as the benefit of increased lives was offset by deficiencies in certain accumulated depreci- ation balances. The study conducted in 2000 for the Company’s U.S. properties did not have an impact on depreciation expense. In 2002, the Company recorded total depreciation and amortization expense of $506 million ($469 million in 2001 and $421 million in 2000). At December 31, 2002, the Company had Properties of $16,898 million, net of accumulated depreciation of $6,285 million ($16,723 million in 2001, net of accumulated depreciation of $6,070 million). Pensions and other post-retirement benefits The Company accounts for pension and other post-retirement benefits as required by CICA Handbook Section 3461 “Employee Future Benefits.” Under this accounting standard, assumptions are made regarding the valuation of benefit obligations and performance of plan assets. Deferred recognition of differences between actual results and those assumed is a guiding principle of these standards. This approach allows for a gradual recognition of changes in benefit obligations and plan performance over the expected average remaining service life of the employee group cov- ered by the plans. The following description pertaining to pensions relate generally to the Company’s main pension plan, the CN Pension Plan. The Company’s other pension plans are not significant. For pensions, an actuarial valuation is required at least on a triennial basis. However, for the last 15 years, the Company has conducted an annual actuarial valuation to account for pensions, which uses manage- ment assumptions for the discount rate, the expected long-term rate of return on plan assets and the rate of compensation increase. The Canadian plans have a measurement date of December 31 whereas the U.S. plans have a measurement date of September 30. For pensions and other post-retirement benefits, assumptions are required for, among others, the discount rate, the expected long-term rate of return on plan assets, the rate of compensation increase, health care cost trend rates, mortality rates, employee early retirements, terminations or disability. Changes in these assumptions result in actuarial gains or losses which in accordance with Section 3461, the Company has elected to amortize over the expected average remaining service life of the employee group covered by the plans only to the extent that the unrecognized net actuarial gains and losses are in excess of 10% of the greater of the beginning of year balances of the projected benefit obligation or market-related value of plan assets. The future effect on the Company’s results of operations is dependent on economic conditions, employee demographics, mortality rates and investment performance. The Company sets its discount rate assumption annually to reflect the rates available on high-quality, fixed-income debt instruments with a duration of approximately 11 years, which is expected to match the timing and amount of expected benefit payments. High quality debt instruments are corporate bonds with a rating of AA or better. A discount rate of 6.5%, based on bond yields prevailing at December 31, 2002, was con- sidered appropriate by the Company and is supported by reports issued by third party advisors. A one-percentage-point change in the discount rate would not cause a material change in the Company’s net periodic benefit cost. Canadian GAAP Canadian National Railway Company 87 Management ’s Discussion and Analysis To develop its expected long-term rate of return assumption used in the calculation of net periodic benefit cost applicable to the market- related value of assets, the Company considers both its past experience and future estimates of long-term investment returns and the expected composition of the plans’ assets. The Company has elected to use a market-related value of assets, whereby realized and unrealized capital gains and losses are recognized over a period of five years, while invest- ment and dividend income are recognized immediately. The Company follows a disciplined investment strategy, which limits investments in international companies and prohibits investments in speculative type assets and as such, the Company does not anticipate the expected average rate of return on plan assets to fluctuate materially when com- pared to major capital market indices. During the last ten years ended December 31, 2002, the CN Pension Plan earned an annual average rate of return of 9.6%. The actual and market-related value rates of return on plan assets for the last five years were as follows: Rates of return 2002 2001 Actual . . . . . . . . . . . . . . . . . . . . . . . . Market-related value . . . . . . . . . «(0.3)% 7.4«% (1.4)% 10.2«% 2000 10.5% 13.7% 1999 15.0% 13.8% 1998 12.6% 10.4% For that same period, the Company used a long-term rate of return assumption on the market-related value of plan assets not exceeding 9% to compute net periodic benefit cost. However, given the recent perfor- mance of its plan assets and the equity markets in North America, the Company will, effective for 2003, reduce the expected long-term rate of return on plan assets from 9% to 8% to reflect management’s current view of long-term investment returns. The effect of this change in management’s assumption will be to increase net periodic benefit cost in 2003 by approximately $50 million. Based on the fair value of the assets held as at December 31, 2002, the plan assets are comprised of 1% in cash and short-term investments, 40% in bonds and mortgages, 50% in Canadian and foreign equities and 9% in real estate and oil and gas assets. The long-term asset allocation percent- ages are not expected to differ materially from the current composition. The rate of compensation increase of 4% is another significant assumption in the actuarial model for pension accounting and is deter- mined by the Company based upon its long-term plans for such increases. For other post-retirement benefits, the Company reviews external data and its own historical trends for health care costs to determine the health care cost trend rates. For measurement purposes, the projected health care cost trend rate was 18% in the current year, and it is assumed that the rate will decrease gradually to 8% in 2012 and remain at that level thereafter. A one-percentage-point change in either the rate of compensation increase or the health care cost trend rate would not cause a material change to the Company’s net periodic benefit cost for both pensions and other post-retirement benefits. The latest actuarial valuation of the CN Pension Plan was conducted as at December 31, 2001 and indicated a funding excess. Based on the Pension Plan’s current position, the Company’s contributions are expected to be approximately $75 million in each of 2003, 2004 and 2005. The assumptions discussed above are not expected to have a significant impact on the cash funding requirements of the pension plan in 2003. For pensions, the Company recorded consolidated net periodic bene- fit income of $20 million and $13 million in 2002 and 2001, respectively, and net periodic benefit cost of $6 million in 2000. Consolidated net periodic benefit cost for other post-retirement benefits was $45 million, $35 million, and $25 million in 2002, 2001, and 2000, respectively. At December 31, 2002, the Company’s accrued benefit cost for post-retire- ment benefits other than pensions was $284 million ($258 million at December 31, 2001). In addition, at December 31, 2002, the Company’s consolidated pension benefit obligation and accumulated post-retirement benefit obligation were $11,243 million and $444 million, respectively ($11,156 million and $309 million at December 31, 2001). 88 Canadian National Railway Company Canadian GAAP Management ’s Discussion and Analysis Income taxes The Company follows the asset and liability method of accounting for income taxes. Under the asset and liability method, the change in the net deferred income tax asset or liability is included in the computation of net income. Deferred income tax assets and liabilities are measured using substantively enacted income tax rates expected to apply to taxable income in the years in which temporary differences are expected to be recovered or settled. As a result, a projection of taxable income is required for those years, as well as an assumption of the ultimate recovery/settle- ment period for temporary differences. The projection of future taxable income is based on management’s best estimate and may vary from actual taxable income. On an annual basis, the Company assesses its need to establish a valuation allowance for its deferred income tax assets, and if it is deemed more likely than not that its deferred income tax assets will not be realized based on its taxable income projections, a valuation allowance is recorded. As at December 31, 2002, the Company expects that its deferred income tax assets will be recovered from future taxable income and therefore, has not set up a valuation allowance. In addition, Canadian and U.S. tax rules and regulations are subject to interpretation and require judgment by the Company that may be chal- lenged by the taxation authorities. The Company believes that its provi- sions for income taxes are adequate pertaining to any assessments from the taxation authorities. The Company’s deferred income tax asset is mainly composed of temporary differences related to accruals for workforce reductions, per- sonal injury and other claims, environmental, and other post-retirement benefits, and losses and tax credit carryforwards. The majority of these accruals will be paid out over the next five years. The Company’s deferred income tax liability is mainly composed of temporary differences related to properties, including purchase accounting adjustments. Estimating the ultimate settlement period, given that depreciation rates in effect are based on information as it develops, requires judgment and management’s best estimates. The reversal of timing differences is expected at future substantively enacted income tax rates which could change due to fiscal budget changes and/or changes in income tax laws. As a result, a change in the timing and the income tax rate at which the components will reverse, could materially affect deferred income tax expense as recorded in the Company’s results of operations. A one- percentage-point change in the Company’s reported effective income tax rate would have the effect of changing the income tax expense by $8 million in 2002. For the year ended December 31, 2002, the Company recorded total income tax expense of $268 million ($392 million in 2001 and $442 million in 2000) of which $156 million was for deferred income taxes ($307 million in 2001 and $218 million in 2000). The Company’s net deferred income tax liability at December 31, 2002 was $3,703 million ($3,576 million at December 31, 2001). Business risks Certain information included in this report may be “forward-looking statements” within the meaning of the United States Private Securities Litigation Reform Act of 1995. Such forward-looking statements are not guarantees of future performance and involve known and unknown risks, uncertainties and other factors which may cause the outlook, the actual results or performance of the Company or the rail industry to be materially different from any future results or performance implied by such state- ments. Such factors include the factors set forth below as well as other risks detailed from time to time in reports filed by the Company with securities regulators in Canada and the United States. Competition The Company faces significant competition from a variety of carriers, including Canadian Pacific Railway Company which operates the other major rail system in Canada, serving most of the same industrial and population centers as the Company, long distance trucking companies and, in certain markets, major U.S. railroads and other Canadian and U.S. railroads. Competition is generally based on the quality and reliability of services provided, price, and the condition and suitability of carriers’ equipment. Competition is particularly intense in eastern Canada where an extensive highway network and population centers, located relatively close to one another, have encouraged significant competition from trucking companies. In addition, much of the freight carried by the Company consists of commodity goods that are available from other sources in competitive markets. Factors affecting the competitive position of suppliers of these commodities, including exchange rates, could mate- rially adversely affect the demand for goods supplied by the sources served by the Company and, therefore, the Company’s volumes, revenues and profit margins. To a greater degree than other rail carriers, the Company’s subsidiary, Illinois Central Railroad Company (ICRR), is vulnerable to barge competi- tion because its main routes are parallel to the Mississippi River system. The use of barges for some commodities, particularly coal and grain, often represents a lower cost mode of transportation. Barge competition and barge rates are affected by navigational interruptions from ice, floods and droughts, which can cause widely fluctuating barge rates. The ability of ICRR to maintain its market share of the available freight has traditionally been affected by the navigational conditions on the river. Canadian GAAP Canadian National Railway Company 89 Management ’s Discussion and Analysis In recent years, there has been significant consolidation of rail systems in the United States. The resulting larger rail systems are able to offer seamless services in larger market areas and effectively compete with the Company in certain markets. There can be no assurance that the Company will be able to compete effectively against current and future competitors in the railroad industry and that further consolidation within the railroad industry will not adversely affect the Company’s competitive position. No assurance can be given that competitive pressures will not lead to reduced revenues, profit margins or both. Environmental matters The Company’s operations are subject to federal, provincial, state, municipal and local regulations under environmental laws and regulations concerning, among other things, emissions into the air; discharges into waters; the generation, handling, storage, transportation, treatment and disposal of waste, hazardous substances and other materials; decommis- sioning of underground and aboveground storage tanks; and soil and groundwater contamination. A risk of environmental liability is inherent in railroad and related transportation operations; real estate ownership, operation or control; and other commercial activities of the Company with respect to both current and past operations. As a result, the Company incurs significant compliance and capital costs, on an ongoing basis, associated with environmental regulatory compliance and clean-up requirements in its railroad operations and relating to its past and present ownership, operation or control of real property. While the Company believes that it has identified the costs likely to be incurred in the next several years, based on known information, for environmental matters, the Company’s ongoing efforts to identify potential environmental concerns that may be associated with its properties may lead to future environmental investigations, which may result in the identification of additional environmental costs and liabilities. In the operation of a railroad, it is possible that derailments, explo- sions or other accidents may occur that could cause harm to human health or to the environment. As a result, the Company may incur costs in the future, which may be material, to address any such harm, including costs relating to the performance of clean-ups, natural resource damages and compensatory or punitive damages relating to harm to individuals or property. The ultimate cost of known contaminated sites cannot be definitely established, and the estimated environmental liability for any given site may vary depending on the nature and extent of the contamination, the available clean-up technique, the Company’s share of the costs and evolving regulatory standards governing environmental liability. Also, additional contaminated sites yet unknown may be discovered or future operations may result in accidental releases. For these reasons, there can be no assurance that material liabilities or costs related to environmental matters will not be incurred in the future, or will not have a material adverse effect on the Company’s financial position or results of operations in a particular quarter or fiscal year, or that the Company’s liquidity will not be adversely impacted by such environmental liabilities or costs. Personal injury and other claims In the normal course of its operations, the Company becomes involved in various legal actions, including claims relating to personal injuries, occupational disease and damage to property. The Company maintains provisions for such items, which it considers to be adequate for all of its outstanding or pending claims. The final outcome with respect to actions outstanding or pending at December 31, 2002, or with respect to future claims, cannot be predicted with certainty, and therefore there can be no assurance that their resolution will not have a material adverse effect on the Company’s financial position or results of operations in a particular quarter or fiscal year. Labor negotiations Canadian workforce As of January 2003, the Company has labor agreements with bargaining groups representing substantially its entire Canadian unionized work- force. These agreements are generally effective until December 31, 2003. U.S. workforce The general approach to labor negotiations by U.S. Class 1 railroads is to bargain on a collective national basis. Grand Trunk Western (GTW), Duluth, Winnipeg and Pacific (DWP), ICRR, CCP Holdings, Inc. (CCP) and just recently WC, have bargained on a local basis rather than holding national, industry wide negotiations because it results in agreements that better address both the employees’ concerns and preferences, and the railways’ actual operating environment. However, local negotiations may not generate federal intervention in a strike or lockout situation, since a dispute may be localized. The Company believes the potential mutual benefits of local bargaining outweigh the risks. 90 Canadian National Railway Company Canadian GAAP Management ’s Discussion and Analysis As of January 2003, the Company has in place agreements with bar- gaining units representing the entire unionized workforce at ICRR, GTW, DWP, and CCP, and 65% of the unionized workforce at WC. These agree- ments have various moratorium provisions, ranging from the end of 2001 to the end of 2005, which preserve the status quo in respect of given areas during the terms of such moratoriums. Several of these agreements are currently under renegotiation and several will open for negotiation in 2003. Negotiations are ongoing with the bargaining units with which the Company does not have agreements or settlements. Until new agree- ments are reached or until settlements are ratified, the terms and condi- tions of previous agreements continue to apply. Although the Company does not anticipate work action related to these negotiations while they are ongoing, there can be no assurance that their resolution will not have a material adverse effect on the Company’s financial position or results of operations. Regulation The Company’s rail operations in Canada are subject to regulation as to (i) rate setting and network rationalization by the Canadian Transportation Agency (the Agency) under the Canada Transportation Act (Canada) (the CTA), and (ii) safety by the federal Minister of Transport under the Railway Safety Act (Canada) and certain other statutes. The Company’s U.S. rail operations are subject to regulation by the Surface Transportation Board (STB) (the successor to the Interstate Commerce Commission) and the Federal Railroad Administration. In addition, the Company is subject to a variety of health, safety, security, labor, environmental and other reg- ulations, all of which can affect its competitive position and profitability. The CTA Review Panel, which was appointed by the federal govern- ment to carry out a comprehensive review of the Canadian transportation legislation, issued its report to the Minister of Transport at the end of June 2001. The report was released to the public on July 18, 2001 and contains numerous recommendations for legislative changes, which, if adopted, would affect all modes of transportation, including rail. Concurrently, the Minister of Transport launched a transportation blue- print consultation process, which could eventually lead to new legislation affecting rail and other transportation industries. No assurance can be given that any decisions by the federal government pursuant to the report’s recommendations or in connection with the blueprint consulta- tion process will not materially adversely affect the Company’s financial position or results of operations. Financial instruments Although the Company conducts its business and receives revenues primarily in Canadian dollars, a growing portion of its revenues, expenses, assets and debt are denominated in U.S. dollars. Thus, the Company’s results are affected by fluctuations in the exchange rate between these currencies. Changes in the exchange rate between the Canadian dollar and other currencies (including the U.S. dollar) make the goods transported by the Company more or less competitive in the world marketplace and thereby affect the Company’s revenues and expenses. The Company has limited involvement with derivative financial instruments and does not use them for trading purposes. Collateral or other security to support financial instruments subject to credit risk is usually not obtained. However, the credit standing of counterparties or their guarantors is regularly monitored, and losses due to counterparty non-performance are not anticipated. To mitigate the effects of fuel price changes on its operating margins and overall profitability, the Company has a systematic hedging program which calls for regularly entering into swap positions on crude and heat- ing oil to cover a target percentage of future fuel consumption up to two years in advance. At December 31, 2002, the Company has hedged approximately 47% of the estimated 2003 fuel consumption and 25% of the estimated 2004 fuel consumption. This represents approximately 263 million U.S. gallons at an average price of U.S.$0.5865 per U.S. gallon. Realized gains and losses from the Company’s fuel hedging activities were a $3 million gain, a $6 million loss and a $49 million gain for the years ended December 31, 2002, 2001 and 2000, respectively. As a result of fuel hedging activities, the Company had an unrealized gain of $30 million at December 31, 2002 compared to an unrealized loss of $38 million at December 31, 2001. General indemnifications In the normal course of business, the Company has provided indemnifica- tions, customary for the type of transaction or for the railway business, in various agreements with third parties, including indemnification provi- sions where the Company would be required to indemnify third parties and others. Indemnifications are found in various types of contracts with third parties which include, but are not limited to, (a) contracts granting the Company the right to use or enter upon property owned by third parties such as leases, easements, trackage rights and sidetrack agree- ments; (b) contracts granting rights to others to use the Company’s property, such as leases, licenses and easements; (c) contracts for the sale of assets; (d) contracts for the acquisition of services; (e) financing agreements; (f) trust indentures or fiscal agency agreements or similar agreements relating to debt or equity securities of the Company and engagement agreements with financial advisors; (g) transfer agent and Canadian GAAP Canadian National Railway Company 91 Management ’s Discussion and Analysis registrar agreements in respect of the Company’s securities; and (h) trust agreements establishing trust funds to secure the payment to certain officers and senior employees of special retirement compensation arrangements or plans. To the extent of any actual claims under these agreements, the Company maintains provisions for such items, which it considers to be adequate. Due to the nature of the indemnification clauses, the maximum exposure for future payments may be material, however cannot be determined with certainty. Other risks In any given year, the Company, like other railroads, is susceptible to changes in the economic conditions of the industries and geographic areas that produce and consume the freight it transports or the supplies it requires to operate. In addition, many of the goods and commodities carried by the Company experience cyclicality in the demand for them. However, many of the bulk commodities the Company transports move offshore and are impacted more by global economic conditions than North American economic cycles. The Company’s results of operations can be expected to reflect this cyclicality because of the significant fixed costs inherent in railroad operations. Global as well as North American economic conditions, including trade barriers on certain commodities, may interfere with the free circulation of goods across Canada and the United States. Potential terrorist actions can have a direct or indirect impact on the U.S. transportation infrastructure, including railway infrastructure, and interfere with the free flow of trade across the two countries. International conflicts can also have an impact on the Company’s markets. The Company’s revenues in 2001 were affected by widespread reces- sionary conditions. Although growth rebounded strongly in early 2002, there continues to be ongoing concern about the sustainability of the recovery due to uncertain consumer and business confidence. While economic growth is expected to continue in 2003, the Company remains cautious about business prospects. Should a major economic slowdown or recession occur in North America or other key markets, or should major industrial restructuring take place, the volume of rail shipments carried by the Company is likely to be affected. In addition to the inherent risks of the business cycle, the Company is occasionally susceptible to severe weather conditions. For example, in the first quarter of 1998, a severe ice storm hit eastern Canada, which disrupted operations and service for the railroad as well as for CN cus- tomers. More recently, severe drought conditions in western Canada significantly reduced bulk commodity revenues, principally grain. There continues to be widespread concerns about the impact of crop conditions on grain supplies in the near term. Generally accepted accounting principles require the use of historical cost as the basis of reporting in financial statements. As a result, the cumu- lative effect of inflation, which has significantly increased asset replace- ment costs for capital-intensive companies such as CN, is not reflected in operating expenses. Depreciation charges on an inflation-adjusted basis, assuming that all operating assets are replaced at current price levels, would be substantially greater than historically reported amounts. Selected quarterly financial data Selected quarterly financial data for the eight most recently completed quarters ending December 31, 2002 is disclosed in Note 23 to the Company’s 2002 Consolidated Financial Statements. Disclosure controls and procedures The Company’s Chief Executive Officer and its Chief Financial Officer, after evaluating the effectiveness of the Company’s “disclosure controls and procedures” (as defined in Exchange Act Rules 13a-14(c) and 15-d-14(c)) as of January 21, 2003 (the “Evaluation Date”) within the 90-day period leading to and ending on the filing date of this annual report, have concluded that the Company’s disclosure controls and procedures were adequate and effective and designed to ensure that material information relating to the Company and its consolidated sub- sidiaries would have been made known to them. Subsequent to the Evaluation Date, there were no significant changes in the Company’s internal controls or, to their knowledge, in other factors that could significantly affect the Company’s disclosure controls and procedures. 92 Canadian National Railway Company Canadian GAAP Management Report Auditors ’ Report The accompanying consolidated financial statements of Canadian National Railway Company and all information in this annual report are the responsibility of management and have been approved by the Board of Directors. The financial statements have been prepared by management in conformity with generally accepted accounting principles in Canada. These statements include some amounts that are based on best estimates and judgments. Financial information used elsewhere in the annual report is consistent with that in the financial statements. Management of the Company, in furtherance of the integrity and objectivity of data in the financial statements, has developed and main- tains a system of internal accounting controls and supports an extensive program of internal audits. Management believes that this system of internal accounting controls provides reasonable assurance that financial records are reliable and form a proper basis for preparation of financial statements, and that assets are properly accounted for and safeguarded. The Board of Directors carries out its responsibility for the financial statements in this report principally through its Audit, Finance and Risk Committee, consisting solely of outside directors. The Audit, Finance and Risk Committee reviews the Company’s consolidated financial statements and annual report and recommends their approval by the Board of Directors. Also, the Audit, Finance and Risk Committee meets regularly with the Chief, Internal Audit, and with the shareholders’ auditors. These consolidated financial statements have been audited by KPMG LLP, who have been appointed as the sole auditors of the Company by the shareholders. To the shareholders of Canadian National Railway Company We have audited the consolidated balance sheets of Canadian National Railway Company as at December 31, 2002 and 2001 and the consoli- dated statements of income, changes in shareholders’ equity and cash flows for each of the years in the three-year period ended December 31, 2002. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with Canadian and United States generally accepted auditing standards. Those standards require that we plan and perform an audit to obtain reasonable assurance whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant esti- mates made by management, as well as evaluating the overall financial statement presentation. In our opinion, these consolidated financial statements present fairly, in all material respects, the financial position of the Company as at December 31, 2002 and 2001, and the results of its operations and its cash flows for each of the years in the three-year period ended December 31, 2002, in accordance with Canadian generally accepted accounting principles. On January 20, 2003, we reported separately to the Board of Directors of the Company on consolidated financial statements for the same period, prepared in accordance with United States generally accepted accounting principles. (signed) Claude Mongeau Executive Vice-President and Chief Financial Officer January 21, 2003 (signed) KPMG LLP Chartered Accountants Montreal, Canada January 20, 2003 (signed) Serge Pharand Vice-President and Corporate Comptroller January 21, 2003 Canadian GAAP Canadian National Railway Company 93 Consolidated Statement of Income In millions, except per share data Year ended December 31, 2002 2001 2000 Revenues Petroleum and chemicals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Metals and minerals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Forest products. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Coal. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Grain and fertilizers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Intermodal . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Automotive . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other items . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Operating expenses Labor and fringe benefits (Note 14) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Purchased services and material. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Depreciation and amortization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Fuel . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Equipment rents. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Casualty and other (Note 2) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total operating expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Operating income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Interest expense (Note 15) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other income (Note 16) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Income before income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Income tax expense (Note 17) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net income. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Basic earnings per share (Note 19) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Diluted earnings per share (Note 19) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,102 521 1,323 326 986 1,052 591 209 6,110 2,051 908 499 459 353 724 4,994 1,116 (353) 76 839 (268) $÷«571 $««2.87 $««2.82 $÷«923 458 1,088 338 1,161 969 520 195 5,652 1,810 811 463 485 314 403 4,286 1,366 (312) 65 1,119 (392) $÷«727 $««3.72 $««3.62 $÷«894 392 1,008 328 1,136 919 559 210 5,446 1,674 858 412 450 291 376 4,061 1,385 (295) 126 1,216 (442) $÷«774 $÷3.91 $÷3.82 See accompanying notes to consolidated financial statements. 94 Canadian National Railway Company Canadian GAAP Consolidated Balance Sheet In millions Assets Current assets: December 31, 2002 2001 Cash and cash equivalents . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Accounts receivable (Note 4) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Material and supplies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Deferred income taxes (Note 17) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Properties (Note 5). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other assets and deferred charges (Note 6) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $÷÷÷«25 722 127 122 167 1,163 16,898 863 $÷÷÷«53 645 133 153 180 1,164 16,723 901 Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $18,924 $18,788 Liabilities and shareholders’ equity Current liabilities: Accounts payable and accrued charges (Note 8) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Current portion of long-term debt (Note 10) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $÷1,487 574 73 $÷1,374 163 101 Deferred income taxes (Note 17) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other liabilities and deferred credits (Note 9) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Long-term debt (Note 10) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Shareholders’ equity: Common shares (Note 11) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Convertible preferred securities (Note 11) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Contributed surplus . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Currency translation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,134 3,825 1,335 5,003 3,558 – 175 132 2,762 6,627 1,638 3,729 1,296 5,764 3,209 327 178 133 2,514 6,361 Total liabilities and shareholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $18,924 $18,788 On behalf of the Board: David G.A. McLean Director E. Hunter Harrison Director See accompanying notes to consolidated financial statements. Canadian GAAP Canadian National Railway Company 95 Consolidated Statement of Changes in Shareholders ’ Equity Issued and outstanding common shares Issued and outstanding convertible preferred securities In millions Convertible Common shares preferred Contributed surplus securities Currency translation Retained earnings Total shareholders’ equity Balances December 31, 1999 . . . . . . . . . Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . Stock options exercised (Note 11, 12) . Share repurchase program (Note 11) . . Currency translation . . . . . . . . . . . . . . . . . . . Dividends ($0.70 per share) . . . . . . . . . . . Dividends on convertible preferred securities. . . . . . . . . . . . . . . . . Balances December 31, 2000 . . . . . . . . . . Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . Stock options exercised (Note 11, 12) . Currency translation . . . . . . . . . . . . . . . . . . . Dividends ($0.78 per share) . . . . . . . . . . . Dividends on convertible preferred securities. . . . . . . . . . . . . . . . . Balances December 31, 2001 . . . . . . . . . Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . Stock options exercised (Note 11, 12) . Conversion of convertible preferred securities (Note 11) . . . . . . Share repurchase program (Note 11) . . Currency translation . . . . . . . . . . . . . . . . . . . Dividends ($0.86 per share) . . . . . . . . . . . Dividends on convertible preferred securities. . . . . . . . . . . . . . . . . 202.4 – 1.2 (13.0) – – – 190.6 – 2.1 – – – 192.7 – 1.8 6.0 (3.0) – – – Balances December 31, 2002 . . . . . . . . . 197.5 4.6 – – – – – – 4.6 – – – – – 4.6 – – (4.6) – – – – – $ 3,311 – 26 (213) – – – 3,124 – 85 – – – 3,209 – 75 327 (53) – – – $3,558 $ 327 – – – – – – 327 – – – – – 327 – – (327) – – – – $÷÷– $ 190 – – (12) – – – 178 – – – – – 178 – – – (3) – – – $ ÷«(9) – – – 70 – $ 1,626 774 – (304) – (136) – «61 – – 72 – – 133 – – – – (1) – – (11) 1,949 727 – – (150) (12) 2,514 571 – – (147) – (170) (6) $ 5,445 774 26 (529) 70 (136) (11) 5,639 727 85 72 (150) (12) 6,361 571 75 – (203) (1) (170) (6) $175 $132 $2,762 $6,627 See accompanying notes to consolidated financial statements. 96 Canadian National Railway Company Canadian GAAP Consolidated Statement of Cash Flows In millions Operating activities Year ended December 31, 2002 2001 2000 Net income. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Adjustments to reconcile net income to net cash provided from operating activities: $««««571 $««««727 $««««774 Depreciation and amortization (Note 18) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Deferred income taxes (Note 17) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Charge to increase U.S. personal injury and other claims liability (Note 2). . . . . . . . . . . . . . . . . . . . . . . . . Workforce reduction charges (Note 14) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Equity in earnings of English Welsh and Scottish Railway (Note 16) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Gain on sale of investments (Note 16) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Write-down of investment (Note 16). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other changes in: Accounts receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Material and supplies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Accounts payable and accrued charges . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other net current assets and liabilities. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 506 156 281 120 (33) – – (80) – (154) (18) (176) 469 307 – 98 (8) (101) 99 197 11 (378) (26) (163) 421 218 – – – (84) – 71 7 (168) (39) (72) Cash provided from operating activities. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,173 1,232 1,128 Investing activities Net additions to properties (Note 18) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Acquisition of Wisconsin Central Transportation Corporation (Note 3) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cash used by investing activities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Dividends paid. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Financing activities Issuance of long-term debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Reduction of long-term debt. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Issuance of common shares (Note 11). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Repurchase of common shares (Note 11). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cash provided from (used by) financing activities. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net increase (decrease) in cash and cash equivalents. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cash and cash equivalents, beginning of year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (571) – 95 (476) (179) 3,146 (3,558) 69 (203) (546) (28) 53 (605) (1,278) 119 (1,764) (174) 4,015 (3,336) 61 – 740 34 19 (607) – 21 (586) (149) 860 (1,038) 26 (529) (681) (288) 307 Cash and cash equivalents, end of year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $««««««25 $««««««53 $««««««19 Supplemental cash flow information Payments for: Interest (Note 15) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Workforce reductions (Note 9) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Personal injury and other claims (Note 20). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Pensions (Note 13) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Income taxes (Note 17) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $÷÷390 177 156 92 65 $÷÷307 169 149 69 63 $÷÷299 189 111 59 101 See accompanying notes to consolidated financial statements. Canadian GAAP Canadian National Railway Company 97 Notes to Consolidated Financial Statements Canadian National Railway Company (CN or the Company), directly and through its subsidiaries, is engaged in the rail transportation business. CN spans Canada and mid-America, from the Atlantic and Pacific oceans to the Gulf of Mexico, serving the ports of Vancouver, Prince Rupert, B.C., Montreal, Halifax, New Orleans and Mobile, Alabama, and the key cities of Toronto, Buffalo, Chicago, Detroit, Duluth, Minnesota/Superior, Wisconsin, Green Bay, Wisconsin, Minneapolis/St. Paul, Memphis, St. Louis and Jackson, Mississippi, with connections to all points in North America. CN’s revenues are derived from the movement of a diversified and balanced portfolio of goods, including petroleum and chemicals, grain and fertilizers, coal, metals and minerals, forest products, intermodal and automotive. 1 Summary of significant accounting policies These consolidated financial statements are expressed in Canadian dollars, except where otherwise indicated, and have been prepared in accordance with accounting principles generally accepted in Canada (Canadian GAAP). Significant differences between the accounting princi- ples applied in the accompanying financial statements and those under United States generally accepted accounting principles (U.S. GAAP) are quantified and explained in Note 22 to the financial statements. The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of revenues and expenses during the period, the reported amounts of assets and liabilities, and the disclosure of contingent assets and liabilities at the date of the financial statements. On an ongoing basis, management reviews its estimates, including those related to personal injury and other claims, environmen- tal matters, depreciation lives, pensions and other post-retirement bene- fits, and income taxes, based upon currently available information. Actual results could differ from these estimates. A. Principles of consolidation These consolidated financial statements include the accounts of all sub- sidiaries, including Wisconsin Central Transportation Corporation (WC) for which the Company acquired control and consolidated effective October 9, 2001. The Company’s investments in which it has significant influence are accounted for using the equity method and all other investments are accounted for using the cost method. B. Revenues Freight revenues are recognized on services performed by the Company, based on the percentage of completed service method. Costs associated with movements are recognized as the service is performed. C. Foreign exchange All of the Company’s United States (U.S.) operations are self-sustaining foreign entities with the U.S. dollar as their functional currency. The Company also has an equity investment in an international affiliate based in the United Kingdom with the British pound as its functional currency. Accordingly, the U.S. operations’ assets and liabilities and the Company’s foreign equity investment are translated into Canadian dol- lars at the rate in effect at the balance sheet date and the revenues and expenses are translated at average exchange rates during the year. All adjustments resulting from the translation of the foreign operations are recorded in Currency translation, which forms part of Shareholders’ equity. The Company has designated all U.S. dollar denominated long- term debt of the parent company as a foreign exchange hedge of its net investment in U.S. subsidiaries. Accordingly, unrealized foreign exchange gains and losses, from the dates of designation, on the translation of the U.S. dollar denominated long-term debt are also included in Currency translation. D. Cash and cash equivalents Cash and cash equivalents include highly liquid investments purchased three months or less from maturity and are stated at cost, which approx- imates market value. E. Accounts receivable Accounts receivable are recorded at cost net of the provision for doubtful accounts that is based on expected collectibility. Any gains or losses on the sale of accounts receivable are calculated by comparing the carrying amount of the accounts receivable sold to the total of the cash proceeds on sale and the fair value of the retained interest in such receivables on the date of transfer. Fair values are determined on a discounted cash flow basis. Costs related to the sale of accounts receivable are recognized in earnings in the period incurred. F. Material and supplies Inventory is valued at weighted-average cost for ties, rails, fuel and new materials in stores, and at estimated utility or sales value for usable secondhand, obsolete and scrap materials. G. Properties Railroad properties are carried at cost less accumulated depreciation including asset impairment write-downs. All costs of materials associated with the installation of rail, ties, ballast and other track improvements are capitalized to the extent they meet the Company’s minimum thresh- old for capitalization. The related labor and overhead costs are also capi- talized for the installation of new, non-replacement track. All other labor and overhead costs and maintenance costs are expensed as incurred. Related interest costs are charged to expense. Included in property addi- tions are the costs of developing computer software for internal use. 98 Canadian National Railway Company Canadian GAAP Notes to Consolidated Financial Statements The cost of railroad properties, less net salvage value, retired or disposed of in the normal course of business is charged to accumulated depreciation, in accordance with the group method of depreciation. The Company reviews the carrying amounts of properties whenever events or changes in circumstances indicate that such carrying amounts may not be recoverable based on future undiscounted cash flows or estimated net realizable value. Assets that are deemed impaired as a result of such review are recorded at the lower of carrying amount or net recoverable amount. H. Depreciation The cost of properties, net of asset impairment write-downs, is depreci- ated on a straight-line basis over their estimated useful lives as follows: Asset class Annual rate Track and roadway. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2% Rolling stock. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3% Buildings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6% Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4% The Company follows the group method of depreciation and as such conducts comprehensive depreciation studies on a periodic basis to assess the reasonableness of the lives of properties based upon current information and historical activities. Such a study was conducted in 2001 for the Company’s Canadian properties. The study did not have a signifi- cant effect on depreciation expense as the benefit of increased asset lives was offset by deficiencies in certain accumulated depreciation bal- ances. Changes in estimated useful lives are accounted for prospectively. I. Pensions Pension costs are determined using actuarial methods. Net periodic benefit cost is charged to operations and includes: (i) the cost of pension benefits provided in exchange for employees’ services rendered during the year, (ii) the interest cost of pension obligations, (iii) the amortization of the initial net transition obligation on a straight- line basis over the expected average remaining service life of the employee group covered by the plans, (iv) the amortization of prior service costs and amendments over the expected average remaining service life of the employee group covered by the plans, (v) the expected long-term return on pension fund assets, and (vi) the amortization of cumulative unrecognized net actuarial gains and losses in excess of 10% of the greater of the beginning of year bal- ances of the projected benefit obligation or market-related value of plan assets over the expected average remaining service life of the employee group covered by the plans. The pension plans are funded through contributions determined in accordance with the projected unit credit actuarial cost method. J. Post-retirement benefits other than pensions The Company accrues the cost of post-retirement benefits other than pensions using actuarial methods. These benefits, which are funded by the Company as they become due, include life insurance programs, medical benefits, supplemental pension allowances and free rail travel benefits. The Company amortizes the cumulative unrecognized net actuarial gains and losses in excess of 10% of the projected benefit obligation at the beginning of the year, over the expected average remaining service life of the employee group covered by the plans. K. Derivative financial instruments The Company uses derivative financial instruments in the management of its fuel exposure, and may use them from time to time, in the manage- ment of its interest rate and foreign currency exposures. Gains or losses on such instruments entered into for the purpose of hedging financial risk exposures are deferred and amortized in the results of operations over the life of the hedged asset or liability or over the term of the deriv- ative financial instrument. Income and expense related to hedged deriva- tive financial instruments are recorded in the same category as that generated by the underlying asset or liability. L. Personal injury claims In Canada, the Company accounts for costs related to employee work- related injuries based on actuarially developed estimates of the ultimate cost associated with such injuries, including compensation, health care and administration costs. In the U.S., the Company accrues the cost for the expected personal injury claims and existing occupational disease claims, based on actuarial estimates of their ultimate cost. A liability for unasserted occupational disease claims is also accrued to the extent they are probable and can be reasonably estimated. Canadian GAAP Canadian National Railway Company 99 Notes to Consolidated Financial Statements 1 Summary of significant accounting policies (continued) 2 Accounting changes M. Environmental expenditures Environmental expenditures that relate to current operations are expensed unless they relate to an improvement to the property. Expenditures that relate to an existing condition caused by past opera- tions and which are not expected to contribute to current or future oper- ations are expensed. Liabilities are recorded when environmental assessments and/or remedial efforts are likely, and when the costs, based on a specific plan of action in terms of the technology to be used and the extent of the corrective action required, can be reasonably estimated. N. Income taxes The Company follows the asset and liability method of accounting for income taxes. Under the asset and liability method, the change in the net deferred tax asset or liability is included in the computation of net income. Deferred tax assets and liabilities are measured using substan- tively enacted tax rates expected to apply to taxable income in the years in which temporary differences are expected to be recovered or settled. O. Stock-based compensation The Company accounts for stock-based compensation in accordance with the Canadian Institute of Chartered Accountants (CICA) Handbook Section 3870 “Stock-Based Compensation and Other Stock-Based Payments,” as explained in Note 2 – Accounting changes. Accordingly, compensation cost is recorded for the Company’s performance-based stock option awards under the intrinsic value method and recognized over the vesting period. No compensation cost is recorded for the Company’s conventional stock option awards. P. Recent accounting pronouncements In December 2002, the CICA issued Handbook Section 3063 “Impairment of Long-Lived Assets.” Section 3063 provides accounting guidance for the determination of a long-lived asset impairment as well as recogni- tion, measurement and disclosure of the impairment. This section is effective for the Company’s fiscal year beginning January 1, 2004. The Company does not expect Section 3063 to have an initial material impact on its financial statements upon adoption. Also in December 2002, the CICA issued Handbook Section 3475 “Disposal of Long-Lived Assets and Discontinued Operations.” Section 3475 provides accounting guidance for long-lived assets to be disposed of other than by sale, long-lived assets to be disposed of by sale and pre- sentation and disclosure for discontinued operations. This section is effective for disposal activities initiated by the Company on or after May 1, 2003. The Company does not expect Section 3475 to have an initial material impact on its financial statements upon adoption. 2002 U.S. personal injury and other claims In the fourth quarter of 2002, the Company changed its methodology for estimating its liability for U.S. personal injury and other claims, including occupational disease claims and claims for property damage, from a case-by-case approach to an actuarial-based approach. Consequently, the Company recorded a charge of $281 million ($173 million after tax) to increase its provision for these claims. Under the actuarial-based approach, the Company accrues the cost for the expected personal injury and property damage claims and exist- ing occupational disease claims, based on actuarial estimates of their ultimate cost. The Company is unable to estimate the total cost for unasserted occupational disease claims. However, a liability for unasserted occupational disease claims is accrued to the extent they are probable and can be reasonably estimated. Under the case-by-case approach, a liability was recorded only when the expected loss was both probable and reasonably estimable based on currently available information. In addition, the Company did not record a liability for unasserted claims, as such amounts could not be reason- ably estimated under the case-by-case approach. The Company’s U.S. personal injury and other claims expense, including the above-mentioned charge, was $362 million in 2002. Had the Company continued to apply the case-by-case approach to its U.S. personal injury and other claims liability, recognizing the effects of the actual claims experience for existing and new claims in the fourth quarter, these expenses would have been approximately $135 million in 2002. Stock-based compensation Effective January 1, 2002, the Company adopted the CICA Handbook Section 3870 “Stock-Based Compensation and Other Stock-Based Payments.” The new recommendations require the use of a fair value based approach of accounting for all non-employee and certain employee stock-based awards, such as direct awards of stock, awards that call for settlement in cash or other assets, or stock appreciation rights that call for settlement through the issuance of equity instruments. For all other employee stock-based awards, such as stock option awards, the recommendations encourage but do not require that the fair value based approach be used, though require additional disclosure including net income and earnings per share, as if the fair value based accounting method had been used to account for these awards. 100 Canadian National Railway Company Canadian GAAP Notes to Consolidated Financial Statements The Company has elected to prospectively apply the intrinsic value based method of accounting to its awards of conventional and perfor- mance-based employee stock options granted on or after January 1, 2002. These options are granted at an exercise price equal to the market value of the common shares at the date of granting and, as such, compensa- tion cost is not recognized for conventional-based options since both the number of shares to which an individual is entitled and the exercise price are known at the date of granting. Compensation cost attributable to performance-based employee stock option awards, granted on or after January 1, 2002, is measured at intrinsic value and recognized over the vesting period. Changes in intrinsic value between the grant date and the measurement date result in a change in the measure of compensation cost. For the year ended December 31, 2002, no compen- sation cost was recognized as no performance-based employee stock option awards were granted. In prior periods, the Company did not record compensation cost related to employee stock option grants and, any consideration paid by employees on the exercise of stock options was recorded as share capital. In accordance with the new recommendations, the Company accounts for its direct awards of stock to employees, which are issued through the mid-term incentive share unit plan, using the fair value based approach to awards granted on or after January 1, 2002. The mid- term incentive share unit plan entitles employees to receive payout of a combination of common stock of the Company (equity settled portion), as to 50 percent, and cash value (cash settled portion), as to the remain- ing 50 percent. The new recommendations will not be applied to the equity settled portion of this award granted prior to January 1, 2002 since the new recommendations require prospective application for such awards. Compensation cost for the cash settled portion of this award is mea- sured at fair value, which in all respects is equivalent to intrinsic value since the compensation cost stemming from the award must be finally measured at intrinsic value, and is recognized over the vesting period. Changes in intrinsic value between the grant date and the measurement date result in a change in the measure of compensation cost. The new recommendations require retroactive application, without restatement, of the Company’s grants outstanding at January 1, 2002 that call for settlement in cash. Had the new recommendations been retroactively applied to the cash settled portion, there would have been no impact on prior periods’ financial statements, since no compensation cost was, or would have been recognized for prior periods, due to the nature of the vesting conditions. For the year ended December 31, 2002, the Company granted 3.2 million conventional options. For the year ended December 31, 2002, 1.8 million of previously issued stock options were exercised. If compensation cost had been determined as if the fair value based accounting approach had been used for all awards granted for the year ended December 31, 2002, the Company’s net income and earnings per share would have been as follows: Year ended December 31, 2002 Net income (in millions) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $«553 Basic earnings per share . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2.78 Diluted earnings per share . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2.73 As permitted by the new recommendations, these amounts exclude the effect of awards granted prior to January 1, 2002 and include the calculation of compensation cost using the Black-Scholes option-pricing model with the following assumptions: Year ended December 31, 2002 Risk-free interest rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Expected option life (years) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7.0 5.79% 30% Expected stock price volatility. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Average dividend per share . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $÷0.86 Weighted average fair value of options granted. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $30.98 Year ended December 31, 2002 2001 Foreign currency translation In 2001, the Company early adopted the CICA amended recommenda- tions of Section 1650 “Foreign Currency Translation.” The amended sec- tion eliminates the deferral and amortization of unrealized translation gains or losses on foreign currency denominated monetary items that have a fixed or ascertainable life extending beyond the end of a fiscal year. Translation gains or losses on the above items are now recognized in net income immediately. As required by the amended section, the Company retroactively restated all prior period financial statements pre- sented. The cumulative effect of the adoption of the amended section of $93 million ($62 million after tax) has been reflected as a charge to opening retained earnings of 1999. The effect on net income for 2001 and 2000 was an increase of $1 million and $2 million, respectively. 2000 Earnings per share In 2000, the Company early adopted the CICA recommendations related to the presentation of earnings per share. The standard essentially har- monizes Canadian and U.S. standards, specifically in the areas of present- ing earnings per share information, computing diluted earnings per share and disclosure requirements. The new standard requires restatement of prior year comparative information. Canadian GAAP Canadian National Railway Company 101 Notes to Consolidated Financial Statements 3 Acquisition of Wisconsin Central Transportation Corporation 4 Accounts receivable In millions Freight December 31, 2002 2001 Trade. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $321 150 Accrued . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Non-freight . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Provision for doubtful accounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 310 781 (59) $309 119 298 726 (81) $722 $645 The Company has a five-year revolving agreement, expiring in June 2003, to sell eligible freight trade receivables up to a maximum of $350 million of receivables outstanding at any point in time. The Company intends to renew or replace the program upon expiration. At December 31, 2002, pursuant to the agreement, $173 million and U.S.$113 million (Cdn$177 million) had been sold on a limited recourse basis compared to $168 million and U.S.$113 million (Cdn$179 million) at December 31, 2001. Recourse is limited to 10% of receivables sold and consists of additional freight trade receivables that have been recorded in Other current assets. The Company has retained the responsi- bility for servicing, administering and collecting freight trade receivables sold. Other income included $9 million in 2002 and $10 million in each of 2001 and 2000 for costs related to the agreement, which fluctuate with changes in prevailing interest rates. No servicing asset or liability has been recorded since the costs of servicing are compensated by the benefits of the agreement. The Receivables Purchase Agreement provides for customary indem- nification provisions, which survive for a period of two years following the final purchase of any receivable, three years from the final collection date or until statute barred, in the case of taxes. As at December 31, 2002, the Company has not recorded a liability associated with these indemnifications, for which there is no monetary limitation, as the Company does not expect to make any payments pertaining to the indemnifications of this program. On January 29, 2001, the Company, through an indirect wholly owned subsidiary, and WC entered into a merger agreement (the Merger) pro- viding for the acquisition of all of the shares of WC by the Company for an acquisition cost of $1,301 million (U.S.$833 million). The Merger was approved by the shareholders of WC at a special meeting held on April 4, 2001. On September 7, 2001, the U.S. Surface Transportation Board ren- dered a decision, unanimously approving the Company’s acquisition of WC. On October 9, 2001, the Company completed its acquisition of WC and began a phased integration of the companies’ operations. The acqui- sition was financed by debt and cash on hand. The Company accounted for the Merger using the purchase method of accounting as required by CICA Handbook Section 1581 “Business Combinations.” As such, the Company’s consolidated financial state- ments include the assets, liabilities and results of operations of WC as of October 9, 2001, the date of acquisition. The Company had estimated, on a preliminary basis, the fair values of the assets and liabilities acquired based on currently available information. In 2002, the Company finalized the allocation of the purchase price and adjusted the preliminary fair val- ues of the assets and liabilities acquired as follows: Current assets decreased by $10 million, Properties increased by $141 million, Other assets and deferred charges decreased by $98 million, Current liabilities increased by $10 million, Deferred income taxes increased by $16 million and Other liabilities and deferred credits increased by $3 million. The increase in Properties and decrease in Other assets and deferred charges was mainly due to the final valuation of the Company’s foreign equity investment. The remaining adjustments resulted from additional informa- tion obtained for conditions and circumstances that existed at the time of acquisition. The following table outlines the final fair values of WC’s assets and liabilities acquired: In millions Current assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $÷«165 2,576 Properties . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other assets and deferred charges. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total assets acquired . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Current liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Deferred income taxes. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other liabilities and deferred credits. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Long-term debt. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 335 3,076 363 759 181 472 Total liabilities assumed . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net assets acquired . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,301 1,775 102 Canadian National Railway Company Canadian GAAP Notes to Consolidated Financial Statements 5 Properties In millions December 31, 2002 Cost Accumulated depreciation Track, roadway and land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $16,727 3,841 Rolling stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Buildings. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,723 892 $23,183 Capital leases included in rolling stock . . . . . . . . . . . . . . . . . . . . . $÷1,348 $3,604 1,392 778 511 $6,285 $÷«244 Net $13,123 2,449 945 381 $16,898 $÷1,104 December 31, 2001 Accumulated depreciation $3,510 1,336 721 503 $6,070 $÷«218 Cost $16,549 3,703 1,622 919 $22,793 $÷1,246 Net $13,039 2,367 901 416 $16,723 $÷1,028 6 Other assets and deferred charges In millions December 31, 2002 Investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $380 353 Prepaid benefit cost (Note 13) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Deferred receivables . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Unamortized debt issue costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 88 41 1 2001 $496 251 108 42 4 Investment in 360networks Inc. In June 2001, the Company recorded a charge of $99 million, $77 million after tax, to write down 100% of its net investment in 360networks Inc. and subsequently sold all of its shares. In 2000, the Company had recorded a gain of $84 million, $58 million after tax, related to the exchange of its minority equity investments in certain joint venture companies for 11.4 million shares of 360networks Inc. $863 $901 7 Credit facilities Investments As at December 31, 2002, the Company had $368 million ($478 million at December 31, 2001) of investments accounted for under the equity method and $12 million ($18 million at December 31, 2001) of invest- ments accounted for under the cost method. Investment in Tranz Rail Holdings Limited (Tranz Rail) and Australian Transport Network Limited (ATN) In 2002, the Company sold its interests in Tranz Rail and ATN for aggre- gate net proceeds of $69 million, which approximated the carrying value of the investments. Prior to the sale, the Company had accounted for these investments as “available for sale.” Investment in English Welsh and Scottish Railway (EWS) Through its acquisition of WC in 2001, the Company acquired 40.9% of EWS, a company which provides most of the rail freight services in Great Britain, operates freight trains through the English Channel tunnel and carries mail for the Royal Mail. The final fair value of the investment at the date of acquisition was determined based on the discounted cash flow method and a multiple of EWS earnings. The Company accounts for its investment in EWS using the equity method. At December 31, 2002, the excess of the Company’s share of the book value of EWS’ net assets over the carrying value of the investment is being depreciated over the life of its assets and is not significant. In December 2002, the Company entered into a U.S.$1,000 million three- year revolving credit facility and concurrently terminated its previous revolving credit facilities before their scheduled maturity in March 2003. The credit facility provides for borrowings at various interest rates, including the Canadian prime rate, bankers’ acceptance rates, the U.S. federal funds effective rate and the London Interbank Offer Rate, plus applicable margins. The credit facility agreement contains customary financial covenants, based on U.S. GAAP, including limitations on debt as a percentage of total capitalization and maintenance of tangible net worth above pre-defined levels. Throughout the year, the Company was in compliance with all financial covenants contained in its outstanding revolving credit agreements. The Company’s commercial paper program is backed by a portion of its revolving credit facility. As at December 31, 2002, the Company had outstanding commercial paper of U.S.$136 mil- lion (Cdn$214 million) compared to U.S.$213 million (Cdn$339 million) as at December 31, 2001. The Company’s borrowings of U.S.$172 million (Cdn$273 million) outstanding at December 31, 2001 were entirely repaid in the first quarter of 2002. At December 31, 2002, the Company had borrowings under its revolving credit facility of U.S.$90 million (Cdn$142 million) at an average interest rate of 1.77%. Outstanding let- ters of credit under the previous facilities were transferred into the cur- rent facility. As at December 31, 2002, letters of credit under the revolving credit facility amounted to $295 million. Canadian GAAP Canadian National Railway Company 103 Notes to Consolidated Financial Statements 8 Accounts payable and accrued charges In millions December 31, 2002 Trade payables . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $÷«436 251 Income and other taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Payroll-related accruals. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Workforce reduction provisions. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Personal injury and other claims (Note 20) . . . . . . . . . . . . . . . . . . . . . . . . Accrued charges. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Accrued interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Accrued operating leases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 235 168 136 113 104 18 26 2001 $385 236 218 151 51 131 141 19 42 $1,487 $1,374 B. Post-retirement benefits other than pensions (i) Change in benefit obligation In millions Year ended December 31, 2002 Benefit obligation at beginning of year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $309 18 Amendments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Actuarial loss. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Interest cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Service cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Foreign currency changes. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Transfer from other plans. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 101 23 13 (1) – 2001 $242 25 20 19 11 6 5 Benefits paid . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Benefit obligation at end of year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $444 (19) (19) $309 9 Other liabilities and deferred credits (ii) Funded status In millions December 31, 2002 2001 In millions December 31, 2002 Personal injury and other claims, net of current portion (Note 20) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Workforce reduction provisions, net of current portion (A) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Accrual for post-retirement benefits other than pensions (B) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Environmental reserve, net of current portion. . . . . . . . . . . . . . . . . . . . . . Deferred credits and other. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $528 $379 253 284 81 189 340 258 73 246 Unfunded benefit obligation at end of year . . . . . . . . . . . . . . . . . . . . . . . . . . $444 (122) Unrecognized net actuarial loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Unrecognized prior service cost. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (38) Accrued benefit cost for post-retirement benefits other than pensions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $284 (iii) Components of net periodic benefit cost $1,335 $1,296 In millions Year ended December 31, 2002 2001 2001 $309 (26) (25) $258 2000 $15 8 1 1 $25 Interest cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Service cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Amortization of prior service cost . . . . . . . . . . . . . . . . . . . . . . . Recognized net actuarial loss . . . . . . . . . . . . . . . . . . . . . . . . . . . Net periodic benefit cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $23 13 5 4 $45 $19 11 3 2 $35 (iv) Weighted-average assumptions December 31, 2002 2001 2000 Discount rate. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6.65% Rate of compensation increase . . . . . . . . . . . . . . . . . . . . . . . . 4.00% 6.97% 4.00% 6.95% 4.25% For measurement purposes, increases in the per capita cost of cov- ered health care benefits were assumed to be 17% for 2003 and 18% for 2002. It is assumed that the rate will decrease gradually to 8% in 2012 and remain at that level thereafter. A one-percentage-point change in the health care cost trend rate would not cause a material change in the Company’s net periodic benefit cost nor the post-retirement benefit obligation. A. Workforce reduction provisions (Note 14) The workforce reduction provisions, which cover employees in both Canada and the United States, are mainly comprised of payments related to severance, early retirement incentives and bridging to early retire- ment, the majority of which will be disbursed within the next three years. Payments have reduced the provisions by $177 million for the year ended December 31, 2002 ($169 million for the year ended December 31, 2001). As at December 31, 2002, the aggregate provisions, including the current portion, amounted to $421 million ($491 million as at December 31, 2001). 104 Canadian National Railway Company Canadian GAAP Notes to Consolidated Financial Statements 10 Long-term debt In millions Debentures and notes: (A) Canadian National series: Currency in which payable Maturity December 31, 2002 2001 6.63% 10-year notes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . May 15, 2003 7.00% 10-year notes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Mar. 15, 2004 6.45% Puttable Reset Securities (PURS) (B) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . July 15, 2006 6.38% 10-year notes (C) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Oct. 15, 2011 6.80% 20-year notes (C) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . July 15, 2018 7.63% 30-year debentures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . May 15, 2023 6.90% 30-year notes (C) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . July 15, 2028 7.38% 30-year debentures (C) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Oct. 15, 2031 Illinois Central series: 6.75% 10-year notes. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . May 15, 2003 7.75% 10-year notes. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . May 1, 2005 6.98% 12-year notes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . July 12, 2007 6.63% 10-year notes. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . June 9, 2008 5.00% 99-year income debentures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Dec. 1, 2056 7.70% 100-year debentures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Sep. 15, 2096 Wisconsin Central series: 6.63% 10-year notes. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . April 15, 2008 Total debentures and notes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other: Revolving credit facilities (Note 7) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Commercial paper (D) (Note 7) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Capital lease obligations, amounts owing under equipment agreements and other (E) . . . . . . . . . . . . . . . . . . . . Total other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Subtotal . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Less: Current portion of long-term debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net unamortized discount . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . U.S.$ U.S.$ U.S.$ U.S.$ U.S.$ U.S.$ U.S.$ U.S.$ U.S.$ U.S.$ U.S.$ U.S.$ U.S.$ U.S.$ U.S.$ U.S.$ U.S.$ Various $«««236 $«««239 419 394 631 315 236 749 315 158 158 79 32 12 197 236 4,167 142 214 1,068 1,424 5,591 574 14 588 422 398 636 318 239 755 318 159 159 80 32 12 199 239 4,205 273 339 1,125 1,737 5,942 163 15 178 $5,003 $5,764 A. The Company’s debentures and notes are unsecured. B. The PURS contain imbedded simultaneous put and call options at par. At the time of issuance, the Company sold the option to call the securi- ties on July 15, 2006 (the reset date). If the call option is exercised, the imbedded put option is automatically triggered, resulting in the redemp- tion of the original PURS. The call option holder will then have the right to remarket the securities at a new coupon rate for an additional 30-year term ending July 15, 2036. The new coupon rate will be determined according to a pre-set mechanism based on market conditions then pre- vailing. If the call option is not exercised, the put option is deemed to have been exercised, resulting in the redemption of the PURS on July 15, 2006. C. These debt securities are redeemable, in whole or in part, at the option of the Company, at any time, at the greater of par and a formula price based on interest rates prevailing at the time of redemption. D. The Company has a commercial paper program, which is backed by a portion of its revolving credit facility, enabling it to issue commercial paper up to a maximum aggregate principal amount of $600 million, or the U.S. dollar equivalent. Commercial paper debt is due within one year but has been classified as long-term debt, reflecting the Company’s intent and contractual ability to refinance the short-term borrowing through subsequent issuances of commercial paper or drawing down on the revolving credit facility. Interest rates on commercial paper at December 31, 2002 range from approximately 1.4% to 1.7%. Canadian GAAP Canadian National Railway Company 105 Notes to Consolidated Financial Statements 10 Long-term debt (continued) E. Interest rates for the capital leases range from approximately 3.0% to 14.6% with maturity dates in the years 2003 through 2025. The imputed interest on these leases amounted to $498 million as at December 31, 2002, and $545 million as at December 31, 2001. The equipment agreements are payable by monthly or semi-annual installments over various periods to 2007 at interest rates ranging from 6.0% to 6.7%. As at December 31, 2002, the principal amount repayable was $14 million ($19 million as at December 31, 2001). The capital leases, equipment agreements, and other obligations are secured by properties with a net carrying amount of $1,122 million as at December 31, 2002 and $1,096 million as at December 31, 2001. During 2002, the Company recorded $114 million in assets it acquired through the exercise of purchase options on existing leases and leases for new equipment ($91 million in 2001). An equivalent amount was recorded in debt. F. Long-term debt maturities, including repurchase arrangements and capital lease repayments on debt outstanding as at December 31, 2002 but excluding repayments of commercial paper and revolving credit facil- ity of $214 million and $142 million, respectively, for the next five years and thereafter, are as follows: Year 2003. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2004. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2005. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2006. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2007. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2008 and thereafter . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . In millions $÷«574 560 246 438 164 3,239 G. The aggregate amount of debt payable in U.S. currency as at December 31, 2002 is U.S.$3,164 million (Cdn$4,987 million) and U.S.$3,334 million (Cdn$5,302 million) as at December 31, 2001. 11 Capital stock and convertible preferred securities A. Authorized capital stock The authorized capital stock of the Company is as follows: • Unlimited number of Common Shares, without par value • Unlimited number of Class A Preferred Shares, without par value issuable in series • Unlimited number of Class B Preferred Shares, without par value issuable in series B. Issued and outstanding common shares During 2002, the Company issued 7.8 million shares of which 1.8 million shares (2.1 million shares in 2001 and 1.2 million shares in 2000) was related to stock options exercised and 6.0 million shares was related to the conversion of the Company’s convertible preferred securities. The total number of common shares issued and outstanding was 197.5 million as at December 31, 2002. C. Convertible preferred securities (“Securities”) On May 6, 2002, the Company met the conditions required to terminate the Securities holders’ right to convert their Securities into common shares of the Company, and set the conversion termination date as July 3, 2002. The conditions were met when the Company’s common share price exceeded 120% of the conversion price of U.S.$38.48 per share for a specified period, and all accrued interest on the Securities had been paid. On July 3, 2002, Securities that had not been previously surrendered for conversion were deemed converted, resulting in the issuance of 6.0 million common shares of the Company. In 1999, the Company had issued 4.6 million 5.25% Securities due on June 30, 2029, at U.S.$50 per Security. These Securities were subordi- nated securities convertible into common shares of CN at the option of the holder at an original conversion price of U.S.$38.48 per common share, representing an original conversion rate of 1.2995 common shares for each Security. D. Share repurchase programs On October 22, 2002, the Board of Directors of the Company approved a share repurchase program which allows for the repurchase of up to 13.0 million common shares between October 25, 2002 and October 24, 2003 pursuant to a normal course issuer bid, at prevailing market prices. As at December 31, 2002, $203 million was used to repurchase 3.0 mil- lion common shares at an average price of $67.68 per share. In 2001, the Board of Directors of the Company approved a share repurchase program under which the Company did not repurchase any common shares. In 2000, $529 million was used to repurchase 13.0 million common shares, the maximum allowed under the program, pursuant to a normal course issuer bid at an average price of $40.70 per share. 12 Stock plans The Company has various stock-based incentive plans for eligible employ- ees. A description of the Company’s major plans is provided below: A. Employee share plan The Company has an Employee Share Investment Plan (ESIP) giving eligible employees the opportunity to subscribe for up to 6% of their gross salaries to purchase shares of the Company’s common stock on the open market and to have the Company invest, on the employees’ behalf, a further 35% of the amount invested by the employees. Participation at December 31, 2002 was 8,911 employees (9,432 at December 31, 2001). The total number of ESIP shares purchased on behalf of employees, including the Company’s contributions, was 497,459 in 2002, 516,726 in 2001 and 637,531 in 2000, resulting in a pre-tax charge to income of $9 million, $8 million and $6 million for the years ended December 31, 2002, 2001 and 2000, respectively. 106 Canadian National Railway Company Canadian GAAP Notes to Consolidated Financial Statements B. Mid-term incentive share unit plan The Company has a share unit plan, which was approved by the Board of Directors in 2001, for designated senior management employees entitling them to receive payout on June 30, 2004 of a combination of common stock of the Company, as to fifty percent, and cash value, as to the remaining fifty percent. The share units vest conditionally upon the attainment of targets relating to the Company’s share price during the six-month period end- ing June 30, 2004. At December 31, 2002, the total number of share units outstanding was 419,900, representing a potential maximum com- pensation cost of $21 million. Due to the nature of the vesting condi- tions, no compensation cost was recorded for 2002 and 2001. At December 31, 2002, an additional 45,100 share units remained autho- rized for future issuances under this plan. C. Stock options The Company has stock option plans for eligible employees to acquire common shares of the Company upon vesting at a price equal to the market value of the common shares at the date of granting. The options are exercisable during a period not exceeding 10 years. The right to exer- cise options generally accrues over a period of four years of continuous employment. Options are not generally exercisable during the first 12 months after the date of grant. At December 31, 2002, an additional 2.6 million common shares remained authorized for future issuances under these plans. Options issued by the Company include conventional options, which vest over a period of time, and performance options, which vest upon the attainment of Company targets relating to the operating ratio and unlev- ered return on investment. The total conventional and performance options outstanding at December 31, 2002 were 9.1 million and 2.0 mil- lion, respectively. Changes in the Company’s stock options are as follows: Number of options In millions Weighted-average exercise price Outstanding at December 31, 1999 (1) . . . . . . . . . . . . . . . . . . . . . Granted . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Canceled . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Exercised . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Outstanding at December 31, 2000 (1) . . . . . . . . . . . . . . . . . . . . . Conversion of WC options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Granted . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Canceled . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Exercised . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Outstanding at December 31, 2001 (1) (2) . . . . . . . . . . . . . . . . . . . Granted . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Canceled . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8.3 2.2 (0.4) (1.2) 8.9 1.0 2.4 (0.3) (2.1) 9.9 3.2 (0.2) Exercised . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Outstanding at December 31, 2002 (1) (2) . . . . . . . . . . . . . . . . . . . 11.1 (1.8) $«34.88 $«35.33 $«36.23 $«22.19 $«34.95 $«58.63 $«50.65 $«46.01 $«30.43 $«43.62 $«76.78 $«56.98 $«39.16 $53.50 (1) Includes IC converted stock options translated to Canadian dollars using the foreign exchange rate in effect at the balance sheet date. (2) Includes WC converted stock options translated to Canadian dollars using the foreign exchange rate in effect at the balance sheet date. Stock options outstanding and exercisable as at December 31, 2002 were as follows: Range of exercise prices $13.50–$23.72 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $25.18–$35.01 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $35.70–$49.45 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $50.02–$69.77 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $70.04 and above . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Balance at December 31, 2002 (1) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Options outstanding Options exercisable Number of options In millions 0.1 2.1 3.2 2.5 3.2 11.1 Weighted- average years to expiration Weighted- average exercise price 3 6 6 8 9 7 $«17.23 $«33.59 $«44.69 $«51.43 $«77.59 $53.50 Number of options In millions 0.1 1.2 2.7 0.8 0.1 4.9 Weighted- average exercise price $«17.23 $«32.48 $«44.56 $«52.93 $«97.09 $44.01 (1) Includes IC and WC converted stock options translated to Canadian dollars using the foreign exchange rate in effect at the balance sheet date. D. Stock-based compensation cost Compensation cost for performance-based stock option awards under these plans is determined by the options’ intrinsic value in accordance with the CICA Handbook Section 3870 “Stock-Based Compensation and Other Stock-Based Payments.” No compensation cost was recognized for stock-based awards in 2002. Disclosures required under the fair value based accounting approach are presented in Note 2 – Accounting changes. Canadian GAAP Canadian National Railway Company 107 Notes to Consolidated Financial Statements 13 Pensions The Company has retirement benefit plans under which substantially all of its employees are entitled to benefits at retirement age, generally based on compensation and length of service and/or contributions. The tables that follow pertain to all such plans. However, the following descriptions relate solely to the Company’s main pension plan, the CN Pension Plan (the Pension Plan). The Company’s other pension plans are not significant. Description of plan The Pension Plan is a contributory defined benefit pension plan that covers the majority of CN employees. It provides for pensions based mainly on years of service and final average pensionable earnings and is generally applicable from the first day of employment. Indexation of pensions is provided after retirement through a gain (loss) sharing mechanism, subject to guaranteed minimum increases. An independent trust company is the Trustee of the Canadian National Railways Pension Trust Funds (CN Pension Trust Funds). As Trustee, the trust company performs certain duties, which include holding legal title to the assets of the CN Pension Trust Funds and ensuring that the Company, as Administrator, complies with the provisions of the Pension Plan and the related legislation. Funding policy Employee contributions to the Pension Plan are determined by the plan rules. Company contributions are in accordance with the requirements of the Government of Canada legislation, The Pension Benefits Standards Act, 1985, and are determined by actuarial valuations conducted at least on a triennial basis. These valuations are made in accordance with leg- islative requirements and with the recommendations of the Canadian Institute of Actuaries for the valuation of pension plans. The latest actu- arial valuation of the Pension Plan was conducted as at December 31, 2001 and indicated a funding excess. Based on the Pension Plan’s cur- rent position, the Company’s contributions are expected to be approxi- mately $75 million in each of 2003, 2004 and 2005. Description of fund assets The assets of the Pension Plan are accounted for separately in the CN Pension Trust Funds and consist of cash and short-term investments, bonds, mortgages, Canadian and foreign equities, real estate, and oil and gas assets. Based on the fair value of the assets held at December 31, 2002, the plan assets are comprised of 1% in cash and short-term investments, 40% in bonds and mortgages, 50% in Canadian and foreign equities and 9% in real estate and oil and gas assets. (a) Change in benefit obligation In millions Year ended December 31, 2002 2001 Benefit obligation at beginning of year . . . . . . . . . . . . . . . . . . . . . . . . . . $11,156 714 Interest cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $10,855 701 Actuarial (gain) loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Service cost. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Plan participants’ contributions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Foreign currency changes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (92) 99 61 (1) 94 92 73 6 Benefit payments and transfers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Benefit obligation at end of year. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $11,243 (694) (665) $11,156 (b) Change in plan assets In millions Year ended December 31, 2002 2001 Fair value of plan assets at beginning of year . . . . . . . . . . . . . . . . . . . . $11,763 92 Employer contributions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Plan participants’ contributions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Foreign currency changes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Actual return on plan assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 61 (1) (39) Benefit payments and transfers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Fair value of plan assets at end of year . . . . . . . . . . . . . . . . . . . . . . . . . . $11,182 (694) $12,455 69 73 6 (175) (665) $11,763 (c) Funded status In millions December 31, 2002 2001 Excess (deficiency) of fair value of plan assets over benefit obligation at end of year (1) . . . . . . . . . . . . . . . . . . . . . . . . . . $«(61) 282 Unrecognized net actuarial (gain) loss (1). . . . . . . . . . . . . . . . . . . . . . . . . . . . . Unrecognized net transition obligation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19 Unrecognized prior service cost. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net amount recognized. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $353 113 (1) Subject to future reduction for gain sharing under the terms of the plan. (d) Amount recognized in the Consolidated Balance Sheet In millions December 31, 2002 Prepaid benefit cost (Note 6) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $353 – Accrued benefit cost. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net amount recognized. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $353 (e) Components of net periodic benefit cost In millions Year ended December 31, 2002 Interest cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $«714 99 Service cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Amortization of net transition obligation. . . . . . . . . . . . . . . Amortization of prior service cost . . . . . . . . . . . . . . . . . . . . . . Expected return on plan assets. . . . . . . . . . . . . . . . . . . . . . . . . 20 20 (874) Recognized net actuarial loss . . . . . . . . . . . . . . . . . . . . . . . . . . Net periodic benefit cost (income) . . . . . . . . . . . . . . . . . . . . . $÷(20) 1 2001 $«701 92 20 20 (846) – $÷(13) $÷÷«6 $«607 (537) 39 133 $«242 2001 $251 (9) $242 2000 $«690 70 19 19 (792) – 108 Canadian National Railway Company Canadian GAAP Notes to Consolidated Financial Statements (f) Weighted-average assumptions 16 Other income December 31, 2002 2001 2000 In millions Year ended December 31, 2002 Discount rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Rate of compensation increase. . . . . . . . . . . . . . . . . . . . . . . . 6.50% 4.00% 6.50% 4.00% 6.50% 4.25% Expected return on plan assets for year ending December 31. . . . . . . . . . . . . . . . . . . . . . . . . . Gain on disposal of properties . . . . . . . . . . . . . . . . . . . . . . . . . . $«41 Equity in earnings of English Welsh and Scottish Railway (Note 6). . . . . . . . . . . . . . . . . . . . . . . . 9.00% 9.00% 9.00% Investment income. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Foreign exchange gain . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Effective January 1, 2003, the Company will reduce the expected Gain on sale of interest in Detroit River long-term rate of return on plan assets from 9% to 8% to reflect man- agement’s current view of long-term investment returns. The effect of this change in management’s assumption will be to increase net periodic benefit cost in 2003 by approximately $50 million. The Company has indemnified and held harmless the current trustee and the former trustee of the Canadian National Railways Pension Trust Funds, and the respective officers, directors, employees and agents of such trustees, from any and all taxes, claims, liabilities, damages, costs and expenses arising out of the performance of their obligations under the relevant trust agreements and trust deeds, including in respect of their reliance on authorized instructions of the Company or for failing to act in the absence of authorized instructions. These indemnifications survive the termination of such agreements or trust deeds. As at December 31, 2002, the Company has not recorded a liability associated with these indemni- fications, as the Company does not expect to make any payments per- taining to these indemnifications. 14 Workforce reduction charges In 2002, the Company announced 1,146 job reductions, in a renewed drive to improve productivity in all its corporate and operating func- tions, and recorded a charge of $120 million, $79 million after tax. In 2001, a charge of $98 million, $62 million after tax, was recorded for the reduction of 690 positions. Reductions relating to these charges were 388 in 2001, 433 in 2002, with the remainder to be completed by the end of 2003. The charges included payments for severance, early retirement incentives and bridging to early retirement, to be made to affected employees. 15 Interest expense In millions Year ended December 31, Interest on long-term debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cash interest payments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2002 $353 – $353 $390 2001 $314 (2) $312 $307 2000 $306 (11) $295 $299 2001 $«53 2000 $÷57 8 22 7 101 (99) – (20) (7) – – 10 – – 84 (22) (3) $«65 $126 33 18 12 – – – (15) (13) $«76 Tunnel Company (A) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Write-down of investment in 360networks Inc. (Note 6). . . . . . . . . . . . . . . . . . . . . . . . . Gain on exchange of investment (Note 6) . . . . . . . . . . . . . . . Net real estate costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . A. In March 2001, the Company completed the sale of its 50 percent interest in the Detroit River Tunnel Company (DRT) for proceeds of $112 million and recorded a gain of $101 million, $82 million after tax. The DRT is a 1.6 mile rail-only tunnel crossing the Canada-U.S. border between Detroit and Windsor, Ontario. 17 Income taxes The Company’s consolidated effective income tax rate differs from the statutory Federal tax rate. The reconciliation of income tax expense is as follows: In millions Year ended December 31, 2002 2001 2000 Federal tax rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26.1% 28.1% 29.1% Income tax expense at the statutory Federal tax rate. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Income tax (expense) recovery resulting from: $(219) $÷(314) $÷(353) Provincial and other taxes . . . . . . . . . . . . . . . . . . . . . . . . . (97) (134) (148) Deferred income tax adjustment due to rate reductions . . . . . . . . . . . . . . . . . . . . . . . . . . U.S. tax rate differential. . . . . . . . . . . . . . . . . . . . . . . . . . . . Gain on disposals and dividends . . . . . . . . . . . . . . . . . . . Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . – 1 6 41 – 1 27 28 (4) 7 20 36 Income tax expense. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $(268) $÷(392) $÷(442) Income before income taxes Canada . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . U.S. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Current income taxes Canada . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . U.S. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Deferred income taxes Canada . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . U.S. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $«900 $÷«955 $÷«999 (61) 164 217 $«839 $1,119 $1,216 $(130) $÷÷(99) $÷(153) 18 14 (71) $(112) $÷÷(85) $÷(224) $(161) $÷(226) $÷(228) 5 (81) 10 $(156) $÷(307) $÷(218) Cash payments for income taxes . . . . . . . . . . . . . . . . . . . . . . $÷«65 $÷÷«63 $÷«101 Canadian GAAP Canadian National Railway Company 109 Notes to Consolidated Financial Statements 17 Income taxes (continued) Significant components of deferred income tax assets and liabilities are as follows: In millions December 31, 2002 2001 Deferred income tax assets Workforce reduction provisions. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $÷«144 263 Accruals and other reserves . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Post-retirement benefits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Losses and tax credit carryforwards . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 99 69 575 $÷«178 182 85 53 498 Deferred income tax liabilities Properties and other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,278 4,074 Total net deferred income tax liability . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,703 Net current deferred income tax asset . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net long-term deferred income tax liability . . . . . . . . . . . . . . . . . . . . . . . . $3,825 122 3,576 153 $3,729 Net deferred income tax liability Canada . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $÷«436 3,267 U.S. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $÷«291 3,285 In millions Year ended December 31, 2002 2001 2000 Depreciation and amortization: Canadian rail (A) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $«÷278 228 U.S. rail . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $÷«255 $÷«232 214 189 $«÷506 $÷«469 $÷«421 Capital expenditures: (B) Canadian rail (C) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $«÷491 194 U.S. rail . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $÷«484 $÷«541 177 215 In millions Identifiable assets: $«÷685 $÷«661 $÷«756 December 31, 2002 2001 Canadian rail . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $÷7,402 11,522 U.S. rail (D) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $÷6,987 11,801 $18,924 $18,788 (A) Includes $7 million (2001: $6 million, 2000: $9 million) of depreciation and amortization of properties related to other business activities. (B) Represents additions to properties that include non-cash capital expenditures financed through capital lease arrangements. (C) Includes $4 million (2001: $5 million, 2000: $9 million) of additions to properties related to other business activities. $3,703 $3,576 (D) Includes equity holdings in foreign investments held by the Company’s U.S. subsidiaries. The Company expects to realize its deferred income tax assets from the generation of future taxable income, as the related payments are made and losses and tax credits carryforwards are utilized. The Company recognized tax credits of $9 million in 2002 for research and development expenditures ($35 million in 2001 for invest- ment tax credits) not previously recognized, which reduced the cost of properties. 18 Segmented information The Company operates in one business segment with operations and assets in Canada and the United States. Information on geographic areas In millions Revenues: Year ended December 31, 2002 2001 2000 Canadian rail . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $3,726 2,384 U.S. rail . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $6,110 $3,675 1,977 $5,652 $3,668 1,778 $5,446 Operating income: Canadian rail . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $÷«954 162 U.S. rail . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $÷«966 $1,025 400 360 $1,116 $1,366 $1,385 Net income: Canadian rail . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $«÷577 (6) U.S. rail . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $÷«591 $÷«589 136 185 $«÷571 $÷«727 $÷«774 19 Earnings per share The 2000 comparative figures have been restated to conform to the new accounting standard as explained in Note 2. The amended CICA Section 1650 “Foreign Currency Translation” requires restatement of prior years’ income and, as such, earnings per basic and diluted share for 2000 have increased by $0.01, respectively. Year ended December 31, 2002 Basic earnings per share . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2.87 Diluted earnings per share . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2.82 2001 $3.72 $3.62 2000 $3.91 $3.82 The following table provides a reconciliation between basic and diluted earnings per share: In millions Year ended December 31, Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Dividends on convertible preferred securities (Note 11) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2002 $571 6 $565 Weighted-average shares outstanding . . . . . . . . . . . . . . . . . 196.7 6.1 Effect of dilutive securities and stock options . . . . . . . . . . Weighted-average diluted shares outstanding . . . . . . . . . 202.8 2001 $727 12 $715 192.1 8.9 201.0 2000 $774 11 $763 195.0 7.8 202.8 At December 31, 2002, 3.2 million stock options at a weighted- average exercise price of $77.56 were not included in the calculation of diluted earnings per share since their inclusion would have had an anti-dilutive impact. 110 Canadian National Railway Company Canadian GAAP Notes to Consolidated Financial Statements 20 Major commitments and contingencies A. Leases The Company has lease commitments for locomotives, freight cars and intermodal equipment, many of which provide the option to purchase the leased items at fixed values during or at the end of the lease term. As at December 31, 2002, the Company’s commitments under operating and capital leases are $1,154 million and $1,407 million, respectively. Annual net minimum payments in each of the next five years and there- after, are as follows: Year In millions Operating Capital 2003 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $÷«212 $÷«168 2004 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2005 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2006 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2007 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2008 and thereafter . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 188 167 139 120 328 153 111 68 123 784 $1,154 1,407 Less: imputed interest on capital leases at rates ranging from approximately 3.0% to 14.6%. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 498 Present value of minimum lease payments at current rate included in debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $÷«909 Rent expense for operating leases was $269 million, $258 million and $219 million for the years ended December 31, 2002, 2001 and 2000, respectively. Contingent rentals and sublease rentals were not significant. The Company has guaranteed a portion of the residual values of certain of its assets under operating leases with expiry dates between 2004 and 2012, for the benefit of the lessor. If the fair value of the assets, at the end of their respective lease term, is less than the fair value, as estimated at the inception of the lease, then the Company must, under certain conditions, compensate the lessor for the shortfall. The maximum exposure in respect of these guarantees is $63 million. As at December 31, 2002, the Company has not recorded a liability associated with these guarantees, as the Company does not expect to make any payments pertaining to the guarantees of these leases. B. Other commitments As at December 31, 2002, the Company had commitments to acquire railroad ties, rail, freight cars and locomotives at an aggregate cost of $183 million. Furthermore, as at December 31, 2002, the Company had entered into agreements with fuel suppliers to purchase approximately 38% of its anticipated 2003 volume and 8% of its anticipated 2004 volume at market prices prevailing on the date of the purchase. C. Contingencies In the normal course of its operations, the Company becomes involved in various legal actions, including claims relating to personal injuries, occupational disease and damage to property. In Canada, employee injuries are governed by the workers’ compen- sation legislation in each province whereby employees may be awarded either a lump sum or future stream of payments depending on the nature and severity of the injury. Accordingly, the Company accounts for costs related to employee work-related injuries based on actuarially developed estimates of the ultimate cost associated with such injuries, including compensation, health care and administration costs. For all other legal actions, the Company maintains, and regularly updates on a case-by-case basis, provisions for such items when the expected loss is both probable and can be reasonably estimated based on currently available information. In the United States, employee work-related injuries, including occupational disease claims, are compensated according to the provi- sions of the Federal Employers’ Liability Act (FELA) and represent a major expense for the railroad industry. The FELA system, which requires either the finding of fault through the U.S. jury system or individual settlements, has contributed to the significant increase in the Company’s personal injury expense in recent years. In view of the Company’s growing pres- ence in the United States and the increase in the number of occupational disease claims over the past few years, an actuarial study was conducted in 2002, and in the fourth quarter of 2002 the Company changed its methodology for estimating its liability for U.S. personal injury and other claims, including occupational disease claims and claims for property damage, from a case-by-case approach to an actuarial-based approach. Consequently, and as discussed in Note 2, the Company recorded a charge of $281 million ($173 million after tax) to increase its provision for these claims. Under the actuarial-based approach, the Company accrues the cost for the expected personal injury and property damage claims and existing occupational disease claims, based on actuarial estimates of their ultimate cost. The Company is unable to estimate the total cost for unasserted occupational disease claims. However, a liability for unasserted occupa- tional disease claims is accrued to the extent they are probable and can be reasonably estimated. Under the case-by-case approach, the Company was accruing the cost for claims as incidents were reported based on currently available information. In addition, the Company did not record a liability for unasserted claims, as such amounts could not be reasonably estimated under the case-by-case approach. The Company’s expenses for personal injury and other claims, net of recoveries, and including the above-mentioned charge, were $393 million in 2002, ($78 million in 2001 and $60 million in 2000) and payments for such items were $156 million in 2002 ($149 million in 2001 and $111 million in 2000). As at December 31, 2002, the Company had aggregate reserves for personal injury and other claims of $664 million ($430 million at December 31, 2001). Although the Company considers such provisions to be adequate for all its outstanding and pending claims, the final outcome with respect to actions outstanding or pending at December 31, 2002, or with respect to future claims, cannot be predicted with certainty, and therefore there can be no assurance that their resolution will not have a material adverse effect on the Company’s financial position or results of operations in a particular quarter or fiscal year. Canadian GAAP Canadian National Railway Company 111 Notes to Consolidated Financial Statements 20 Major commitments and contingencies (continued) D. Environmental matters The Company’s operations are subject to federal, provincial, state, municipal and local regulations under environmental laws and regula- tions concerning, among other things, emissions into the air; discharges into waters; the generation, handling, storage, transportation, treatment and disposal of waste, hazardous substances, and other materials; decommissioning of underground and aboveground storage tanks; and soil and groundwater contamination. A risk of environmental liability is inherent in railroad and related transportation operations; real estate ownership, operation or control; and other commercial activities of the Company with respect to both current and past operations. As a result, the Company incurs significant compliance and capital costs, on an ongoing basis, associated with environmental regulatory compliance and clean-up requirements in its railroad operations and relating to its past and present ownership, operation or control of real property. While the Company believes that it has identified the costs likely to be incurred in the next several years, based on known information, for environmental matters, the Company’s ongoing efforts to identify poten- tial environmental concerns that may be associated with its properties may lead to future environmental investigations, which may result in the identification of additional environmental costs and liabilities. The mag- nitude of such additional liabilities and the costs of complying with envi- ronmental laws and containing or remediating contamination cannot be reasonably estimated due to: (i) (ii) the lack of specific technical information available with respect to many sites; the absence of any government authority, third-party orders, or claims with respect to particular sites; (iii) the potential for new or changed laws and regulations and for development of new remediation technologies and uncertainty regarding the timing of the work with respect to particular sites; (iv) the ability to recover costs from any third parties with respect to particular sites; and therefore, the likelihood of any such costs being incurred or whether such costs would be material to the Company cannot be determined at this time. There can thus be no assurance that material liabilities or costs related to environmental matters will not be incurred in the future, or will not have a material adverse effect on the Company’s financial posi- tion or results of operations in a particular quarter or fiscal year, or that the Company’s liquidity will not be adversely impacted by such environ- mental liabilities or costs. Although the effect on operating results and liquidity cannot be reasonably estimated, management believes, based on current information, that environmental matters will not have a mate- rial adverse effect on the Company’s financial condition or competitive position. Costs related to any future remediation will be accrued in the year in which they become known. As at December 31, 2002, the Company had aggregate accruals for environmental costs of $106 million ($112 million as at December 31, 2001). During 2002, payments of $16 million were applied to the provision for environmental costs compared to $14 million in 2001 and $11 million in 2000. The Company anticipates that the majority of the liability at December 31, 2002 will be paid out over the next five years. In addition, related environmental capital expenditures were $19 mil- lion in both 2002 and 2001 and $20 million in 2000. The Company expects to incur capital expenditures relating to environmental matters of approx- imately $20 million in each of 2003 and 2004 and $17 million in 2005. E. Standby letters of credit The Company, including certain of its subsidiaries, has granted irrevoca- ble standby letters of credit, issued by highly rated banks, to third parties to indemnify them in the event the Company does not perform its con- tractual obligations. As at December 31, 2002, the maximum potential liability under these letters of credit was $403 million of which $334 mil- lion was for workers’ compensation and other employee benefits and $69 million was for equipment under leases and other. As at December 31, 2002, the Company has not recorded a liability with respect to these guarantees, as the Company does not expect to make any payments in excess of what is recorded on the Company’s financial statements for the aforementioned items. The standby letters of credit mature at various dates between 2003 and 2007. F. General indemnifications In the normal course of business, the Company has provided indemnifica- tions, customary for the type of transaction or for the railway business, in various agreements with third parties, including indemnification provisions where the Company would be required to indemnify third parties and others. Indemnifications are found in various types of contracts with third parties which include, but are not limited to, (a) contracts granting the Company the right to use or enter upon property owned by third par- ties such as leases, easements, trackage rights and sidetrack agreements; (b) contracts granting rights to others to use the Company’s property, such as leases, licenses and easements; (c) contracts for the sale of assets; (d) contracts for the acquisition of services; (e) financing agreements; (f) trust indentures or fiscal agency agreements or similar agreements relating to debt or equity securities of the Company and engagement agreements with financial advisors; (g) transfer agent and registrar agreements in respect of the Company’s securities; and (h) trust agree- ments establishing trust funds to secure the payment to certain officers and senior employees of special retirement compensation arrangements or plans. To the extent of any actual claims under these agreements, the Company maintains provisions for such items, which it considers to be adequate. Due to the nature of the indemnification clauses, the maximum exposure for future payment cannot be determined with certainty, how- ever, may be material. 112 Canadian National Railway Company Canadian GAAP Notes to Consolidated Financial Statements 21 Financial instruments A. Risk management The Company has limited involvement with derivative financial instru- ments in the management of its fuel, foreign currency and interest rate exposures, and does not use them for trading purposes. (i) Credit risk In the normal course of business, the Company monitors the financial con- dition of its customers and reviews the credit history of each new customer. The Company is exposed to credit risk in the event of non-perfor- mance by counterparties to its derivative financial instruments. Although collateral or other security to support financial instruments subject to credit risk is usually not obtained, counterparties are of high credit quality and their credit standing or that of their guarantor is regularly monitored. As a result, losses due to counterparty non-performance are not antici- pated. The total risk associated with the Company’s counterparties was immaterial at December 31, 2002. The Company believes there are no significant concentrations of credit risk. (ii) Fuel To mitigate the effects of fuel price changes on its operating margins and overall profitability, the Company has a systematic hedging program which calls for regularly entering into swap positions on crude and heat- ing oil to cover a target percentage of future fuel consumption up to two years in advance. Realized gains and losses from the Company’s fuel hedging activi- ties were a $3 million gain, a $6 million loss and a $49 million gain for the years ended December 31, 2002, 2001 and 2000, respectively. At December 31, 2002, the Company has hedged approximately 47% of the estimated 2003 fuel consumption and 25% of the estimated 2004 fuel consumption. This represents approximately 263 million U.S. gallons at an average price of U.S.$0.5865 per U.S. gallon. Unrecognized gains and losses from the Company’s fuel hedging activities were a $30 million gain, a $38 million loss and a $17 million loss as at December 31, 2002, 2001 and 2000, respectively. (iii) Foreign currency Although the Company conducts its business and receives revenues pri- marily in Canadian dollars, a growing portion of its revenues, expenses, assets and debt are denominated in U.S. dollars. Thus, the Company’s results are affected by fluctuations in the exchange rate between these currencies. Changes in the exchange rate between the Canadian dollar and other currencies (including the U.S. dollar) make the goods trans- ported by the Company more or less competitive in the world market- place and thereby affect the Company’s revenues and expenses. For the purpose of minimizing volatility of earnings resulting from the conversion of U.S. dollar denominated long-term debt into the Canadian dollar, the Company has designated all U.S. dollar denominated long-term debt of the parent company as a foreign exchange hedge of its net investment in U.S. subsidiaries. As a result, from the dates of des- ignation, unrealized foreign exchange gains and losses on the translation of the Company’s U.S. dollar denominated long-term debt are recorded in Currency translation, which forms part of Shareholders’ equity. (iv) Interest rates From time to time, the Company enters into interest rate swap transactions for the purpose of minimizing the volatility in the fair value of certain fixed-interest long-term debt. In 2002 and 2001, the Company did not enter into any interest rate swap transactions. (v) Other The Company does not currently have any derivative instruments not designated as hedging instruments. B. Fair value of financial instruments Generally accepted accounting principles define the fair value of a financial instrument as the amount at which the instrument could be exchanged in a current transaction between willing parties. The Company uses the following methods and assumptions to estimate the fair value of each class of financial instruments for which the carrying amounts are included in the Consolidated Balance Sheet under the following captions: (i) Cash and cash equivalents, Accounts receivable, Accounts payable and accrued charges, and Other current liabilities: The carrying amounts approximate fair value because of the short matu- rity of these instruments. (ii) Other assets and deferred charges: Investments: The Company has various debt and equity investments for which the carrying value approximates the fair value, with the exception of a cost investment for which the fair value was estimated based on the Company’s proportionate share of its net assets. (iii) Long-term debt: The fair value of the Company’s long-term debt is estimated based on the quoted market prices for the same or similar debt instruments, as well as discounted cash flows using current interest rates for debt with similar terms, company rating, and remaining maturity. (iv) Convertible preferred securities: In 2001, the fair value of the Company’s convertible preferred securities was estimated based on the quoted market price. Canadian GAAP Canadian National Railway Company 113 Notes to Consolidated Financial Statements 21 Financial instruments (continued) The following table presents the carrying amounts and estimated fair values of the Company’s financial instruments as at December 31, 2002 and 2001 for which the carrying values on the Consolidated Balance Sheet are different from the fair values: In millions December 31, 2002 December 31, 2001 Carrying amount Fair value Carrying amount Fair value Financial assets Investments . . . . . . . . . . . . . . . . . . . . . . . . . . $÷«380 Financial liabilities Long-term debt (including current portion). . . . . . . . . $5,577 Other Convertible preferred securities . . . . . . . $÷«÷÷– $÷÷440 $÷«496 $÷÷551 $5,738 $5,927 $5,986 $÷«÷÷– $÷«327 $÷«479 22 Reconciliation of Canadian and United States generally accepted accounting principles The consolidated financial statements of Canadian National Railway Company are expressed in Canadian dollars and are prepared in accor- dance with Canadian GAAP which conform, in all material respects, with U.S. GAAP except as described below: A. Reconciliation of net income The application of U.S. GAAP would have the following effects on the net income as reported: In millions Year ended December 31, 2002 Net income – Canadian GAAP . . . . . . . . . . . . . . . . . . . . . . . . . $«571 Adjustments in respect of: Property capitalization, net of depreciation . . . . . . . . . Interest on convertible preferred securities. . . . . . . . . . Stock-based compensation cost . . . . . . . . . . . . . . . . . . . . . Income tax rate reductions . . . . . . . . . . . . . . . . . . . . . . . . . 363 (9) (9) – Income tax expense on current year U.S. GAAP adjustments . . . . . . . . . . . . . . . . . . . . . . . . . . Net income – U.S. GAAP. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $«800 (116) 2001 $727 339 (19) (19) 122 (110) $1,040 2000 $774 278 (18) (3) (4) (90) $937 (i) Property capitalization Under Canadian GAAP, the Company capitalizes only the material com- ponent of track replacement costs, to the extent it meets the Company’s minimum threshold for capitalization, whereas under U.S. GAAP the labor, material and related overheads are capitalized. Furthermore, the Company capitalizes under U.S. GAAP all major expenditures for work that extends the useful life and/or improves the functionality of bridges and other structures and freight cars. (ii) Stock-based compensation As explained in Note 2, effective January 1, 2002, the Company adopted the CICA recommendations related to the accounting for stock-based compensation and other stock-based payments. The Company has elected to prospectively apply the recommendations to its awards of con- ventional and performance-based employee stock options granted on or after January 1, 2002. Compensation cost attributable to performance- based employee stock option awards granted before such date continues to be a reconciling difference. (iii) Convertible preferred securities As explained in Note 11, the Convertible preferred securities (Securities) were converted into common shares of the Company on July 3, 2002. Prior to such date, the Securities were treated as equity under Canadian GAAP, whereas under U.S. GAAP they were treated as debt. Consequently, the interest on the Securities until July 3, 2002 was treated as a dividend for Canadian GAAP but as interest expense for U.S. GAAP. (iv) Foreign exchange In 2001, the Company early adopted the CICA amended recommenda- tions of Section 1650 “Foreign Currency Translation,” which essentially harmonizes Canadian and U.S. accounting standards by eliminating the deferral and amortization of unrealized translation gains or losses on for- eign currency denominated monetary items that have a fixed or ascer- tainable life extending beyond the end of a fiscal year and recognizing them into net income immediately. As required by the amended section, the Company has retroactively restated all prior period financial state- ments presented. (v) Income tax expense In 2001, under U.S. GAAP, the Company recorded a reduction to its net deferred income tax liability resulting from the enactment of lower cor- porate tax rates in Canada. As a result, a deferred income tax recovery of $122 million was recorded in the Consolidated statement of income and a deferred income tax expense of $32 million was recorded in Other comprehensive income. For Canadian GAAP purposes, there was no adjustment in 2001 as the impact resulting from lower corporate tax rates was accounted for in 2000 when the rates were substantively enacted. For the year ended December 31, 2000, the Canadian GAAP adjustment was a $4 million expense as the deferred tax position under Canadian GAAP was different. 114 Canadian National Railway Company Canadian GAAP Notes to Consolidated Financial Statements B. Earnings per share In 2000, the Company early adopted the CICA recommendations related to the presentation of earnings per share. Although the standard essen- tially harmonizes Canadian and U.S. standards, the earnings per share calculations continue to differ due to differences in the earnings figures. (i) Basic earnings per share Year ended December 31, 2002 Net income – U.S. GAAP. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $4.07 Weighted-average number of common shares outstanding (millions) – U.S. GAAP . . . . . . . . . . . . . . . . . 196.7 (ii) Diluted earnings per share Year ended December 31, 2002 Net income – U.S. GAAP. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $3.97 Weighted-average number of common shares outstanding (millions) – U.S. GAAP . . . . . . . . . . . . . . . . . 202.8 2001 $5.41 2000 $4.81 192.1 195.0 2001 $5.23 2000 $4.67 201.0 202.8 C. Reconciliation of significant balance sheet items (i) Shareholders’ equity As permitted under Canadian GAAP, the Company eliminated its accumu- lated deficit of $811 million as of June 30, 1995 through a reduction of the capital stock in the amount of $1,300 million, and created a contributed surplus of $489 million. Such a reorganization within Shareholders’ equity is not permitted under U.S. GAAP. Under Canadian GAAP, the dividend in kind declared in 1995 (with respect to land transfers) and other capital transactions were deducted from Contributed surplus. For U.S. GAAP purposes, these amounts would have been deducted from Retained earnings. Under Canadian GAAP, costs related to the sale of shares have been deducted from Contributed surplus. For U.S. GAAP purposes, these amounts would have been deducted from Capital stock. Under Canadian GAAP, the excess in cost over the stated value resulting from the repurchase of shares was allocated first to Capital stock, then to Contributed surplus and finally to Retained earnings. Under U.S. GAAP, the excess would have been allocated to Capital stock followed by Retained earnings. For Canadian and U.S. GAAP purposes, the Company designated all U.S. dollar denominated long-term debt of the parent company as a for- eign exchange hedge of its net investment in U.S. subsidiaries. Under Canadian GAAP, the resulting net unrealized foreign exchange gain, from the date of designation, has been included in Currency translation. For U.S. GAAP purposes, the resulting net unrealized foreign exchange gain has been included as part of Accumulated other comprehensive income, a separate component of Shareholders’ equity, as required under Statement of Financial Accounting Standards (SFAS) No. 130, “Reporting Comprehensive Income.” (ii) Minimum pension liability adjustment In 2002 and 2001, one of the Company’s pension plans had an accumu- lated benefit obligation in excess of the fair value of the plan assets. Under U.S. GAAP, this gave rise to an additional minimum pension liability. An intangible asset was recognized up to the amount of the unrecognized prior service cost and the difference has been recorded in Accumulated other comprehensive income, a separate component of Shareholders’ equity. There are no requirements under Canadian GAAP to record a minimum pension liability adjustment. (iii) Derivative instruments On January 1, 2001, under U.S. GAAP, the Company adopted SFAS No. 133 “Accounting for Derivative Instruments and Hedging Activities,” as amended by SFAS No. 138 “Accounting for Certain Derivative Instruments and Certain Hedging Activities.” In accordance with these statements, the Company has recorded in its balance sheet the fair value of derivative instruments used to hedge a portion of the Company’s fuel requirements. Changes in the market value of these derivative instru- ments have been recorded in Accumulated other comprehensive income, a separate component of Shareholders’ equity. There are no similar requirements under Canadian GAAP. (iv) Convertible preferred securities As explained in Note 11, the Convertible preferred securities (Securities) were converted into common shares of the Company on July 3, 2002. Prior to such date, the Securities were treated as equity under Canadian GAAP, whereas under U.S. GAAP they were treated as debt. Consequently, the initial costs related to the issuance of the Securities, net of amortiza- tion, which were previously deferred and amortized for U.S. GAAP, have since been reclassified to equity. Canadian GAAP Canadian National Railway Company 115 Notes to Consolidated Financial Statements 22 Reconciliation of Canadian and United States generally accepted accounting principles (continued) (v) The application of U.S. GAAP would have a significant effect on the following balance sheet items as reported: In millions December 31, 2002 2001 Current assets – Canadian GAAP . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $÷1,163 29 Fuel derivative instruments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Current assets – U.S. GAAP . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $÷1,192 Properties – Canadian GAAP. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $16,898 2,783 Property capitalization, net of depreciation . . . . . . . . . . . . . . . . . . . . . . Properties – U.S. GAAP . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $19,681 Other assets and deferred charges – Canadian GAAP . . . . . . . . . . . . $÷÷«863 1 Fuel derivative instruments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Intangible asset. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 Debt issue costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other assets and deferred charges – U.S. GAAP . . . . . . . . . . . . . . . . . $÷÷«865 – Current liabilities – Canadian GAAP . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $÷2,134 – Fuel derivative instruments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Current liabilities – U.S. GAAP . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $÷2,134 Deferred income tax liability – Canadian GAAP . . . . . . . . . . . . . . . . . . $÷3,825 955 Cumulative effect of prior years’ adjustments to income . . . . . . . . . Income taxes on current year U.S. GAAP adjustments . . . . . . . . . . . . Income taxes on translation of U.S. to Canadian GAAP adjustments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Income taxes on minimum pension liability adjustment . . . . . . . . . . Income taxes on fuel derivative instruments . . . . . . . . . . . . . . . . . . . . . Income tax rate reductions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 116 16 (13) 10 (86) Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Deferred income tax liability – U.S. GAAP. . . . . . . . . . . . . . . . . . . . . . . . $÷4,826 3 Other liabilities and deferred credits – Canadian GAAP . . . . . . . . . . $÷1,335 33 Stock-based compensation. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Minimum pension liability adjustment . . . . . . . . . . . . . . . . . . . . . . . . . . . 38 Fuel derivative instruments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other liabilities and deferred credits – U.S. GAAP. . . . . . . . . . . . . . . . $÷1,406 – $÷1,164 – $÷1,164 $16,723 2,422 $19,145 $÷÷«901 – 1 12 $÷÷«914 $÷1,638 31 $÷1,669 $÷3,729 845 110 13 (6) (13) (86) (1) 24 18 7 $÷1,345 In millions December 31, 2002 2001 Convertible preferred securities – Canadian GAAP . . . . . . . . . . . . . . . $÷÷÷÷«– – Debt issue costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Foreign exchange loss on convertible preferred securities . . . . . . . . – Convertible preferred securities (classified as debt) – U.S. GAAP . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $÷÷÷÷«– Contributed surplus – Canadian GAAP . . . . . . . . . . . . . . . . . . . . . . . . . . . $÷÷«175 248 Dividend in kind with respect to land transfers. . . . . . . . . . . . . . . . . . . Costs related to the sale of shares . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other transactions and related income tax effect . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Share repurchase program . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33 18 15 Capital reorganization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Contributed surplus – U.S. GAAP . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $÷÷÷÷«– (489) Currency translation – Canadian GAAP . . . . . . . . . . . . . . . . . . . . . . . . . . $÷÷«132 Unrealized foreign exchange gain (loss) on U.S. to Canadian GAAP adjustments, net of applicable taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Fuel derivative instruments, net of applicable taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Income tax rate reductions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Minimum pension liability adjustment, net of applicable taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 20 (32) (24) Accumulated other comprehensive income – U.S. GAAP . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $÷÷÷«97 Retained earnings – Canadian GAAP . . . . . . . . . . . . . . . . . . . . . . . . . . . . $÷2,762 Cumulative effect of prior years’ adjustments to income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Current year adjustments to net income . . . . . . . . . . . . . . . . . . . . . . . . . Share repurchase program . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cumulative dividend on convertible preferred securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Capital reorganization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,449 229 86 38 (811) (248) (18) $÷÷«327 12 27 $÷÷«366 $÷÷«178 248 33 18 12 (489) $÷÷÷÷«– $÷÷«133 (7) (25) (32) (11) $÷÷÷«58 $÷2,514 1,136 313 70 32 (811) (248) (18) $÷4,591 Dividend in kind with respect to land transfers. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $÷1,296 Other transactions and related income tax effect . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Retained earnings – U.S. GAAP . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $÷3,487 $÷2,988 Capital stock – Canadian GAAP. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $÷3,558 1,300 Capital reorganization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $÷3,209 1,300 Stock-based compensation. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Foreign exchange loss on convertible preferred securities . . . . . . . . Costs related to the sale of shares . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 49 12 (33) Share repurchase program . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Capital stock – U.S. GAAP . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $÷4,785 (101) 48 – (33) (82) $÷4,442 116 Canadian National Railway Company Canadian GAAP Notes to Consolidated Financial Statements 23 Quarterly financial data – unaudited In millions, except per share data 2002 2001 First Second Third Fourth (1) First Second Revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Operating income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,509 $÷«372 $÷«211 $1,551 $÷«385 $÷«212 $1,503 $÷«362 $÷«187 $1,547 $÷÷÷(3) $÷÷(39) $1,398 $÷«362 $÷«271 $1,392 $÷«245 $÷÷«40 Third $1,325 $÷«331 $÷«178 Fourth $1,537 $÷«428 $÷«238 Basic earnings per share . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $÷1.08 $÷1.08 $÷0.93 $«(0.20) $÷1.40 $÷0.19 $÷0.91 $÷1.22 Diluted earnings per share . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $÷1.04 $÷1.04 $÷0.92 $«(0.19) $÷1.36 $÷0.19 $÷0.88 $÷1.18 Dividend declared per share . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $0.215 $0.215 $0.215 $0.215 $0.195 $0.195 $0.195 $0.195 (1) In the fourth quarter of 2002, the Company recorded a charge of $281 million ($173 million after tax) to increase its liability for U.S. personal injury and other claims and a charge for workforce reductions of $120 million ($79 million after tax). 24 Comparative figures Certain figures, previously reported for 2001 and 2000, have been reclassified to conform with the basis of presentation adopted in the current year. Canadian GAAP Canadian National Railway Company 117 The CN Pension Plan and the CN 1935 Pension Plan General review Trustee Effective January 1, 2002, CIBC Mellon Trust Company (CIBC Mellon) was appointed as Trustee of the Canadian National Railways Pension Trust Funds (CN Pension Trust Funds, or Funds), replacing Montreal Trust Company of Canada. As Trustee, CIBC Mellon performs certain duties which include holding legal title to the assets of the Funds and providing a certificate confirming that Canadian National Railway Company (CN), as Administrator, complied with the provisions of the CN Pension Plan, the CN 1935 Pension Plan and the Pension Benefits Standards Act, 1985 and its regulations. The checks and direct deposit payments in respect of these plans were issued in the name of the CN Pension Trust Funds from bank accounts in the name of CIBC Mellon, Trustee of the CN Pension Trust Funds. Administration of the pension plans Overall accountability for the pension and benefit administration is the responsibility of CN. Mercer Human Resource Consulting, an employee benefits consulting firm, performs agreed-on pension and benefit admin- istration services on behalf of CN. Pension benefits A. Pension improvements The following pension improvements are effective January 1, 2002 and are based on recommendations made by the Pension Committee in 2001 and approved by CN’s Board of Directors: • The pension formula was increased from 1.6%/2.0% to 1.7%/2.0% for active members on January 1, 2002, for each year of pensionable service from January 1, 1966 for the CN Pension Plan only. The eligibility requirements to qualify for indexation were shortened from age 60 and at least five complete calendar years since retire- ment to age 59 and at least four complete calendar years since retirement. Pensions were indexed at 75% of inflation rather than 60% of infla- tion for the year 2002. Retirees and survivors who met the eligibility requirements saw their 2002 pension increase by 2.25% instead of 1.8% on the first $3,000 of basic monthly pension. This was a life- time pension benefit increase. A special improvement to pensions was paid to eligible retirees and surviving spouses entitled to indexation on January 1, 2002, based on the number of years that such retirees were on pension and their pensionable service at the time of retirement. This was a lifetime pension benefit increase. • • • In addition to these improvements, the CN Pension Plan was amended to provide for a reduction in the basic employee contribution rates, subject to certain conditions, from 5.48%/6.98% to 4.3%/6.3%, effective January 1, 2002. This improvement reflected an agreement 118 The CN Pension Plan and the CN 1935 Pension Plan that CN reached with five of its six unions on the implementation of an employee-paid Long Term Disability (LTD) plan for unionized employees active on January 1, 2002 and thereafter. The remaining union had established an employee-paid LTD plan in 1999 and the members of such union also benefited from the contribution reductions, subject to the same conditions applicable to the other unionized members. Disability pensions under the CN Pension Plan will be reduced to reflect the benefit payable under such employee-paid LTD plans. The non-unionized employees also benefited from the contribution reductions and the full cost of this reduction was charged to the Non- Unionized Employees’ Improvement Account as they have been covered by a CN-paid LTD plan under the CN Flex Benefit Program for many years. In 2002, CN’s Board of Directors approved the recommendation made by the Pension Committee to index pensions at 75% of inflation rather than 60% of inflation for the year 2003. Therefore, retirees and survivors who meet the eligibility requirements will see their 2003 pension increase by 1.275% instead of 1.02% on the first $3,250 of basic monthly pension. This is a lifetime pension benefit increase. B. Indexation agreement and escalation account As a result of the indexation agreement negotiated with the railway unions in 1989 and improvements to such agreement negotiated in 1992 and 1998, approximately 41,500 retirees and surviving spouses received permanent pension increases in 2002. These increases amounted to 2.25% on the first $3,000 of basic CN monthly pension, with a guaran- teed minimum monthly pension increase of $9.00 for eligible retirees and $4.50 for eligible surviving spouses. Under this indexation agreement, effective January 1, 1989, 50% of the experience gains or losses related to pensioners are accounted for separately in the Escalation Account. Net experience gains are used to pay for indexation of pensions above the minimum up to the maximum annual amount. The maximum annual indexation for eligible retirees and survivors is 60% (75% for the 2002 and 2003 indexation) of the increase in the Consumer Price Index (CPI) to a maximum increase in CPI of 6%, with an annual limit on the amount of pension which can be indexed. The Pension Committee may recommend additional benefits for pensioners, financed through the Escalation Account, if the balance in the account exceeds a certain threshold. These additional benefits are subject to approval by CN’s Board of Directors. Such additional benefits were granted on January 1, 2002 as indicated under section A. Pension improvements. In 2002, CN’s Board of Directors approved the Pension Committee’s recommendation to increase maximum indexa- tion for 2003 only, effective January 1, 2003 as indicated under section A. Pension improvements. The value of such improvements was charged to the Escalation Account in the current valuation. The CN Pension Plan and the CN 1935 Pension Plan C. Improvement accounts Effective January 1, 1998, the unions and CN agreed to share the experi- ence gains (losses) resulting from investment earnings related to active unionized members of the CN Pension Plan, based on the same concept as the indexation agreement. Under this agreement, annual calculations determine the amount of experience gains or losses to be credited (debited) to an account referred to as the Unionized Employees’ Improvement Account. The balance of such account, if positive, may be used to improve benefits of unionized active members or reduce their contributions, as recommended by the Pension Committee and approved by CN’s Board of Directors. The improvement account concept was also extended to non-unionized members and separate accounts were created for unionized and non-unionized members. The increase in the pension formula on January 1, 2002 as described under section A. Pension improvements was financed through the Improvement Accounts as of January 1, 2002. Annual pension statements As required by the Pension Benefits Standards Act, 1985 and to keep employees who are members of the CN Pension Plan and the CN 1935 Pension Plan updated annually on their personal entitlement, personal- ized pension statements were prepared as at December 31, 2001 and distributed by June 2002. Services to pensioners A. Direct deposit: The Direct Deposit System (DDS) is available to all retirees and survivors. Under this system, the monthly pension benefit is deposited directly into the individual’s personal account. An itemized pension pay stub is sent to that individual initially, each January and whenever the gross or net amount changes. About 40,700 pensioners used this service in 2002. B. Toll-free help lines: Approximately 45,400 calls were handled in 2002 through the central toll-free help line (1-800-361-0739). Staff handling the toll-free tele- phone line have ready access to records and information required for quick, efficient and accurate responses to most callers’ needs – in both of Canada’s official languages. Trustee’s report To the Administrator and the Members of the CN Pension Plan and the CN 1935 Pension Plan We, CIBC Mellon Trust Company, are the Trustee of the Canadian National Railways Pension Trust Funds (”CN Pension Trust Funds“). As Trustee, we have appointed KPMG LLP to examine the systems, procedures and internal controls used in respect to the custody, invest- ment and administration of the assets of the CN Pension Trust Funds, the administration of the CN Pension Plan and the CN 1935 Pension Plan (”1935 Plan“), and the performance of the Canadian National Railway Company (”CN“) as Administrator of the CN Pension Plan and the 1935 Plan for the year ended December 31, 2002. Our examination included such tests and procedures as were considered necessary in the circumstances taking into consideration the requirements of the Trust Deeds and our experience in the Canadian pension industry. In our opinion, based on the reasonable, but not absolute, degree of assurance obtained from the examination performed, the aforemen- tioned systems, procedures and internal controls used by CN as Adminis- trator, operated effectively during the year ended December 31, 2002 and complied with the objectives of the Pension Benefits Standards Act, 1985 and its Regulations. (signed) CIBC Mellon Trust Company Trustee of the Canadian National Railways Pension Trust Funds Toronto, January 20, 2003 The CN Pension Plan and the CN 1935 Pension Plan 119 The CN Pension Plan and the CN 1935 Pension Plan Actuary’s report Auditors’ report To the Board of Directors of Canadian National Railway Company To the Board of Directors of Canadian National Railway Company We have conducted actuarial valuations for funding purposes as at December 31, 2001 for the CN Pension Plan and the CN 1935 Pension Plan. As at December 31, 2001, these valuations revealed a consolidated actuarial liability of $10,486 million, a consolidated surplus of $482 mil- lion and a current service cost net of plan members’ contributions of $87 million in 2002. The next actuarial valuations will be conducted as at December 31, 2004, at the latest. In my opinion, for the purposes of the valuations, • • • the data on which these valuations were based were sufficient and reliable, the assumptions are, in aggregate, appropriate, and the methods employed in the valuations are appropriate. We have also conducted actuarial valuations for accounting purposes as at December 31, 2001 for the CN Pension Plan and the CN 1935 Pension Plan. These valuations were made in accordance with the requirements of Section 3461 of the Handbook of the Canadian Institute of Chartered Accountants (CICA). They revealed a consolidated actuarial liability of $10,933 million. The difference between the results of the actuarial valuations conducted for funding purposes and those conducted for accounting purposes is mainly due to the CICA Section 3461 requirement to use an interest rate inherent in the amount at which the actuarial liability could be settled at the date of valuation. Both valuations have been prepared and, my opinions given, in accordance with accepted actuarial practice. (signed) Bernard Morency Fellow of the Canadian Institute of Actuaries Mercer Human Resource Consulting Limited Montreal, January 21, 2003 We have audited the consolidated statement of net assets of the CN Pension Plan and the CN 1935 Pension Plan as at December 31, 2002 and the consolidated statement of changes in net assets for the year then ended. These financial statements are the responsibility of the Administrator. Our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audit in accordance with Canadian generally accepted auditing standards. Those standards require that we plan and perform an audit to obtain reasonable assurance whether the financial statements are free of material misstatement. An audit includes examin- ing, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by the Administrator, as well as evaluating the overall financial statement presentation. In our opinion, these consolidated financial statements present fairly, in all material respects, the net assets of the CN Pension Plan and the CN 1935 Pension Plan as at December 31, 2002 and the changes in their net assets for the year then ended in accordance with Canadian generally accepted accounting principles. (signed) KPMG LLP Chartered Accountants Montreal, Canada January 20, 2003 120 The CN Pension Plan and the CN 1935 Pension Plan Consolidated Statement of Net Assets at Market Value In millions As at December 31, 2002 2001 Bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $÷4,096 $÷3,733 Mortgages. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Real estate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Oil and gas . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Equities. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cash and short-term investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 319 318 657 5,565 143 272 271 468 6,033 890 Receivable from Canadian National Railway Company . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net other liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11,098 11,667 4 (9) 5 (1) $11,093 $11,671 On behalf of the Board: David G.A. McLean Director E. Hunter Harrison Director See accompanying notes to consolidated financial statements. The CN Pension Plan and the CN 1935 Pension Plan 121 Consolidated Statement of Changes in Net Assets at Market Value In millions Year ended December 31, 2002 2001 Net assets at market value, beginning of year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $11,671 $12,356 Investment income Bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Mortgages . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Real estate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Oil and gas . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Equities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Short-term investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Less administrative expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Investment income before net gain (loss) on sale of investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net gain (loss) on sale of investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total investment income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Unrealized depreciation in value of investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Contributions Employees . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Company. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total contributions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Disbursements for members Pension benefits paid . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Refunds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total disbursements for members. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Transfers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net decrease . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 240 23 10 52 84 14 423 (19) 404 (167) 237 (268) 61 74 135 (645) (37) (682) – (578) 238 18 11 48 88 20 423 (18) 405 486 891 (1,060) 73 69 142 (618) (43) (661) 3 (685) Net assets at market value, end of year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $11,093 $11,671 See accompanying notes to consolidated financial statements. 122 The CN Pension Plan and the CN 1935 Pension Plan Notes to Consolidated Financial Statements 1 Description of plans These consolidated financial statements cover two pension plans, the CN Pension Plan and the CN 1935 Pension Plan (CN Plans), and include the accounts of the Canadian National Railways Pension Trust Funds and its wholly owned companies. All references in these financial statements to the “Company” refer to Canadian National Railway Company, which is the Administrator of the CN Plans. The CN 1935 Pension Plan is for a closed group of members and represents less than 1% of the pension obligation of the plans. Therefore, the following is a summarized descrip- tion of the CN Pension Plan only. Please refer to the rules of the CN Pension Plan for additional information. A. General The CN Pension Plan (the Plan) is a contributory defined benefit pension plan generally applicable for employees from the first day of employ- ment. Under this Plan, employees contribute between 4.3% and 4.7% (5.48% and 5.88% prior to January 1, 2002) of earnings up to the Year’s Maximum Pensionable Earnings (YMPE) under the Canada or Quebec Pension Plan and between 6.3% and 6.7% (6.98% and 7.38% prior to January 1, 2002) of earnings in excess of the YMPE up to a maxi- mum of $4,989 in 2002. Participants are not required to make contribu- tions after 35 years of pensionable service. Company contributions are determined on the basis of actuarial valuations done at least on a trien- nial basis in accordance with the requirements of the Pension Benefits Standards Act, 1985 and Regulations thereunder. B. Pensions Pensions are based on the employee’s average pensionable earnings for the best five consecutive calendar years or the last 60 months of employ- ment at the rate of 2% for each year of pensionable service prior to January 1, 1966, 1.7% for each year of pensionable service thereafter up to the average YMPE over the last 60 months and 2% of the excess of such average pensionable earnings over the average YMPE. The maxi- mum annual pension payable is $1,715 multiplied by the pensionable service of the member. Pensionable service is limited to 35 years. C. Retirement age The normal retirement age is 65. However, with the Company’s consent, employees who are at least 55 years of age and have 85 points (age plus years of pensionable service) are entitled to an early retirement pension without reduction. Employees with less than 85 points can retire anytime from age 55 with a reduction in their pension of 0.5% for each month (6% per year) between their date of retirement and their 65th birthday. D. Disability pensions A member with 10 years of pensionable service who is declared either unfit to perform his/her usual employment with the Company due to a permanent disability which occurred prior to 1992, or totally and perma- nently disabled due to a disability which occurred after 1991, may, sub- ject to certain conditions, apply for an immediate reduced or unreduced pension. Any declarations in respect of a member’s disability are the responsibility of CN’s Chief Medical Officer. The disability pension may be adjusted to take into account benefits payable under a long-term disability plan or under a Workers’ Compensation Act of any province. E. Pre-retirement survivors’ pensions and death refunds A survivor’s pension is payable to the eligible spouse of a member who had a minimum of two years of plan membership upon his/her death. Otherwise, a death refund is payable to the spouse, or, if there is no spouse, to the estate of the member. F. Post-retirement survivors’ pensions and estate settlements Upon the death of a retiree who had an eligible spouse at retirement, either 55% or 60% of the basic pension of the retiree is payable to that spouse during his/her lifetime depending on the option elected at retire- ment. The survivor’s pension is guaranteed for the first 10 years after retirement. If the retiree and the surviving spouse, if any, die in the first 10 years after retirement, the survivor’s pension will be payable to the estate of the retiree until the 10-year period is over. G. Termination benefits Upon termination of service, a member is entitled to either his/her contributions with interest or to the value of his/her benefits accrued under the Plan or to a deferred pension or a combination of the above, depending on his/her age, pensionable service and years of membership at termination. H. Income taxes The Plan is registered under the Income Tax Act and Regulations. Contributions to the Plan are tax deductible to the Company and invest- ment income of the Canadian National Railways Pension Trust Funds is not taxable in Canada. Investment income from some foreign countries is subject to withholding taxes, which are either fully or partially recovered. The CN Pension Plan and the CN 1935 Pension Plan 123 Notes to Consolidated Financial Statements 2 Summary of significant accounting policies (v) Equities are valued using the closing market price as at December 31. A. Basis of presentation These consolidated financial statements are prepared on a market value basis, in accordance with generally accepted accounting principles in Canada for pension plans. Management is required to make estimates and assumptions that affect the reported amounts at the date of the financial statements. Actual results could differ from these estimates. These financial statements present the aggregate financial position of the CN Plans as a separate financial reporting entity independent of the sponsor and plan members, and are prepared to assist plan members and others in reviewing the activities of the CN Plans for the year and as such, do not portray the funding requirements of the CN Plans nor the benefit security of individual members. B. Investments Investment transactions are recorded at the point when the risks and rewards of ownership are transferred. Publicly traded securities are recorded on the trade date. Investments are stated at market value which is determined using publicly quoted prices where available. When such prices are not avail- able, market values are estimated on the basis of the present value of estimated future net cash flows, the market value of comparable assets, or the breakup value of underlying assets. Market values of investments are determined as follows: (i) Bonds are valued using the closing market price as at December 31. (ii) Mortgages are valued using current market yields of financial instru- ments of similar maturity and at appropriate spreads from instru- ments of comparable quality. (iii) Real estate consists of land and buildings. Land is valued using the market value of comparable assets, and buildings are valued using the present value of estimated future net cash flows and the market value of comparable assets. Independent valuations of land and buildings are performed triennially. (iv) Oil and gas reserves are valued using the present value of estimated future net cash flows, which are based on projected production, prices, and costs. Land is valued using the market value of compar- able assets. Trust units and equities are valued using the closing market price as at December 31. (vi) Short-term investments and other assets are valued at cost, which approximates market value. (vii) Listed derivative financial instruments are valued using the market settlement price as at December 31. Unlisted derivative financial instruments are valued using the present value of future net cash flows determined by using closing market levels and interest rates for instruments of similar maturity and credit risk. The change in market value has been segregated in the Consolidated Statement of Changes in Net Assets at Market Value between net gain (loss) on sale of investments during the year and the unrealized apprecia- tion (depreciation) in value of investments, which represents the balance of the change in market value of investments for the year. C. Income recognition Dividends are accrued on the ex-dividend date; income from other investments is accrued as earned. Gains or losses realized on the sale of investments are recognized on the dates of sales, are calculated based on the average cost of the assets and are included in the Consolidated Statement of Changes in Net Assets at Market Value as a net gain (loss) on sale of investments. D. Foreign exchange Assets and liabilities denominated in foreign currencies are translated using current rates as at December 31 or at the forward foreign exchange contract rates for investments that are hedged. Foreign dividends and interest income are translated at the rates prevailing when accrued. Unrealized foreign exchange gains and losses on investments incurred during the year are included in unrealized appreciation (depreci- ation) in value of investments. The net gain (loss) on sale of investments denominated in foreign currencies includes the foreign exchange gain or loss realized on the transaction. E. Contributions Contributions from employees are recorded in the period in which the Company makes payroll deductions. The contributions from the Company, as determined by the latest actuarial valuations, are recorded using the accrual method. F. Transfers Transfers to/from other funds are accounted for in the period in which the value of the transfers can be reasonably estimated. 124 The CN Pension Plan and the CN 1935 Pension Plan Notes to Consolidated Financial Statements 3 Investments Investments consist of securities, assets or financial instruments where the CN Plans’ original intention is to hold to maturity or until market conditions render alternative investments more attractive. Significant terms and conditions related to investments as at December 31 are as follows: Market risk Market risk is the risk that the value of an investment will fluctuate as a result of changes in market prices whether those changes are caused by factors specific to the individual investment or its issuer, or factors affecting all securities traded in the market. The CN Plans’ policy is to invest in a diversified portfolio of investments, based on criteria established in the Statement of Investment Policies and Procedures, and may include the use of derivative financial instruments to mitigate the impact of market risk. Equities are diversified by issuer and by industry. The most signifi- cant allocations to individual issuers or industry sectors are limited to 4.2% and 15.2%, (3.5% and 17.7% in 2001) respectively. Foreign currency risk Foreign currency exposure arises from investments denominated in cur- rencies other than the Canadian dollar. Fluctuations in foreign currency rates can result in a positive or negative impact on the fair value of the CN Plans’ investments. The CN Plans’ exposure to currencies, as a proportion of total assets and after taking into account the effect of foreign currency derivatives positions, is as follows: As at December 31, Canada. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . United States of America . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Euro zone . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . United Kingdom . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Japan . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2002 78% 11% 3% 2% 2% 4% 100% 2001 73% 18% 4% 2% 1% 2% 100% Interest rate risk Interest rate risk represents the risk that the market value of the CN Plans’ investments will fluctuate due to changes in market interest rates. Sensitivity to interest rates is a function of the timing and amount of cash flows of the assets and liabilities of the CN Plans. The term to maturity of interest rate sensitive investments, based on contractual repricing dates, is as follows: In millions, except percentage data As at December 31, Within 1 year Term to maturity 1 to 5 years Short-term investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Mortgages. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $132 34 – $166 $÷÷÷«– 1,637 76 $1,713 2002 Over 5 years $÷÷÷«– 2,425 243 $2,668 Average effective yield 2.78% 4.59% 5.44% 4.60% Total $÷«132 4,096 319 $4,547 2001 Average effective yield 2.51% 5.06% 6.47% 4.68% Total $÷«881 3,733 272 $4,886 Credit risk Credit risk arises from the potential for an investee to fail or a counter- party to default on its contractual obligations to the CN Plans. are issued or guaranteed by Canadian or U.S. governments and 18% (9% in 2001) by corporations. Mortgages are secured by real estate. At year-end, the CN Plans’ most significant exposures were with In accordance with formally established policies, the CN Plans manage credit risk by dealing with counterparties considered to be of high credit quality, utilizing an internal credit limit monitoring process as well as credit mitigation techniques such as master netting and collateral agreements. Short-term investments consist primarily of securities issued by Canadian chartered banks. Seventy-eight percent (90% in 2001) of Bonds Canadian governments which issued or guaranteed $3,200 million ($3,181 million in 2001) of securities held by the CN Plans. Excluding the above, the remainder of assets are diversified with no other issuer accounting for more than 2.1% (3.3% in 2001) of total net assets. Credit risk resulting from the use by the CN Plans of derivative finan- cial instruments is addressed in Note 4. The CN Pension Plan and the CN 1935 Pension Plan 125 Notes to Consolidated Financial Statements 4 Derivative financial instruments 5 Funding policy In respect of the CN Plans, the contributions by the Company are deter- mined in accordance with the requirements of the Pension Benefits Standards Act, 1985 and Regulations thereunder, and are based on the projected unit credit actuarial cost method, with projection of salaries where future salary changes affect the amount of the projected benefits. In the case of the CN 1935 Pension Plan, the Company makes money purchase contributions in accordance with the rules of the plan. The latest actuarial valuations of the CN Plans were prepared by Mercer Human Resource Consulting Limited as at December 31, 2001 and were submitted to the Superintendent of Financial Institutions and to the Canada Customs and Revenue Agency. In these actuarial valua- tions, the principal assumptions adopted by the CN Plans’ actuary are members’ mortality, disability, retirement, termination of employment, merit and periodic increases in earnings, as well as a long-term rate of return of 7.0% (7.25% at the previous valuation) per annum on invest- ments. Future increases in members’ earnings have been projected using economic assumptions consistent with this long-term rate of return. 6 Transfers In 2002, the accounts include a provision for the amounts to be remitted to/from other funds to cover transfers of members of CN Plans to other pension plans and transfers of members of other plans to the CN Plans. 7 Consolidated actuarial pension obligation and asset value The actuarial valuations as at December 31, 2001 revealed a consoli- dated actuarial liability of $10,933 million and a consolidated actuarial asset value of $10,968 million. The results of these valuations were then used to estimate the corresponding figures as at December 31, 2002, which approximate $11,127 million and $11,212 million, respectively, as at that date. The principal components of the change in the pension obligations are the interest accrued on benefits ($706 million in 2002 and $693 million in 2001), benefit payments and transfers ($683 million in 2002 and $655 million in 2001), benefits accrued during the year ($157 million in 2002 and $163 million in 2001), and actuarial loss ($14 million in 2002 and $10 million in 2001). The consolidated actuarial lia- bility was calculated in accordance with the Canadian Institute of Chartered Accountants (CICA) Handbook Section 3461 using a discount rate of 6.5% as at December 31, 2002 and December 31, 2001. The con- solidated actuarial asset value is based on a market-related method, which recognizes the change in market value over a period of five years using the straight-line method. From time to time, the CN Plans use derivative financial instruments (derivatives) for asset mix management purposes or to hedge their expo- sures to foreign currency, interest rate or market risks of the portfolio or anticipated transactions. Derivatives are financial instruments whose value is derived from interest rates, foreign exchange rates, equity or commodity prices. When derivatives are used for hedging purposes, the gains or losses on the derivatives are offset by a corresponding change in the value of the hedged assets. Derivatives include forwards, futures, swaps and options. Types of contracts used by the CN Plans include: • Swaps, which are contractual agreements between two parties to exchange fixed and/or floating rate payments based on a notional value. Forwards and futures, which are contractual agreements to either buy or sell a specified currency or financial instrument at a specific price and date in the future. Forwards are customized contracts transacted in the over-the-counter market. Futures are standardized contracts traded on regulated exchanges and are subject to daily cash margining. • The credit risk of derivative instruments is limited to the cost of replacing, at current fair value, all contracts which have a positive value. Credit risk on futures contracts is considered minimal as the counterparty to a futures contract is a public exchange, contracts are marked-to- market and margin receivables and payables are settled in cash daily. The following table summarizes the derivatives portfolio of the CN Plans and the related credit exposure: As at December 31, 2002 2001 In millions Interest rate: Swap contracts. . . . . . . . . Futures contracts. . . . . . . Foreign exchange: Forward contracts . . . . . Swap contracts. . . . . . . . . Equity and commodity: Futures contracts. . . . . . . Total . . . . . . . . . . . . . . . . . . . . . Effect of master netting and collateral agreements . . . . . . . . . . . . Net credit risk (replacement cost) . . . . . Notional value (1) Fair value (2) Notional Assets Liabilities value (1) Fair value (2) Assets Liabilities $÷÷«50 $0.7 $÷«– $÷÷«41 $÷«÷– $÷0.2 765 – – 294 – 1,209 1.7 7.5 – 4 – – – – 867 65 9 15.1 – – – 7.2 7.7 – $2,028 2.4 $7.5 $1,276 15.1 $15.1 (0.2) $2.2 (2.0) $13.1 (1) Notional value represents the amount to which a rate or price is applied in order to calculate the exchange of cash flows under a derivative contract. (2) The fair values of all derivative contracts are included in the market value of the assets of the CN Plans. 126 The CN Pension Plan and the CN 1935 Pension Plan 2002 President ’s Awards for Excellence Representing a diverse number of functions and locations, and demonstrating an unprecedented ability to work together at all levels, a record number of employees received CN’s President’s Awards for Excellence in 2002. From across the entire system in both Canada and the United States, they excelled in their efforts to come up with innovative solutions, focus on results, and make a difference at CN and in their communities. Category: Safety L.I.F.E. team – Richard Dare, Benton – Illinois; Scott Lipe – Carbondale, Illinois; Brad Sanders – Centralia, Illinois; Arthur Rapp – Champaign, Illinois; Cathy Cortez, Charles Webster – Chicago, Illinois; Barry Kracht – Duquoin, Illinois; Charles Scholes – Effingham, Illinois; Terry Mason, Michael Mowen – Harvey, Illinois; Paul Adams, Erik Anderson, Larry Anderson, Carol Brinkman, Ronald Ester, David Hall, Bob Keane, Pat Post, Gordon Sharp, David Sprankle – Homewood, Illinois; Kenny Monke – Mattoon, Illinois; Doyle Cowles, Steven Craig, Brian Ott, Joseph Rubino – Waterloo, Iowa; Walter Carlton III, Gary Devall – Baton Rouge, Louisiana; Frank Elkins Jr. – New Orleans, Louisiana; Jeffrey Roberts – Detroit, Michigan; Terry Tindol – Battle Creek, Michigan; John Geary Jr., William Lustig, Ray Townley – Flat Rock, Michigan; Larry Bancroft, Jim McMahon, Ron Merrow – Pontiac, Michigan; David Hayslip, Robbie Harman – Troy, Michigan; William Chesteen – Grenada, Mississippi; Winky Freeman, Johney Grayson Jr., Randy Harris, Michael Strange – Jackson, Mississippi; Bennie Punchard – McComb, Mississippi; Joseph Baroni, Tarie Smith, Michael Wells – Memphis, Tennessee This 47-member union/management team takes its name – L.I.F.E. (for Live Injury-Free Everyday) – to heart, demonstrating an unwavering commitment to railroad safety, a top priority at CN. Representing all occupations, they revised the existing safety rule books from different organizations within CN’s U.S. operations and developed an innovative safety initiative that moves away from more traditional approaches to implementing railroad safety processes and procedures. Their original solution uses a number of creative methods such as peer coaching. Norman J. Witzell – Surrey, British Columbia Constable Witzell is a man with a mission: spreading CN’s message of rail safety to every corner of British Columbia. He goes above and beyond the normal call of duty and leaves nothing out in fulfill- ing his role as Community Services Officer, which he conducts based on a comprehensive action plan. Category: New Business Opportunities Air Canada Jet Fuel team – Patrice Déry – Charny, Quebec; Mike A. Corr, Dave Howett – Concord, Ontario; Ron L. Borden – Mississauga, Ontario; Janet A. Drysdale, Carmino Russo – Montreal, Quebec These team members put their heads together to come up with a non-traditional and innovative approach to improving customer service. The result was a much quicker turnaround time for trans- porting jet fuel for Air Canada. NSC Minerals – Marc Arnaud, Tim Cowieson, Barry Pellerin – Saskatoon, Saskatchewan; Greg Kendall, Gary Parbery – Winnipeg, Manitoba A “cold call” from a Transportation officer was the initiative that got the ball rolling with NSC Minerals. With follow-up efforts from these team members, it led to bringing the company on board as an important new customer and transportation partner. The results: significant benefits to CN annually. Category: Customer Focus Judy Amato – Flat Rock, Michigan Judy’s passion for customer service is what prompted her client, Ford, to nominate her for the President’s Award. In fact, Judy’s contribution has helped both Ford and CN. One of her many client- focused initiatives helped Ford save on costs by using rail instead of trucking. White Pine Team – Douglas Webster – Chicago, Illinois; Jeff Brazeau, Joseph Dennis, Jim Firkus, James Waitanek – Ironwood, Michigan; Brad Koenig – Fond du Lac, Wisconsin; Jack Bratanich, Kenneth Feucht, Albert Hoecherl, Gerard Jiskra, Lyle Nelson, Randy Nichols, Brent Ogle, Wayne Phetteplace, Brian Tucci, Duane Webster – Ladysmith, Wisconsin; Dan Hampston, Ronald Lake, Fred Nafey, John Wickersham – Mellen, Wisconsin; William Lange, James Mabie Sr. – Prentice, Wisconsin; Gary Bright – South Range, Wisconsin; Frederick Bandt, Brad Dupee, Thomas Helton, Gary Hoffman, Richard Hoffman, James Peterson, Corey Quante, Brian Retzlaff – Stevens Point, Wisconsin This team jumped into action during an emergency last April. It was their quick thinking and com- bined efforts that prevented White Pine Copper Refinery from having to shut down when it was threatened by flooding. The consequences of the measures they took were impressive: White Pine avoided substantial losses in delayed deliveries and lost production. Category: People Leadership Denny Duncan – Mattoon, Illinois Denny is a true role model for his staff. A dedicated manager who takes pride in his work, he is a good listener who is open to innovation, comments and suggestions. Even in extreme weather conditions, the teams he leads complete their work on schedule and under budget. And safety is always a priority in Denny’s book; his bridge gangs have not had one reported injury since he took over in 1999. Category: Cost Effectiveness Research and Development team – Helga Audet, Hani Bazerghi, Carla D’Alessandro, Deanna Derocher, Stephen Desabrais, John Edwards, Claude Essiembre, Linda Feudi, Greg Hickson, Stella Karnis, Farveh Momayezzadeh, Bob S. Moore, Susan Parker, Anshu Pathak, Dan Toy, Bob White, Walter Zanelli – Montreal, Quebec; Timothy Keegan – Edmonton, Alberta Using creativity, this cross-functional team contributed to improving CN’s bottom line. They worked together to access Canadian federal and provincial R&D tax incentives arising from CN’s investments in innovation in the areas of Systems, Transportation, Engineering, Environment and Safety. The new process they introduced is generating substantial benefits for CN now and into the future. Category: Operational Breakthrough B&S Gang no. 70 – Doug Bainbridge, Jeff Beaudry, Mike Faubert, Rick Fortier, Don Hicks, Luc Labonté, Liduino Medeiros, Ken Payne, Todd Schell, Ernie Simard, Hank Vanstraten, Robert Zadow – Capreol, Ontario Working together, the members of this team – from field supervisor to the cook on the gang – proved that a revolutionary new procedure results in significant savings. They delivered exceptional performance in the execution of an innovative new method of bridge stringer replacement that completely transforms the traditionally labor-intensive, time-consuming task. WC/BLE Labor Negotiating Team – Jack Gibbins – Chicago, Illinois; Roger MacDougall – Rosemont, Illinois; Jeff Bochman – Fond du Lac, Wisconsin; John Reynolds – Green Bay, Wisconsin; Bill Grimstad, Allan Rothwell, Ed Terbell – Stevens Point, Wisconsin IC/BLE Labor Negotiating Team – Myron Becker – Chicago, Illinois; Thomas J. Goodwine – Homewood, Illinois; John P. Kay – Jackson, Mississippi; John Koonce – Memphis, Tennessee These teams are responsible for a breakthrough in labor/management relations in the United States. The new agreements reached between Wisconsin Central and the Brotherhood of Locomotive Engineers (BLE) and between Illinois Central and the BLE simplify and modernize both the language of the contracts and the nature of the employment relationship between employees and the company, and improve the employees’ quality of life. Category: Bravery/Exceptional Community Service James Jones – Detroit, Michigan (now retired and living in Myrtle Beach, South Carolina) James was honored for an act of bravery that saved a woman’s life. He came to the rescue of the elderly and handicapped senior who was trapped in a burning car in a gas station. It was thanks to his heroic act that the woman survived the life-threatening ordeal. Operation Lifesaver – Tom Bozyk, Sandra Hamm, Tom Hosfield, Rick Small, Ron B. Smith, Cynthia Stotz – Winnipeg, Manitoba; Don Marquis – Fort Frances, Ontario; Gerald Koopman – North Battleford, Saskatchewan; Hugh Beechy, Greg Smerchynski – Regina, Saskatchewan This team performs an important community service through Operation Lifesaver, a program to which they are totally dedicated. Their commitment to this rail industry initiative translates into increased awareness of the dangers of highway/railroad crossings and trespassing on railroad property. Team members work closely together using as many different and imaginative means as possible to get this important message out to their communities. Category: Diversity Brent Ballingall – Kamloops, British Columbia Brent demonstrated his commitment to diversity by taking it upon himself to actively participate in several initiatives for Aboriginal peoples. He attended conferences and workshops, took part in the development of an Aboriginal/CN database on native sites, and was involved in CN’s contribution to the construction of the Skeetchestn Pow-Wow arbor. Judy MacKenzie – Edmonton, Alberta Judy was singled out for championing diversity in recruiting for seasonal track opportunities. In addition to advertising through TMP Worldwide recruitment services, she directly contacted the employment offices of several local Aboriginal bands. Her actions resulted in the hiring of 55 people, a third of whom represent diverse groups. Canadian National Railway Company 127 Left to right: David G.A. McLean, E. Hunter Harrison, Gilbert H. Lamphere, V. Maureen Kempston Darkes, James K. Gray, Cedric E. Ritchie Board of Directors (As of December 31, 2002) David G.A. McLean, O.B.C., LL.D. Chairman of the Board Canadian National Railway Company Chairman and Chief Executive Officer The McLean Group Committees: 2*, 3, 4, 5, 6, 7 E. Hunter Harrison President and Chief Executive Officer Canadian National Railway Company Committees: 3, 7 Gilbert H. Lamphere Private Investor and Former Chairman of the Board Illinois Central Corporation Committees: 1, 4, 5, 7 V. Maureen Kempston Darkes, O.C., D.Comm., LL.D. Group Vice-President General Motors Corporation and President GM Latin America, Africa and Middle East Committees: 2, 5, 7 James K. Gray, O.C., A.O.E., LL.D. Corporate Director and Former Chairman and Chief Executive Officer Canadian Hunter Exploration Ltd. Committees: 1, 2, 4, 7 Cedric E. Ritchie, O.C., LL.D. Corporate Director and Former Chairman and Chief Executive Officer The Bank of Nova Scotia Committees: 1, 2, 5, 6, 7 Paul M. Tellier resigned from the Board of Directors on December 31, 2002. 128 Canadian National Railway Company Left to right: Robert Pace, Michael R. Armellino, Edward C. Lumley, Denis Losier, Gordon D. Giffin, Purdy Crawford, Edith E. Holiday, J.V. Raymond Cyr Robert Pace President and Chief Executive Officer The Pace Group Committees: 1*, 2, 6, 7 Michael R. Armellino Retired Partner The Goldman Sachs Group Committees: 1, 2, 4, 6, 7* The Honorable Edward C. Lumley, P.C., LL.D. Vice-Chairman BMO Nesbitt Burns Committees: 4, 5, 6*, 7 Denis Losier President and Chief Executive Officer Assumption Life Committees: 1, 4, 5, 7 Ambassador Gordon D. Giffin Senior Partner McKenna Long & Aldridge Committees: 1, 2, 7 Purdy Crawford, O.C., Q.C., LL.D. Chairman AT&T Canada Corp. Counsel Osler, Hoskin & Harcourt Committees: 2, 5*, 6, 7 Edith E. Holiday Corporate Director and Trustee, Former General Counsel, United States Treasury Department and Secretary of the Cabinet The White House Committees: 1, 6, 7 J.V. Raymond Cyr, O.C., LL.D. Chairman PolyValor Inc. Committees: 1, 4*, 5, 6, 7 Committees: 1 Audit, finance and risk 2 Corporate governance and nominating 3 Donations 4 Environment, safety and security 5 Human resources and compensation 6 Investment 7 Strategic planning *denotes chairman of the committee Canadian National Railway Company 129 Executive O f f icers of the Company David G.A. McLean Chairman of the Board E. Hunter Harrison President and Chief Executive Officer Tullio Cedraschi President and Chief Executive Officer CN Investment Division Les Dakens Senior Vice-President People Sean Finn Senior Vice-President Public Affairs, Chief Legal Officer and Corporate Secretary James M. Foote Executive Vice-President Sales and Marketing Jack T. McBain Senior Vice-President Operations Keith L. Heller Senior Vice-President Eastern Canada Division Claude Mongeau Executive Vice-President and Chief Financial Officer Robert E. Noorigian Vice-President Investor Relations 130 Canadian National Railway Company Shareholder and investor information Annual meeting The annual meeting of shareholders will be held at 10:30 am on Tuesday, April 15, 2003, at the Sheraton Center, Montreal, QC Annual information form The annual information form may be obtained by writing to: The Corporate Secretary Canadian National Railway Company 935 de La Gauchetière Street West Montreal, Quebec H3B 2M9 Stock exchanges Canadian National common shares are listed on the Toronto and New York stock exchanges. Ticker symbols: CNR (Toronto Stock Exchange) CNI (New York Stock Exchange) Investor relations Robert Noorigian Vice-President, Investor Relations Telephone: (514) 399-0052 or 1-800-319-9929 of our model and our mettle, a test we believe we passed. In 2002, of our model and our mettle, a test we believe we passed. In 2002, Shareholder serv ices Shareholders having inquiries concerning their shares or wishing to obtain information about CN should contact: one of our markets, and economic uncertainty. one of our markets, and economic uncertainty. Transfer agent and registrar Computershare Trust Company of Canada Offices in: Montreal, QC; Toronto, ON; Calgary, AB; Vancouver, BC Telephone: 1-800-332-0095 Fax: 1-888-453-0330 Web: www.computershare.com haul, with a solid trip plan, a powerful engine and a worthy destina- haul, with a solid trip plan, a powerful engine and a worthy destina- Computershare Trust Company of Canada Shareholder Services 100 University Avenue, 9th Floor Toronto, Ontario M5J 2Y1 Telephone: 1-800-332-0095 Fax: 1-888-453-0330 Email: caregistryinfo@computershare.com Head of f ice Canadian National Railway Company 935 de La Gauchetière Street West Montreal, Quebec H3B 2M9 P.O. Box 8100 Montreal, Quebec H3C 3N4 Co-transfer agent and co-registrar Computershare Trust Company of New York 88 Pine Street, 19th Floor Wall Street Plaza, New York, NY 10005 Telephone: (212) 701-7600 or 1-800-245-7630 U.S. cash div idends Shareholders wishing to receive dividends in U.S. dollars may obtain detailed information by communicating with: Computershare Trust Company of Canada Telephone: 1-800-332-0095 Additional copies of this report are available from: CN Public Af fairs 935 de La Gauchetière Street West Montreal, Quebec H3B 2M9 Telephone:1-888-888-5909 Fax: (204) 987-9310 Email: cn@wpg.faneuil.com This report has been printed on recycled paper. La version française du présent rapport est disponible à l’adresse suivante : Af faires publiques CN 935, rue de La Gauchetière Ouest Montréal (Québec) H3B 2M9 Téléphone : 1 888 888-5909 Télécopieur : (204) 987-9310 Courriel : cn@wpg.faneuil.com 935 de La Gauchetière Street West, Montreal, Quebec H3B 2M9 www.cn.ca 

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