Canadian National Railway Company Annual Report 2004

Plain-text annual report

2004 Annual Report This is excellence. Contents Financial summary This is CN 1 This is excellence . . . 7 A message from E. Hunter Harrison 8 11 12 Changing mindsets: IMX and beyond 14 Converting the GLT acquisition 16 BC Rail and CN: a perfect ﬁ t 18 A new approach to service 20 Building a railroader culture 22 CN at a glance 24 A message from the Chairman In the community 25 28 Glossary of terms 29 Financial Section (U.S. GAAP) 81 Financial Section (Canadian GAAP) 130 Non-GAAP Measures – unaudited 132 Corporate Governance 133 2004 President’s Awards for Excellence 134 Board of Directors 136 Chairman of the Board and Executive Ofﬁ cers of the Company 137 Shareholder and investor information Except where otherwise indicated, all ﬁ nancial infor- mation reﬂ ected in this docu- ment is expressed in Canadian dollars and determined on the basis of United States generally accepted accounting principles (U.S. GAAP). To CN, an empty rail yard represents excellence because it means our assets are out on the network – moving product, earning revenue and helping customers compete. Looking at our business differently is key to delivering the full beneﬁ t of precision railroading to our customers and shareholders. It has been integral to our approach at CN for nearly a decade, and it is at the root of our conﬁ dence that we can lead and grow for years to come. Canadian National Railway Company 1 This is the competition. With the increasing speed, precision and reliability of the CN service plan, we can provide real value when compared with truck transportation. 2 Canadian National Railway Company This is our capacity. We see the glass as half empty. We have signiﬁ cant capacity in our operations to handle more trafﬁ c and grow at low incremental cost. Canadian National Railway Company 3 This is the engine. We are cultivating a unique, passionate railroader mentality across our entire workforce – to leverage the CN scheduled railroading concept and get better at it every day. 4 Canadian National Railway Company Revenues In million $ Adjusted operating ratio (1) In per cent (1) 2001 and 2002 have been adjusted for items affecting the comparability of the results of operations. See page 130 of this report for a reconciliation of this non-GAAP measure. 6,750 6,500 6,250 6,000 5,750 5,500 5,250 5,000 75 70 65 60 55 50 45 40 00 01 02 03 04 00 01 02 03 04 This is the scorecard. We know what we’re supposed to do: deliver value to our shareholders. Do that by delivering value to our customers. Do that by executing and continuously improving at every level of our business. Free cash flow (2) In million $ (2) See page 131 of this report for a reconciliation of this non-GAAP measure. CN stock performance January 1, 2000 to December 31, 2004 January 1, 2000 = 100 CNR CNI S&P 500 S&P/TSX 1,050 ÷«900 ÷«750 ÷«600 ÷«450 ÷«300 ÷«150 ÷÷÷«0 350 300 250 200 150 100 50 0 00 01 02 03 04 Jan. 1 00 Jan. 1 01 Jan. 1 02 Jan. 1 03 Jan. 1 04 Dec. 31 04 Canadian National Railway Company 5 This is the limit. We see no limit to what we can achieve with our business model, operating philosophy and attitude. There is room to get better in every area of performance. 6 Canadian National Railway Company A message from E. Hunter Harrison Dear shareholders: We’ve built a highly productive and resilient franchise, capable of delivering results even in the face of signiﬁ cant challenges. We’ve proven what we can do, but there’s much more for us to prove. This is CN: a journey that’s far from over. I remember one of the turning points of my career. I was a young man, in my ﬁ rst management job at BN’s Memphis yard. W.F. Thompson, a great railroader who would eventually become a mentor of mine, was visiting the facility. He looked out at a rail yard packed with cars and asked me, “Son, what do you see out there?” I was young, and he was a big, intimidating man. I wanted to say the right thing. My answer was, “Sir, that’s a lot of business out there in the yard.” Mr. Thompson’s answer changed forever my view of railroading. He said, “You know, that’s the problem. You look at a crowded yard and see a lot of business. I see a lot of delayed trains.” A passion for seeing things differently It’s been a tradition throughout CN’s history as a publicly held cor- poration to look beyond the conventions of traditional railroading to drive excellence. Those of you familiar with CN’s track record know that is our central theme. Since that moment in the Memphis yard long ago, getting the absolute maximum out of rail assets has been a major focus of mine, and it’s a passion here at CN. It’s one of the ﬁ ve guiding principles of successful railroading. The ﬁ rst is providing good service – con- sistently doing what you say you’ll do. The second is controlling your costs. The third is asset utilization. The fourth is to make sure you operate safely, and the ﬁ fth is developing your people. I’ve always believed that if I focus 90 per cent of my time as leader on the ﬁ fth principle, the other four will follow naturally. Without a doubt, CN people enabled the company to translate improved economic conditions into excellent results for this company in 2004. Thanks to their dedication and execution, 2004 was a record year by nearly every measure. Canadian National Railway Company Canadian National Railway Company 7 7 Financial summary $ in millions, except per share data, or unless otherwise indicated 2004(1) 2003(1) 2002(1) Financial results Revenues Operating income Net income Diluted earnings per share (2) Dividend per share (2) Net capital expenditures Financial position Total assets Long-term debt, including current portion Shareholders’ equity Financial ratios (%) Operating ratio Debt to total capitalization $÷6,548 2,168 1,258 4.34 0.78 1,072 $÷5,884 $÷6,110 1,777 1,014 3.49 0.67 1,043 1,469 800 2.65 0.57 938 22,365 5,164 9,284 20,337 21,738 4,658 8,432 5,577 8,369 66.9 35.7 69.8 35.6 76.0 40.0 (1) 2004 includes GLT and BC Rail from May 10 and July 14, respectively. In addition, the Company’s ﬁ nancial results for 2003 and 2002 include items affecting the comparability of the results of operations as discussed in the Company’s Management’s Discussion and Analysis on pages 32 and 38. (2) Reﬂ ects a three-for-two common stock split that took effect February 2004. Employees (average for the year) 2002 2003 2004 (1) Adjusted diluted earnings per share (dollars) (2) (3) 2002 2003 2004 (1) Adjusted operating ratio (percentage) (2) 2002 2003 2004 (1) 3.48 3.60 23,190 22,012 22,470 4.34 69.4 69.8 66.9 (1) Includes GLT and BC Rail from May 10, 2004 and July 14, 2004, respectively. (2) See discussion and reconciliation of these non-GAAP adjusted performance measures in the Company’s Management’s Discussion and Analysis on pages 32, 33 and 38. (3) Reﬂ ects a three-for-two common stock split that took effect February 2004. 8 Canadian National Railway Company Success always comes back to the ﬁ ve principles I’ve preached my entire career as a railroader: Do what you say you’re going to do, keep your costs down, get the most out of your assets, don’t get anybody hurt, and develop your people. We’re doing well. But I know we can do better. Record ﬁ nancial results chises. We continue to innovate to improve our products, our ability It was a banner year for CN. Volumes, measured in revenue ton miles, to sell them and our customer support capability. Our efforts to increased in 2004 by 8 per cent over what we achieved in 2003. Total increase speed, efﬁ ciency and reliability through the execution of the revenues grew by 11 per cent year-over-year to a record $6,548 million, CN precision railroading concept are ongoing and never-ending. despite a strong Canadian dollar that continued to negatively affect The GLT and BC Rail transactions extended our reach and the translation of our U.S. dollar-denominated revenues. created opportunities to improve trafﬁ c ﬂ ows. These acquisitions Revenues from the Great Lakes Transportation LLC railroads also strengthened CN’s ability to grow in the steel, forest products and related holdings (GLT) and BC Rail transactions began to con- and coal industries. Both GLT and BC Rail have been accretive to tribute to CN results starting in May and July of 2004, respectively. CN’s earnings from day one; our proven step-by-step integration Excluding the conversion impact of the stronger Canadian dollar – model proceeded smoothly throughout 2004. approximately $255 million – our revenues grew 16 per cent in 2004; CN’s groundbreaking Intermodal Excellence product – called of that, 6 per cent was due to our two acquisitions, indicating the IMX – exceeded our expectations in 2004, contributing signiﬁ cantly strength of our core franchise. to the bottom line. There’s still plenty of room for improvement in Our operating ratio for the year was a record 66.9 per cent. this business, and there are more customers that can beneﬁ t from Driven by our ability to absorb volume growth at low incremental the speed and efﬁ ciency of scheduling all intermodal operations. cost, performance in this key measure improved 2.9 percentage points Meanwhile, we are expanding the IMX precision railroading mindset when compared with the 69.8 operating ratio we reported for 2003. in our carload business and starting another journey of industry Perhaps the most dramatic yardstick for CN ﬁ nancial perfor- innovation with Carload Excellence. mance in 2004 was in the area of free cash ﬂ ow. Here, our business The creation of a dedicated CN service department in 2004 model and success in executing it delivered powerful results: record promises to do more than increase the value we can bring to custom- free cash ﬂ ow in 2004 of $1,025 million, a signiﬁ cant increase over ers. This initiative represents a broader enhancement of the way we the $578 million we generated in 2003.* run our business in which dedicated marketing, sales and service We are committed to rewarding our investors for their conﬁ - functions create new opportunities for continuous performance dence in us. In early 2005, we announced CN’s ninth consecu- improvement. Now, CN has marketing professionals focused solely tive dividend increase. In fourth quarter 2004 we announced our on product design and pricing; sales professionals free to concen- intention to repurchase up to 14 million shares of CN stock between trate exclusively on selling; service professionals whose mandate is November 1, 2004 and October 31, 2005. to help customers and improve CN’s ability to meet their needs. Rail transportation still has unrealized potential for growth. A solid foundation for continued performance By working together as an industry, there are signiﬁ cant opportuni- Our performance in 2004 was the result of years of work, of strate- ties to improve transit times, increase capacity, reduce congestion gies begun several years ago, of a superior and highly effective and become a more competitive transportation option. In 2004, business model and operating philosophy – factors that also form we announced a number of network initiatives and co-production a solid base for growth in the future. agreements with Canadian Paciﬁ c Railway. We continued our rout- In other words, this story is by no means over. ing protocol initiative with a series of agreements announced with I am convinced that our performance is sustainable. We have our U.S. interline partners. Our opportunity is to expedite trafﬁ c by just begun to realize the beneﬁ ts from the GLT and BC Rail fran- reducing the number of handlings, shortening routes and avoiding the most congested gateways. *See page 42 of this report for a reconciliation of this non-GAAP measure. Canadian National Railway Company 9 Our future boils down to one word: Change. Embracing change, and driving it. Being resilient while always searching for ways to change for the better. Looking at things from new and different angles. And not giving up on a good idea. That’s what we’ve got to do across the company. We see future growth in overseas trafﬁ c, particularly to and with the “Railroad MBA,” it’s why I’m spending the time I am from Asia through Canada’s west coast. With its growing economy, with the training program that’s come to be known as “Hunter China is particularly important, both as a destination for natural Camps,” and it’s why we’re investing what we are in other people- resources and merchandise located along CN’s network, and as development initiatives throughout the organization. an originator of containers bound for points in North America. In I believe the capacity for people to learn and improve is limit- fourth quarter 2004, CN announced the establishment of ofﬁ ces in less. That belief is behind my conﬁ dence that this journey is far Shanghai and Beijing with the objective of growing the railroad’s from over. share of China-North America trafﬁ c. With our signiﬁ cant presence We are going to continue to build on what we’ve accomplished in the port of Vancouver and what we see as the potential for Prince together so far. I can see it happening, one person at a time – that Rupert as a gateway, we believe we are well positioned to beneﬁ t light going on, that look I see on someone’s face when he or she sees from increasing trade between China and North America. his or her place in what we’re trying to accomplish. What is most Managing change, moving forward doing. It’s seeing our workforce get on board the CN train. The success we have had so far is the result of our ability to meet For each CN individual and for this company, I truly believe that gratifying to me is seeing people get passionate about what we’re challenges by managing change. Continuing to improve and develop the sky’s the limit. this ability is the key to our future. When I say managing change, I mean more than just reacting to it. We have to lead change. That Sincerely, starts with developing the right culture, which doesn’t happen over- night. I’ve seen the CN culture steadily evolve since I ﬁ rst got here almost seven years ago. We are trying to get every single employee to adopt the CN railroader mentality – a passion for excellence in everything we do, even the smallest things; a resistance to accept- ing the status quo, a drive to look for innovative ways to improve E. Hunter Harrison performance in every corner of our business. President and Chief Executive Ofﬁ cer To a signiﬁ cant degree, we have gotten to this point by bucking conventional wisdom – in our precision railroading operating model, in our labor agreements, in our intermodal and carload products, in the way we are organized and how we work with other railroads – and that’s how we’re going to continue to build on our leadership. Embracing change and driving it. My top priority as I lead this company is to develop our people. The way I see it, if we continue to get smarter, move up the learning curve and work better together as a team, that alone has powerful potential to drive growth. That’s why we’re doing what we’re doing 10 Canadian National Railway Company We are constantly striving to get the most out of our unique CN precision railroading approach, whether by challenging the way we do things in order to do them better, or by extending This is CN. the network upon which we apply our model. In 2004, we converted on a number of initiatives and focused on developing the engine that will continue to take us forward: our people. Canadian National Railway Company 11 Changing mindsets: 12 Canadian National Railway Company IMX and beyond In 2003, CN introduced Intermodal we can extend our disciplined operating Next is to apply the IMX mindset Excellence – IMX – an entirely new practices to additional activities. to our carload business with Carload approach to operating our most complex IMX is more than a program or Excellence, or CX, which we launched business. IMX applies the discipline product. It’s a mindset – at CN and, in 2004. By utilizing equipment reser- and precision of scheduled railroading more important, among CN customers. vations, off-peak pricing and our new to remove randomness, smooth trafﬁ c Equipment, gate and train reservations interline route protocols, CX is bringing ﬂ ows, reduce transit times and improve maximize customer access to ﬁ xed fundamental change to the way carload reliability. One year later, the results are capacity and improve customers’ shipping is done. Like IMX, CX has real showing in steadily increasing customer ability to plan; day-of-the-week and potential to free additional capacity, acceptance and improved margins. As seasonal pricing provides opportuni- smooth trafﬁ c ﬂ ows, improve asset we continue to improve our execution, ties to both CN and its customers performance and increase proﬁ tability. to better manage costs. Canadian National Railway Company 13 Converting 14 Canadian National Railway Company the GLT acquisition Initiated in late 2003 and closed in mid-2004, CN’s acquisi- In addition, it extended our network with port and rail assets tion of the Great Lakes Transportation LLC railroads and in Pennsylvania. related holdings (GLT) represented a twofold strategy – ﬁ rst, Equally important, the GLT acquisition strengthened to enhance our rail network in a key corridor, and second, CN’s position as a hauler of bulk commodities for the U.S. steel to build our bulk commodities franchise serving the steel industry, which is in the midst of a recovery. In addition, we industry. The transaction gave CN ownership of a key 17-mile now are beneﬁ ting from growing world demand for iron ore segment of track in the Duluth, Minnesota/Superior, Wisconsin that reﬂ ects dramatic changes in the global economy. area and 64 miles of parallel track just north of there, two important enhancements in our fast-growing western corridor. Canadian National Railway Company 15 BC Rail and CN: When we announced CN’s partnership with BC Rail in late 2003, we knew it would be a perfect strategic ﬁ t. Approved and closed in mid-2004, the transaction is already delivering results. The joining of CN and BC Rail strengthens our franchise and growth prospects, particularly in forest products, and expands our presence in British Columbia. Plans for new facilities in Prince George offer operational beneﬁ ts, while the addition of BC Rail track to our western network provides a number of signiﬁ cant opportunities to improve trafﬁ c ﬂ ow and serve our customers better, many of which we already have implemented. Meanwhile, our partnership with BC Rail strengthens CN’s commitment to the development of the port of Prince Rupert, which we believe holds potential as a gateway for growing trade between North America and Asia. 16 Canadian National Railway Company a perfect ﬁ t Canadian National Railway Company 17 A new approach 18 Canadian National Railway Company to service CN has steadily increased the effective- ness of its sales force by reﬁ ning the organizational structure and transform- ing the traditional order-taker mentality to a more proactive, solutions-oriented approach. As our sales professionals continue to improve and excel, we are raising the quality of service after the sale with a new, fully dedicated service department. The CN Service Department provides a new level of responsiveness and expertise to help customers quickly resolve issues beyond normal shipment tracking and transactional questions and maximize the beneﬁ t they can draw from our precision railroading model. We have assembled a group of highly experienced railroaders from a broad range of expertise, from operations, service design, sales and marketing to accounting and traditional customer service. CN service professionals have the tools and authority to coordinate solutions across the CN system – provid- ing customers new avenues for faster and more consistent problem resolution. Canadian National Railway Company 19 Building To power CN’s future, we aspire always to become better rail- The “Railroad MBA” is a tailored 12- to 18-month program roaders. Two unique CN programs designed to help us achieve in which CN managers take a leave of absence from their that goal gained momentum in 2004 – “Hunter Camps” and regular positions to gain hands-on experience in every aspect the “Railroad MBA.” of CN’s operations. Participants rotate through key areas To develop CN’s next generation of performers and lead- of the business, learning to lay track, repair engines, run ers, we have instituted a program that has become known trains and manage the network, developing railroading skills, across the company as “Hunter Camps.” In each session – four knowledge and perspective that add tremendous value to were held in 2003, eight in 2004, 12 are planned for 2005 their capabilities. along with a video – Hunter Harrison spends three days with In both programs we’re breaking new ground to build a a group of 20–25 CN employees, passing on the knowledge strong railroader culture at CN. One person at a time, creating of his 40-plus years in this business. an unstoppable passion to improve, lead and excel. This is our future; this is CN. 20 Canadian National Railway Company a railroader culture Canadian National Railway Company 21 CN at a glance Statistical summary CN derives revenue from a balanced mix of goods moving over a network of approximately 19,300 route miles of track spanning North America. CN is the only rail network on the continent to con- nect three coasts – the Paciﬁ c, the Atlantic and the Gulf of Mexico. Route miles (includes Canada and the U.S.) Carloads (thousands) Gross ton miles (millions) Revenue ton miles (millions) Employees (average for the year) Diesel fuel consumed (U.S. gallons in millions) Average fuel price per U.S. gallon (dollars) (2) (1) Includes GLT and BC Rail from May 10, 2004 and July 14, 2004, respectively. (2) Includes the impact of the Company’s hedging program. 2004 data Petroleum and chemicals Metals and minerals Forest products Coal Grain and fertilizers Intermodal Automotive 2004 (1) 19,304 4,654 332,807 175,355 22,470 391 ÷«1.30 2003 17,544 4,177 313,593 162,901 22,012 374 ÷«1.21 2002 17,821 4,153 309,102 159,259 23,190 369 ÷«1.20 Certain of the comparative statistical data and productivity measures have been restated to reﬂ ect changes to estimated data previously reported. Freight revenues (millions) $1,123 713 1,452 284 1,053 1,117 510 Revenue ton miles (RTM) (millions) 32,618 16,421 38,414 13,614 39,965 31,002 3,321 Freight revenue per RTM (cents) 3.44 4.34 3.78 2.09 2.63 3.60 15.36 Freight revenues 2004 percentage data 8% 18% 18% 17% 23% 5% 11% 18% Petroleum and chemicals 11% Metals and minerals 23% Forest products 5% Coal 17% Grain and fertilizers 18% Intermodal 8% Automotive Revenue – traffic mix Per cent 23% 23% 34% 20% 23% Canadian domestic 20% Overseas 34% Transborder 23% U.S. domestic Petroleum and chemicals Metals and minerals Forest products We believe the balance of our business mix positions us well to face economic ﬂ uctuations and enhances our potential to grow revenue. 22 Canadian National Railway Company Petroleum and chemicals comprise a wide range of commodities includ- ing petroleum, liqueﬁ ed petroleum gas, plastics and oleﬁ ns, sulfur and chemicals products. Most of CN’s petroleum and chemicals shipments originate in Alberta, eastern Canada and the Gulf of Mexico, and are destined for customers in Canada, the United States and overseas. CN’s metals and minerals commodity group consists primarily of nonferrous base metals, iron ore, steel, equipment and parts and construction materials. The company’s superior rail access to major mines, ports and smelters throughout North America has made the company a leader in the transportation of copper, lead, zinc concentrates, iron ore, reﬁ ned metals and aluminum. CN is the largest carrier of forest products in North America. This commodity group includes various types of lumber, panels, wood chips, woodpulp, printing paper, liner- board and newsprint. In Canada, CN enjoys superior access to the major ﬁ ber-producing regions. In the United States, CN is strategically located to serve both the mid- western and southern U.S. corridors with interline capabilities to other Class 1 railroads. Fort Nelson Prince Rupert Prince George Dawson Creek Edmonton Whistler Kamloops Calgary Vancouver CN – North America’s railroad Saskatoon Winnipeg Thunder Bay Hearst Oba Quebec Montreal Moncton Halifax Duluth Sault Ste. Marie Toronto Minneapolis/St. Paul Stevens Point Fond du Lac Green Bay Sarnia Buffalo Fort Dodge Waterloo Chicago Sioux City Omaha Topeka Cedar Rapids Springfield Council Bluffs Kansas City St. Louis East St. Louis Conneaut Detroit Pittsburgh Cincinnati Tulsa Memphis Counce Alliance Dallas Shreveport Jackson Baton Rouge Houston Beaumont Port Arthur Galveston Birmingham Mobile Gulfport New Orleans Laredo Monterrey Corpus Christi San Luis Potosí Tampico Mexico City Veracruz Lazaro Cardenas CN KCS KCS/TFM Alliance Coal Grain and fertilizers Intermodal Automotive CN moves both Canadian and U.S. thermal coal. Canadian thermal coal is delivered to power utilities primarily in eastern Canada. U.S. thermal coal is transported from mines in southern Illinois or from western U.S. mines via interchange with other railroads to utilities in the Midwest and southeastern United States. CN also moves metallurgi- cal coal to export markets via the Canadian west coast ports of Vancouver and Prince Rupert. CN’s grain and fertilizer business transports commodities grown in western Canada and the U.S. Midwest. The majority of western Canadian grain carried by CN is for export. In the United States, CN handles grain grown in Illinois and Iowa for export, as well as for domestic processing facilities and feed markets. CN also serves producers of potash, urea and other fertilizers. CN leads the industry with its innovative IMX intermodal service offering. At CN, intermodal business consists of two segments. The ﬁ rst segment, domestic, is responsible for consumer products and manu- factured goods, operating through both retail and wholesale channels. The second, the international segment, handles import and export container trafﬁ c, serving the ports of Vancouver, Montreal, Halifax and New Orleans. CN is a leading carrier of auto- motive products originating in southwestern Ontario, Michigan and Mississippi. This commodity group moves both ﬁ nished 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. Canadian National Railway Company 23 A message from the Chairman Dear fellow shareholders: In an improved but still-challenging environment, CN achieved or surpassed nearly all its ﬁ nancial objectives, successfully closed two important acquisitions and extended its track record of delivering solid value to its shareholders. On behalf of the CN Board, I commend the management team and all of our employees for another year of outstanding accomplishment. 24 Canadian National Railway Company The CN Board is very pleased with the performance of our company under the leadership of Hunter Harrison and his team. Hunter has a rare gift, a combination of broad strategic vision and a hands-on management style that I believe is a force, not just within CN, but also throughout the industry. The Board was delighted with Hunter’s decision during the year to accept an extension of his employment contract with the company through 2008. At the same time, we are gratiﬁ ed to see the depth of talent the company is developing at all levels of the organization. It has long been a priority of the Board to see CN build upon the strength of its management team, to attract – and retain – the best and brightest minds in the industry. We believe the company is perform- ing exceedingly well in this critical area. The Board of Directors is particularly proud of its corporate governance. I am pleased to report that in 2004 CN rose to a rank of ﬁ fth out of more than 200 Canadian companies in the Globe and Mail Report on Business Annual Review of Corporate Governance in Canada. Based on the Review’s evaluation of board composition, share holding and compensation, shareholder rights, and disclosure, CN scored 93 points out of a possible 100. Shareholders can view and obtain copies of CN corporate governance guidelines, as well as key committee charters and other information, on our Web site at www.cn.ca/cngovernance. Our drive for ongoing improvement as a Board continued in 2004. During the year we initiated a peer review process in which each Director was evaluated against a number of criteria by his or her fellow Board members. Our goal is to remain constantly vigilant for opportunities to become more effective representatives of our shareholders’ best interests. Each year, I have expressed the Board’s conﬁ dence in the future of this company. We have seen CN consistently deliver outstanding results, but perhaps most encouraging is the solid foundation that underpins our performance. CN has a superior business model, a solid balance sheet, and likely the best leadership team and work- force in the rail industry, with an insatiable drive to get better. We on the Board believe this combination adds up to excellence that is sustainable in the long term. I am grateful to my fellow Board members for their integrity, wisdom and dedication, as well as to our investors for their contin- ued support. Our future shines brighter than ever. As Hunter might say, stay aboard. This train is running strong. Sincerely, David McLean, O.B.C., LL.D. Chairman of the Board In the community Canadian National Railway Company 25 All aboard . . . Safety is one of CN’s guiding principles. Within our operations and in our com- munities, it guides our decisions and actions every day. The goal of our com- munity safety program is to help save lives and prevent injuries on or near our railroad property and at crossings. The CN All Aboard for Safety program For more than 20 years in Canada and the United States, CN employees, from management to police ofﬁ cers and risk managers, from train crews to retirees, have been promoting the importance of safety at highway/railroad crossings and warning of the dangers of trespassing on railroad property. In 2004, we renamed this comprehensive community safety effort All Aboard for Safety. Promoting safety to students Every year, CN makes All Aboard for Safety presentations to more than 100,000 students in more than 700 schools throughout Canada and the United States. The presenta- tions include videos, demonstrations and information handouts. Safety blitzes CN holds “safety blitzes” at busy rail crossings with local police services to help make drivers aware of the impor- tance of safety. 26 Canadian National Railway Company for safety. The CN safety train Little Obie, CN’s safety train, travels to CN Community outreach CN employees staff All Aboard for Safety communities across North America to promote safety in a fun and displays at community events such as safety villages, Police Safety highly memorable way to thousands of children at community events Week, family days, fairs, shopping malls and trade shows, talking to and parades. Little Obie is a scale model of a CN locomotive measur- more than 100,000 children and adults every year about safety. They ing six feet high with authentic details such as a full-sized train horn also make presentations to school bus drivers, truck drivers, driver’s along with a caboose. education classes and adult groups. Community safety partnerships Part of the strength of CN’s Mock train-vehicle collisions CN brings real-life drama to the All Aboard for Safety program is the collaborative relationship we’ve community through high-proﬁ le events. Working closely with cultivated with our major community safety partners: Operation emergency measures organizations, CN conducts simulations of Lifesaver, a public education program focused on rail safety, and train-vehicle collisions. High school drama students volunteer to Mothers Against Drunk Driving (MADD). In Canada, we also support play the role of injured victims to demonstrate the potentially dire the Safe Communities Foundation, an organization that helps com- consequences of unsafe practices around rail crossings. munities implement safety programs; Safe Kids Canada, an injury prevention program for children; and SMARTRISK, an injury preven- Throughout our operations and out in our communities, safety tion program for students in high school. is a deep, cultural commitment at CN. Increasingly, one hears the CN works closely with local, provincial, state and federal following refrain among CN employees: “Have a safe day!” agencies, the Royal Canadian Mounted Police, ﬁ reﬁ ghters and paramedics. We all share a common goal – to help prevent injuries and save lives. 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. Carload – A one-car shipment of freight from one consignor to one consignee. Route miles – The miles of right-of-way owned or leased and operated by the designated railroad. Route miles exclude mainline trackage oper- ated under trackage rights. In multiple track territories only one mainline 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 speciﬁ c plan where possible and that manages expectations to meet agreed- upon customer commitments. Class 1 railroad – As determined by the Surface Transportation Board, a freight railroad with annual operating revenues that exceed a threshold indexed to a base of $250 million in 1991 U.S. dollars. The threshold in 2003 was $277.7 million. Gross ton miles – The number of tons behind the locomotives (cars and contents) including company service equipment multiplied by the miles of road moved from originating to destination stations on a designated railroad. Siding – A track auxiliary to the main track for meeting or passing trains, or in the case of industrial siding, a track serving various indus- trial customers. 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 to a speciﬁ c customer location, day of week and time of release. Intermodal service – In railroad transportation, the movement of trailers or containers on railroad freight cars. Unit train – A train with a ﬁ xed, 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. 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. 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. Rolling stock – Transportation equipment on wheels, especially locomotives and freight cars. 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 commodity, instructions for special services, the rate, total charges, advances and the waybill reference for previous services, and the amount prepaid. Yard – A system of tracks within deﬁ ned limits, designed for switching services. Yard dwell – Yard dwell is the average duration, expressed in hours, that cars spend in a speciﬁ c operating terminal. 28 Canadian National Railway Company Financial Section (U.S. GAAP) Contents Canadian National Railway Company Selected Railroad Statistics 30 31 Management’s Discussion and Analysis 53 Management Report Auditors’ Report 53 Consolidated Statement of Income 54 Consolidated Statement of Comprehensive Income 55 Consolidated Balance Sheet 56 Consolidated Statement of Changes in Shareholders’ Equity 57 Consolidated Statement of Cash Flows 58 Notes to Consolidated Financial Statements 59 61 62 63 63 64 64 64 64 66 67 67 69 71 71 71 72 72 72 74 76 77 80 1 Summary of significant accounting policies 2 Accounting changes 3 Acquisitions 4 Accounts receivable 5 Properties 6 Intangible and other assets 7 Credit facility 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 Interest expense 15 Other income (loss) 16 Income taxes 17 Segmented information 18 Earnings per share 19 Major commitments and contingencies 20 Financial instruments 21 Other comprehensive income (loss) 22 Reconciliation of United States and Canadian generally accepted accounting principles 23 Comparative figures U.S. GAAP Canadian National Railway Company 29 Selected Railroad Statistics Year ended December 31, Statistical operating data Freight revenues ($ millions) Gross ton miles (GTM) (millions) Revenue ton miles (RTM) (millions) Carloads (thousands) Route miles (includes Canada and the U.S.) Employees (end of period) Employees (average during period) Productivity Operating ratio (%) Adjusted operating ratio (%) (2) Freight revenue per RTM (cents) Freight revenue per carload ($) Operating expenses per GTM (cents) Adjusted operating expenses per GTM (cents) (2) Labor and fringe benefits expense per GTM (cents) Adjusted labor and fringe benefits expense per GTM (cents) (2) GTMs per average number of employees (thousands) Diesel fuel consumed (U.S. gallons in millions) Average fuel price ($/U.S. gallon) (3) GTMs per U.S. gallon of fuel consumed Safety indicators Injury frequency rate per 200,000 person hours Accident rate per million train miles 2004 (1) 2003 2002 6,252 332,807 175,355 4,654 19,304 22,679 22,470 66.9 66.9 3.57 1,343 1.32 1.32 0.55 0.55 14,811 391 1.30 851 2.6 1.6 5,694 313,593 162,901 4,177 17,544 21,489 22,012 69.8 69.8 3.50 1,363 1.31 1.31 0.54 0.54 14,246 374 1.21 838 5,901 309,102 159,259 4,153 17,821 22,114 23,190 76.0 69.4 3.71 1,421 1.50 1.37 0.59 0.56 13,329 369 1.20 838 2.9 2.0 3.0 2.0 (1) (2) Includes GLT and BC Rail from May 10, 2004 and July 14, 2004, respectively. 2002 has been adjusted for items affecting the comparability of the results of operations. See discussion and reconciliation of these non-GAAP adjusted performance measures in the Company’s Management’s Discussion and Analysis on page 38. (3) Includes the impact of the Company’s hedging program. Certain of the comparative statistical data and related productivity measures have been restated to reflect changes to estimated data previously reported. 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 the railroads and related holdings of Great Lakes Transportation LLC (GLT) as of May 10, 2004 and BC Rail as of July 14, 2004. 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 accounting principles (U.S. GAAP). The Company also prepares consolidated financial statements in accordance with Canadian GAAP, which are different in some respects from these financial statements, principally in the treatment of track replacement costs, expenditures relating to improvements of bridges and other structures and freight cars, derivative instruments and stock-based compensation. A reconciliation of the U.S. to Canadian GAAP financial statements is pro- vided in Note 22 to the Company’s Consolidated Financial Statements. The Company’s objective is to provide meaningful and relevant information reflecting the Company’s financial condition and results of operations. In certain instances, the Company may make reference to certain non-GAAP measures that, from management’s perspective, are useful measures of performance. In such instances, the reader is advised to read all informa- tion provided in the MD&A in conjunction with the Company’s 2004 Annual Consolidated Financial Statements and notes thereto. Business profile CN, directly and through its subsidiaries, is engaged in the rail and related transportation business. CN’s network of approximately 19,300 route miles of track spans Canada and mid-America, connecting three coasts: the Atlantic, the Pacific and the Gulf of Mexico. CN’s revenues are derived from seven commodity groups consisting of the movement of a diversified and balanced portfolio of goods which positions it well to face economic fluctuations and enhances its potential to grow rev- enues. In 2004, no individual commodity group accounted for more than 22% of revenues. The sources of revenue also reflect a balanced mix of destinations. In 2004, 23% of revenues came from U.S. domestic traffic, 34% from transborder traffic, 23% from Canadian domestic traffic and 20% from overseas traffic. The Company originates approximately 85% of traffic moving along its network, which allows it both to capitalize on service advantages and build on opportunities to efficiently use assets. Strategy CN is committed to creating value for both its customers and sharehold- ers. By providing quality and cost-effective service, CN seeks to create value for its customers, which solidifies existing customer relationships, while enabling it to pursue new ones. Sustainable financial performance is a critical element of shareholder value, which CN strives to achieve by pursuing revenue growth, steadily increasing profitability, solid free cash flow generation and an adequate return on investment. CN’s business strategy is guided by five core values: providing good service, controlling costs, focusing on asset utilization, committing to safety and developing employees. Overview For 2005 and the foreseeable future, CN’s challenge is to remain at the forefront of rail industry financial performance and to build value for shareholders and customers by aiming to make the railroad the continent’s best-performing transportation company. CN’s plan is premised on the deployment of its business model to generate quality revenues, while leveraging capacity and maintaining its current level of plant quality. The “scheduled railroad” is the foundation for the Company’s business model. For CN’s merchandise business, the scheduled railroad, which is defined as a trip plan for every car measured in hours, has reduced transit times, improved the consistency of CN’s transportation product, dramatically improved productivity and helped to improve network capacity. In 2003, the Company began to apply the same prin- ciples of scheduled railroading to its intermodal business through the IMX initiative. IMX is designed to smooth demand and balance the flow of intermodal traffic through pre-defined daily train capacity, slot, gate and equipment reservations, and day-of-the-week pricing. CN’s acquisition and control of Illinois Central and Wisconsin Central, in 1999 and 2001, respectively, extended the Company’s reach into the central and southern United States. Among the benefits of single line service afforded by these transactions have been improved transit and cycle times for freight cars and the penetration of new markets. The acquisition of GLT in May 2004 has permitted new efficien- cies in train operations north of Duluth/Superior in the key Winnipeg- Chicago corridor and positioned CN as a major player in the supply chain for the United States steel industry in the midst of a strong recovery. The purchase of BC Rail in July 2004 not only grew CN’s for- est products business substantially, but also expanded the railroad’s capacity in British Columbia, where the Port of Prince Rupert has the potential to become an important gateway for traffic moving to and from Asia and the heartland of North America. Over the past five years, the Company has also invested heavily in new locomotives and freight cars, extended sidings and centralized traf- fic control to permit the operation of longer, more efficient trains. These strategic initiatives have improved service, reduced costs and created a fluid North American rail network that can accommodate business growth at low incremental cost. The Company intends to continue to make targeted capital expenditures to improve plant capacity as war- ranted by market conditions and satisfactory returns on investment. The Company intends to pursue further operating efficiencies by optimizing its workforce, improving asset utilization, reducing accidents and related costs, and continuing to focus on legal claims and health care costs. The Company partners with connecting carriers to implement routing protocol agreements for carload freight and pursues co-produc- tion initiatives to further improve service, generate system capacity and gradually reduce costs. The Company’s ultimate goal is to generate profitable, sustain- able growth at low incremental cost by striving to improve yield and increase market share to maximize its return on assets. U.S. GAAP Canadian National Railway Company 31 Management’s Discussion and Analysis Financial highlights In millions, except per share data, or unless otherwise indicated 2004 2003 2002 Financial results Revenues Operating income Net income Operating ratio Basic earnings per share Diluted earnings per share Dividend declared per share Financial position Total assets Total long-term financial liabilities Financial results 2004 compared to 2003 In 2004, net income increased by $244 million, or 24%, when com- pared to 2003, with diluted earnings per share rising 24%. Revenues increased by $664 million, or 11%, due to the inclusion of $351 million of GLT and BC Rail revenues, core business growth in a strong North American economy, and an improved Canadian grain crop, which were partly offset by the translation impact of the stronger Canadian dollar on U.S. dollar denominated revenues of $255 million. Operating expenses increased by $273 million, or 7%, driven mainly by the inclusion of $228 million of GLT and BC Rail expenses, higher labor and fringe benefits, increased fuel costs and higher casu- alty and other expense, which were partly offset by the translation impact of the stronger Canadian dollar on U.S. dollar denominated expenses of $170 million and lower equipment rents. The operating ratio, defined as operating expenses as a percent- age of revenues, was 66.9% in 2004 compared to 69.8% in 2003, a 2.9-point betterment. The results for the year ended December 31, 2004 included the results of operations of GLT as of May 10, 2004 and BC Rail as of July 14, 2004. Also in 2004, a strike by the Company’s employees represented by the Canadian Auto Workers (CAW) union (the “CAW strike”) in the first quarter, negatively impacted operating income and net income by $35 million and $24 million, respectively. The significant appreciation in the Canadian dollar relative to the U.S. dollar which has impacted the conversion of the Company’s U.S. dollar denominated rev- enues and expenses, resulted in a reduction in net income of approxi- mately $45 million for 2004. $÷6,548 $÷2,168 $÷1,258 66.9% $÷÷4.41 $÷÷4.34 $÷÷0.78 $22,365 $10,822 $÷5,884 $÷1,777 $÷1,014 69.8% $÷÷3.54 $÷÷3.49 $÷÷0.67 $20,337 $÷9,928 $÷6,110 $÷1,469 $÷÷«800 76.0% $÷÷2.71 $÷÷2.65 $÷÷0.57 $21,738 $11,180 For the year ended December 31, 2003, the Company’s results of operations included a fourth-quarter deferred income tax expense of $79 million resulting from the enactment of higher corporate tax rates in the province of Ontario. Also included in 2003 was a cumulative ben- efit of $75 million, $48 million after tax, resulting from a change in the accounting for removal costs for certain track structure assets pursuant to the requirements of Statement of Financial Accounting Standards (SFAS) No. 143, “Accounting for Asset Retirement Obligations,” as explained in Note 2 to the attached Annual Consolidated Financial Statements. This change in policy will result in lower depreciation expense and higher labor and fringe benefits and other expenses in the period in which removal costs are incurred. For the year ended December 31, 2003, this change in policy resulted in an increase to net income of $2 million ($0.01 per basic and diluted share). 2004 compared to 2003 – Adjusted performance measures The year ended December 31, 2003 included items impacting the com- parability of the results of operations (see reconciliation of adjusted performance measures presented herein). In 2003, the Company recorded a fourth-quarter deferred income tax expense of $79 million resulting from the enactment of higher cor- porate tax rates and a cumulative benefit of $75 million, $48 million after tax, as discussed herein. Excluding these items, net income was $1,258 million ($4.41 per basic share or $4.34 per diluted share) in 2004 compared to adjusted net income of $1,045 million ($3.65 per basic share or $3.60 per diluted share) in 2003, an increase of $213 million, or 20%. 32 Canadian National Railway Company U.S. GAAP Management’s Discussion and Analysis Reconciliation of adjusted performance measures Management believes that non-GAAP measures such as adjusted net income and the resulting adjusted performance measures for such items as operating income, operating ratio and per share data are useful measures of performance that can facilitate period-to-period comparisons as they exclude items that do not arise as part of the normal day-to-day operations or that could potentially distort the analysis of trends in business per- formance. The exclusion of specified items in the adjusted measures below does not imply that they are necessarily non-recurring. These adjusted measures do not have any standardized meaning prescribed by GAAP and may, therefore, not be comparable to similar measures presented by other companies. The reader is advised to read all information provided in the MD&A in conjunction with the Company’s Annual Consolidated Financial Statements and notes thereto. In millions, except per share data, or unless otherwise indicated Year ended December 31, 2004 2003 Reported Reported Change in policy Rate enactment Adjusted Revenues Operating expenses Operating income Interest expense Other income (loss) Income before income taxes and cumulative effect of change in accounting policy Income tax expense Income before cumulative effect of change in accounting policy Cumulative effect of change in accounting policy, net of applicable taxes Net income Operating ratio Basic earnings per share Diluted earnings per share Revenues Year ended December 31, Total revenues (millions) Rail freight Revenues (millions) RTMs (millions) Revenue/RTM (cents) Carloads (thousands) Revenue/Carload (dollars) 2004 $6,548 2003 % Change $5,884 11% $6,252 175,355 3.57 4,654 1,343 $5,694 162,901 3.50 4,177 1,363 10% 8% 2% 11% (1%) Revenues for the year ended December 31, 2004 totaled $6,548 mil- lion compared to $5,884 million in 2003. The increase of $664 million, or 11%, was mainly due to the inclusion of GLT and BC Rail revenues $6,548 4,380 2,168 (294) (20) 1,854 (596) 1,258 – $1,258 66.9% $÷4.41 $÷4.34 $5,884 4,107 1,777 (315) 21 1,483 (517) 966 48 $1,014 69.8% $÷3.54 $÷3.49 $÷÷– $÷– – – – – – – – (48) $(48) $5,884 4,107 1,777 (315) 21 1,483 (438) 1,045 – – – – – – 79 79 – $79 $1,045 69.8% $÷3.65 $÷3.60 of $351 million, strong merchandise revenue, an improved Canadian grain crop, and a higher fuel surcharge. Partially offsetting these gains was the translation impact of the stronger Canadian dollar on U.S. dollar denominated revenue. Revenue ton miles, measuring the volume of freight transported by the Company, increased by 8% relative to 2003. Freight revenue per revenue ton mile, a measurement of yield defined as revenue earned on the movement of a ton of freight over one mile, increased by 2% when compared to 2003. In 2004, freight revenue per revenue ton mile was positively affected by freight rate increases and an overall decrease in the average length of haul, and was negatively affected by the translation impact of the stronger Canadian dollar. U.S. GAAP Canadian National Railway Company 33 Management’s Discussion and Analysis Petroleum and chemicals Year ended December 31, Revenues (millions) RTMs (millions) Revenue/RTM (cents) 2004 $1,123 32,618 3.44 2003 % Change $1,058 30,901 3.42 6% 6% 1% Petroleum and chemicals comprise a wide range of commodities, includ- ing chemicals, sulfur, plastics, petroleum and gas products. Most of the Company’s petroleum and chemicals shipments originate in the Gulf of Mexico, Alberta and eastern Canada, and are destined for customers in Canada, the United States and overseas. The performance of this com- modity group is closely correlated with the North American economy. For the year ended December 31, 2004, revenues for this commodity group increased by $65 million, or 6%, from 2003. The increase was due to freight rate improvements in several key segments, particularly in the first half of the year, the inclusion of $25 million of BC Rail revenues (primarily sulfur), higher offshore demand for Canadian sulfur, a shift from offshore to Canadian suppliers for petroleum gas and a higher fuel surcharge. These gains were partially offset by the translation impact of the stronger Canadian dollar. Freight revenue per revenue ton mile increased by 1% due to freight rate improvements and a decrease in the average length of haul, partly offset by the translation impact of the stronger Canadian dollar. Petroleum and chemicals Percentage of revenues Carloads* In thousands and sand) and cement. The Company has access to major cement and aggregate producers in Canada as well as in the U.S. Metals and miner- als traffic is sensitive to fluctuations in the economy. For the year ended December 31, 2004, revenues for this commodity group increased by $186 million, or 35%, from 2003. The increase is mainly due to the inclusion of $126 million of GLT revenues, higher volumes of iron ore, largely from new business, freight rate improvements, and increased shipments of raw materials and metal bars. Partially offsetting these gains was the translation impact of the stronger Canadian dollar. Revenue per revenue ton mile increased by 14% in 2004, mainly due to GLT shorter-haul traffic which was partly offset by the translation impact of the stronger Canadian dollar. Metals and minerals Percentage of revenues Carloads* In thousands 9 0 8 21% 24% 55% Metals 24% Minerals 21% Iron ore 55% 8 8 3 6 9 3 6 5 2 7 8 2 00 01 02 03 04 * Includes WC from October 9, 2001, GLT from May 10, 2004 and BC Rail from July 14, 2004 7 8 5 4 0 6 7 3 6 Forest products 2 1 5 9 1 5 Year ended December 31, 43% 57% Revenues (millions) RTMs (millions) Revenue/RTM (cents) 2004 $1,452 38,414 3.78 2003 % Change $1,284 34,516 3.72 13% 11% 2% 57% Petroleum and plastics 43% Chemicals 00 01 02 03 04 * Includes Wisconsin Central Transportation Corporation (WC) from October 9, 2001, GLT from May 10, 2004 and BC Rail from July 14, 2004 Metals and minerals Year ended December 31, Revenues (millions) RTMs (millions) Revenue/RTM (cents) 2004 $713 16,421 4.34 2003 % Change $527 13,876 3.80 35% 18% 14% The metals and minerals commodity group consists primarily of nonfer- rous base metals, iron ore, steel, equipment and parts and construction materials. The Company’s superior rail access to major mines, ports and smelters throughout North America has made the Company a transpor- tation leader of copper, lead, zinc concentrates, iron ore, refined metals and aluminum. Construction materials are mainly aggregates (stone The forest products commodity group includes various types of lumber, panels, wood chips, wood pulp, printing paper, linerboard and news- print. The Company has superior rail access to the western and eastern Canadian fiber-producing regions, which are among the largest fiber source areas in North America. In the United States, the Company is strategically located to serve both the midwest and southern U.S. cor- ridors with interline capabilities to other Class 1 railroads. The key driv- ers for the various commodities are: for newsprint, advertising lineage and overall economic conditions in the United States; for fibers (mainly wood pulp), the consumption of paper worldwide; and for lumber and panels, housing starts and renovation activities in the United States. Although demand for forest products can be cyclical, the Company’s geographical advantages and product diversity tend to reduce the impact of market fluctuations. For the year ended December 31, 2004, revenues for this commodity group increased by $168 million, or 13%, from 2003. The increase was largely due to the inclusion of $85 mil- lion of BC Rail revenues (mainly lumber and panels), continued solid demand for lumber, freight rate improvements and a higher fuel sur- charge. The translation impact of the stronger Canadian dollar partially offset these gains. Revenue per revenue ton mile increased by 2% in 34 Canadian National Railway Company U.S. GAAP Management’s Discussion and Analysis 2004 as the benefit of freight rate improvements and a positive change in traffic mix were partially offset by the translation impact of the stronger Canadian dollar. Forest products Percentage of revenues Carloads* In thousands Grain and fertilizers Year ended December 31, Revenues (millions) RTMs (millions) Revenue/RTM (cents) 2004 $1,053 39,965 2.63 2003 % Change $938 35,556 2.64 12% 12% – The grain and fertilizers commodity group depends primarily on crops grown and fertilizers processed in western Canada and the U.S. Midwest. The grain segment consists of three primary commodities: food grains, mainly wheat; oilseeds and oilseed products, primarily canola seed, oil and meal; and feed grains, including feed barley, feed wheat and corn. Production of grain varies considerably from year to year, affected primarily by weather conditions. Grain exports are vola- tile, reflecting the size of the crop produced, international market condi- tions and foreign government policy. In the U.S., grain grown in Illinois and Iowa is exported, as well as transported to domestic processing facilities and feed markets. The Company also serves producers of pot- ash, ammonium nitrate, urea and other fertilizers. For the year ended December 31, 2004, revenues for this commodity group increased by $115 million, or 12%, from 2003. The increase reflects higher Canadian wheat and barley exports, which was partially offset by weak ship- ments of U.S. soybeans due to tight supply, a shift in exports from the Gulf to the Pacific Northwest and the translation impact of the stronger Canadian dollar. Revenue per revenue ton mile remained flat as the benefit of freight rate improvements was offset by an increase in the average length of haul and the translation impact of the stronger Canadian dollar. Grain and fertilizers Percentage of revenues Carloads* In thousands 12% 13% 28% 7 6 5 0 9 5 5 3 5 8 4 5 2 7 5 23% 24% 28% Food grain 24% Oilseeds 23% Feed grain 13% Fertilizers 12% Potash 00 01 02 03 04 * Includes WC from October 9, 2001, GLT from May 10, 2004 and BC Rail from July 14, 2004 12% 26% 0 0 6 4 9 5 3 5 6 33% 6 8 4 1 0 5 29% 33% Lumber 29% Fibers 26% Paper 12% Panels 00 01 02 03 04 * Includes WC from October 9, 2001, GLT from May 10, 2004 and BC Rail from July 14, 2004 Coal Revenues (millions) RTMs (millions) Revenue/RTM (cents) Year ended December 31, 2004 $284 13,614 2.09 2003 % Change $261 13,659 1.91 9% – 9% The coal commodity group consists primarily of thermal grades of bitu- minous coal. Canadian thermal coal is delivered to power utilities pri- marily in eastern Canada, while in the United States, thermal coal is transported from mines served in southern Illinois, or from western U.S. mines via interchange with other railroads, to major utilities in the Midwest and southeast United States. The coal business also includes the transport of metallurgical coal, which is largely exported to steel markets in Japan and other Asian markets. For the year ended December 31, 2004, revenues for this commodity group increased by $23 million, or 9%, from 2003. The increase was due to higher coal shipments to U.S. utili- ties and the inclusion of GLT and BC Rail revenues of $20 million, partly offset by metallurgical mine closures in western Canada and the trans- lation impact of the stronger Canadian dollar. The revenue per revenue ton mile increase of 9% was mainly due to a decrease in the average length of haul and a positive change in traffic mix that were partly off- set by the translation impact of the stronger Canadian dollar. Coal Percentage of revenues Carloads* In thousands 18% 8 2 5 7 1 5 9 9 4 1 7 4 6 8 4 82% 82% Coal 18% Petroleum coke 00 01 02 03 04 * Includes WC from October 9, 2001, GLT from May 10, 2004 and BC Rail from July 14, 2004 Ang_029-053 MDA USA_R4.indd 35 Ang_029-053 MDA USA_R4.indd 35 2/22/05 3:48:23 AM 2/22/05 3:48:23 AM U.S. GAAP Canadian National Railway Company 35 Management’s Discussion and Analysis Intermodal Revenues (millions) RTMs (millions) Revenue/RTM (cents) Year ended December 31, 2004 $1,117 31,002 3.60 Automotive 2003 % Change Year ended December 31, $1,101 31,168 3.53 1% (1%) 2% Revenues (millions) RTMs (millions) Revenue/RTM (cents) 2004 $510 3,321 15.36 2003 % Change $525 3,225 16.28 (3%) 3% (6%) The intermodal commodity group is comprised of two segments: domes- tic and international. The domestic segment is responsible for consumer products and manufactured goods, operating through both retail and wholesale channels while the international segment handles import and export container traffic, serving the ports of Vancouver, Montreal, Halifax and New Orleans. The domestic segment is driven by consumer markets, with growth generally tied to the economy. The international segment is driven mainly by North American economic conditions. For the year ended December 31, 2004, revenues for this commodity group increased by $16 million, or 1%, from 2003. Revenues for 2004 benefited from heavy import volumes through the Port of Vancouver, freight rate improvements and a higher fuel surcharge. Revenues were negatively affected by the first quarter CAW strike, the closure of the Company’s smaller terminal facilities in the U.S., the discontinuance of the Roadrailer service and the translation impact of the stronger Canadian dollar. Revenue per revenue ton mile increased by 2% in 2004 driven by a positive change in traffic mix and freight rate improve- ments that were partly offset by an increase in the average length of haul and the translation impact of the stronger Canadian dollar. Intermodal Percentage of revenues Carloads* In thousands The automotive commodity group moves both finished vehicles and parts, originating in southwestern Ontario, Michigan and Mississippi, destined for the United States, Canada and Mexico. The Company’s broad coverage, including its access to all of the Canadian assembly plants, enables it to consolidate full trainloads of automotive traf- fic for delivery to connecting railroads at key interchange points. The Company also serves shippers of import vehicles via the ports of Halifax and Vancouver, and through interchange with other railroads. The Company’s automotive revenues are closely correlated to auto- motive production and sales in North America. For the year ended December 31, 2004, revenues for this commodity group decreased by $15 million, or 3%, from 2003. The decrease was due to the translation impact of the stronger Canadian dollar that was partially offset by the benefit of new finished vehicle traffic that began in late 2003. Revenue per revenue ton mile decreased by 6% in 2004 due to the translation impact of the stronger Canadian dollar. Automotive Percentage of revenues Carloads* In thousands 18% 8 1 3 7 0 3 8 8 2 8 8 2 5 9 2 7 3 2 , 1 6 7 2 , 1 2 0 2 , 1 1 2 1 , 1 3 0 1 , 1 48% 52% 52% Domestic 48% International 00 01 02 03 04 * Includes WC from October 9, 2001, GLT from May 10, 2004 and BC Rail from July 14, 2004 82% 82% Finished vehicles 18% Auto parts 00 01 02 03 04 * Includes WC from October 9, 2001, GLT from May 10, 2004 and BC Rail from July 14, 2004 Other In 2004, other revenues increased by $106 million, when compared to 2003, mainly due to revenues from GLT’s maritime division of $90 million. 36 Canadian National Railway Company U.S. GAAP Ang_029-053 MDA USA_R4.indd 36 Ang_029-053 MDA USA_R4.indd 36 2/22/05 3:48:28 AM 2/22/05 3:48:28 AM Management’s Discussion and Analysis Operating expenses Operating expenses amounted to $4,380 million in 2004 compared to $4,107 million in 2003. The increase of $273 million, or 7%, in 2004 was mainly due to the inclusion of $228 million of GLT and BC Rail expenses, higher expenses for labor and fringe benefits, increased fuel costs and higher casualty and other expense. Partly offsetting the increase was the translation impact of the stronger Canadian dollar on U.S. dollar denominated expenses and lower equipment rents. The month-long CAW strike had a minimal impact on overall operating expenses for the year ended December 31, 2004 as the benefit from lower labor and fringe benefit expenses was mostly offset by increases in other expense categories. In millions Year ended December 31, 2004 2003 Labor and fringe benefits Purchased services and material Depreciation and amortization Fuel Equipment rents Casualty and other Total Amount $1,819 746 598 528 244 445 $4,380 % of revenue 27.8% 11.4% 9.1% 8.1% 3.7% 6.8% 66.9% Amount $1,698 703 554 469 293 390 % of revenue 28.9% 11.9% 9.4% 8.0% 5.0% 6.6% $4,107 69.8% Labor and fringe benefits: Labor and fringe benefits includes wages, payroll taxes, and employee benefits such as incentive compensation, stock-based compensation, health and welfare, pensions and other post-employment benefits. These expenses increased by $121 million, or 7%, in 2004 as compared to 2003. The increase was attributable to the inclusion of GLT and BC Rail labor expense of $91 million, higher wages and employee benefits, including increased costs for stock-based compensation, and charges and adjustments relating to the workforce reduction provision. Partly offsetting these factors were the translation impact of the stronger Canadian dollar, the effects of a reduced work- force, lower expenses for pensions and other post-retirement benefits and wage and benefits savings during the CAW strike. Purchased services and material: Purchased services and material pri- marily includes the costs of services purchased from outside contractors, materials used in the maintenance of the Company’s track, facilities and equipment, transportation and lodging for train crew employees, utility costs and the net costs of operating facilities jointly used by the Company and other railroads. These expenses increased by $43 mil- lion, or 6%, in 2004 as compared to 2003. The increase was due to the inclusion of $77 million of GLT and BC Rail expenses, higher repair and maintenance expenses, partly related to the CAW strike, and other strike-related costs. Partly offsetting the increase was the translation impact of the stronger Canadian dollar and lower net expenses for operating joint facilities. Depreciation and amortization: Depreciation and amortization relates to the Company’s rail operations. These expenses increased by $44 million, or 8%, in 2004 as compared to 2003. The increase was mainly due to the inclusion of GLT and BC Rail expenses of $30 million and the impact of net capital additions, partially offset by the translation impact of the stronger Canadian dollar. Fuel: Fuel expense includes the cost of fuel consumed by locomotives, intermodal equipment and other vehicles. These expenses increased by $59 million, or 13%, in 2004 as compared to 2003. The increase was mainly due to a higher average price per gallon, net of the impact of the hedging program, the inclusion of GLT and BC Rail expenses of $21 million and higher volumes. The increase was partly offset by the translation impact of the stronger Canadian dollar, increased productiv- ity and a fuel excise tax refund in the second quarter. Equipment rents: Equipment rents includes rental expense for the use of freight cars owned by other railroads or private companies and for the short or long-term lease of freight cars, locomotives and intermodal equipment, net of rental income from other railroads for the use of the Company’s cars and locomotives. These expenses decreased by $49 mil- lion, or 17%, in 2004 as compared to 2003. The decrease was due to higher car hire income, including that of BC Rail, the translation impact of the stronger Canadian dollar and a reduction in car hire expenses that were partly offset by higher lease expense for freight cars. Casualty and other: Casualty and other includes expenses for personal injuries, environmental, freight and property damage, insurance, bad debt and operating taxes, as well as travel and travel-related expenses. These expenses increased by $55 million, or 14%, in 2004 as compared to 2003. The increase was due to higher expenses for personal injuries, the inclusion of GLT and BC Rail expenses of $14 million, increased environmental expenses and favorable adjustments to U.S. property taxes in 2003. Partially offsetting the increase was the translation impact of the stronger Canadian dollar. Other Interest expense: Interest expense decreased by $21 million, or 7%, for the year ended December 31, 2004 as compared to 2003 as the benefit of lower interest rates on issued debt to replace matured debt and the translation impact of the stronger Canadian dollar were partly offset by interest expense on debt related to the Company’s recent acquisitions. Other income (loss): In 2004, the Company recorded a loss of $20 mil- lion compared to income of $21 million in 2003. The change from income to loss in 2004 was due to lower gains on disposal of surplus properties and lower equity income from the Company’s investment in English Welsh and Scottish Railway (EWS) as a result of restructured operations. Income tax expense: The Company recorded income tax expense of $596 million for the year ended December 31, 2004 compared to $517 million in 2003. The effective tax rate for the year ended December 31, 2004 was 32.1% compared to 34.9% in 2003. The decrease in the effective tax rate in 2004 was mainly due to higher deferred income tax expense in 2003 resulting from the enactment of higher corporate tax rates in the province of Ontario, which was partly offset by net favorable adjustments relating to the resolution of matters per- taining to prior years’ income taxes. U.S. GAAP Canadian National Railway Company 37 Management’s Discussion and Analysis 2003 compared to 2002 For the year ended December 31, 2003, the Company recorded consoli- dated net income of $1,014 million ($3.54 per basic share) compared to $800 million ($2.71 per basic share) for the year ended December 31, 2002. Diluted earnings per share were $3.49 for 2003 compared to $2.65 in 2002. The Company’s operating income for 2003 was $1,777 million compared to $1,469 million in 2002, and its operating ratio, defined as operating expenses as a percentage of revenues, was 69.8% in 2003 compared to 76.0% in 2002 (see discussion on adjusted per formance measures herein). The Company’s results of operations for the year ended December 31, 2003 included a cumulative benefit of $75 million, or $48 million after tax, resulting from a change in the accounting for removal costs for certain track structure assets pursuant to the requirements of SFAS No. 143, “Accounting for Asset Retirement Obligations,” as explained in Note 2 to the attached Annual Consolidated Financial Statements. 2003 compared to 2002 – Adjusted performance measures The years ended December 31, 2003 and 2002 included items impact- ing the comparability of the results of operations (see reconciliation of adjusted performance measures presented herein). In 2003, the Company recorded a fourth quarter deferred income tax expense of $79 million resulting from the enactment of higher corporate tax rates in the province of Ontario. The year ended December 31, 2002 included fourth quarter charges of $281 million, or $173 million after tax, to increase the Company’s provision for U.S. personal injury and other claims, and $120 million, or $79 million after tax, for workforce reductions. Excluding these items, adjusted net income was $1,045 million ($3.65 per basic share or $3.60 per diluted share) in 2003 compared to adjusted net income of $1,052 million ($3.57 per basic share or $3.48 per diluted share) for 2002, a decrease of $7 million, or 1%. Operating income for 2003 decreased by $93 million, or 5%, compared to adjusted operating income of $1,870 million for 2002. The operating ratio for 2003 was 69.8% compared to the adjusted operating ratio of 69.4% in 2002, a 0.4-point increase. The decrease in adjusted net income and adjusted operating income in 2003 was due to the significant year-over-year apprecia- tion in the Canadian dollar relative to the U.S. dollar. This significant appreciation in the Canadian dollar impacted the conversion of the Company’s U.S. dollar denominated revenues and expenses and accord- ingly, reduced 2003 revenues, operating income and net income by approximately $380 million, $120 million and $62 million, respectively. This decrease in adjusted net income was partly offset by net deferred income tax recoveries of $44 million in 2003 relating mainly to the resolution of matters pertaining to prior years’ income taxes. Reconciliation of adjusted performance measures Management believes that non-GAAP measures such as adjusted net income and the resulting adjusted performance measures for such items as operating income, operating ratio and per share data are useful measures of performance that can facilitate period-to-period comparisons as they exclude items that do not arise as part of the normal day-to-day operations or that could potentially distort the analysis of trends in business per- formance. The exclusion of specified items in the adjusted measures below does not imply that they are necessarily non-recurring. These adjusted measures do not have any standardized meaning prescribed by GAAP and may, therefore, not be comparable to similar measures presented by other companies. The reader is advised to read all information provided in the MD&A in conjunction with the Company’s Annual Consolidated Financial Statements and notes thereto. In millions, except per share data, or unless otherwise indicated Year ended December 31, 2003 Adjusted Reported 2002 Personal injury Workforce reductions charge Change in policy Rate enactment $÷« – $÷ – Revenues Operating expenses Operating income Interest expense Other income Income before income taxes and cumulative effect of change in accounting policy Income tax expense Income before cumulative effect of change in accounting policy Cumulative effect of change in accounting policy, net of applicable taxes Net income Operating ratio Basic earnings per share Diluted earnings per share Reported $«5,884 4,107 1,777 (315) 21 1,483 (517) 966 48 $1,014 69.8% $÷3.54 $÷3.49 – – – – – – – (48) $(48) $«5,884 4,107 1,777 (315) 21 1,483 (438) 1,045 – $«6,110 4,641 1,469 (361) 76 1,184 (384) 800 – $÷÷« – (281) 281 – – 281 (108) 173 – – – – – – 79 79 – Adjusted $«6,110 4,240 $÷÷«– (120) 120 1,870 – – 120 (41) 79 – (361) 76 1,585 (533) 1,052 – $79 $1,045 $÷«800 $«173 $ ««79 $1,052 69.8% $÷3.65 $÷3.60 76.0% $÷2.71 $÷2.65 69.4% $÷3.57 $÷3.48 38 Canadian National Railway Company U.S. GAAP Management’s Discussion and Analysis Revenues Forest products Year ended December 31, 2003 2002 % Change Year ended December 31, 2003 2002 % Change Total revenues (millions) $5,884 $6,110 (4%) Revenues (millions) Rail freight Revenues (millions) RTMs (millions) Revenue/RTM (cents) Carloads (thousands) Revenue/Carload (dollars) $5,694 $5,901 162,901 159,259 3.50 4,177 1,363 3.71 4,153 1,421 (4%) 2% (6%) 1% (4%) Revenues for the year ended December 31, 2003 totaled $5,884 million compared to $6,110 million in 2002. The decrease of $226 million, or 4%, was mainly due to the higher Canadian dollar, which negatively impacted the translation of U.S. dollar denominated revenue, continued weakness in coal shipments and a slowdown in the automotive sector. Partially offsetting these losses were increased intermodal, metals and minerals and petroleum and chemicals volumes. For 2003, revenue ton miles, measuring the volume of freight transported by the Company, increased by 2% relative to 2002. Freight revenue per revenue ton mile, a measurement of yield defined as revenue earned on the movement of a ton of freight over one mile, decreased by 6% when compared to 2002, reflecting the higher Canadian dollar. Petroleum and chemicals Year ended December 31, 2003 2002 % Change Revenues (millions) RTMs (millions) Revenue/RTM (cents) $1,058 30,901 3.42 $1,102 30,006 3.67 (4%) 3% (7%) Revenues for the year ended December 31, 2003 decreased by $44 mil- lion, or 4%, from 2002. The decrease was due to the translation impact of the stronger Canadian dollar, partially offset by higher U.S. and offshore demand for Canadian sulfur and strong demand for liquefied petroleum gas due to cold weather conditions at the beginning of 2003. Revenue per revenue ton mile decreased by 7% from 2002 due to the translation impact of the stronger Canadian dollar. Metals and minerals Revenues (millions) RTMs (millions) Revenue/RTM (cents) Year ended December 31, 2003 $527 2002 % Change $521 13,876 13,505 3.80 3.86 1% 3% (2%) Revenues for the year ended December 31, 2003 increased by $6 million, or 1%, from 2002. The increase was due to improved market conditions and increased market share for steel in 2003 and new ore traffic which began in the second quarter of 2002 and the last quarter of 2003. These gains were largely offset by the translation impact of the stronger Canadian dollar. Revenue per revenue ton mile decreased by 2% from 2002 due to the translation impact of the stronger Canadian dollar which was partially offset by a positive change in traffic mix. RTMs (millions) Revenue/RTM (cents) $1,284 34,516 3.72 $1,323 33,551 3.94 (3%) 3% (6%) Revenues for the year ended December 31, 2003 decreased by $39 mil- lion, or 3%, from 2002. The decrease was due to the translation impact of the stronger Canadian dollar that was partially offset by solid demand for lumber and pulp and paper. Revenue per revenue ton mile decreased by 6% from 2002 due to the translation impact of the stronger Canadian dollar which more than offset the continued improvement in pricing and a positive change in traffic mix. Coal Revenues (millions) RTMs (millions) Revenue/RTM (cents) Year ended December 31, 2003 2002 % Change $261 13,659 1.91 $326 13,886 2.35 (20%) (2%) (19%) Revenues for the year ended December 31, 2003 decreased by $65 mil- lion, or 20%, from 2002. The decrease was due to reduced coal produc- tion in western Canada, the translation impact of the stronger Canadian dollar and a metallurgical mine closure. Revenue per revenue ton mile decreased by 19% from 2002 mainly due to a change in traffic mix, an increase in the average length of haul, and the translation impact of the stronger Canadian dollar. Grain and fertilizers Year ended December 31, 2003 2002 % Change Revenues (millions) RTMs (millions) Revenue/RTM (cents) $938 35,556 2.64 $986 35,773 2.76 (5%) (1%) (4%) Revenues for the year ended December 31, 2003 decreased by $48 mil- lion, or 5%, from 2002. The decrease was mainly due to the translation impact of the stronger Canadian dollar and a decrease in Canadian export wheat shipments due to the smaller 2002/2003 Canadian crop. Partially offsetting these decreases were increased Canadian canola shipments and strong U.S. corn shipments to North American markets. Revenue per revenue ton mile decreased by 4% from 2002 as the trans- lation impact of the stronger Canadian dollar was partially offset by a decrease in the average length of haul. Intermodal Revenues (millions) RTMs (millions) Revenue/RTM (cents) Year ended December 31, 2003 2002 % Change $1,101 31,168 3.53 $1,052 29,257 3.60 5% 7% (2%) Revenues for the year ended December 31, 2003 increased by $49 mil- lion, or 5%, from 2002. The increase was mainly due to increased import volumes, the higher fuel surcharge in 2003 to offset the U.S. GAAP Canadian National Railway Company 39 Management’s Discussion and Analysis significant increase in fuel costs and new traffic through the Port of Vancouver. Partially offsetting these gains was reduced traffic in the domestic segment due to the closure of smaller terminal facilities in the U.S. Revenue per revenue ton mile decreased by 2% from 2002 due to the translation impact of the stronger Canadian dollar and an increase in the average length of haul, partially offset by the higher fuel surcharge. In 2002, the Company had recorded a workforce reduction charge of $120 million in a renewed drive to improve productivity across all its corporate and operating functions. Reductions relating to this ini- tiative and the 2001 workforce reduction charge of $98 million were completed in 2003. The charges included payments for severance, early retirement incentives and bridging to early retirement to be made to affected employees. Automotive Revenues (millions) RTMs (millions) Revenue/RTM (cents) Year ended December 31, 2003 $525 3,225 16.28 2002 % Change $591 3,281 18.01 (11%) (2%) (10%) Revenues for the year ended December 31, 2003 decreased by $66 mil- lion, or 11%, from 2002. The decrease was primarily due to the transla- tion impact of the stronger Canadian dollar, weaker North American vehicle sales and production, and a change in shipping patterns for a significant customer. Revenue per revenue ton mile decreased by 10% from 2002 mainly due to the translation impact of the stronger Canadian dollar and a significant increase in the average length of haul. Operating expenses Operating expenses amounted to $4,107 million in 2003 compared to $4,641 million in 2002. The decrease was mainly due to the charges recorded in the fourth quarter of 2002 for personal injury and other claims and workforce reductions, and the translation impact of the stronger Canadian dollar on U.S. dollar denominated expenses. Partly offsetting these decreases were higher casualty and other expenses and higher fuel costs. In millions Year ended December 31, 2003 2002 Labor and fringe benefits Purchased services and material Depreciation and amortization Fuel Equipment rents Casualty and other Total Amount $1,698 703 554 469 293 390 % of revenue 28.9% 11.9% 9.4% 8.0% 5.0% 6.6% Amount $1,837 778 584 459 346 637 $4,107 69.8% $4,641 % of revenue 30.1% 12.7% 9.6% 7.5% 5.7% 10.4% 76.0% Labor and fringe benefits: Labor and fringe benefits expenses in 2003 decreased by $139 million, or 8%, as compared to 2002. The decrease was mainly due to the workforce reduction charge of $120 million recorded in the fourth quarter of 2002, the effects of a reduced work- force and the translation impact of the stronger Canadian dollar. Higher wages and employee benefits, including increased costs for pensions resulting from a change in management’s assumption for the expected long-term rate of return on pension plan assets from 9% to 8%, partly offset the decrease. Purchased services and material: Purchased services and material expenses in 2003 decreased by $75 million, or 10%, as compared to 2002. The decrease was mainly due to lower expenses for consulting and professional services, lower discretionary spending (courier, com- munication charges, occupancy costs, etc.), reflecting the Company’s continued focus on cost containment, and the translation impact of the stronger Canadian dollar. Depreciation and amortization: Depreciation and amortization expenses in 2003 decreased by $30 million, or 5%, as compared to 2002. Reduced depreciation for certain asset classes pursuant to the adop- tion of SFAS No. 143, “Accounting for Asset Retirement Obligations,” and the translation impact of the stronger Canadian dollar were partly offset by increases related to net capital additions. In accordance with SFAS No. 143, the Company changed its accounting policy for certain track structure assets to exclude removal costs as a component of depreciation expense where the inclusion of such costs would result in accumulated depreciation balances exceeding the historical cost basis of the assets. For the year ended December 31, 2003, this change in policy had the effect of reducing depreciation expense by $18 million. Fuel: Fuel expense in 2003 increased by $10 million, or 2%, as com- pared to 2002. The increase was mainly due to a higher average price per gallon, net of the impact of the hedging program, and higher vol- umes. These increases were partly offset by the translation impact of the stronger Canadian dollar. Equipment rents: Equipment rents in 2003 decreased by $53 million, or 15%, as compared to 2002. The decrease was due to the Company’s continued focus on asset utilization, which resulted in lower lease expense for freight cars and locomotives and a reduction in net car hire expense. Also contributing to the decrease was the translation impact of the stronger Canadian dollar and a reduction in intermodal car hire rates. Casualty and other: Casualty and other expenses in 2003 decreased by $247 million, or 39%, as compared to 2002, which included a fourth quarter charge of $281 million to increase the provision for U.S. per- sonal injury and other claims. Excluding this charge, the increase was mainly due to higher expenses for personal injury claims and increased insurance premiums. Partly offsetting the increase were lower travel- related expenses and lower provincial capital taxes. 40 Canadian National Railway Company U.S. GAAP Management’s Discussion and Analysis Other Interest expense: Interest expense decreased by $46 million to $315 mil- lion for the year ended December 31, 2003 as compared to 2002. The decrease was mainly due to the translation impact of the stronger Canadian dollar, the conversion of the convertible preferred securities in July 2002, and lower interest rates on new debt to replace matured debt. Other income: In 2003, the Company recorded other income of $21 million compared to $76 million in 2002. The decrease was mainly due to lower right of way fees due to the termination of a contract in late 2002, lower income from the Company’s equity investments, and real- ized foreign exchange losses in 2003. Income tax expense: The Company recorded income tax expense of $517 million for the year ended December 31, 2003 compared to $384 million in 2002. The effective tax rate for the year ended December 31, 2003 was 34.9% compared to 32.4% in 2002. The increase was mainly due to a $79 million deferred income tax expense recorded in the fourth quarter of 2003 resulting from the enactment of higher corporate tax rates in the province of Ontario, which was partly offset by net favorable adjustments relating to the resolution of matters pertaining to prior years’ income taxes of $44 million and lower corporate income tax rates in Canada. Summary of quarterly financial data – unaudited In millions, except per share data Revenues Operating income Net income Basic earnings per share Diluted earnings per share Dividend declared per share 2004 Third Second $1,709 $÷«591 $÷«346 $÷1.21 $÷1.19 $1,665 $÷«575 $÷«326 $÷1.14 $÷1.13 Fourth $1,736 $÷«607 $÷«376 $÷1.32 $÷1.29 $0.195 $0.195 $0.195 First $1,438 $÷«395 $÷«210 $÷0.74 $÷0.73 $0.195 2003 Third Second $1,413 $÷«454 $÷«294 $÷1.04 $÷1.02 $1,463 $÷«437 $÷«244 $÷0.85 $÷0.84 Fourth $1,512 $÷«512 $÷«224 $÷0.79 $÷0.78 $0.167 $0.167 $0.167 First $1,496 $÷«374 $÷«252 $÷0.86 $÷0.85 $0.167 The volume of goods and commodities transported by the Company during the year is influenced by seasonal weather conditions, general economic conditions, cyclical demand for rail transportation, and competitive forces in the transportation marketplace. Operating expenses reflect the impact of freight volumes, seasonal weather conditions, labor costs, fuel prices, and the Company’s productivity initiatives. The Company’s quarterly results include items that affect the quarter-over-quarter comparability of the results of operations. The Company’s results of operations for 2004 included GLT as of May 10, 2004 and BC Rail as of July 14, 2004. First-quarter 2004 results were affected by the month-long CAW strike, which negatively impacted operating income and net income by $35 million and $24 million, respectively. In 2003, the Company recorded a fourth-quarter deferred income tax expense of $79 million resulting from the enactment of higher corporate tax rates in the province of Ontario and a first-quarter cumulative benefit of $75 million, $48 million after tax, pursuant to SFAS No. 143 as previously discussed. Also affecting comparability was the significant appreciation in the Canadian dollar relative to the U.S. dollar which has impacted the conversion of the Company’s U.S. dollar denominated revenues and expenses and resulted in a reduction in net income of approximately $45 million for 2004, particularly in the first quarter. Liquidity and capital resources The Company’s principal source of liquidity is cash generated from operations. The Company also has the ability to fund liquidity require- ments through its revolving credit facility, the issuance of debt and/or equity, and the sale of a portion of its accounts receivable through a 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 $2,139 million for the year ended December 31, 2004 compared to $1,976 million for 2003. Net cash receipts from customers and others were $6,501 million for the year ended December 31, 2004 compared to $6,022 million in 2003. In 2004, payments for employee services, suppliers and other expenses were $3,628 million, an increase of $366 million when compared to 2003. Also consuming cash in 2004 were payments for interest, workforce reductions and personal injury and other claims of $282 million, $93 million and $106 million, respec- tively, compared to $325 million, $155 million and $126 million, respec- tively, in 2003. In 2004, pension contributions and payments for income taxes were $161 million and $92 million, respectively, compared to $92 million and $86 million, respectively, in 2003. The Company increased the level of accounts receivable sold under its accounts receivable securitization program by $12 million in 2004 and $132 million in 2003. Payments in 2005 for workforce reductions are expected to be $90 million while pension contributions are expected to be approxi- mately $120 million. As at December 31, 2004, the Company had outstanding informa- tion technology service contracts of $18 million. U.S. GAAP Canadian National Railway Company 41 Management’s Discussion and Analysis Investing activities: Cash used by investing activities in 2004 amounted to $2,411 million compared to $1,075 million in 2003. The Company’s investing activities in 2004 included $984 million related to the acquisi- tion of BC Rail and $547 million related to the acquisition of GLT, net proceeds of $141 million from the EWS capital reorganization and $52 million from the sale of its Canac Inc. and Beltpack subsidiar- ies. Net capital expenditures for the year ended December 31, 2004 amounted to $1,072 million, an increase of $29 million over 2003. The following table details capital expenditures for 2004 and 2003. In millions Year ended December 31, Rail infrastructure Rolling stock Information technology and other Less: capital leases Net capital expenditures 2004 $÷«769 253 210 1,232 160 2003 $÷«762 168 160 1,090 47 $1,072 $1,043 The Company expects that its capital expenditures will increase in 2005 due to the acquisition of rolling stock and increased expenditures required for ongoing renewal of the basic plant and other acquisitions and investments required to improve the Company’s operating effi- ciency and customer service. As at December 31, 2004, the Company had commitments to acquire railroad ties, rail, freight cars, locomotives and other equipment at an aggregate cost of $194 million ($211 million at December 31, 2003). Dividends: During 2004, the Company paid dividends totaling $222 mil- lion to its shareholders at the quarterly rate of $0.195 per share com- pared to $191 million at the rate of $0.167 per share, in 2003. Free cash flow The Company generated $1,025 million of free cash flow for the year ended December 31, 2004, compared to $578 million in 2003. Free cash flow does not have any standardized meaning prescribed by GAAP and may, therefore, not be comparable to similar measures presented by other companies. The Company believes that free cash flow is a useful measure of performance as it demonstrates the Company’s ability to generate cash after the payment of capital expenditures and dividends. The Company defines free cash flow as cash provided from operating activities, excluding changes in the level of accounts receivable sold under the securitization program, less investing activities and dividends paid, and adjusted for significant acquisitions as they are not indicative of normal day-to-day investments in the Company’s asset base, calcu- lated as follows: In millions Year ended December 31, 2004 2003 Cash provided from operating activities $«2,139 $«1,976 Less: Investing activities Dividends paid Cash provided (used) before financing activities Adjustments: Change in accounts receivable sold Acquisition of BC Rail & GLT Free cash flow (2,411) (222) (494) (1,075) (191) 710 (12) 1,531 $«1,025 (132) – $÷÷578 Financing activities: Cash provided from financing activities totaled $511 million for the year ended December 31, 2004 compared to cash used by financing activities of $605 million in 2003. In July 2004, the Company issued U.S.$300 million (Cdn$395 million) of 4.25% Notes due 2009 and U.S.$500 million (Cdn$658 million) of 6.25% Debentures due 2034. In March 2004, the Company had repaid U.S.$266 million (Cdn$355 million) of 7.00% 10-year Notes with cash on hand and the proceeds received from the issuance of commercial paper. In May 2003, the Company had repaid U.S.$150 million (Cdn$207 million) of 6.625% 10-year Notes and U.S.$100 million (Cdn$138 million) of 6.75% 10-year Notes with the proceeds received in March 2003 from the issuance of U.S.$400 million (Cdn$586 million) 4.40% Notes due 2013. In 2004 and 2003, issuances and repayments of long-term debt related principally to the Company’s commercial paper and revolving credit facility. In 2004, the Company used $273 million to repurchase 4.0 million common shares under its current share repurchase program whereas in 2003, the Company used $656 million to repurchase the remaining 15.0 million common shares under its previous share repurchase pro- gram initiated in 2002. During 2004, the Company recorded $160 million in capital lease obligations ($47 million in 2003) related to new equipment and the exercise of purchase options on existing equipment. The Company has access to various financing arrangements: Revolving credit facility The Company has a U.S.$1,000 million three-year revolving credit facil- ity expiring in December 2005, which it intends to renew before such date. 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, with which the Company has been in compliance. The Company’s borrowings of U.S.$180 million (Cdn$233 million) outstanding at December 31, 2003 at an average interest rate of 1.49% were entirely repaid in the first quarter of 2004. As at December 31, 2004, the Company had borrowings under its revolving credit facility of U.S.$90 million (Cdn$108 million) at an average inter- est rate of 2.77% and letters of credit drawn of $342 million. Commercial paper The Company has a commercial paper program, which is backed by a por- tion of its revolving credit facility, enabling it to issue commercial paper up to a maximum aggregate principal amount of $800 million, or the U.S. dollar equivalent. As the revolving credit facility will mature within the next twelve months and the refinancing has not been renegotiated, the outstanding balance of U.S.$211 million (Cdn$254 million) of commercial paper at an average interest rate of 2.37% has been included in the current portion of long-term debt at December 31, 2004. The Company had no commercial paper outstanding at December 31, 2003. 42 Canadian National Railway Company U.S. GAAP Management’s Discussion and Analysis Shelf registration statement On July 9, 2004, the Company issued U.S.$300 million (Cdn$395 mil- lion) of 4.25% Notes due 2009 and U.S.$500 million (Cdn$658 million) of 6.25% Debentures due 2034. The debt offering was made under the Company’s shelf prospectus and registration statement filed in October 2003. Accordingly, the amount available under the shelf prospectus and registration statement has been reduced to U.S.$200 million. The Company used the net proceeds of U.S.$790 million to finance a portion of the acquisition costs of BC Rail and GLT. The Company’s access to current and alternate sources of financing at competitive costs is dependent on its credit rating. The Company is not currently aware of any adverse trend, event or condition that would affect the Company’s credit rating. Contractual obligations In the normal course of business, the Company incurs contractual obligations. The following table sets forth the Company’s contractual obligations for the following items as at December 31, 2004: In millions Long-term debt obligations (a) Capital lease obligations (b) Operating lease obligations Purchase obligations (c) Total obligations Total $4,403 1,103 992 212 $6,710 2005 $÷«497 113 206 191 $1,007 2006 $308 106 194 10 $618 2007 $÷60 130 146 5 $341 2008 $207 52 116 3 $378 2009 $363 93 90 3 2010 and thereafter $2,968 609 240 – $549 $3,817 (a) Presented net of unamortized discounts, of which $838 million relates to non-interest bearing notes due in 2094 assumed as part of the BC Rail acquisition and excludes capital lease obligations of $761 million which are included in “Capital lease obligations.” (b) Includes $342 million of imputed interest on capital leases at rates ranging from approximately 2.23% to 13.13%. (c) Includes commitments for railroad ties, rail, freight cars, locomotives and other equipment and outstanding information technology service contracts. For 2005 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. Acquisitions BC Rail In November 2003, the Company entered into an agreement with British Columbia Railway Company, a corporation owned by the Government of the Province of British Columbia (Province), to acquire all the issued and outstanding shares of BC Rail Ltd. and all the part- nership units of BC Rail Partnership (collectively BC Rail), and the right to operate over BC Rail’s roadbed under a long-term lease, for a pur- chase price of $1 billion. fair value of BC Rail’s assets acquired, owned and leased, and liabilities assumed at acquisition, as presented in Note 3 – Acquisitions, of the Company’s Annual Consolidated Financial Statements, is subject to a final valuation, the impact of which is not expected to have a material effect on the results of operations. Great Lakes Transportation LLC’s Railroads and Related Holdings In October 2003, the Company, through an indirect wholly owned subsidiary, entered into an agreement for the acquisition of GLT for a purchase price of U.S.$380 million. On July 2, 2004, the Company reached a consent agreement with As of April 2004, the Company received all necessary regulatory Canada’s Competition Bureau, allowing for the closing of the trans- action, whereby the Company reaffirmed its commitment to share merger efficiencies with BC Rail shippers and assure them competitive transportation options through its Open Gateway Rate and Service Commitment. The consent agreement also maintains competitive rates and service for grain shippers in the Peace River region. On July 14, 2004, the Company completed its acquisition of BC Rail and began a phased integration of the companies’ operations. The acquisition was financed by debt and cash on hand. The Company accounted for the acquisition using the purchase method of accounting as required by SFAS No. 141, “Business Combinations,” and SFAS No. 142, “Goodwill and Other Intangible Assets.” As such, the consolidated financial statements of the Company include the assets, liabilities and results of operations of BC Rail as of July 14, 2004, the date of acquisition. The Company’s cost to acquire BC Rail of $991 million includes purchase price adjustments and trans- action costs. The preliminary purchase price allocation, based on the approvals, including the U.S. Surface Transportation Board (STB) ruling rendered on April 9, 2004. On May 10, 2004, the Company completed its acquisition of GLT and began a phased integration of the companies’ operations. The acquisition was financed by debt and cash on hand. The Company accounted for the acquisition using the purchase method of accounting. As such, the consolidated financial statements of the Company include the assets, liabilities and results of operations of GLT as of May 10, 2004, the date of acquisition. The Company’s cost to acquire GLT of U.S.$395 million (Cdn$547 million) includes purchase price adjustments and transaction costs. The preliminary purchase price allocation, based on the fair value of GLT’s assets acquired and liabili- ties assumed at acquisition, as presented in Note 3 – Acquisitions, of the Company’s Annual Consolidated Financial Statements, is subject to a final valuation, the impact of which is not expected to have a mate- rial effect on the results of operations. U.S. GAAP Canadian National Railway Company 43 Management’s Discussion and Analysis These acquisitions involve the integration of two previously inde- pendent businesses to provide shippers enhanced rail services over a coordinated network. There can be no assurance that CN will be able to integrate its business with that of either BC Rail or GLT without encoun- tering operational difficulties or experiencing the loss of key employees or customers, or that the rail service levels and other efficiencies or syn- ergies expected from these acquisitions will be attained. Investment in English Welsh and Scottish Railway (EWS) – Capital reorganization On January 6, 2004, EWS shareholders approved a plan to reduce the EWS share capital to enable cash to be returned to the shareholders by offering them the ability to cancel a portion of their EWS shares. For each share cancelled, EWS shareholders would receive cash and 8% notes due in 2009, redeemable in whole or in part at any time by EWS, at their principal amount together with accrued but unpaid interest up to the date of repayment. The Company elected to have the maximum allowable number of shares cancelled under the plan, thereby reducing its ownership interest of EWS to approximately 31% on a fully diluted basis (13.7 million shares) compared to approximately 37% on a fully diluted basis (43.7 million shares) prior to the capital reorganization. In the first quarter of 2004, the Company received £57.7 million (Cdn$141 million) in cash and a note receivable of £23.9 million (Cdn$58 million) from EWS. Off balance sheet arrangements Accounts receivable securitization program The Company has an accounts receivable securitization program, expiring in June 2006, under which it may sell, on a revolving basis, a maximum of $450 million of eligible freight trade and other receivables outstanding at any point in time, to an unrelated trust. The Company has a contingent residual interest of approximately 10% of receivables sold, which is recorded in Other current assets. The Company is subject to customary reporting requirements for which failure to perform could result in termination of the program. In addition, the trust is subject to customary credit rating requirements, which if not met could also result in termination of the program. The Company monitors these reporting and credit rating requirements for any trends, events or conditions that could cause such termination. The accounts receivable securitization program provides the Company with readily available short-term financing for general corpo- rate uses. In the event the program is terminated before its scheduled maturity, the Company expects to meet its future payment obligations through its various sources of financing, including its revolving credit facility and commercial paper program, and/or access to capital markets. At December 31, 2004, pursuant to the agreement, $445 million had been sold compared to $448 million at December 31, 2003. Guarantees and indemnifications In the normal course of business, the Company, including certain of its subsidiaries, enters into agreements that may involve providing certain guarantees or indemnifications to third parties and others, which extend over the term of the agreement. These include, but are not limited to, residual value guarantees on operating leases, standby letters of credit and surety bonds, and indemnifications that are customary for the type of transaction or for the railway business. Effective January 1, 2003, the Company is required to recognize a liability for the fair value of the obligation undertaken in issuing certain guarantees on the date the guarantee is issued or modified. Where the Company expects to make a payment in respect of a guarantee, a liability will be recognized to the extent that one has not yet been recognized. The nature of these guarantees or indemnifications, the maximum potential amount of future payments, the carrying amount of the liability, if any, and the nature of any recourse provisions are disclosed in Note 19 – Major commitments and contingencies of the Company’s Annual Consolidated Financial Statements. Financial instruments The Company has limited involvement with derivative financial instru- ments and does not use them for trading purposes. Collateral or other security to support financial instruments subject to credit risk is usually not obtained. While the Company is exposed to counterparty credit risk in the event of non-performance, the credit standing of counterparties or their guarantors is regularly monitored, and losses due to counter- party non-performance are not anticipated. Fuel To mitigate the effects of fuel price changes on its operating margins and overall profitability, the Company has a systematic hedging pro- gram which calls for regularly entering into swap positions on crude and heating oil to cover a target percentage of future fuel consumption up to two years in advance. However, in the fourth quarter of 2004, the Company did not enter into any swap positions on crude and heating oil. At December 31, 2004, the Company had hedged approximately 50% of the estimated 2005 fuel consumption, representing approxi- mately 203 million U.S. gallons at an average price of U.S.$0.74 per U.S. gallon, and 17% of the estimated 2006 fuel consumption, representing 69 million U.S. gallons at an average price of U.S.$0.89 per U.S. gallon. Realized gains from the Company’s fuel hedging activities were $112 million, $49 million and $3 million for the years ended December 31, 2004, 2003 and 2002, respectively. At December 31, 2004, Accumulated other comprehensive loss included an unrealized gain of $92 million, $62 million after tax ($38 million unrealized gain, $26 million after tax at December 31, 2003), of which $81 million relates to derivative instruments that will mature within the next year. 44 Canadian National Railway Company U.S. GAAP Management’s Discussion and Analysis Interest rate In the first quarter of 2004, in anticipation of future debt issuances, the Company had entered into treasury lock transactions for a notional amount of U.S.$380 million to fix the treasury component on these future debt issuances. Upon expiration in June 2004, these treasury rate locks were rolled into new contracts expiring in September 2004, at an average locked-in rate of 5.106%. The Company settled these treasury locks at a gain of U.S.$9 million (Cdn$12 million) upon the pricing of the U.S.$500 million 6.25% Debentures due 2034, subsequently issued on July 9, 2004. Beginning July 9, 2004, upon the issuance of debt, the realized gain of $12 million accumulated in other comprehensive income will be recorded into income, as a reduction of interest expense, over the term of the debt based on the interest payment schedule. At December 31, 2004, Accumulated other comprehensive loss included an unamortized gain of $12 million, $8 million after tax. Recent accounting pronouncement In December 2004, the Financial Accounting Standards Board (FASB) issued SFAS No. 123(R), “Share-Based Payment,” which requires expensing of all options issued, modified or settled based on the grant- date fair value and recognizing the expense over the period during which an employee is required to provide service (vesting period). The standard also requires that cash settled awards be measured at fair value at each reporting date until ultimate settlement. This standard is effective as of the beginning of the first interim reporting period after June 15, 2005. The Company has elected to apply the modified prospec- tive approach, which requires compensation cost to be recognized for unvested awards based on their grant-date fair value. Pursuant to the application of this standard, stock-based compensation expense for the second half of 2005 will increase by approximately $10 million for awards outstanding at December 31, 2004. Common stock Share repurchase program On October 26, 2004, the Board of Directors of the Company approved a share repurchase program which allows for the repurchase of up to 14.0 million common shares between November 1, 2004 and October 31, 2005 pursuant to a normal course issuer bid, at prevailing market prices. As at December 31, 2004, 4.0 million common shares have been repur- chased for $273 million, at an average price of $68.31 per share. Common stock split On January 27, 2004, the Board of Directors of the Company approved a three-for-two common stock split which was effected in the form of a stock dividend of one-half additional common share of CN payable for each share held. The stock dividend was paid on February 27, 2004, to shareholders of record on February 23, 2004. All equity-based ben- efit plans were adjusted to reflect the issuance of additional shares or options due to the declaration of the stock split. All share and per share data has been adjusted to reflect the stock split. Outstanding share data As at January 25, 2005, the Company had 283.1 million common shares outstanding. 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 claims, depreciation, pensions and other post-retirement benefits, and income taxes, based upon currently available information. Actual results could differ from these estimates. The following account- ing 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 information should be read in conjunction with the Company’s Annual 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’ com- pensation 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 not changed any of these assumptions. 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 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 set- tlements, has contributed to the significant increase in the Company’s personal injury expense in recent years. In view of the Company’s U.S. GAAP Canadian National Railway Company 45 Management’s Discussion and Analysis growing presence 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 Annual 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 expected cost for personal injury and property damage claims and asserted occupational disease claims, based on actuarial estimates of their ultimate cost. A liability for the minimum amount of unasserted occupational disease claims is also accrued to the extent they can be reasonably estimated. The amount recorded reflects a 25-year horizon as the Company expects that a large majority of these cases will be received over such period. 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 sever- ity would have the effect of changing the provision by approximately $23 million and the annual expense by approximately $8 million. In 2004, the Company’s expenses for personal injury and other claims, net of recoveries, were $149 million ($127 million in 2003 and $393 million in 2002) and payments for such items were $106 million ($126 million in 2003 and $156 million in 2002). As at December 31, 2004, the Company had aggregate reserves for personal injury and other claims of $642 million ($590 million at December 31, 2003). Environmental claims 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 compli- ance and capital costs, on an ongoing basis, associated with environ- mental regulatory compliance and clean-up requirements in its railroad operations and relating to its past and present ownership, operation or control of real property. Environmental expenditures that relate to cur- rent 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. Known existing environmental concerns The Company is subject to environmental clean-up and enforce- ment actions. In particular, the Federal Comprehensive Environmental Response, Compensation and Liability Act of 1980 (CERCLA), also known as the Superfund law, as well as similar state laws generally impose joint and several liability for clean-up and enforcement costs on current and former owners and operators of a site without regard to fault or the legality of the original conduct. The Company has been notified that it is a potentially responsible party for study and clean-up costs at approximately 17 Superfund sites for which investigation and remediation payments are or will be made or are yet to be determined and, in many instances, is one of several potentially responsible parties. 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 assessment conducted on a site-by-site basis. Cost scenarios established by external consultants based on extent of contamination and expected costs for remedial efforts are used by the Company to estimate the costs related to a particular site. A liability is initially recorded when environmental assessments and/or remedial efforts are likely, and when 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. Adjustments to initial estimates are recorded as additional information becomes available. Based on the information currently available, the Company considers its provisions to be adequate. At December 31, 2004, most of the Company’s properties not acquired through recent acquisitions have reached the final assessment stage and therefore costs related to such sites have been anticipated. For properties acquired through recent acquisitions, the Company obtains assessments from both external and internal consultants and a liability has been or will be accrued based on such assessments. Unknown existing environmental concerns 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. 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 period they become known. 46 Canadian National Railway Company U.S. GAAP Management’s Discussion and Analysis 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, includ- ing costs relating to the performance of clean-ups, natural resource damages and compensatory or punitive damages relating to harm to individuals or property. In 2004, the Company’s expenses relating to environmental matters, net of recoveries, were $10 million ($6 million in both 2003 and 2002) and payments for such items were $8 million ($12 million in 2003 and $16 million in 2002). As at December 31, 2004, the Company had aggregate accruals for environmental costs of $113 million ($83 million as at December 31, 2003). The Company anticipates that the majority of the liability will be paid out over the next five years. Depreciation Railroad properties are carried at cost less accumulated depreciation including asset impairment write-downs. The Company follows the group method of depreciation for railroad properties 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 busi- ness, is charged to accumulated depreciation. Assessing the reasonableness of the estimated useful lives of prop- erties requires judgment and is based on currently available informa- tion, including periodic depreciation studies conducted by the Company. The Company’s U.S. properties are subject to comprehensive deprecia- tion studies conducted by external consultants as required by the STB. Depreciation studies for Canadian properties are not required by regula- tion 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 composite 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 2004, the Company conducted a comprehensive study for its Canadian properties and U.S. rolling stock and equipment. The study did not have a signifi- cant effect on depreciation expense. In 2004, the Company recorded total depreciation and amortiza- tion expense of $602 million ($560 million in 2003 and $591 million in 2002). At December 31, 2004, the Company had Properties of $19,715 million, net of accumulated depreciation of $9,232 million ($18,305 mil- lion in 2003, net of accumulated depreciation of $9,038 million). Pensions and other post-retirement benefits The Company accounts for pensions 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 Company has various pension plans, however, the following description pertaining to pensions relates generally to the Company’s main pension plan, the CN Pension Plan. 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, termina- tions 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 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 12 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 dis- count rate of 5.75%, based on bond yields prevailing at December 31, 2004, was considered appropriate by the Company and is supported by reports issued by third party advisors. A one-percentage-point decrease in the discount rate would cause annual net periodic benefit cost to increase by approximately $33 million whereas a one-percentage-point increase would not have a material change in net periodic benefit cost as the Company amortizes actuarial gains and losses over the expected average remaining service life of the employee group covered by the plans, only to the extent they 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. U.S. GAAP Canadian National Railway Company 47 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, the expected composition of the plans’ assets as well as the expected long-term market returns in the future. The Company has elected to use a market- related value of assets, whereby realized and unrealized gains/losses and appreciation/depreciation in the value of the investments are recog- nized over a period of five years, while investment income is recognized immediately. The Company follows a disciplined investment strategy, which limits concentration of investments by asset class, foreign cur- rency, sector or company. The Investment Committee of the Board of Directors has approved an investment policy that establishes long-term asset mix targets based on a review of historical returns achieved by worldwide investment markets. Investment managers may deviate from these targets but their performance is evaluated in relation to the mar- ket performance of the target mix. The Company does not anticipate the return on plan assets to fluctuate materially from related capital market indices. The Investment Committee reviews investments regularly with specific approval required for major investments in illiquid securities. The policy also permits the use of derivative financial instruments to implement asset mix decisions or to hedge existing or anticipated expo- sures. The Pension Plan does not invest in the securities of the Company or its subsidiaries. During the last ten years ended December 31, 2004, the CN Pension Plan earned an annual average rate of return of 9.8%. The actual and market-related value rates of return on plan assets for the last five years were as follows: Rates of return Actual Market-related value 2004 11.7% 6.3% 2003 9.6% 7.0% 2002 2001 2000 (0.3)% 7.4% (1.4)% 10.2% 10.5% 13.7% 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. In 2003, the Company had reduced the expected long-term rate of return on plan assets from 9% to 8% to reflect management’s view of long-term investment returns. The effect of this change in management’s assumption was 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, 2004, the plan assets are comprised of 56% in Canadian and foreign equities, 34% in debt securities, 3% in real estate assets and 7% in other assets. The long-term asset allocation percentages are not expected to differ materially from the current composition. The rate of compensation increase, 3.75% to determine both the benefit obligation and the net periodic benefit cost, is another signifi- cant assumption in the actuarial model for pension accounting and is determined 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 15% in the current year, and it is assumed that the rate will decrease gradually to 6% in 2013 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. For pension funding purposes, 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. The latest actuarial valuation of the CN Pension Plan was conducted as at December 31, 2003 and indicated a funding excess. Total con- tributions for all of the Company’s pension plans are expected to be approximately $120 million in each of 2005, 2006 and 2007 based on the plans’ current position. The assumptions discussed above are not expected to have a significant impact on the cash funding requirements of the pension plans. The Canadian Institute of Actuaries (CIA) has adopted a new standard that will be used to calculate the values that pension plan members are entitled to receive on termination of employ- ment. The new standard will impact the calculation of the pension plan liabilities under a solvency or wind-up scenario when the Company conducts an actuarial valuation for purposes of determining the fund- ing position of the Company’s Canadian pension plans. The standard is effective in February 2005 and may significantly impact future funding requirements. For pensions, the Company recorded consolidated net periodic ben- efit cost of $22 million and $49 million in 2004 and 2003, respectively, and no net periodic benefit cost in 2002. Consolidated net periodic ben- efit cost for other post-retirement benefits was $29 million, $33 million and $25 million in 2004, 2003 and 2002, respectively. At December 31, 2004, the Company’s accrued benefit cost for post-retirement benefits other than pensions was $309 million ($164 million at December 31, 2003). In addition, at December 31, 2004, the Company’s consolidated pension benefit obligation and accumulated post-retirement benefit obligation (APBO) were $13,137 million and $319 million, respectively ($12,020 million and $309 million at December 31, 2003). The Medicare Prescription Drug, Improvement, and Modernization Act of 2003 (the “Act”), signed into law in the United States in December 2003, provides for prescription drug benefits under Medicare, as well as a federal subsidy to sponsors of retiree health care benefit plans that provide prescription drug benefits that have been concluded to be actuarially equivalent to the Medicare benefit. Pursuant to FASB Staff Position 106-2, “Accounting and Disclosure Requirements Related to the Medicare Prescription Drug, Improvement and Modernization Act of 2003,” adopted on July 1, 2004, the Company evaluated and deter- mined the prescription drug benefits provided by its health care plans to be actuarially equivalent to the Medicare benefit under the Act. The Company measured the effects of the Act on the APBO as of January 1, 2004 and, as such, the APBO was reduced by $49 million. Net periodic benefit cost for the year ended December 31, 2004 was reduced by $7 million due to the effects of the Act. 48 Canadian National Railway Company U.S. GAAP Management’s Discussion and Analysis In 2004, with the acquisitions of GLT and BC Rail, the Company assumed two additional defined benefit plans. The following table provides the Company’s plan assets by category, benefit obligation at end of year and Company and employee contributions by major pension plan: In millions Plan assets by category Equity securities Debt securities Real estate Other Total Benefit obligation at end of year Company contributions in 2004 Employee contributions in 2004 December 31, 2004 CN Pension Plan BC Rail Pension Plan U.S. and Other Plans Total $÷6,812 3,888 348 1,208 $12,256 $12,172 $÷÷÷«74 $÷÷÷«55 $312 212 16 73 $613 $626 $÷20 $÷÷– $105 $÷7,229 54 1 24 $184 $339 $÷71 $÷÷– 4,154 365 1,305 $13,053 $13,137 $÷÷«165 $÷÷÷«55 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/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 projec- tions, a valuation allowance is recorded. As at December 31, 2004, 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 assets are mainly composed of temporary differences related to accruals for workforce reductions, personal injury and other claims, environmental and other post-retire- ment 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 liabilities are mainly composed of temporary dif- ferences related to properties and prepaid benefit cost for pensions. The reversal of temporary 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/or the income tax rate at which the components will reverse, could materi- ally 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 $19 million in 2004. In the fourth quarter of 2003, the Company had recorded an increase of $81 million to its net deferred income tax liability resulting from the enactment of higher corporate tax rates in the province of Ontario. As a result, for the year ended December 31, 2003, a deferred income tax expense of $79 mil- lion was recorded in income and $2 million was recorded in Other comprehensive loss. For the year ended December 31, 2004, the Company recorded total income tax expense of $596 million ($517 million in 2003 and $384 million in 2002) of which $366 million was for deferred income taxes ($411 million in 2003 and $272 million in 2002). The Company’s net deferred income tax liability at December 31, 2004 was $4,359 mil- lion ($4,425 million at December 31, 2003). 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. Competition The Company faces significant competition from a variety of carriers, including Canadian Pacific Railway Company (CP) which operates the other major rail system in Canada, serving most of the same industrial and population centers as the Company, long distance trucking compa- nies and, in many markets, major U.S. railroads and other Canadian and U.S. railroads. Competition is generally based on the quality and reliabil- ity of services provided, price, and the condition and suitability of car- riers’ equipment. Competition is particularly intense in eastern Canada U.S. GAAP Canadian National Railway Company 49 Management’s Discussion and Analysis where an extensive highway network and population centers, located relatively close to one another, have encouraged significant competi- tion 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 materially adversely affect the demand for goods supplied by the sources served by the Company and, therefore, the Company’s volumes, revenues and profit margins. In addition to trucking competition, and to a greater degree than other rail carriers, the Company’s subsidiary, Illinois Central Railroad Company (ICRR), is vulnerable to barge competition 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. The significant consolidation of rail systems in the United States has resulted in larger rail systems that are able to offer seamless ser- vices in larger market areas and accordingly, compete effectively with the Company in certain markets. This requires the Company to consider transactions that would similarly enhance its own service, such as its acquisitions of BC Rail and the GLT carriers. 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 com- petitive 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 numerous federal, provin- cial, state, municipal and local environmental laws and regulations in Canada and the United States concerning, among other things, emis- sions 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 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 compli- ance and capital costs, on an ongoing basis, associated with environ- mental 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 for environmental matters in the next several years, based on known information, 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 railroad and related transportation operations, 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 relat- ing 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 envi- ronmental 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, 2004, 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 opera- tions in a particular quarter or fiscal year. Labor negotiations Canadian workforce Labor agreements covering approximately 97% of the Company’s Canadian unionized workforce expired on December 31, 2003. As of January 2005, the Company has successfully negotiated four collective agreements with the CAW, retroactive to January 1, 2004, covering the Company’s shopcraft forces, clerical workers, intermodal yard employ- ees and owner operators. Agreements were also reached with the Company’s Rail Traffic Controllers, Toronto Terminal employees and the Canadian Railway Police Association as well as a United Transportation Union (UTU) group that represents employees in the Company’s north- ern Quebec territory (CFIL). In addition, the Company has reached a tentative labor agreement with the United Steelworkers of America, rep- resenting approximately 2,250 track, bridges and structures employees, whose agreement also expired on December 31, 2003. The UTU, rep- resenting 2,520 brakemen and conductors, the Teamsters Canada Rail Conference (TCRC), which represents 1,750 locomotive engineers, and the 630-member International Brotherhood of Electrical Workers (IBEW), representing close to 40% of the unionized workforce in Canada, filed for conciliation in the fourth quarter and the negotiations have since 50 Canadian National Railway Company U.S. GAAP Management’s Discussion and Analysis been conducted with government assistance. On December 29, 2004, the Minister of Labour also referred to the Canadian Industrial Relations Board (CIRB) a question respecting the maintenance of essential ser- vices should there be a strike or lockout involving these groups. Until the Board renders its decision, the right to strike or lockout is sus- pended. In addition to the Board’s decision, at least 72 hours’ strike or lockout notice would be required prior to any legal strike or lockout. In the third quarter of 2004, the Company acquired BC Rail. At December 2004, the Company had reached implementing agreements for BC Rail employees with the Council of Trade Unions and its mem- bers, representing all unions, regarding the integration of the various collective agreements. In the first quarter of 2004, the Company’s shopcraft forces, cleri- cal workers and intermodal yard employees, represented by the CAW had rejected three tentative agreements signed by the CAW and the Company on January 23, 2004. The strike that ensued lasted one month and disrupted the Company’s operations and affected operating income by approximately $35 million in the first quarter of 2004. There can be no assurance that the Company will be able to have all its collective agreements renewed and ratified without any other strikes or lockouts, or that such strikes or lockouts or the resolution of these collective bargaining negotiations will not have a material adverse effect on the Company’s financial position or results of operations. 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 Wisconsin Central Transportation Corporation (WC), have bargained on a local basis rather than holding national, industry wide negotia- tions because it results in agreements that better address both the employees’ concerns and preferences, and the railways’ actual operat- ing 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 2005, the Company had in place agreements with bargaining units representing the entire unionized workforce at ICRR, GTW, DWP, CCP and GLT, and 93% of the unionized workforce at WC. Agreements in place 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 2005. Negotiations are ongoing with the bargaining units with which the Company does not have agreements or settlements. Until new agree- ments are reached or the processes of the Railway Labor Act have been exhausted, the terms and conditions of existing agreements or policies 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 there will not be any such work action and that the resolution of these negotiations 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 as to (i) economic regulation by the STB (the successor to the Interstate Commerce Commission) and (ii) safety by the Federal Railroad Administration. As such, various Company business transactions must gain prior regulatory approval, with attendant risks and uncertainties. The Company is also subject to a variety of health, safety, security, labor, environmental and other regulations, all of which can affect its com- petitive position and profitability. The CTA Review Panel, which was appointed by the federal govern- ment to carry out a comprehensive review of the Canadian transporta- tion 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 affect- ing all modes of transportation, including rail. On February 25, 2003, the Canadian Minister of Transport released its policy document Straight Ahead – A Vision for Transportation in Canada and tabled in the House of Commons Bill C-26 entitled An Act to Amend the Canada Transportation Act and the Railway Safety Act, to enact the VIA Rail Canada Act and to make consequential amendments to other Acts. Bill C-26 died on the Order Paper (was terminated) when Parliament was prorogued on November 12, 2003. No assurance can be given that any future legislative action by the federal government pursuant to the report’s recommendations and the policy document, or other future governmental initiatives will not materially adversely affect the Company’s financial position or results of operations. The U.S. Congress has had under consideration for several years various pieces of legislation that would increase federal economic regulation of the railroad industry. In addition, the STB is authorized by statute to commence regulatory proceedings if it deems them to be appropriate. No assurance can be given that any future regulatory initia- tives by the U.S. federal government will not materially adversely affect the Company’s operations, or its competitive and financial position. The Company is subject to statutory and regulatory directives in the United States addressing homeland security concerns. These include new border security arrangements, pursuant to an agreement the Company and CP entered into with U.S. Customs and Border Protection (CBP) and the Canada Border Services Agency (CBSA). These require- ments include advance electronic transmission of cargo information for U.S.-bound traffic and cargo screening (including gamma ray and radiation screening), as well as U.S. government imposed restrictions on the transportation into the United States of certain commodities. In the fourth quarter of 2003, the CBP issued regulations to extend advance notification requirements to all modes of transportation and the U.S. Food and Drug Administration promulgated interim final rules requir- ing advance notification by all modes for certain food imports into the United States. The Company has also worked with the Association of U.S. GAAP Canadian National Railway Company 51 Management’s Discussion and Analysis American Railroads to develop and put in place an extensive industry- wide security plan. While the Company will continue to work closely with the CBSA, CBP, and other Canadian and U.S. agencies, as above, no assurance can be given that future decisions by the U.S. and/or Canadian governments on homeland security matters, or joint decisions by the industry in response to threats to the North American rail net- work, will not materially adversely affect the Company’s operations, or its competitive and financial position. In October 2002, the Company became the first North American railroad to gain membership in the U.S. Customs Service‘s Customs- Trade Partnership Against Terrorism (C-TPAT). C-TPAT is a joint govern- ment-business initiative designed to build cooperative relationships that strengthen overall supply chain and border security on goods exported to the U.S. The Company is also designated as a low-risk carrier under the Customs Self-Assessment (CSA) program, a CBSA program designed to expedite the cross-border movement of goods of CSA-accredited importing companies for goods imported into Canada. The Company’s ownership of the former Great Lakes Transportation vessels is subject to regulation by the U.S. Coast Guard and the Department of Transportation, Maritime Administration, which regu- late the ownership and operation of vessels operating on the Great Lakes and in U.S. coastal waters. On February 4, 2004, the Maritime Administration and the U.S. Coast Guard issued a Joint Notice of Proposed Rulemaking, proposing modifications to the regulations gov- erning vessel documentation for lease financing for vessels engaged in the coastwise trade. In addition, the U.S. Congress has from time to time considered modifications to the legislation governing the United States coastwise trade. As a result of maritime legislation enacted in 2004, the regulations governing the Company’s acquisition of these vessels should not be affected. No assurance can be given that any future legislative or regulatory initiatives by the U.S. federal government will not materially adversely affect the Company’s operations, or its competitive and financial position. Business prospects and 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 commodi- ties carried by the Company experience cyclicality in demand. Many of the bulk commodities the Company transports move offshore and are affected more by global rather than North American economic condi- tions. The Company’s results of operations can be expected to reflect these conditions because of the significant fixed costs inherent in rail- road operations. Although the Company conducts its business and receives rev- enues 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. Based on the Company’s current operations, the estimated annual impact on net income of a year-over-year one- cent change in the Canadian dollar relative to the U.S. dollar is approxi- mately $8 million. 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 mar- ketplace and thereby affect the Company’s revenues and expenses. 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 adversely affected. In addition to the inherent risks of the business cycle, the Company’s operations are occasionally susceptible to severe weather conditions, which can disrupt operations and service for the railroad as well as for the Company’s customers. Recent severe drought conditions in western Canada, for instance, significantly reduced bulk commodity revenues, principally grain. 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 infla- tion-adjusted basis, assuming that all operating assets are replaced at current price levels, would be substantially greater than historically reported amounts. 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-15(e) and 15d- 15(e)) as of December 31, 2004, 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. During the fourth quarter ending December 31, 2004, there was no change in the Company’s internal control over financial reporting that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting. Global, as well as North American trade conditions, including trade barriers on certain commodities, may interfere with the free circulation of goods across Canada and the United States. Additional information, including the Company’s 2003 Annual Information Form and Form 40-F, may be found on SEDAR at www.sedar.com and on EDGAR at www.sec.gov/edgar.shtml, respectively. Potential terrorist actions can have a direct or indirect impact on the transportation infrastructure, including railway infrastructure in North America, and interfere with the free flow of goods. International conflicts can also have an impact on the Company’s markets. Montreal, Canada January 25, 2005 52 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 these 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 exten- sive 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 state- ments and annual report and recommends their approval by the Board of Directors. Also, the Audit, Finance and Risk Committee meets regu- larly 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, 2004 and 2003 and the consoli- dated statements of income, comprehensive income, changes in share- holders’ equity and cash flows for each of the years in the three-year period ended December 31, 2004. 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 generally accepted auditing standards and with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform an audit to obtain reasonable assur- ance whether the financial statements are free of material misstate- ment. 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, 2004 and 2003, and the results of its operations and its cash flows for each of the years in the three-year period ended December 31, 2004, in accordance with generally accepted accounting principles in the United States. On January 25, 2005, 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. Claude Mongeau Executive Vice-President and Chief Financial Officer January 25, 2005 KPMG LLP Chartered Accountants Montreal, Canada January 25, 2005 Serge Pharand Vice-President and Corporate Comptroller January 25, 2005 U.S. GAAP Canadian National Railway Company 53 Consolidated Statement of Income In millions, except per share data Year ended December 31, 2004 2003 2002 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 Purchased services and material Depreciation and amortization Fuel Equipment rents Casualty and other (Note 2) Total operating expenses Operating income Interest expense (Note 14) Other income (loss) (Note 15) Income before income taxes and cumulative effect of change in accounting policy Income tax expense (Note 16) Income before cumulative effect of change in accounting policy Cumulative effect of change in accounting policy (net of applicable taxes) (Note 2) Net income Basic earnings per share (Note 18) Income before cumulative effect of change in accounting policy Net income Diluted earnings per share (Note 18) Income before cumulative effect of change in accounting policy Net income $1,123 713 1,452 284 1,053 1,117 510 296 6,548 1,819 746 598 528 244 445 4,380 2,168 (294) (20) 1,854 (596) 1,258 – $1,058 527 1,284 261 938 1,101 525 190 5,884 1,698 703 554 469 293 390 4,107 1,777 (315) 21 1,483 (517) 966 48 $1,102 521 1,323 326 986 1,052 591 209 6,110 1,837 778 584 459 346 637 4,641 1,469 (361) 76 1,184 (384) 800 – $1,258 $1,014 $÷«800 $÷4.41 $÷4.41 $÷4.34 $÷4.34 $÷3.38 $÷3.54 $÷3.33 $÷3.49 $÷2.71 $÷2.71 $÷2.65 $÷2.65 See accompanying notes to consolidated financial statements. 54 Canadian National Railway Company U.S. GAAP Year ended December 31, 2004 2003 Consolidated Statement of Comprehensive Income In millions Net income Other comprehensive income (loss) (Note 21) : 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 20) Realized gain on settlement of interest rate swaps (Note 20) Minimum pension liability adjustment (Note 13) Other comprehensive income (loss) before income taxes Income tax (expense) recovery on other comprehensive income (loss) Other comprehensive income (loss) Comprehensive income $1,258 $«1,014 326 (428) 54 12 8 (28) 9 (19) 754 (1,101) 8 – 7 (332) 106 (226) 2002 $800 51 (40) 68 – (20) 59 (20) 39 $1,239 $÷÷788 $839 See accompanying notes to consolidated financial statements. U.S. GAAP Canadian National Railway Company 55 Consolidated Balance Sheet In millions Assets Current assets: Cash and cash equivalents Accounts receivable (Note 4) Material and supplies Deferred income taxes (Note 16) Other Properties (Note 5) Intangible and other assets (Note 6) Total assets Liabilities and shareholders’ equity Current liabilities: Accounts payable and accrued charges (Note 8) Current portion of long-term debt (Note 10) Other Deferred income taxes (Note 16) Other liabilities and deferred credits (Note 9) Long-term debt (Note 10) Shareholders’ equity: Common shares (Note 11) Accumulated other comprehensive loss (Note 21) Retained earnings December 31, 2004 2003 $÷«÷147 793 127 364 279 1,710 19,715 940 $22,365 $÷«÷130 529 120 125 223 1,127 18,305 905 $20,337 $÷1,605 578 76 $÷1,421 483 73 2,259 4,723 1,513 4,586 4,706 (148) 4,726 9,284 1,977 4,550 1,203 4,175 4,664 (129) 3,897 8,432 Total liabilities and shareholders’ equity $22,365 $20,337 On behalf of the Board: David G.A. McLean Director E. Hunter Harrison Director See accompanying notes to consolidated financial statements. 56 Canadian National Railway Company U.S. GAAP Consolidated Statement of Changes in Shareholders’ Equity In millions Balances December 31, 2001 Net income Stock options exercised (Notes 11, 12) Conversion of convertible preferred securities (Note 11) Share repurchase program (Note 11) Other comprehensive income (Note 21) Dividends ($0.57 per share) Balances December 31, 2002 Net income Stock options exercised and other (Notes 11, 12) Share repurchase program (Note 11) Other comprehensive loss (Note 21) Dividends ($0.67 per share) Balances December 31, 2003 Net income Stock options exercised and other (Notes 11, 12) Share repurchase program (Note 11) Other comprehensive loss (Note 21) Dividends ($0.78 per share) Balances December 31, 2004 Issued and outstanding common shares 289.1 – 2.7 9.0 (4.5) – – 296.3 – 2.9 (15.0) – – 284.2 – 2.9 (4.0) – – Common shares $«4,442 – 75 340 (72) – – 4,785 – 122 (243) – – 4,664 – 108 (66) – – Accumulated other comprehensive income (loss) Retained earnings Total shareholders’ equity $÷«÷58 – – – – 39 – 97 – – – (226) – (129) – – – (19) – $«2,988 800 – – (131) – (170) 3,487 1,014 – (413) – (191) 3,897 1,258 – (207) – (222) $«7,488 800 75 340 (203) 39 (170) 8,369 1,014 122 (656) (226) (191) 8,432 1,258 108 (273) (19) (222) 283.1 $4,706 $«(148) $4,726 $9,284 See accompanying notes to consolidated financial statements. U.S. GAAP Canadian National Railway Company 57 Consolidated Statement of Cash Flows In millions Operating activities Net income Year ended December 31, 2004 2003 2002 $÷1,258 $÷1,014 $÷÷800 Adjustments to reconcile net income to net cash provided from operating activities: Depreciation and amortization Deferred income taxes (Note 16) Equity in earnings of English Welsh and Scottish Railway (Note 15) Charge to increase U.S. personal injury and other claims liability (Note 2) Workforce reduction charge (Note 9) Cumulative effect of change in accounting policy (Note 2) Other changes in: Accounts receivable Material and supplies Accounts payable and accrued charges Other net current assets and liabilities Other Cash provided from operating activities Investing activities Net additions to properties Acquisition of BC Rail (Note 3) Acquisition of GLT (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 Cash and cash equivalents, end of year Supplemental cash flow information Net cash receipts from customers and other Net cash payments for: Employee services, suppliers and other expenses Interest (Note 14) Workforce reductions (Note 9) Personal injury and other claims (Note 19) Pensions (Note 13) Income taxes (Note 16) Cash provided from operating activities See accompanying notes to consolidated financial statements. 58 Canadian National Railway Company U.S. GAAP 602 366 4 – – – (233) 10 5 21 106 2,139 (1,072) (984) (547) 192 (2,411) (222) 8,277 (7,579) 86 (273) 511 17 130 560 411 (17) – – (48) 153 (3) (96) (29) 31 591 272 (33) 281 120 – (80) – (154) (18) (167) 1,976 1,612 (1,043) – – (32) (1,075) (191) 4,109 (4,141) 83 (656) (605) 105 25 (938) – – 14 (924) (170) 3,146 (3,558) 69 (203) (546) (28) 53 $÷÷«147 $«««««130 $««««««25 $÷6,501 $÷6,022 $«6,285 (3,628) (282) (93) (106) (161) (92) (3,262) (325) (155) (126) (92) (86) (3,784) (398) (177) (156) (93) (65) $÷2,139 $÷1,976 $«1,612 Notes to Consolidated Financial Statements Canadian National Railway Company (CN or the Company), directly and through its subsidiaries, is engaged in the rail and related 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 the United States (U.S. GAAP). Significant differences between the accounting principles applied in the accompanying financial statements and those under Canadian generally accepted accounting principles (Canadian GAAP) are quantified and explained in Note 22 to the financial state- ments. 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 rev- enues 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 claims, depreciation, pensions and other post-retirement benefits, and income taxes, based upon currently avail- able information. Actual results could differ from these estimates. A. Principles of consolidation These consolidated financial statements include the accounts of all subsidiaries, including Great Lakes Transportation LLC’s railroads and related holdings (GLT) and BC Rail for which the Company acquired control and consolidated effective May 10, 2004 and July 14, 2004, respectively. 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-sustain- ing 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 Other comprehensive income (loss) (Note 21). The Company designates the 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 comprehensive income (loss). 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 approximates market value. E. Accounts receivable Accounts receivable are recorded at cost net of the provision for doubt- ful 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 dis- counted 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. 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 addi- tions are the costs of developing computer software for internal use. Maintenance costs are expensed as incurred. 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 held and used whenever events or changes in circumstances indicate that such carry- ing 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 recognized in income when the asset meets the criteria for classification as held for sale whereas losses resulting from aban- donment are recognized in income when the asset ceases to be used. Gains are recognized in income when they are realized. U.S. GAAP Canadian National Railway Company 59 Notes to Consolidated Financial Statements 1 Summary of significant accounting policies (continued) H. Depreciation The cost of properties, including those under capital leases, net of asset impairment write-downs, is depreciated on a straight-line basis over their estimated useful lives as follows: Asset class Track and roadway Rolling stock Buildings Other Annual rate 2% 3% 6% 4% The Company follows the group method of depreciation for railroad properties and, as such, conducts comprehensive depreciation studies on a periodic basis to assess the reasonableness of the lives of proper- ties based upon current information and historical activities. Changes in estimated useful lives are accounted for prospectively. I. Intangible assets Intangible assets relate to customer contracts and relationships assumed through recent acquisitions and are being amortized on a straight-line basis over 40 to 50 years. J. Pensions Pension costs are determined using actuarial methods. Net periodic benefit cost is charged to income 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 balances 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. K. 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 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. 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 expected cost for personal injury claims and asserted occupational disease claims, based on actuarial estimates of their ultimate cost. A liability for the minimum amount of unasserted occupational disease claims is also accrued to the extent they 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 opera- tions 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. 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. 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 man- agement 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 (loss) depending on the nature and effectiveness of the hedge transaction. Income and expense related to hedged derivative financial instruments are recorded in the same category as that generated by the underlying asset or liability. P. Stock-based compensation The Company follows the fair value based approach for stock option awards and had prospectively applied this method of accounting to all awards granted, modified or settled on or after January 1, 2003, as explained in Note 2 – Accounting changes. The Company follows the intrinsic value method for cash settled awards. 60 Canadian National Railway Company U.S. GAAP Notes to Consolidated Financial Statements Prior to 2003, compensation cost was recorded for the intrinsic value of the Company’s performance-based stock option awards and no compensation cost was recognized for the Company’s conventional awards, in accordance with Accounting Principles Board Opinion (APB) 25, “Accounting for Stock Issued to Employees,” and related interpreta- tions. If compensation cost had been determined based upon fair values at the date of grant for awards under all plans, the Company’s pro forma net income and earnings per share would have been as follows: Year ended December 31, 2004 2003 Net income, as reported (in millions) Add (deduct) compensation cost, net of applicable taxes, determined under: Fair value method for all awards granted after Jan. 1, 2003 (SFAS No. 123) Intrinsic value method for performance-based awards granted prior to 2003 (APB 25) Fair value method for all awards (SFAS No. 123) Pro forma net income (in millions) Basic earnings per share, as reported Basic earnings per share, pro forma Diluted earnings per share, as reported Diluted earnings per share, pro forma $1,258 $1,014 38 9 (78) $1,227 $÷4.41 $÷4.30 $÷4.34 $÷4.23 10 13 (53) $÷«984 $÷3.54 $÷3.43 $÷3.49 $÷3.39 2002 $«800 – 9 (45) $«764 $2.71 $2.59 $2.65 $2.53 Compensation cost related to stock option awards under the fair value based approach was calculated using the Black-Scholes option- pricing model with the following assumptions: Year ended December 31, 2004 (1) 2003 Expected option life (years) Risk-free interest rate Expected stock price volatility Average dividend per share – – – – 5.0 4.12% 30% $÷0.67 2002 7.0 5.79% 30% $÷0.57 Year ended December 31, 2004 (1) 2003 2002 Weighted average fair value of options granted $«– $11.88 $20.65 (1) The Company did not grant any stock option awards in 2004. Q. Recent accounting pronouncement In December 2004, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (SFAS) No. 123(R), “Share-Based Payment,” which requires expensing of all options issued, modified or settled based on the grant-date fair value and recognizing the expense over the period during which an employee is required to provide service (vesting period). The standard also requires that cash settled awards be measured at fair value at each reporting date until ultimate settlement. This standard is effective as of the beginning of the first interim reporting period after June 15, 2005. The Company has elected to apply the modified prospective approach, which requires compensation cost to be recognized for unvested awards based on their grant-date fair value. Pursuant to the application of this stan- dard, stock-based compensation expense for the second half of 2005 will increase by approximately $10 million for awards outstanding at December 31, 2004. 2 Accounting changes 2003 Asset retirement obligations Effective January 1, 2003, the Company adopted the recommenda- tions of the FASB’s SFAS No. 143, “Accounting for Asset Retirement Obligations.” SFAS No. 143 requires that the fair value of an asset retirement obligation be recorded as a liability only when there is a legal obligation associated with a removal activity. The Company has concluded that no legal obligation exists for its various removal pro- grams. In accordance with SFAS No. 143, the Company changed its accounting policy for certain track structure assets to exclude removal costs as a component of depreciation expense where the inclusion of such costs would result in accumulated depreciation balances exceeding the historical cost basis of the assets. As a result, a cumulative benefit of $75 million, or $48 million after tax, was recorded for the amount of removal costs accrued in accumulated depreciation on certain track structure assets at January 1, 2003. This change in policy will result in lower depreciation expense and higher labor and fringe benefits and other expenses in the period in which removal costs are incurred. For the year ended December 31, 2003, this change in policy resulted in an increase to net income of $2 million ($0.01 per basic and diluted share). Had the Company applied this accounting policy retroactively to 2002, pro forma net income and earnings per share would have been as follows: Net income, as reported (in millions) Effect of SFAS No. 143 Pro forma net income (in millions) Basic earnings per share, as reported Basic earnings per share, pro forma Diluted earnings per share, as reported Diluted earnings per share, pro forma Year ended December 31, 2002 $«800 6 $«806 $2.71 $2.73 $2.65 $2.67 Stock-based compensation Effective January 1, 2003, the Company voluntarily adopted the fair value based approach of SFAS No. 123, “Accounting for Stock-Based Compensation,” as amended by SFAS No. 148, “Accounting for Stock- Based Compensation – Transition and Disclosure.” The Company elected to prospectively apply this method of accounting to all stock option awards granted, modified or settled on or after January 1, 2003, as permitted by SFAS No. 148. Prior to 2003, the Company accounted for stock-based compensation in accordance with APB 25, “Accounting for Stock Issued to Employees,” and related interpretations. Accordingly, compensation cost was recorded for the intrinsic value of the Company’s performance-based stock option awards and no compen- sation cost was recognized for the Company’s conventional awards. In 2003, the Company granted 3.0 million stock options, which will be expensed over their vesting period based on their estimated fair value on the date of grant, determined using the Black-Scholes option- pricing model. For the year ended December 31, 2003, the Company recorded compensation cost of $23 million, of which $10 million ($0.03 per basic and diluted share) was related to the change in policy. For the year ended December 31, 2002, the Company recorded compensation cost of $9 million. U.S. GAAP Canadian National Railway Company 61 Notes to Consolidated Financial Statements 2 Accounting changes (continued) 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 dam- age, from a case-by-case approach to an actuarial-based approach. Consequently, for the year ended December 31, 2002, 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 expected cost for personal injury and property damage claims and asserted 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 was accrued to the extent they were reasonably estimable. 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. In 2002, the Company’s U.S. personal injury and other claims expense, including the above-mentioned charge, was $362 million. 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. 3 Acquisitions BC Rail In November 2003, the Company entered into an agreement with British Columbia Railway Company, a corporation owned by the Government of the Province of British Columbia (Province), to acquire all the issued and outstanding shares of BC Rail Ltd. and all the part- nership units of BC Rail Partnership (collectively BC Rail), and the right to operate over BC Rail’s roadbed under a long-term lease, for a pur- chase price of $1 billion. On July 2, 2004, the Company reached a consent agreement with Canada’s Competition Bureau, allowing for the closing of the trans- action, whereby the Company reaffirmed its commitment to share merger efficiencies with BC Rail shippers and assure them competitive transportation options through its Open Gateway Rate and Service Commitment. The consent agreement also maintains competitive rates and service for grain shippers in the Peace River region. On July 14, 2004, the Company completed its acquisition of BC Rail and began a phased integration of the companies’ operations. The acquisition was financed by debt and cash on hand. The Company accounted for the acquisition using the pur- chase method of accounting as required by SFAS No. 141, “Business Combinations” and SFAS No. 142, “Goodwill and Other Intangible Assets.” As such, the accompanying consolidated financial statements include the assets, liabilities and results of operations of BC Rail as of July 14, 2004, the date of acquisition. The Company’s cost to acquire BC Rail of $991 million includes purchase price adjustments and transac- tion costs. The following table reflects the preliminary purchase price allocation, based on the fair value of BC Rail’s assets acquired, owned and leased, and liabilities assumed at acquisition, which is subject to a final valuation, the impact of which is not expected to have a material effect on the results of operations. In millions Current assets Deferred income taxes Properties Other assets Total assets acquired Current liabilities Other liabilities and deferred credits Long-term debt Total liabilities assumed Net assets acquired July 14, 2004 $÷«202 397 620 3 1,222 76 142 13 231 $÷«991 Great Lakes Transportation LLC’s Railroads and Related Holdings In October 2003, the Company, through an indirect wholly owned subsidiary, entered into an agreement for the acquisition of GLT for a purchase price of U.S.$380 million. As of April 2004, the Company received all necessary regulatory approvals, including the U.S. Surface Transportation Board (STB) ruling rendered on April 9, 2004. On May 10, 2004, the Company completed its acquisition of GLT and began a phased integration of the companies’ operations. The acquisition was financed by debt and cash on hand. The Company accounted for the acquisition using the purchase method of accounting. As such, the accompanying consolidated finan- cial statements include the assets, liabilities and results of operations of GLT as of May 10, 2004, the date of acquisition. The Company’s cost to acquire GLT of U.S.$395 million (Cdn$547 million) includes purchase price adjustments and transaction costs. The following table reflects the preliminary purchase price allocation, based on the fair value of GLT’s assets acquired and liabilities assumed at acquisition, which is subject to a final valuation, the impact of which is not expected to have a material effect on the results of operations. In millions Current assets Properties Intangible and other assets Total assets acquired Current liabilities Deferred income taxes Other liabilities and deferred credits Total liabilities assumed Net assets acquired May 10, 2004 $÷÷«67 977 87 1,131 64 290 230 584 $÷«547 62 Canadian National Railway Company U.S. GAAP Notes to Consolidated Financial Statements If the Company had acquired BC Rail and GLT on January 1, 2003, based on their respective historical amounts, net of the amortization of the difference between the Company’s cost to acquire BC Rail and GLT and their respective net assets (based on preliminary estimates of the fair values of BC Rail’s and GLT’s assets and liabilities), revenues, income before cumulative effect of change in accounting policy, net income, and basic and diluted earnings per share for the year ended December 31, 2004 and 2003 would have been as follows: 4 Accounts receivable In millions Freight Trade Accrued Non-freight Provision for doubtful accounts December 31, 2004 2003 $414 93 356 863 (70) $793 $252 55 277 584 (55) $529 In millions, except per share data Year ended December 31, Revenues Income before cumulative effect of change in accounting policy Net income Basic earnings per share Income before cumulative effect of change in accounting policy Net income Diluted earnings per share Income before cumulative effect of change in accounting policy Net income 2004 2003 $6,773 $6,428 $1,272 $1,272 $1,026 $1,077 $÷4.46 $÷4.46 $÷3.58 $÷3.76 $÷4.39 $÷4.39 $÷3.53 $÷3.70 The pro forma figures for both BC Rail and GLT do not reflect syn- ergies, and accordingly, do not account for any potential increases in operating income, any estimated cost savings or facilities consolidation. The Company has an accounts receivable securitization program, expiring in June 2006, under which it may sell, on a revolving basis, a maximum of $450 million of eligible freight trade and other receivables outstanding at any point in time, to an unrelated trust. The Company has a contingent residual interest of approximately 10% of receivables sold, which is recorded in Other current assets. The Company has retained the responsibility for servicing, administering and collecting freight receivables sold. Other income (loss) included $9 million in each of 2004, 2003 and 2002, for costs related to the agreement, which fluc- tuate with changes in prevailing interest rates. At December 31, 2004, pursuant to the agreement, $445 million had been sold compared to $448 million at December 31, 2003. 5 Properties In millions Track, roadway and land Rolling stock Buildings Other Capital leases included in properties Track and roadway Rolling stock Buildings Other December 31, 2004 Accumulated depreciation $6,300 1,549 877 506 Cost $21,524 4,336 2,009 1,078 $28,947 $9,232 $÷÷«395 1,155 113 119 $÷÷÷«5 241 7 9 $÷1,782 $÷«262 Net $15,224 2,787 1,132 572 $19,715 $÷÷«390 914 106 110 $÷1,520 December 31, 2003 Accumulated depreciation $6,122 1,498 918 500 Cost $20,613 3,942 1,867 921 Net $14,491 2,444 949 421 $27,343 $9,038 $18,305 $÷÷÷«41 1,213 24 105 $÷÷÷«2 260 4 8 $÷÷÷«39 953 20 97 $÷1,383 $÷«274 $÷1,109 U.S. GAAP Canadian National Railway Company 63 Notes to Consolidated Financial Statements 6 Intangible and other assets 7 Credit facility In millions December 31, Prepaid benefit cost (Note 13) Investments (A) Deferred receivables Intangible assets (B) Note receivable from EWS Unamortized debt issue costs Other 2004 $515 166 77 69 57 35 21 $940 2003 $411 367 69 – – 35 23 $905 A. Investments As at December 31, 2004, the Company had $157 million ($356 million at December 31, 2003) of investments accounted for under the equity method and $9 million ($11 million at December 31, 2003) of invest- ments accounted for under the cost method. Investment in English Welsh and Scottish Railway (EWS) As at December 31, 2004, the Company owned approximately 32% of EWS, a company which provides most of the rail freight services in Great Britain and operates freight trains through the English Channel tunnel, and accounted for this investment using the equity method. At December 31, 2004, the excess of the Company’s share of the book value of EWS’ net assets over the carrying value of the investment was not significant. On January 6, 2004, EWS shareholders approved a plan to reduce the EWS share capital to enable cash to be returned to the shareholders by offering them the ability to cancel a portion of their EWS shares. For each share cancelled, EWS shareholders would receive a combination of cash and notes receivable. The Company elected to have the maximum allowable number of shares cancelled under the plan, thereby reducing its ownership interest in EWS to approximately 31% on a fully diluted basis (13.7 million shares) compared to approximately 37% on a fully diluted basis (43.7 million shares) prior to the capital reorganization. In the first quarter of 2004, the Company received £57.7 million (Cdn$141 million) in cash and a note receivable of £23.9 million (Cdn$58 million) from EWS. The note receivable is due in 2009, carries interest at 8% and is redeemable in whole or in part at any time by EWS, at the principal amount together with accrued but unpaid interest up to the date of repayment. B. Intangible assets Intangible assets relate to customer contracts and relationships assumed through the GLT acquisition. The Company has a U.S.$1,000 million three-year revolving credit facil- ity expiring in December 2005, which it intends to renew before such date. 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. The Company has been in compliance with these financial covenants. The Company’s borrowings of U.S.$180 million (Cdn$233 million) outstanding at December 31, 2003 at an average interest rate of 1.49% were entirely repaid in the first quarter of 2004. At December 31, 2004, the Company had borrowings under its revolving credit facility of U.S.$90 million (Cdn$108 million) at an aver- age interest rate of 2.77% and letters of credit drawn of $342 million. The Company’s commercial paper program is backed by its revolv- ing credit facility. As at December 31, 2004, the Company had U.S.$211 million (Cdn$254 million) of commercial paper outstanding at an aver- age interest rate of 2.37%, compared to no commercial paper outstand- ing as at December 31, 2003. 8 Accounts payable and accrued charges December 31, In millions Trade payables Income and other taxes Payroll-related accruals Accrued charges Personal injury and other claims provision Accrued interest Workforce reduction provisions Other 2004 $÷«491 310 259 179 118 106 90 52 $1,605 2003 $÷«444 270 205 131 123 94 89 65 $1,421 9 Other liabilities and deferred credits In millions December 31, 2004 2003 Personal injury and other claims provision, net of current portion Workforce reduction provisions, net of current portion (A) Accrual for post-retirement benefits other than pensions (B) Accrued benefit cost for pensions (Note 13) Environmental reserve, net of current portion Additional minimum pension liability (Note 13) Deferred credits and other $÷«524 149 284 156 93 22 285 $1,513 $÷«467 136 139 126 62 30 243 $1,203 64 Canadian National Railway Company U.S. GAAP Notes to Consolidated Financial Statements A. Workforce reduction provisions 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 retirement, the majority of which will be disbursed within the next five years. In 2004, liabilities assumed through recent acquisitions and other charges and adjustments increased the provisions by $107 million. Payments have reduced the provisions by $93 million for the year ended December 31, 2004 ($155 million for the year ended December 31, 2003). As at December 31, 2004, the aggregate provisions, including the current por- tion, amounted to $239 million ($225 million as at December 31, 2003). In 2002, the Company had 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. Reductions relating to this charge were completed in 2003. (iv) Weighted-average assumptions December 31, 2004 2003 2002 To determine benefit obligation Discount rate Rate of compensation increase To determine net periodic benefit cost Discount rate Rate of compensation increase 5.90% 3.75% 6.00% 3.75% 6.00% 3.75% 6.69% 4.00% 6.69% 4.00% 7.14% 4.00% (v) For measurement purposes, increases in the per capita cost of cov- ered health care benefits were assumed to be 14% for 2005 and 15% for 2004. It is assumed that the rate will decrease gradually to 6% in 2013 and remain at that level thereafter. A one-percentage-point change in the assumed health care cost trend rates would have the following effect: B. Post-retirement benefits other than pensions In millions One-percentage-point Increase Decrease $÷2 28 $÷(2) (24) Effect on total service and interest costs Effect on benefit obligation The Medicare Prescription Drug, Improvement, and Modernization Act of 2003 (the “Act”), signed into law in the United States in December 2003, provides for prescription drug benefits under Medicare, as well as a federal subsidy to sponsors of retiree health care benefit plans that provide prescription drug benefits that have been concluded to be actuarially equivalent to the Medicare benefit. Pursuant to FASB Staff Position 106-2, “Accounting and Disclosure Requirements Related to the Medicare Prescription Drug, Improvement and Modernization Act of 2003,” adopted on July 1, 2004, the Company evaluated and determined the prescription drug benefits provided by its health care plans to be actuarially equivalent to the Medicare benefit under the Act. The Company measured the effects of the Act on the accumulated post-retirement benefit obligation (APBO) as of January 1, 2004 and, as such, the APBO was reduced by $49 million. Net periodic benefit cost for the year ended December 31, 2004 was reduced by $7 million due to the effects of the Act. (vi) The estimated future benefit payments for each of the next five years and the subsequent five-year period are as follows: (i) Change in benefit obligation In millions Year ended December 31, Benefit obligation at beginning of year Acquisition of GLT and BC Rail Amendments Actuarial (gain) loss Interest cost Service cost Foreign currency changes Benefits paid 2004 $«309 151 (12) (111) 17 8 (25) (18) 2003 $311 – 8 29 18 5 (44) (18) Benefit obligation at end of year $«319 $309 The Company uses a measurement date of September 30 for its U.S. plans and December 31 for its Canadian plans. (ii) Funded status In millions December 31, Unfunded benefit obligation at end of year Unrecognized net actuarial gain (loss) Unrecognized prior service cost Accrued benefit cost for post-retirement benefits other than pensions (including current portion) 2004 $319 6 (16) 2003 $«309 (112) (33) $309 $«164 (iii) Components of net periodic benefit cost In millions Year ended December 31, Interest cost Service cost Amortization of prior service cost Recognized net actuarial loss Net periodic benefit cost 2004 $17 8 3 1 $29 2003 $18 5 3 7 2002 $15 4 3 3 In millions 2005 2006 2007 2008 2009 $33 $25 Years 2010 to 2014 $÷20 21 22 22 23 130 U.S. GAAP Canadian National Railway Company 65 Notes to Consolidated Financial Statements 10 Long-term debt In millions Debentures and notes: (A) Canadian National series: 7.00% 10-year notes 6.45% Puttable Reset Securities (PURS) (B) 4.25% 5-year notes (C) 6.38% 10-year notes (C) 4.40% 10-year notes (C) 6.80% 20-year notes (C) 7.63% 30-year debentures 6.90% 30-year notes (C) 7.38% 30-year debentures (C) 6.25% 30-year notes (C) Illinois Central series: 7.75% 10-year notes 6.98% 12-year notes 6.63% 10-year notes 5.00% 99-year income debentures 7.70% 100-year debentures Wisconsin Central series: 6.63% 10-year notes BC Rail series: Currency in which payable Maturity Mar. 15, 2004 July 15, 2006 Aug. 1, 2009 Oct. 15, 2011 Mar. 15, 2013 July 15, 2018 May 15, 2023 July 15, 2028 Oct. 15, 2031 Aug. 1, 2034 May 1, 2005 July 12, 2007 June 9, 2008 Dec. 1, 2056 Sept. 15, 2096 April 15, 2008 U.S.$ 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.$ Non-interest bearing 90-year subordinated notes (D) July 14, 2094 CDN$ Total debentures and notes Other: Revolving credit facility (A) (Note 7) Commercial paper (E) (Note 7) Capital lease obligations and other (F) Total other Less: Current portion of long-term debt Net unamortized discount U.S.$ U.S.$ Various December 31, 2004 2003 $÷«÷÷– $÷«344 301 361 482 482 241 181 572 241 602 120 60 24 9 151 181 4,008 843 4,851 108 254 805 1,167 6,018 578 854 1,432 324 – 518 518 259 194 615 259 – 129 65 26 10 162 194 3,617 – 3,617 233 – 822 1,055 4,672 483 14 497 A. The Company’s debentures, notes and revolving credit facility 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 exer- cised, the imbedded put option is automatically triggered, resulting in the redemption 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 con- ditions then prevailing. 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. $4,586 $4,175 D. The Company records these notes as a discounted debt of $5 million, using an imputed interest rate of 5.75%. The discount of $838 million is included in the net unamortized discount. E. The Company has a commercial paper program, which is backed by its revolving credit facility, enabling it to issue commercial paper up to a maximum aggregate principal amount of $800 million, or the U.S. dol- lar equivalent. At December 31, 2004, the amounts outstanding under both the revolving credit facility and the commercial paper program have been presented as short-term debt given the maturity in December 2005 of the revolving credit facility. During 2003, the commercial paper debt was due within one year but was 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. 66 Canadian National Railway Company U.S. GAAP Notes to Consolidated Financial Statements F. Interest rates for the capital leases range from approximately 2.23% to 13.13% with maturity dates in the years 2005 through 2025. The imputed interest on these leases amounted to $342 million as at December 31, 2004 and $395 million as at December 31, 2003. The capital lease obligations are secured by properties with a net carrying amount of $1,080 million as at December 31, 2004 and $1,110 million as at December 31, 2003. During 2004, the Company recorded $160 million in assets it acquired through the exercise of purchase options on existing leases and leases for new equipment ($47 million in 2003). An equivalent amount was recorded in debt. G. Long-term debt maturities, including repurchase arrangements and capital lease repayments on debt outstanding as at December 31, 2004, for the next five years and thereafter, are as follows: In millions 2005 2006 2007 2008 2009 2010 and thereafter $÷«578 376 154 230 427 3,399 H. The aggregate amount of debt payable in U.S. currency as at December 31, 2004 is U.S.$4,022 million (Cdn$4,845 million) and U.S.$3,273 million (Cdn$4,236 million) as at December 31, 2003. I. The Company has U.S.$200 million available under its currently effective shelf prospectus and registration statement providing for the issuance of debt securities in one or more offerings. 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 2004, the Company issued 2.9 million shares (2.9 million shares in 2003 and 2.7 million shares in 2002) related to stock options exer- cised. The total number of common shares issued and outstanding was 283.1 million as at December 31, 2004. In 2002, the Company issued 9.0 million common shares related to the conversion of the Company’s convertible preferred securities. 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 had 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.$25.65 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 9.0 million common shares of the Company. In 1999, the Company had issued 6.9 million 5.25% Securities due on June 30, 2029, at U.S.$33.33 per Security. These Securities were sub- ordinated securities convertible into common shares of CN at the option of the holder at an original conversion price of U.S.$25.65 per common share, representing an original conversion rate of 1.2995 common shares for each Security. D. Share repurchase program On October 26, 2004, the Board of Directors of the Company approved a share repurchase program which allows for the repurchase of up to 14.0 million common shares between November 1, 2004 and October 31, 2005 pursuant to a normal course issuer bid, at prevailing market prices. As at December 31, 2004, 4.0 million common shares have been repur- chased for $273 million, at an average price of $68.31 per share. The Company’s previous share repurchase program initiated in 2002 allowed for the repurchase of up to 19.5 million common shares between October 25, 2002 and October 24, 2003 pursuant to a normal course issuer bid, at prevailing market prices. By October 2003, the Company had completed its program, repurchasing 19.5 million com- mon shares for $859 million, at an average price of $44.04 per share (15.0 million and 4.5 million shares in 2003 and 2002, respectively). E. Common stock split On January 27, 2004, the Board of Directors of the Company approved a three-for-two common stock split which was effected in the form of a stock dividend of one-half additional common share of CN payable for each share held. The stock dividend was paid on February 27, 2004, to shareholders of record on February 23, 2004. All equity-based ben- efit plans were adjusted to reflect the issuance of additional shares or options due to the declaration of the stock split. All share and per share data has been adjusted to reflect the stock split. 12 Stock plans The Company has various stock-based incentive plans for eligible employees. A description of the Company’s major plans is provided below: Employee share investment plan The Company has an Employee Share Investment Plan (ESIP) giving eligible employees the opportunity to subscribe for up to 10% (6% prior to 2003) 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, up to 6% of their gross salaries. Participation at December 31, 2004 was 10,073 employees (8,894 at December 31, 2003 and 8,911 at December 31, 2002). The total number of ESIP shares purchased on behalf of employees, including the Company’s contributions, was 723,663 in 2004, 855,210 in 2003 and 746,189 in 2002, resulting in a pre-tax charge to income of $11 million, $8 million and $9 million for the years ended December 31, 2004, 2003 and 2002, respectively. U.S. GAAP Canadian National Railway Company 67 Notes to Consolidated Financial Statements 12 Stock plans (continued) Stock-based plans Compensation cost for awards under all stock-based plans was $65 mil- lion, $23 million and $9 million for the years ended December 31, 2004, 2003 and 2002, respectively. A. Restricted share units In 2004, the Company granted approximately 1.2 million restricted share units (RSUs) to designated management employees entitling them to receive payout in cash based on the Company’s share price. The RSUs granted are generally scheduled for payout after three years and vest upon the attainment of targets relating to return on invested capital over the three-year period and to the Company’s share price during the three-month period ending December 31, 2006. If specified targets related to the Company’s 20-day average share price are attained during any period ending on or after December 31, 2005, payout can be accelerated. For the year ended December 31, 2004, the Company recorded compensation cost of $36 million for RSUs. B. Mid-term incentive share unit plan The mid-term incentive share unit plan, approved by the Board of Directors in 2001, entitled designated senior management employees to receive payout on June 30, 2004. The share units vested conditionally upon the attainment of targets relating to the Company’s share price during the six-month period ending June 30, 2004. On June 30, 2004, upon the partial attainment of these targets, the Company recorded additional compensation cost of $13 million based on the number of share units vested multiplied by the Company’s share price on such date. For the year ended December 31, 2003, the Company recorded compensation cost of $7 million related to the plan and no compensa- tion cost was recorded for 2002. C. Voluntary incentive deferral plan The Company has a voluntary incentive deferral plan (VIDP), provid- ing eligible senior management employees the opportunity to elect to receive their annual incentive bonus payment and other eligible incen- tive payments in deferred share units (DSUs). For each participant, the Company will grant 25% of DSUs, which will vest over a period of four years. A DSU is equivalent to a common share of the Company and also earns dividends when normal cash dividends are paid on common shares. The number of DSUs received by each participant is established using the average closing price for the 20 trading days prior to and including the date of the incentive payment. The value of each partici- pant’s DSUs is payable in cash at the time of cessation of employment. At December 31, 2004, the total liability under the VIDP was $22 million, representing 354,745 units outstanding under the plan. For the year ended December 31, 2004, the Company recognized an expense of $7 million related to the plan. D. 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 contin- uous employment. Options are not generally exercisable during the first 12 months after the date of grant. At December 31, 2004, an additional 1.2 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, performance options, which vest upon the attainment of Company targets relating to the operating ratio and unlevered return on investment, and performance-accelerated options, which vest on the sixth anniversary of the grant or prior if certain Company targets relating to return on investment and revenues are attained. The total conventional, performance, and performance-acceler- ated options outstanding at December 31, 2004 were 8.9 million, 1.3 million and 2.9 million, respectively. Changes in the Company’s stock options are as follows: Outstanding at December 31, 2001 (1) Granted Canceled and expired Exercised Outstanding at December 31, 2002 (1) Granted Canceled and expired Exercised Outstanding at December 31, 2003 (1) Granted Canceled and expired Exercised Outstanding at December 31, 2004 (1) Weighted- average exercise price Number of options In millions 14.9 4.8 (0.3) (2.7) 16.7 3.0 (0.6) (2.9) 16.2 – (0.2) (2.9) 13.1 $29.08 $51.19 $37.99 $26.11 $35.67 $40.95 $45.11 $26.60 $37.16 – $42.58 $28.70 $38.85 (1) Includes IC and WC converted stock options translated to Canadian dollars using the foreign exchange rate in effect at the balance sheet date. 68 Canadian National Railway Company U.S. GAAP Notes to Consolidated Financial Statements Stock options outstanding and exercisable as at December 31, 2004 were as follows: Range of exercise prices $ 9.00–$16.02 $18.13–$27.08 $27.31–$33.35 $37.17–$49.21 $51.05–$58.44 Balance at December 31, 2004 (1) Options outstanding Options exercisable Number of options In millions 0.2 1.6 4.1 3.1 4.1 13.1 Weighted- average years to expiration Weighted- average exercise price 1 4 5 8 7 6 $15.40 $23.33 $32.10 $40.98 $51.19 $38.85 Weighted- average exercise price Number of options In millions 0.2 1.6 3.3 1.1 2.0 8.2 $15.40 $23.33 $31.82 $41.03 $51.20 $35.55 (1) Includes IC and WC converted stock options translated to Canadian dollars using the foreign exchange rate in effect at the balance sheet date. At December 31, 2003 and 2002, the Company had 7.5 million and 7.4 million options exercisable at a weighted-average exercise price of $31.39 and $29.34, respectively. Compensation cost for awards of employee stock options granted, modified or settled on or after January 1, 2003 was determined using the fair value based approach in accordance with SFAS No. 123, “Accounting for Stock-Based Compensation,“ as amended by SFAS No. 148, “Accounting for Stock-Based Compensation – Transition and Disclosure,“ as explained in Note 2 – Accounting changes. Prior to 2003, compensation cost was recorded for the intrinsic value of the Company’s performance-based stock option awards and no compensa- tion cost was recognized for the Company’s conventional stock option awards, in accordance with APB 25, “Accounting for Stock Issued to Employees,” and related interpretations. Compensation cost recognized for stock option awards was $9 million, $16 million and $9 million in 2004, 2003 and 2002, respectively. Disclosures required under the fair value measurement and recognition method for awards under all plans, as prescribed by SFAS No. 123, “Accounting for Stock-Based Compensation,” as well as the assumptions used to calculate com- pensation cost related to stock option awards are presented in Note 1 – Summary of significant accounting policies. 13 Pensions The Company has various retirement benefit plans under which sub- stantially all of its employees are entitled to benefits at retirement age, generally based on compensation and length of service and/or contributions. The information in the tables that follow pertains to all such plans. However, the following descriptions relate solely to the Company’s main pension plan, the CN Pension Plan (the Pension Plan), unless otherwise specified. Description of Pension 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. The Company utilizes a measurement date of December 31 for the Pension Plan. Funding policy Employee contributions to the Pension Plan are determined by the plan rules. Company contributions are in accordance with the require- ments of the Government of Canada legislation, The Pension Benefits Standards Act, 1985, and are determined by actuarial valuations con- ducted at least on a triennial basis. These valuations are made in accor- dance with legislative 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, 2003 and indicated a funding excess. Total contributions for all of the Company’s pension plans are expected to be approxi- mately $120 million in each of 2005, 2006 and 2007 based on the plans’ current position. All of the Company’s contributions are expected to be in the form of cash. 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. The assets of the Pension Plan have a fair market value of $12,256 million as at December 31, 2004 ($11,573 million at December 31, 2003). The Pension Plan’s target percentage allocation and weighted-average asset allocations as at December 31, 2004 and 2003, by asset category are as follows: Plan assets by category Target Allocation December 31, 2004 Equity securities Debt securities Real estate Other 53% 40% 4% 3% 100% 56% 34% 3% 7% 100% 2003 56% 38% 3% 3% 100% U.S. GAAP Canadian National Railway Company 69 $11,671 611 165 55 (15) 1,371 (805) $13,053 $11,182 – 90 60 (15) 1,049 (695) $11,671 December 31, 2004 2003 $«(84) 368 75 $359 $(349) 540 94 $«285 2003 $«411 (126) (30) 30 $«285 In millions Year ended December 31, 2004 2003 Notes to Consolidated Financial Statements 13 Pensions (continued) (b) Change in plan assets The Company follows a disciplined investment strategy, which lim- its concentration of investments by asset class, foreign currency, sector or company. The Investment Committee of the Board of Directors has approved an investment policy that establishes long-term asset mix targets based on a review of historical returns achieved by worldwide investment markets. Investment managers may deviate from these targets but their performance is evaluated in relation to the market performance of the target mix. The Company does not anticipate the return on plan assets to fluctuate materially from related capital market indices. The Investment Committee reviews investments regularly with specific approval required for major investments in illiquid securities. The policy also permits the use of derivative financial instruments to implement asset mix decisions or to hedge existing or anticipated expo- sures. The Pension Plan does not invest in the securities of the Company or its subsidiaries. Fair value of plan assets at beginning of year Acquisition of GLT and BC Rail Employer contributions Plan participants’ contributions Foreign currency changes Actual return on plan assets Benefit payments and transfers Fair value of plan assets at end of year (c) Funded status In millions Deficiency of fair value of plan assets over benefit obligation at end of year (1) Unrecognized net actuarial loss (1) Unrecognized prior service cost Net amount recognized Weighted-average assumptions December 31, 2004 2003 2002 (1) Subject to future reduction for gain sharing under the terms of the plan. To determine benefit obligation Discount rate Rate of compensation increase To determine net periodic benefit cost Discount rate Rate of compensation increase Expected return on plan assets 5.75% 3.75% 6.00% 3.75% 8.00% (d) Amount recognized in the Consolidated Balance Sheet 6.00% 3.75% 6.50% 4.00% In millions December 31, 6.50% 4.00% 8.00% 6.50% 4.00% 9.00% Prepaid benefit cost (Note 6) Accrued benefit cost (Note 9) Additional minimum pension liability (Note 9) Accumulated other comprehensive loss (Note 21) Net amount recognized 2004 $«515 (156) (22) 22 $«359 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, the expected composition of the plans’ assets as well as the expected long-term market returns in the future. The Company has elected to use a market- related value of assets, whereby realized and unrealized gains/losses and appreciation/depreciation in the value of the investments are recognized over a period of five years, while investment income is recognized immediately. Information about the Company’s defined benefit pension plans: (a) Change in benefit obligation In millions Year ended December 31, 2004 2003 (e) Additional information In millions Year ended December 31, 2004 2003 2002 Adjustment to minimum pension liability as a component of other comprehensive income (loss) $8 $7 $(20) The accumulated benefit obligation for all defined benefit pension plans was $12,450 million and $11,381 million at December 31, 2004 and 2003, respectively. The projected benefit obligation, accumu- lated benefit obligation, and fair value of plan assets for the pension plan with an accumulated benefit obligation in excess of plan assets were $98 million, $93 million, and $86 million, respectively, as at December 31, 2004, and $103 million, $98 million, and $74 million, respectively, as at December 31, 2003. Benefit obligation at beginning of year Acquisition of GLT and BC Rail Interest cost Actuarial loss Service cost Plan participants’ contributions Foreign currency changes Benefit payments and transfers Benefit obligation at end of year $12,020 684 733 349 124 55 (23) (805) $13,137 $11,376 (f) Components of net periodic benefit cost – 720 482 103 60 (26) (695) $12,020 In millions Year ended December 31, Service cost Interest cost Amortization of net transition obligation Amortization of prior service cost Expected return on plan assets Recognized net actuarial loss Net periodic benefit cost 2004 $«124 733 – 19 (857) 3 $÷«22 2003 $«103 720 19 22 (819) 4 2002 $«108 722 20 22 (874) 2 $÷«49 $÷÷«– 70 Canadian National Railway Company U.S. GAAP Notes to Consolidated Financial Statements (g) Estimated future benefit payments The following table provides tax information for Canada and the The estimated future benefit payments for each of the next five years and the subsequent five-year period are as follows: United States: In millions Year ended December 31, 2004 2003 2002 (1) Before cumulative effect of change in accounting policy. Significant components of deferred income tax assets and liabilities In millions 2005 2006 2007 2008 2009 Income before income taxes (1) Canada $÷«957 U.S. 821 845 869 893 Current income taxes Canada Years 2010 to 2014 4,760 U.S. 14 Interest expense In millions Year ended December 31, Interest on debt and capital leases Interest income Cash interest payments 15 Other income (loss) In millions Year ended December 31, Gain on disposal of properties Investment income Foreign exchange gain (loss) Equity in earnings of English Welsh and Scottish Railway (Note 6) Net real estate costs Other 16 Income taxes 2004 $294 – $294 $282 2004 $«32 5 (2) (4) (18) (33) $(20) 2003 $316 (1) $315 $325 2003 $«56 1 (3) 17 (19) (31) 2002 $361 – $361 $398 2002 $«41 18 12 33 (15) (13) Deferred income taxes Canada U.S. are as follows: In millions Deferred income tax assets Workforce reduction provisions Personal injury claims and other reserves Post-retirement benefits Losses and tax credit carryforwards Deferred income tax liabilities Net prepaid benefit cost for pensions $«21 $«76 Properties and other Total net deferred income tax liability Total net deferred income tax liability The Company’s consolidated effective income tax rate differs from the statutory Federal tax rate. The reconciliation of income tax expense is as follows: Canada U.S. 2004 22.1% 2003 2002 Total net deferred income tax liability 24.1% 26.1% Net current deferred income tax asset Long-term deferred income tax liability In millions Year ended December 31, Federal tax rate Income tax expense at the statutory Federal tax rate Income tax (expense) recovery resulting from: Provincial and other taxes Deferred income tax adjustments due to rate enactments Gain on disposals and dividends Adjustments to prior years’ income taxes (1) Other Income tax expense Cash payments for income taxes $÷«(410) $÷«(358) $÷«(309) (263) (199) (140) 5 10 11 51 $÷«(596) $÷«÷«92 (79) 11 44 64 – 6 – 59 $÷«(517) $÷«(384) $÷«÷«86 $÷«÷«65 (1) Adjustments relating mainly to the resolution of matters pertaining to prior years’ income taxes. $1,501 353 $1,854 $÷(222) (8) $÷(230) $÷(244) (122) $÷(366) $1,322 $1,101 161 83 $1,483 $1,184 $÷÷(94) $÷(130) (12) 18 $÷(106) $÷(112) $÷(377) $÷(221) (34) (51) $÷(411) $÷(272) December 31, 2004 2003 $÷÷«86 197 115 278 676 121 4,914 5,035 $4,359 $1,349 3,010 $4,359 $4,359 364 $4,723 $÷÷«81 254 61 81 477 102 4,800 4,902 $4,425 $1,527 2,898 $4,425 $4,425 125 $4,550 It is more likely than not that the Company will realize its deferred income tax assets from the generation of future taxable income, as the payments for provisions, reserves and accruals are made and losses and tax credit carryforwards are utilized. At December 31, 2004, the Company had $794 million of operating loss carryforwards, mainly resulting from the BC Rail acquisition, available to reduce future taxable income expiring between 2005 and 2023. The Company recognized tax credits of $4 million in 2004 for research and development expenditures ($15 million in 2003 and $9 million in 2002) not previously recognized, which reduced the cost of properties. U.S. GAAP Canadian National Railway Company 71 Operating Capital $206 $÷«113 194 146 116 90 240 106 130 52 93 609 $992 1,103 342 $÷«761 Notes to Consolidated Financial Statements 17 Segmented information 19 Major commitments and contingencies The Company operates in one business segment with operations in Canada and the United States. Information on geographic areas In millions Year ended December 31, 2004 2003 2002 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, 2004, the Company’s commitments under operating and capital leases were $992 million and $1,103 million, respectively. Minimum lease payments in each of the next five years and thereafter are as follows: Revenues Canada U.S. In millions Properties Canada U.S. $4,126 2,422 $6,548 $3,707 2,177 $5,884 $3,726 2,384 $6,110 In millions December 31, 2004 2003 $÷9,945 9,770 $19,715 $÷8,934 9,371 $18,305 2005 2006 2007 2008 2009 2010 and thereafter 18 Earnings per share Year ended December 31, 2004 2003 2002 Basic earnings per share Income before cumulative effect of change in accounting policy Cumulative effect of change in accounting policy Net income Diluted earnings per share Income before cumulative effect of change in accounting policy Cumulative effect of change in accounting policy Net income $4.41 – $4.41 $4.34 – $4.34 $3.38 0.16 $3.54 $3.33 0.16 $3.49 $2.71 – $2.71 $2.65 – $2.65 The following table provides a reconciliation between basic and diluted earnings per share: In millions Year ended December 31, Net income Income impact on assumed conversion of preferred securities (Note 11) Weighted-average shares outstanding Effect of dilutive securities and stock options Weighted-average diluted shares outstanding 2004 2003 $1,258 $1,014 2002 $800 – $1,258 285.1 4.8 289.9 – 6 $1,014 $806 286.8 3.9 290.7 295.0 9.2 304.2 For the years ended December 31, 2003 and 2002, the weighted- average number of stock options that were not included in the calcula- tion of diluted earnings per share, as their inclusion would have had an anti-dilutive impact, was 6.0 million and 4.8 million, respectively. The 2003 and 2002 figures have been adjusted for the three-for-two com- mon stock split (see Note 11(E)). Less: imputed interest on capital leases at rates ranging from approximately 2.23% to 13.13% Present value of minimum lease payments included in debt Rent expense for operating leases was $242 million, $230 million and $269 million for the years ended December 31, 2004, 2003 and 2002, respectively. Contingent rentals and sublease rentals were not significant. B. Other commitments As at December 31, 2004, the Company had commitments to acquire railroad ties, rail, freight cars, locomotives and other equipment at an aggregate cost of $194 million. Furthermore, as at December 31, 2004, the Company had outstanding information technology service contracts of $18 million and agreements with fuel suppliers to purchase approxi- mately 56% of its anticipated 2005 volume, 19% of its anticipated 2006 volume, and 2% of its anticipated 2007 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’ com- pensation 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. 72 Canadian National Railway Company U.S. GAAP Notes to Consolidated Financial Statements 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), which requires either the finding of fault through the U.S. jury system or individual settlements, and represent a major expense for the railroad industry. The Company follows an actuarial-based approach and accrues the expected cost for personal injury and property damage claims and asserted occupational disease claims, based on actuarial estimates of their ultimate cost. A liability for the minimum amount of unasserted occupational disease claims is also accrued to the extent they can be reasonably estimated. The amount recorded reflects a 25-year horizon as the Company expects that a large majority of these cases will be received over such period. In 2004, the Company’s expenses for personal injury and other claims, net of recoveries, were $149 million ($127 million in 2003 and $393 million in 2002) and payments for such items were $106 million ($126 million in 2003 and $156 million in 2002). As at December 31, 2004, the Company had aggregate reserves for personal injury and other claims of $642 million ($590 million at December 31, 2003). 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, 2004, 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, 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, treat- ment 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 potential environmental concerns that may be associated with its prop- erties 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 can- not 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 operat- ing 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. In 2004, the Company’s expenses relating to environmental matters, net of recoveries, were $10 million ($6 million in both 2003 and 2002) and payments for such items were $8 million ($12 million in 2003 and $16 million in 2002). As at December 31, 2004, the Company had aggregate accruals for environmental costs of $113 million ($83 million as at December 31, 2003). The Company anticipates that the majority of the liability at December 31, 2004 will be paid out over the next five years. In addition, related environmental capital expenditures were $13 million in 2004, $23 million in 2003 and $19 million in 2002. The Company expects to incur capital expenditures relating to environmen- tal matters of approximately $20 million in 2005, $17 million in 2006 and $16 million in 2007. E. Guarantees and indemnifications In the normal course of business, the Company, including certain of its subsidiaries, enters into agreements that may involve providing certain guarantees or indemnifications to third parties and others, which extend over the term of the agreement. These include, but are not limited to, residual value guarantees on operating leases, standby letters of credit and surety bonds, and indemnifications that are customary for the type of transaction or for the railway business. U.S. GAAP Canadian National Railway Company 73 Notes to Consolidated Financial Statements 19 Major commitments and contingencies (continued) Effective January 1, 2003, the Company is required to recognize a liability for the fair value of the obligation undertaken in issuing certain guarantees on the date the guarantee is issued or modified. In addition, where the Company expects to make a payment in respect of a guar- antee, a liability will be recognized to the extent that one has not yet been recognized. 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 2005 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. At December 31, 2004, the maximum exposure in respect of these guaran- tees was $97 million, of which $8 million has been recorded. Of that amount, $6 million represents the expected cash outlay for such guar- antees, while the remaining $2 million represents the Company’s obli- gation to stand ready and honor the guarantees that were entered into subsequent to January 1, 2003. There are no recourse provisions to recover any amounts from third parties. Other guarantees The Company, including certain of its subsidiaries, has granted irrevo- cable standby letters of credit and surety bonds, issued by highly rated financial institutions, to third parties to indemnify them in the event the Company does not perform its contractual obligations. As at December 31, 2004, the maximum potential liability under these guarantees was $439 million of which $359 million was for workers’ compensation and other employee benefits and $80 million was for equipment under leases and other. During 2004, the Company granted guarantees for which no liability has been recorded, as they relate to the Company’s future performance. As at December 31, 2004, the Company had not recorded any additional liability with respect to these guarantees, as the Company does not expect to make any additional payments associated with these guarantees. The guarantee instruments mature at various dates between 2005 and 2007. CN Pension Plan, CN 1935 Pension Plan and BC Rail Ltd Pension Plan The Company has indemnified and held harmless the current trustee and the former trustee of the Canadian National Railways Pension Trust Funds, the trustee of the BC Rail Ltd Pension Trust Fund, 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, 2004, the Company had not recorded a liability associated with these indemnifications, as the Company does not expect to make any pay- ments pertaining to these indemnifications. General indemnifications In the normal course of business, the Company has provided indem- nifications, customary for the type of transaction or for the railway business, in various agreements with third parties, including indemnifi- cation 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 parties such as leases, easements, trackage rights and sidetrack agreements; (b) contracts granting rights to oth- ers to use the Company’s property, such as leases, licenses and ease- ments; (c) contracts for the sale of assets and securitization of accounts receivable; (d) contracts for the acquisition of services; (e) financing agreements; (f) trust indentures, fiscal agency agreements, underwriting 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; (h) trust agreements relating to pension plans and other plans, including those establishing trust funds to secure payment to certain officers and senior employees of special retirement compensa- tion arrangements; (i) master agreements with financial institutions governing derivative transactions; and (j) settlement agreements with insurance companies or other third parties whereby such insurer or third party has been indemnified for any present or future claims relat- ing to insurance policies, incidents or events covered by the settlement agreements. 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, such exposure cannot be determined with certainty. In 2004 and 2003, the Company entered into various indemnifica- tion contracts with third parties for which the maximum exposure for future payments cannot be determined with certainty. As a result, the Company was unable to determine the fair value of these guarantees and accordingly, no liability was recorded. As at December 31, 2004, the carrying value for guarantees for which the Company was able to determine the fair value, was $1 million. There are no recourse provi- sions to recover any amounts from third parties. 20 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 condition of its customers and reviews the credit history of each new customer. The Company is exposed to credit risk in the event of non-per- formance 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 74 Canadian National Railway Company U.S. GAAP Notes to Consolidated Financial Statements regularly monitored. As a result, losses due to counterparty non-perfor- mance are not anticipated. The total risk associated with the Company’s counterparties was immaterial at December 31, 2004. 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 pro- gram which calls for regularly entering into swap positions on crude and heating oil to cover a target percentage of future fuel consumption up to two years in advance. However, in the fourth quarter of 2004, the Company did not enter into any swap positions on crude and heating oil. At December 31, 2004, the Company had hedged approximately 50% of the estimated 2005 fuel consumption, representing approximately 203 million U.S. gallons at an average price of U.S.$0.74 per U.S. gallon, and 17% of the estimated 2006 fuel consumption, representing 69 million U.S. gallons at an average price of U.S.$0.89 per U.S. gallon. The changes in the fair value of the swap positions are highly cor- related to changes in the price of fuel and therefore, these fuel hedges are being accounted for as cash flow hedges, whereby the effective portion of the cumulative change in the market value of the derivative instruments has been recorded in Accumulated other comprehensive loss. The amounts in Accumulated other comprehensive loss 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 loss would be reclassified into income immediately. Realized gains from the Company’s fuel hedging activities, which are recorded in fuel expense, were $112 million, $49 million, and $3 million for the years ended December 31, 2004, 2003 and 2002, respectively. At December 31, 2004, Accumulated other comprehensive loss included an unrealized gain of $92 million, $62 million after tax ($38 million unrealized gain, $26 million after tax at December 31, 2003), of which $81 million relates to derivative instruments that will mature within the next year and are presented in Other current assets. The Company did not recognize any material gains or losses in 2004, 2003 and 2002 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) Interest rate In the first quarter of 2004, in anticipation of future debt issuances, the Company had entered into treasury lock transactions for a notional amount of U.S.$380 million to fix the treasury component on these future debt issuances. Upon expiration in June 2004, these treasury rate locks were rolled into new contracts expiring in September 2004, at an average locked-in rate of 5.106%. The Company settled these treasury locks at a gain of U.S.$9 million (Cdn$12 million) upon the pricing of the U.S.$500 million 6.25% Debentures due 2034, subsequently issued on July 9, 2004. These derivatives were accounted for as cash flow hedges whereby the cumulative change in the market value of the derivative instruments was recorded in Other comprehensive loss. Beginning July 9, 2004, upon the issuance of debt, the realized gain of $12 million accumulated in other comprehensive income (loss) will be recorded into income, as a reduction of interest expense, over the term of the debt based on the interest payment schedule. At December 31, 2004, Accumulated other comprehensive loss included an unamortized gain of $12 million, $8 million after tax. (iv) 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 designates the 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 designation, unrealized foreign exchange gains and losses on the trans- lation of the Company’s U.S. dollar denominated long-term debt are recorded in Accumulated other comprehensive loss. (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 fol- lowing captions: (i) Cash and cash equivalents, Accounts receivable, Other current assets, Accounts payable and accrued charges, and Other current liabilities: The carrying amounts approximate fair value because of the short maturity of these instruments. (ii) Other assets: Investments: The Company has various debt and equity investments for which the carrying value approximates the fair value, with the excep- tion 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. U.S. GAAP Canadian National Railway Company 75 Notes to Consolidated Financial Statements 20 Financial instruments (continued) In millions The following table presents the carrying amounts and estimated fair values of the Company’s financial instruments as at December 31, 2004 and 2003 for which the carrying values on the Consolidated Balance Sheet are different from their fair values: In millions December 31, 2004 December 31, 2003 Carrying amount Fair value Carrying amount Fair value 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 20) Financial assets Investments Financial liabilities Long-term debt (including current portion) $÷«166 $÷«220 $÷«367 $÷«420 Minimum pension liability adjustment (Note 13) Deferred income tax (DIT) rate enactment Other comprehensive loss $÷«(332) $«106 $(226) $5,164 $5,857 $4,658 $5,128 In millions Year ended December 31, 2003 Before tax amount Income tax (expense) recovery Net of tax amount $÷««754 $(245) $«509 (1,101) 358 (743) 8 7 – (2) (3) (2) 6 4 (2) Year ended December 31, 2002 Before tax amount Income tax (expense) recovery Net of tax amount 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 20) Minimum pension liability adjustment (Note 13) Other comprehensive income $«51 (40) 68 (20) $«59 $(17) $«34 13 (27) (23) 7 $(20) 45 (13) $«39 21 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 20) Realized gain on settlement of interest rate swaps (Note 20) Minimum pension liability adjustment (Note 13) Year ended December 31, 2004 Before tax amount Income tax (expense) recovery Net of tax amount $«326 $(106) $«220 (428) 54 12 8 140 (18) (4) (3) (288) 36 8 5 Other comprehensive loss $÷(28) $÷÷«9 $÷(19) B. Changes in the balances of each classification within Accumulated other comprehensive income (loss) are as follows: In millions Balance at January 1, 2002 Period change Balance at December 31, 2002 Period change Balance at December 31, 2003 Period change Balance at December 31, 2004 Foreign exchange – Net investment in foreign operations Foreign exchange – U.S.$ debt Holding gain (loss) on fuel derivative instruments Realized gain on settlement of interest rate swaps Minimum pension liability adjustment Accumulated other comprehensive income (loss) DIT rate enactment $(221) $«347 $(25) 34 (187) 509 322 220 (27) 320 (743) (423) (288) 45 20 6 26 36 $«542 $(711) $«62 $– – – – – 8 $8 $(11) (13) (24) 4 (20) 5 $(15) $(32) – (32) (2) (34) – $(34) $÷«58 39 97 (226) (129) (19) $(148) 76 Canadian National Railway Company U.S. GAAP Notes to Consolidated Financial Statements 22 Reconciliation of United States and Canadian generally This change effectively harmonizes the Company’s Canadian and accepted accounting principles The Consolidated Financial Statements of the Company are expressed in Canadian dollars and are prepared in accordance with U.S. GAAP which conform, in all material respects, with Canadian GAAP except as follows: A. Reconciliation of net income The application of Canadian GAAP would have the following effects on the net income as reported: In millions Year ended December 31, Net income – U.S. GAAP Adjustments in respect of: Property capitalization, net of depreciation Stock-based compensation cost Interest expense Income tax rate enactments Interest on convertible preferred securities Income tax (expense) recovery on current year Canadian GAAP adjustments Income before cumulative effect of change in accounting policy Cumulative effect of change in accounting policy (net of applicable taxes) Net income – Canadian GAAP 2004 $1,258 2003 2002 $1,014 $«800 81 (19) 12 (3) – (32) 1,297 – $1,297 (384) (27) – 46 – 133 782 (48) (363) (9) – – 9 116 553 – $÷«734 $«553 (i) Property capitalization Effective January 1, 2004, the Company changed its capitalization policy under Canadian GAAP, on a prospective basis, to conform with the Canadian Institute of Chartered Accountants (CICA) Handbook Section 3061, “Properties, Plant and Equipment.” The change was made in response to the CICA Handbook Section 1100, “Generally Accepted Accounting Principles,” issued in July 2003. The Company’s accounting for Properties under Canadian GAAP had been based on the rules and regulations of the Canadian Transportation Agency’s (CTA) Uniform Classification of Accounts, which for railways in Canada, were considered Canadian GAAP prior to the issuance of Section 1100. Under the CTA rules, the Company capitalized only the material component of track replacement costs, to the extent it met the Company’s minimum threshold for capitalization. In accor- dance with the CICA Handbook Section 3061, “Properties, Plant and Equipment,” the Company now capitalizes the cost of labor, material and related overhead associated with track replacement activities pro- vided they meet the Company’s minimum threshold for capitalization. Also, all major expenditures for work that extends the useful life and/or improves the functionality of bridges, other structures and freight cars, are capitalized. U.S. GAAP capitalization policy. However, since the change was applied prospectively, there continues to be a difference in depreciation and amortization expense between Canadian and U.S. GAAP relating to the difference in the amounts previously capitalized under Canadian and U.S. GAAP as at January 1, 2004. (ii) Interest expense In the first quarter of 2004, in anticipation of future debt issu- ances, the Company had entered into treasury lock transactions for a notional amount of U.S.$380 million to fix the treasury component on these future debt issuances. Under U.S. GAAP, these derivatives were accounted for as cash flow hedges whereby the cumulative change in the market value of the derivative instruments was recorded in Other comprehensive loss. On July 9, 2004, upon the pricing and subsequent issuance of U.S.$500 million 6.25% Debentures due 2034, the Company settled these treasury-rate locks and realized a gain of $12 million. Under U.S. GAAP, this gain was recorded in Other comprehensive loss and will be amortized and recorded into income, as a reduction of inter- est expense, over the term of the debt based on the interest payment schedule. Under Canadian GAAP, this gain was recorded immediately into income, as a reduction of interest expense. (iii) Stock-based compensation cost As explained in Note 2, effective January 1, 2003, the Company volun- tarily adopted the recommendations of SFAS No. 123, “Accounting for Stock-Based Compensation,” and applied the fair value based approach prospectively to all awards of employee stock options granted, modified or settled on or after January 1, 2003. Under Canadian GAAP, effective January 1, 2003, the Company adopted the fair value based approach of the CICA’s Handbook Section 3870, “Stock-Based Compensation and Other Stock-Based Payments.” The Company retroactively applied the fair value method of accounting to all awards of employee stock options granted, modified or settled on or after January 1, 2002 and restated the 2002 comparative period to reflect this change in accounting policy. Compensation cost attributable to employee stock options granted prior to January 1, 2003 continues to be a reconciling difference. (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 interest on the Securities until July 3, 2002 was treated as a dividend for Canadian GAAP but as interest expense for U.S. GAAP. (v) Income tax expense The provincial and federal governments enact new corporate tax rates resulting in either lower or higher tax liabilities under both U.S. and Canadian GAAP. The difference in the deferred income tax expense or recovery recorded is a function of the net deferred income tax liability position, which is larger under U.S. GAAP due essentially to the dif- ference in the property capitalization policy prior to 2004. In addition, U.S. GAAP Canadian National Railway Company 77 Notes to Consolidated Financial Statements 22 Reconciliation of United States and Canadian generally accepted accounting principles (continued) under U.S. GAAP, the resulting deferred income tax expense or recovery is recorded when the rates are enacted, whereas under Canadian GAAP, when they are substantively enacted. In 2004, under U.S. GAAP, the Company recorded a decrease to its net deferred income tax liability of $5 million resulting from the enactment of lower corporate tax rates in the province of Alberta, with the corresponding decrease of $2 million under Canadian GAAP. In 2003, under U.S. GAAP, the Company recorded an increase to its net deferred income tax liability resulting from the enactment of higher corporate tax rates in the province of Ontario. As a result, the Company recorded deferred income tax expense of $79 million and $2 million in income and Other comprehensive loss, respectively. For Canadian GAAP, the corresponding increase to the net deferred income tax liability was $33 million. (vi) Cumulative effect of change in accounting policy As explained in Note 2, in accordance with SFAS No. 143, “Accounting for Asset Retirement Obligations,” the Company changed its account- ing policy for certain track structure assets to exclude removal costs as a component of depreciation expense where the inclusion of such costs would result in accumulated depreciation balances exceeding the historical cost basis of the assets. As a result, a cumulative benefit of $75 million, or $48 million after tax, was recorded for the amount C. Reconciliation of significant balance sheet items In millions Current assets – U.S. GAAP Derivative instruments Deferred income taxes related to derivative instruments Other Current assets – Canadian GAAP Properties – U.S. GAAP Property capitalization, net of depreciation Cumulative effect of change in accounting policy Properties – Canadian GAAP Intangible and other assets – U.S. GAAP Derivative instruments Intangible and other assets – Canadian GAAP Deferred income tax liability – U.S. GAAP Cumulative effect of prior years’ adjustments to income Income taxes on current year Canadian GAAP adjustments to income Income taxes on cumulative effect of change in accounting policy Income taxes on translation of U.S. to Canadian GAAP adjustments Income taxes on minimum pension liability adjustment Income taxes on derivative instruments Income taxes on settlement of interest rate swaps recorded in Other comprehensive loss Income tax rate enactments Other Deferred income tax liability – Canadian GAAP of removal costs accrued in accumulated depreciation on certain track structure assets at January 1, 2003. Under Canadian GAAP, the recom- mendations of Handbook Section 3110, “Asset Retirement Obligations,” which are similar to those under SFAS No. 143, were effective for the Company’s fiscal year beginning January 1, 2004 and did not have an impact on the Canadian GAAP financial statements since removal costs, as a component of depreciation expense, have not resulted in accumulated depreciation balances exceeding the historical cost basis of the assets. B. Earnings per share The earnings per share calculation under U.S. GAAP differs from Canadian GAAP essentially due to differences in the earnings figures: In millions Year ended December 31, Net income – Canadian GAAP Dividends on convertible preferred securities Weighted-average shares outstanding Effect of dilutive securities and stock options Weighted-average diluted shares outstanding Year ended December 31, Basic earnings per share Diluted earnings per share 2004 $1,297 – $1,297 285.1 4.5 289.6 2004 $4.55 $4.48 2003 $734 – $734 286.8 3.9 290.7 2003 $2.56 $2.52 December 31, 2004 $÷1,710 (81) 29 (4) $÷1,654 $19,715 (2,952) (75) $16,688 $÷÷«940 (11) $÷÷«929 $÷4,723 (1,204) 32 (27) 28 7 (1) (4) 41 (4) $÷3,591 2002 $553 6 $547 295.0 9.2 304.2 2002 $1.85 $1.82 2003 $÷1,127 (33) – (2) $÷1,092 $18,305 (3,072) (75) $15,158 $÷÷«905 (5) $÷÷«900 $÷4,550 (1,071) (133) (27) 15 10 (12) – 38 (5) $÷3,365 78 Canadian National Railway Company U.S. GAAP Notes to Consolidated Financial Statements In millions Other liabilities and deferred credits – U.S. GAAP Stock-based compensation Minimum pension liability Other Other liabilities and deferred credits – Canadian GAAP Common shares – U.S. GAAP Capital reorganization Stock-based compensation Foreign exchange loss on convertible preferred securities Costs related to the sale of shares Share repurchase program Common shares – Canadian GAAP Contributed surplus – U.S. GAAP 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 Capital reorganization Contributed surplus – Canadian GAAP Accumulated other comprehensive loss – U.S. GAAP Unrealized foreign exchange loss on translation of U.S. to Canadian GAAP adjustments, net of applicable taxes Derivative instruments, net of applicable taxes Unamortized gain on settlement of interest rate swaps, net of applicable taxes Income tax rate enactments Minimum pension liability adjustment, net of applicable taxes Currency translation – Canadian GAAP Retained earnings – U.S. GAAP Cumulative effect of prior years’ adjustments to income Cumulative effect of change in accounting policy Current year adjustments to net income Share repurchase program Cumulative dividend on convertible preferred securities Capital reorganization Dividend in kind with respect to land transfers Other transactions and related income tax effect Retained earnings – Canadian GAAP December 31, 2004 $÷1,513 – (22) (3) $÷1,488 $÷4,706 (1,300) (18) (12) 33 178 $÷3,587 $÷÷÷÷«– (248) (33) (18) (26) 489 $÷÷«164 $÷÷(148) 89 (62) (8) 34 15 $÷÷÷(80) $÷4,726 (1,928) (48) 39 (152) (38) 811 248 18 $÷3,676 2003 $÷1,203 (20) (30) – $÷1,153 $÷4,664 (1,300) (17) (12) 33 162 $÷3,530 $÷÷÷÷«– (248) (33) (18) (24) 489 $÷÷«166 $÷÷(129) 63 (26) – 34 20 $÷÷÷(38) $÷3,897 (1,696) (48) (232) (138) (38) 811 248 18 $÷2,822 U.S. GAAP Canadian National Railway Company 79 Notes to Consolidated Financial Statements 22 Reconciliation of United States and Canadian generally accepted accounting principles (continued) (i) Shareholders’ equity As permitted under Canadian GAAP, the Company eliminated its accu- mulated deficit of $811 million as of June 30, 1995 through a reduc- tion 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 Common shares. Under Canadian GAAP, the cost resulting from the repurchase of shares was allocated first to Common shares, then to Contributed sur- plus and finally to Retained earnings. Under U.S. GAAP, the cost would have been allocated to Common shares followed by Retained earnings. For Canadian and U.S. GAAP purposes, the Company designates the U.S. dollar denominated long-term debt of the parent company as a foreign exchange hedge of its net investment in U.S. subsidiaries. Under Canadian GAAP, the resulting net unrealized foreign exchange loss from the date of designation, has been included in Currency translation. For U.S. GAAP purposes, the resulting net unrealized foreign exchange loss has been included as part of Accumulated other comprehensive loss, a separate component of Shareholders’ equity, as required under SFAS No. 130, “Reporting Comprehensive Income.” (ii) Minimum pension liability adjustment At each measurement date, if the Company’s pension plans have an accumulated benefit obligation in excess of the fair value of the plan assets, under U.S. GAAP, this gives rise to an additional minimum pen- sion liability. As a result, an intangible asset is recognized up to the amount of the unrecognized prior service cost and the difference is recorded in Accumulated other comprehensive loss, a separate compo- nent of Shareholders’ equity. There are no requirements under Canadian GAAP to record a minimum pension liability adjustment. (iii) Derivative instruments Under U.S. GAAP, pursuant to 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,” the Company records in its balance sheet the fair value of derivative instruments used in its hedging activities. Changes in the market value of these derivative instruments have been recorded in Accumulated other comprehensive loss, 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 amortization, which were previously deferred and amortized for U.S. GAAP, have since been reclassified to equity. 23 Comparative figures Certain figures, previously reported for 2003 and 2002, have been reclassified to conform with the basis of presentation adopted in the current year. 80 Canadian National Railway Company U.S. GAAP Financial Section (Canadian GAAP) Contents Canadian National Railway Company 82 Management’s Discussion and Analysis 105 Management Report 105 106 107 108 109 Auditors’ Report Consolidated Statement of Income Consolidated Balance Sheet Consolidated Statement of Changes in Shareholders’ Equity Consolidated Statement of Cash Flows Notes to Consolidated Financial Statements 11 Capital stock and convertible preferred securities 1 Summary of significant accounting policies 2 Accounting changes 3 Acquisitions 4 Accounts receivable 5 Properties 6 Intangible and other assets 7 Credit facility 8 Accounts payable and accrued charges 9 Other liabilities and deferred credits 110 112 113 113 114 114 114 115 115 116 10 Long-term debt 117 118 12 Stock plans 120 13 Pensions 121 14 Interest expense 121 15 Other income (loss) 121 16 Income taxes 122 17 Segmented information 122 18 Earnings per share 123 125 20 Financial instruments 126 129 22 Comparative figures 19 Major commitments and contingencies 21 Reconciliation of Canadian and United States generally accepted accounting principles Canadian GAAP Canadian National Railway Company 81 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 the railroads and related holdings of Great Lakes Transportation LLC (GLT) as of May 10, 2004 and BC Rail as of July 14, 2004. 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 Canadian generally accepted accounting principles (Canadian GAAP). The Company also prepares consolidated financial statements in accordance with U.S. GAAP, which are different in some respects from these financial statements, principally in the treatment of track replacement costs, expenditures relating to improvements of bridges and other structures and freight cars, derivative instruments and stock-based compensation. A reconciliation of the Canadian to U.S. GAAP financial statements is provided in Note 21 to the Company’s Consolidated Financial Statements. The Company’s objective is to provide meaningful and relevant information reflecting the Company’s financial condition and results of operations. In certain instances, the Company may make reference to certain non-GAAP measures that, from management’s perspective, are useful measures of performance. In such instances, the reader is advised to read all informa- tion provided in the MD&A in conjunction with the Company’s 2004 Annual Consolidated Financial Statements and notes thereto. Business profile CN, directly and through its subsidiaries, is engaged in the rail and related transportation business. CN’s network of approximately 19,300 route miles of track spans Canada and mid-America, connecting three coasts: the Atlantic, the Pacific and the Gulf of Mexico. CN’s revenues are derived from seven commodity groups consisting of the movement of a diversified and balanced portfolio of goods which positions it well to face economic fluctuations and enhances its potential to grow reve- nues. In 2004, no individual commodity group accounted for more than 22% of revenues. The sources of revenue also reflect a balanced mix of destinations. In 2004, 23% of revenues came from U.S. domestic traffic, 34% from transborder traffic, 23% from Canadian domestic traffic and 20% from overseas traffic. The Company originates approximately 85% of traffic moving along its network, which allows it both to capitalize on service advantages and build on opportunities to efficiently use assets. Strategy CN is committed to creating value for both its customers and sharehold- ers. By providing quality and cost-effective service, CN seeks to create value for its customers, which solidifies existing customer relationships, while enabling it to pursue new ones. Sustainable financial performance is a critical element of shareholder value, which CN strives to achieve by pursuing revenue growth, steadily increasing profitability, solid free cash flow generation and an adequate return on investment. CN’s business strategy is guided by five core values: providing good service, controlling costs, focusing on asset utilization, committing to safety and developing employees. Overview For 2005 and the foreseeable future, CN’s challenge is to remain at the forefront of rail industry financial performance and to build value for shareholders and customers by aiming to make the railroad the continent’s best-performing transportation company. CN’s plan is premised on the deployment of its business model to generate quality revenues, while leveraging capacity and maintaining its current level of plant quality. The “scheduled railroad” is the foundation for the Company’s business model. For CN’s merchandise business, the scheduled railroad, which is defined as a trip plan for every car measured in hours, has reduced transit times, improved the consistency of CN’s transportation product, dramatically improved productivity and helped to improve network capacity. In 2003, the Company began to apply the same prin- ciples of scheduled railroading to its intermodal business through the IMX initiative. IMX is designed to smooth demand and balance the flow of intermodal traffic through pre-defined daily train capacity, slot, gate and equipment reservations, and day-of-the-week pricing. CN’s acquisition and control of Illinois Central and Wisconsin Central, in 1999 and 2001, respectively, extended the Company’s reach into the central and southern United States. Among the benefits of single line service afforded by these transactions have been improved transit and cycle times for freight cars and the penetration of new markets. The acquisition of GLT in May 2004 has permitted new efficien- cies in train operations north of Duluth/Superior in the key Winnipeg- Chicago corridor and positioned CN as a major player in the supply chain for the United States steel industry in the midst of a strong recovery. The purchase of BC Rail in July 2004 not only grew CN’s for- est products business substantially, but also expanded the railroad’s capacity in British Columbia, where the Port of Prince Rupert has the potential to become an important gateway for traffic moving to and from Asia and the heartland of North America. Over the past five years, the Company has also invested heavily in new locomotives and freight cars, extended sidings and centralized traf- fic control to permit the operation of longer, more efficient trains. These strategic initiatives have improved service, reduced costs and created a fluid North American rail network that can accommodate business growth at low incremental cost. The Company intends to continue to make targeted capital expenditures to improve plant capacity as war- ranted by market conditions and satisfactory returns on investment. The Company intends to pursue further operating efficiencies by optimizing its workforce, improving asset utilization, reducing accidents and related costs, and continuing to focus on legal claims and health care costs. The Company partners with connecting carriers to implement routing protocol agreements for carload freight and pursues co-produc- tion initiatives to further improve service, generate system capacity and gradually reduce costs. The Company’s ultimate goal is to generate profitable, sustain- able growth at low incremental cost by striving to improve yield and increase market share to maximize its return on assets. 82 Canadian National Railway Company Canadian GAAP Management’s Discussion and Analysis Financial highlights In millions, except per share data, or unless otherwise indicated 2004 2003 2002 Financial results Revenues Operating income Net income Operating ratio Basic earnings per share Diluted earnings per share Dividend declared per share Financial position Total assets Total long-term financial liabilities Financial results Change in property capitalization policy Effective January 1, 2004, the Company changed its capitalization policy, on a prospective basis, to conform with the Canadian Institute of Chartered Accountants (CICA) Handbook Section 3061, “Properties, Plant and Equipment.” The change was made in response to the CICA Handbook Section 1100, “Generally Accepted Accounting Principles,” issued in July 2003, as explained in Note 2 – Accounting changes, of the Company’s Annual Consolidated Financial Statements. The Company’s accounting for Properties had been based on the rules and regulations of the Canadian Transportation Agency’s (CTA) Uniform Classification of Accounts, which for railways in Canada, were considered Canadian GAAP prior to the issuance of Section 1100. Under the CTA rules, the Company capitalized only the material component of track replacement costs, to the extent it met the Company’s minimum threshold for capitalization. In accordance with the CICA Handbook Section 3061, “Properties, Plant and Equipment,” the Company now capitalizes the cost of labor, material and related overhead associated with track replacement activities provided they meet the Company’s minimum threshold for capitalization. Also, all major expenditures for work that extends the useful life and/or improves the functionality of bridges, other structures and freight cars, are capitalized. The change in policy had the effect of decreasing 2004 operating expenses by $464 million, $312 million after tax. 2004 compared to 2003 In 2004, net income increased by $563 million, or 77%, when com- pared to 2003, with diluted earnings per share rising 78%. Excluding the change in capitalization policy as discussed herein, net income increased by $251 million, or 34%, when compared to 2003. Revenues increased by $664 million, or 11%, due to the inclusion of $351 million of GLT and BC Rail revenues, core business growth in a strong North American economy, and an improved Canadian grain crop, which were partly offset by the translation impact of the stronger Canadian dollar on U.S. dollar denominated revenues of $255 million. Operating expenses decreased by $198 million, or 4%. The decrease was mainly due to the change in the property capitalization policy, which mainly affected labor, purchased services and material, $÷6,548 $÷2,230 $÷1,297 65.9% $÷÷4.55 $÷÷4.48 $÷÷0.78 $19,271 $÷9,665 $÷5,884 $÷1,368 $÷÷«734 76.8% $÷÷2.56 $÷÷2.52 $÷÷0.67 $17,150 $÷8,693 $÷6,110 $÷1,098 $÷÷«553 82.0% $÷÷1.85 $÷÷1.82 $÷÷0.57 $18,924 $10,108 and casualty and other, the translation impact of the stronger Canadian dollar on U.S. dollar denominated expenses of $170 million and lower equipment rents. Partly offsetting the decrease was the inclusion of GLT and BC Rail expenses of $228 million, and otherwise higher labor and fringe benefits, increased fuel costs and higher casualty and other expense. The operating ratio, defined as operating expenses as a percentage of revenues, was 65.9% in 2004 compared to 76.8% in 2003, a 10.9- point betterment, mainly due to the change in the property capitaliza- tion policy. The results for the year ended December 31, 2004 included the results of operations of GLT as of May 10, 2004 and BC Rail as of July 14, 2004. Also in 2004, a strike by the Company’s employees represented by the Canadian Auto Workers (CAW) union (the “CAW strike”) in the first quarter, negatively impacted operating income and net income by $35 million and $24 million, respectively. The significant appreciation in the Canadian dollar relative to the U.S. dollar which has impacted the conversion of the Company’s U.S. dollar denominated rev- enues and expenses, resulted in a reduction in net income of approxi- mately $45 million for 2004. For the year ended December 31, 2003, the Company’s results of operations included a fourth-quarter deferred income tax expense of $33 million resulting from the enactment of higher corporate tax rates in the province of Ontario. 2004 compared to 2003 – Adjusted performance measures The year ended December 31, 2003 included an item impacting the comparability of the results of operations (see reconciliation of adjusted performance measures presented herein). In 2003, the Company recorded a fourth-quarter deferred income tax expense of $33 million resulting from the enactment of higher cor- porate tax rates, as discussed herein. Excluding this item, net income was $1,297 million ($4.55 per basic share or $4.48 per diluted share) in 2004 compared to adjusted net income of $767 million ($2.67 per basic share or $2.63 per diluted share) in 2003, an increase of $530 million, or 69%. Canadian GAAP Canadian National Railway Company 83 Management’s Discussion and Analysis Reconciliation of adjusted performance measures Management believes that non-GAAP measures such as adjusted net income and the resulting adjusted performance measures for such items as operating income, operating ratio and per share data are useful measures of performance that can facilitate period-to-period comparisons as they exclude items that do not arise as part of the normal day-to-day operations or that could potentially distort the analysis of trends in business per- formance. The exclusion of specified items in the adjusted measures below does not imply that they are necessarily non-recurring. These adjusted measures do not have any standardized meaning prescribed by GAAP and may, therefore, not be comparable to similar measures presented by other companies. The reader is advised to read all information provided in the MD&A in conjunction with the Company’s Annual Consolidated Financial Statements and notes thereto. In millions, except per share data, or unless otherwise indicated Year ended December 31, Revenues Operating expenses Operating income Interest expense Other income (loss) Income before income taxes Income tax expense Net income Operating ratio Basic earnings per share Diluted earnings per share 2004 Reported Reported $«6,548 4,318 2,230 (282) (20) 1,928 (631) $1,297 65.9% $÷4.55 $÷4.48 $«5,884 4,516 1,368 (317) 21 1,072 (338) $÷«734 76.8% $÷2.56 $÷2.52 2003 Rate enactment $÷– – – – – – 33 $33 Adjusted $«5,884 4,516 1,368 (317) 21 1,072 (305) $÷«767 76.8% $÷2.67 $÷2.63 Revenues Year ended December 31, Total revenues (millions) Rail freight Revenues (millions) RTMs (millions) Revenue/RTM (cents) Carloads (thousands) Revenue/Carload (dollars) 2004 $6,548 2003 % Change $5,884 11% $6,252 175,355 3.57 4,654 1,343 $5,694 162,901 3.50 4,177 1,363 10% 8% 2% 11% (1%) Revenues for the year ended December 31, 2004 totaled $6,548 million compared to $5,884 million in 2003. The increase of $664 million, or 11%, was mainly due to the inclusion of GLT and BC Rail revenues of $351 million, strong merchandise revenue, an improved Canadian grain crop, and a higher fuel surcharge. Partially offsetting these gains was the translation impact of the stronger Canadian dollar on U.S. dollar denominated revenue. Revenue ton miles, measuring the volume of freight transported by the Company, increased by 8% relative to 2003. Freight revenue per revenue ton mile, a measurement of yield defined as revenue earned on the movement of a ton of freight over one mile, increased by 2% when compared to 2003. In 2004, freight revenue per revenue ton mile was positively affected by freight rate increases and an overall decrease in the average length of haul, and was negatively affected by the translation impact of the stronger Canadian dollar. 84 Canadian National Railway Company Canadian GAAP Management’s Discussion and Analysis Petroleum and chemicals Year ended December 31, Revenues (millions) RTMs (millions) Revenue/RTM (cents) 2004 $1,123 32,618 3.44 2003 % Change $1,058 30,901 3.42 6% 6% 1% Petroleum and chemicals comprise a wide range of commodities, includ- ing chemicals, sulfur, plastics, petroleum and gas products. Most of the Company’s petroleum and chemicals shipments originate in the Gulf of Mexico, Alberta and eastern Canada, and are destined for customers in Canada, the United States and overseas. The performance of this com- modity group is closely correlated with the North American economy. For the year ended December 31, 2004, revenues for this commodity group increased by $65 million, or 6%, from 2003. The increase was due to freight rate improvements in several key segments, particularly in the first half of the year, the inclusion of $25 million of BC Rail revenues (primarily sulfur), higher offshore demand for Canadian sulfur, a shift from offshore to Canadian suppliers for petroleum gas and a higher fuel surcharge. These gains were partially offset by the translation impact of the stronger Canadian dollar. Freight revenue per revenue ton mile increased by 1% due to freight rate improvements and a decrease in the average length of haul, partly offset by the translation impact of the stronger Canadian dollar. Petroleum and chemicals Percentage of revenues Carloads* In thousands and sand) and cement. The Company has access to major cement and aggregate producers in Canada as well as in the U.S. Metals and miner- als traffic is sensitive to fluctuations in the economy. For the year ended December 31, 2004, revenues for this commodity group increased by $186 million, or 35%, from 2003. The increase is mainly due to the inclusion of $126 million of GLT revenues, higher volumes of iron ore, largely from new business, freight rate improvements, and increased shipments of raw materials and metal bars. Partially offsetting these gains was the translation impact of the stronger Canadian dollar. Revenue per revenue ton mile increased by 14% in 2004, mainly due to GLT shorter-haul traffic which was partly offset by the translation impact of the stronger Canadian dollar. Metals and minerals Percentage of revenues Carloads* In thousands 9 0 8 21% 24% 55% Metals 24% Minerals 21% Iron ore 55% 8 8 3 6 9 3 6 5 2 7 8 2 00 01 02 03 04 * Includes WC from October 9, 2001, GLT from May 10, 2004 and BC Rail from July 14, 2004 7 8 5 4 0 6 7 3 6 Forest products 2 1 5 9 1 5 Year ended December 31, 43% 57% Revenues (millions) RTMs (millions) Revenue/RTM (cents) 2004 $1,452 38,414 3.78 2003 % Change $1,284 34,516 3.72 13% 11% 2% 57% Petroleum and plastics 43% Chemicals 00 01 02 03 04 * Includes Wisconsin Central Transportation Corporation (WC) from October 9, 2001, GLT from May 10, 2004 and BC Rail from July 14, 2004 Metals and minerals Year ended December 31, Revenues (millions) RTMs (millions) Revenue/RTM (cents) 2004 $713 16,421 4.34 2003 % Change $527 13,876 3.80 35% 18% 14% The metals and minerals commodity group consists primarily of nonfer- rous base metals, iron ore, steel, equipment and parts and construction materials. The Company’s superior rail access to major mines, ports and smelters throughout North America has made the Company a transpor- tation leader of copper, lead, zinc concentrates, iron ore, refined metals and aluminum. Construction materials are mainly aggregates (stone The forest products commodity group includes various types of lumber, panels, wood chips, wood pulp, printing paper, linerboard and news- print. The Company has superior rail access to the western and eastern Canadian fiber-producing regions, which are among the largest fiber source areas in North America. In the United States, the Company is strategically located to serve both the midwest and southern U.S. cor- ridors with interline capabilities to other Class 1 railroads. The key driv- ers for the various commodities are: for newsprint, advertising lineage and overall economic conditions in the United States; for fibers (mainly wood pulp), the consumption of paper worldwide; and for lumber and panels, housing starts and renovation activities in the United States. Although demand for forest products can be cyclical, the Company’s geographical advantages and product diversity tend to reduce the impact of market fluctuations. For the year ended December 31, 2004, revenues for this commodity group increased by $168 million, or 13%, from 2003. The increase was largely due to the inclusion of $85 mil- lion of BC Rail revenues (mainly lumber and panels), continued solid demand for lumber, freight rate improvements and a higher fuel sur- charge. The translation impact of the stronger Canadian dollar partially offset these gains. Revenue per revenue ton mile increased by 2% in Canadian GAAP Canadian National Railway Company 85 Management’s Discussion and Analysis 2004 as the benefit of freight rate improvements and a positive change in traffic mix were partially offset by the translation impact of the stronger Canadian dollar. Forest products Percentage of revenues Carloads* In thousands Grain and fertilizers Year ended December 31, Revenues (millions) RTMs (millions) Revenue/RTM (cents) 2004 $1,053 39,965 2.63 2003 % Change $938 35,556 2.64 12% 12% – The grain and fertilizers commodity group depends primarily on crops grown and fertilizers processed in western Canada and the U.S. Midwest. The grain segment consists of three primary commodities: food grains, mainly wheat; oilseeds and oilseed products, primarily canola seed, oil and meal; and feed grains, including feed barley, feed wheat and corn. Production of grain varies considerably from year to year, affected primarily by weather conditions. Grain exports are vola- tile, reflecting the size of the crop produced, international market condi- tions and foreign government policy. In the U.S., grain grown in Illinois and Iowa is exported, as well as transported to domestic processing facilities and feed markets. The Company also serves producers of pot- ash, ammonium nitrate, urea and other fertilizers. For the year ended December 31, 2004, revenues for this commodity group increased by $115 million, or 12%, from 2003. The increase reflects higher Canadian wheat and barley exports, which was partially offset by weak ship- ments of U.S. soybeans due to tight supply, a shift in exports from the Gulf to the Pacific Northwest and the translation impact of the stronger Canadian dollar. Revenue per revenue ton mile remained flat as the benefit of freight rate improvements was offset by an increase in the average length of haul and the translation impact of the stronger Canadian dollar. Grain and fertilizers Percentage of revenues Carloads* In thousands 12% 13% 28% 7 6 5 0 9 5 5 3 5 8 4 5 2 7 5 23% 24% 28% Food grain 24% Oilseeds 23% Feed grain 13% Fertilizers 12% Potash 00 01 02 03 04 * Includes WC from October 9, 2001, GLT from May 10, 2004 and BC Rail from July 14, 2004 12% 26% 0 0 6 4 9 5 3 5 6 33% 6 8 4 1 0 5 29% 33% Lumber 29% Fibers 26% Paper 12% Panels 00 01 02 03 04 * Includes WC from October 9, 2001, GLT from May 10, 2004 and BC Rail from July 14, 2004 Coal Revenues (millions) RTMs (millions) Revenue/RTM (cents) Year ended December 31, 2004 $284 13,614 2.09 2003 % Change $261 13,659 1.91 9% – 9% The coal commodity group consists primarily of thermal grades of bituminous coal. Canadian thermal coal is delivered to power utilities primarily in eastern Canada, while in the United States, thermal coal is transported from mines served in southern Illinois, or from western U.S. mines via interchange with other railroads, to major utilities in the Midwest and southeast United States. The coal business also includes the transport of metallurgical coal, which is largely exported to steel markets in Japan and other Asian markets. For the year ended December 31, 2004, revenues for this commodity group increased by $23 million, or 9%, from 2003. The increase was due to higher coal shipments to U.S. utilities and the inclusion of GLT and BC Rail revenues of $20 million, partly offset by metallurgical mine closures in western Canada and the translation impact of the stronger Canadian dollar. The revenue per revenue ton mile increase of 9% was mainly due to a decrease in the average length of haul and a positive change in traffic mix that were partly offset by the translation impact of the stronger Canadian dollar. Coal Percentage of revenues Carloads* In thousands 18% 8 2 5 7 1 5 9 9 4 1 7 4 6 8 4 82% 82% Coal 18% Petroleum coke 00 01 02 03 04 * Includes WC from October 9, 2001, GLT from May 10, 2004 and BC Rail from July 14, 2004 86 Canadian National Railway Company Canadian GAAP Management’s Discussion and Analysis Intermodal Revenues (millions) RTMs (millions) Revenue/RTM (cents) Year ended December 31, 2004 $1,117 31,002 3.60 Automotive 2003 % Change Year ended December 31, $1,101 31,168 3.53 1% (1%) 2% Revenues (millions) RTMs (millions) Revenue/RTM (cents) 2004 $510 3,321 15.36 2003 % Change $525 3,225 16.28 (3%) 3% (6%) The intermodal commodity group is comprised of two segments: domes- tic and international. The domestic segment is responsible for consumer products and manufactured goods, operating through both retail and wholesale channels while the international segment handles import and export container traffic, serving the ports of Vancouver, Montreal, Halifax and New Orleans. The domestic segment is driven by consumer markets, with growth generally tied to the economy. The international segment is driven mainly by North American economic conditions. For the year ended December 31, 2004, revenues for this commodity group increased by $16 million, or 1%, from 2003. Revenues for 2004 benefited from heavy import volumes through the Port of Vancouver, freight rate improvements and a higher fuel surcharge. Revenues were negatively affected by the first quarter CAW strike, the closure of the Company’s smaller terminal facilities in the U.S., the discontinuance of the Roadrailer service and the translation impact of the stronger Canadian dollar. Revenue per revenue ton mile increased by 2% in 2004 driven by a positive change in traffic mix and freight rate improvements that were partly offset by an increase in the average length of haul and the translation impact of the stronger Canadian dollar. Intermodal Percentage of revenues Carloads* In thousands The automotive commodity group moves both finished vehicles and parts, originating in southwestern Ontario, Michigan and Mississippi, destined for the United States, Canada and Mexico. The Company’s broad coverage, including its access to all of the Canadian assembly plants, enables it to consolidate full trainloads of automotive traffic for delivery to connecting railroads at key interchange points. The Company also serves shippers of import vehicles via the ports of Halifax and Vancouver, and through interchange with other railroads. The Company’s automotive revenues are closely correlated to automotive production and sales in North America. For the year ended December 31, 2004, revenues for this commodity group decreased by $15 million, or 3%, from 2003. The decrease was due to the translation impact of the stronger Canadian dollar that was partially offset by the benefit of new finished vehicle traffic that began in late 2003. Revenue per revenue ton mile decreased by 6% in 2004 due to the translation impact of the stronger Canadian dollar. Automotive Percentage of revenues Carloads* In thousands 18% 8 1 3 7 0 3 8 8 2 8 8 2 5 9 2 7 3 2 , 1 6 7 2 , 1 2 0 2 , 1 1 2 1 , 1 3 0 1 , 1 48% 52% 52% Domestic 48% International 00 01 02 03 04 * Includes WC from October 9, 2001, GLT from May 10, 2004 and BC Rail from July 14, 2004 82% 82% Finished vehicles 18% Auto parts 00 01 02 03 04 * Includes WC from October 9, 2001, GLT from May 10, 2004 and BC Rail from July 14, 2004 Other In 2004, other revenues increased by $106 million, when compared to 2003, mainly due to revenues from GLT’s maritime division of $90 million. Canadian GAAP Canadian National Railway Company 87 Management’s Discussion and Analysis Operating expenses Operating expenses amounted to $4,318 million in 2004 compared to $4,516 million in 2003. The decrease was mainly due to the change in the property capitalization policy of $464 million, which mainly affected labor, purchased services and material, and casualty and other, the translation impact of the stronger Canadian dollar and lower equip- ment rents. Partly offsetting the decrease was the inclusion of GLT and BC Rail expenses of $228 million, higher labor and fringe benefits, increased fuel costs and higher casualty and other expense. The month- long CAW strike had a minimal impact on overall operating expenses for the year ended December 31, 2004 as the benefit from lower labor and fringe benefit expenses was mostly offset by increases in other expense categories. In millions Year ended December 31, 2004 2003 Labor and fringe benefits Purchased services and material Depreciation and amortization Fuel Equipment rents Casualty and other Total Amount $1,838 746 517 528 244 445 $4,318 % of revenue 28.0% 11.4% 7.9% 8.1% 3.7% 6.8% 65.9% Amount $1,929 879 472 471 299 466 % of revenue 32.8% 15.0% 8.0% 8.0% 5.1% 7.9% $4,516 76.8% Labor and fringe benefits: Labor and fringe benefits includes wages, payroll taxes, and employee benefits such as incentive compensation, stock-based compensation, health and welfare, pensions and other post-employment benefits. These expenses decreased by $91 million, or 5%, in 2004 as compared to 2003. The decrease was mainly due to the change in the property capitalization policy of $204 million, the transla- tion impact of the stronger Canadian dollar, the effects of a reduced workforce, lower expenses for pensions and other post-retirement ben- efits and wage and benefits savings during the CAW strike. Partly off- setting the decrease was the inclusion of GLT and BC Rail labor expense of $91 million, higher wages and employee benefits, including increased costs for stock-based compensation, and charges and adjustments relat- ing to the workforce reduction provision. Purchased services and material: Purchased services and material pri- marily includes the costs of services purchased from outside contractors, materials used in the maintenance of the Company’s track, facilities and equipment, transportation and lodging for train crew employees, utility costs and the net costs of operating facilities jointly used by the Company and other railroads. These expenses decreased by $133 mil- lion, or 15%, in 2004 as compared to 2003. The decrease was mainly due to the change in the property capitalization policy of $176 million, the translation impact of the stronger Canadian dollar and lower net expenses for operating joint facilities. Partly offsetting the decrease was the inclusion of $77 million of GLT and BC Rail expenses, higher repair and maintenance expenses, partly related to the CAW strike, and other strike-related costs. Depreciation and amortization: Depreciation and amortization relates to the Company’s rail operations. These expenses increased by $45 million, or 10%, in 2004 as compared to 2003. The increase was mainly due to the inclusion of GLT and BC Rail expenses of $30 million and the impact of net capital additions, partially offset by the translation impact of the stronger Canadian dollar. Fuel: Fuel expense includes the cost of fuel consumed by locomotives, intermodal equipment and other vehicles. These expenses increased by $57 million, or 12%, in 2004 as compared to 2003. The increase was mainly due to a higher average price per gallon, net of the impact of the hedging program, the inclusion of GLT and BC Rail expenses of $21 million and higher volumes. The increase was partly offset by the trans- lation impact of the stronger Canadian dollar, increased productivity and a fuel excise tax refund in the second quarter. Equipment rents: Equipment rents includes rental expense for the use of freight cars owned by other railroads or private companies and for the short or long-term lease of freight cars, locomotives and intermodal equipment, net of rental income from other railroads for the use of the Company’s cars and locomotives. These expenses decreased by $55 mil- lion, or 18%, in 2004 as compared to 2003. The decrease was due to higher car hire income, including that of BC Rail, the translation impact of the stronger Canadian dollar and a reduction in car hire expenses that were partly offset by higher lease expense for freight cars. Casualty and other: Casualty and other includes expenses for personal injuries, environmental, freight and property damage, insurance, bad debt and operating taxes, as well as travel and travel-related expenses. These expenses decreased by $21 million, or 5%, in 2004 as compared to 2003. The decrease was due to the change in the property capitaliza- tion policy of $76 million and the translation impact of the stronger Canadian dollar. Partly offsetting the decrease were higher expenses for personal injuries, the inclusion of GLT and BC Rail expenses of $14 mil- lion, increased environmental expenses and favorable adjustments to U.S. property taxes in 2003. Other Interest expense: Interest expense decreased by $35 million, or 11%, for the year ended December 31, 2004 as compared to 2003. The decrease was due to lower interest rates on issued debt to replace matured debt, a realized gain on the settlement of interest rate swaps and the transla- tion impact of the stronger Canadian dollar that were partly offset by interest expense on debt related to the Company’s recent acquisitions. Other income (loss): In 2004, the Company recorded a loss of $20 million compared to income of $21 million in 2003. The change from income to loss in 2004 was due to lower gains on disposal of surplus properties and lower equity income from the Company’s investment in English Welsh and Scottish Railway (EWS) as a result of restructured operations. Income tax expense: The Company recorded income tax expense of $631 million for the year ended December 31, 2004 compared to $338 million in 2003. The effective tax rate for the year ended December 31, 2004 was 32.7% compared to 31.5% in 2003. The increase in the effec- tive tax rate in 2004 was mainly due to higher pre-tax income gener- ated in the current year, which was primarily a result of the change in capitalization policy. 88 Canadian National Railway Company Canadian GAAP Management’s Discussion and Analysis 2003 compared to 2002 For the year ended December 31, 2003, the Company recorded consoli- dated net income of $734 million ($2.56 per basic share) compared to $553 million ($1.85 per basic share) for the year ended December 31, 2002. Diluted earnings per share were $2.52 for 2003 compared to $1.82 in 2002. The Company’s operating income for 2003 was $1,368 million compared to $1,098 million in 2002, and its operating ratio, defined as operating expenses as a percentage of revenues, was 76.8% in 2003 compared to 82.0% in 2002 (see discussion on adjusted per formance measures herein). 2003 compared to 2002 – Adjusted performance measures The years ended December 31, 2003 and 2002 included items impact- ing the comparability of the results of operations (see reconciliation of adjusted performance measures presented herein). In 2003, the Company recorded a fourth quarter deferred income tax expense of $33 million resulting from the enactment of higher cor- porate tax rates in the province of Ontario. The year ended December 31, 2002 included fourth quarter charges of $281 million, or $173 million after tax, to increase the Company’s provision for U.S. personal injury and other claims, and $120 million, or $79 million after tax, for work- force reductions. Excluding these items, adjusted net income was $767 million ($2.67 per basic share or $2.63 per diluted share) in 2003 compared to adjusted net income of $805 million ($2.71 per basic share or $2.65 per diluted share) for 2002, a decrease of $38 million, or 5%. Operating income for 2003 decreased by $131 million, or 9%, compared to adjusted operating income of $1,499 million for 2002. The operating ratio for 2003 was 76.8% compared to the adjusted operating ratio of 75.5% in 2002, a 1.3-point increase. The decrease in adjusted net income and adjusted operating income in 2003 was due to the significant year-over-year appreciation in the Canadian dollar relative to the U.S. dollar. This significant appreci- ation in the Canadian dollar impacted the conversion of the Company’s U.S. dollar denominated revenues and expenses and accordingly, reduced revenues, operating income and net income by approximately $380 million, $110 million and $55 million, respectively. This decrease in adjusted net income was partly offset by net deferred income tax recov- eries of $44 million in 2003 relating mainly to the resolution of matters pertaining to prior years’ income taxes. Reconciliation of adjusted performance measures Management believes that non-GAAP measures such as adjusted net income and the resulting adjusted performance measures for such items as operating income, operating ratio and per share data are useful measures of performance that can facilitate period-to-period comparisons as they exclude items that do not arise as part of the normal day-to-day operations or that could potentially distort the analysis of trends in business per- formance. The exclusion of specified items in the adjusted measures below does not imply that they are necessarily non-recurring. These adjusted measures do not have any standardized meaning prescribed by GAAP and may, therefore, not be comparable to similar measures presented by other companies. The reader is advised to read all information provided in the MD&A in conjunction with the Company’s Annual Consolidated Financial Statements and notes thereto. In millions, except per share data, or unless otherwise indicated Year ended December 31, 2003 Reported Rate enactment Adjusted Reported 2002 Personal injury Workforce reductions charge Revenues Operating expenses Operating income Interest expense Other income Income before income taxes Income tax expense Net income Operating ratio Basic earnings per share Diluted earnings per share $«5,884 4,516 1,368 (317) 21 1,072 (338) $÷«734 76.8% $÷2.56 $÷2.52 $÷– – – – – – 33 $33 $«5,884 4,516 1,368 (317) 21 1,072 (305) $÷«767 76.8% $÷2.67 $÷2.63 $6,110 5,012 1,098 (353) 76 821 (268) $«÷÷ – (281) 281 – – 281 (108) Adjusted $«6,110 4,611 $«÷÷ – (120) 120 1,499 – – 120 (41) (353) 76 1,222 (417) $÷«553 $«173 $÷«79 $÷«805 82.0% $÷1.85 $÷1.82 75.5% $÷2.71 $÷2.65 Canadian GAAP Canadian National Railway Company 89 Management’s Discussion and Analysis Revenues Forest products Year ended December 31, 2003 2002 % Change Year ended December 31, 2003 2002 % Change Total revenues (millions) $5,884 $6,110 (4%) Revenues (millions) Rail freight Revenues (millions) RTMs (millions) Revenue/RTM (cents) Carloads (thousands) Revenue/Carload (dollars) $5,694 $5,901 162,901 159,259 3.50 4,177 1,363 3.71 4,153 1,421 (4%) 2% (6%) 1% (4%) Revenues for the year ended December 31, 2003 totaled $5,884 million compared to $6,110 million in 2002. The decrease of $226 million, or 4%, was mainly due to the higher Canadian dollar, which negatively impacted the translation of U.S. dollar denominated revenue, continued weakness in coal shipments and a slowdown in the automotive sector. Partially offsetting these losses were increased intermodal, metals and minerals and petroleum and chemicals volumes. For 2003, revenue ton miles, measuring the volume of freight transported by the Company, increased by 2% relative to 2002. Freight revenue per revenue ton mile, a measurement of yield defined as revenue earned on the movement of a ton of freight over one mile, decreased by 6% when compared to 2002, reflecting the higher Canadian dollar. Petroleum and chemicals Year ended December 31, 2003 2002 % Change Revenues (millions) RTMs (millions) Revenue/RTM (cents) $1,058 30,901 3.42 $1,102 30,006 3.67 (4%) 3% (7%) Revenues for the year ended December 31, 2003 decreased by $44 mil- lion, or 4%, from 2002. The decrease was due to the translation impact of the stronger Canadian dollar, partially offset by higher U.S. and offshore demand for Canadian sulfur and strong demand for liquefied petroleum gas due to cold weather conditions at the beginning of 2003. Revenue per revenue ton mile decreased by 7% from 2002 due to the translation impact of the stronger Canadian dollar. Metals and minerals Year ended December 31, 2003 2002 % Change Revenues (millions) RTMs (millions) Revenue/RTM (cents) $527 13,876 3.80 $521 13,505 3.86 1% 3% (2%) Revenues for the year ended December 31, 2003 increased by $6 mil- lion, or 1%, from 2002. The increase was due to improved market conditions and increased market share for steel in 2003 and new ore traffic which began in the second quarter of 2002 and the last quarter of 2003. These gains were largely offset by the translation impact of the stronger Canadian dollar. Revenue per revenue ton mile decreased by 2% from 2002 due to the translation impact of the stronger Canadian dollar which was partially offset by a positive change in traffic mix. RTMs (millions) Revenue/RTM (cents) $1,284 34,516 3.72 $1,323 33,551 3.94 (3%) 3% (6%) Revenues for the year ended December 31, 2003 decreased by $39 million, or 3%, from 2002. The decrease was due to the translation impact of the stronger Canadian dollar that was partially offset by solid demand for lumber and pulp and paper. Revenue per revenue ton mile decreased by 6% from 2002 due to the translation impact of the stronger Canadian dollar which more than offset the continued improvement in pricing and a positive change in traffic mix. Coal Revenues (millions) RTMs (millions) Revenue/RTM (cents) Year ended December 31, 2003 2002 % Change $261 13,659 1.91 $326 13,886 2.35 (20%) (2%) (19%) Revenues for the year ended December 31, 2003 decreased by $65 mil- lion, or 20%, from 2002. The decrease was due to reduced coal produc- tion in western Canada, the translation impact of the stronger Canadian dollar and a metallurgical mine closure. Revenue per revenue ton mile decreased by 19% from 2002 mainly due to a change in traffic mix, an increase in the average length of haul, and the translation impact of the stronger Canadian dollar. Grain and fertilizers Year ended December 31, 2003 2002 % Change Revenues (millions) RTMs (millions) Revenue/RTM (cents) $938 35,556 2.64 $986 35,773 2.76 (5%) (1%) (4%) Revenues for the year ended December 31, 2003 decreased by $48 mil- lion, or 5%, from 2002. The decrease was mainly due to the translation impact of the stronger Canadian dollar and a decrease in Canadian export wheat shipments due to the smaller 2002/2003 Canadian crop. Partially offsetting these decreases were increased Canadian canola shipments and strong U.S. corn shipments to North American markets. Revenue per revenue ton mile decreased by 4% from 2002 as the trans- lation impact of the stronger Canadian dollar was partially offset by a decrease in the average length of haul. Intermodal Revenues (millions) RTMs (millions) Revenue/RTM (cents) Year ended December 31, 2003 2002 % Change $1,101 31,168 3.53 $1,052 29,257 3.60 5% 7% (2%) Revenues for the year ended December 31, 2003 increased by $49 million, or 5%, from 2002. The increase was mainly due to increased import volumes, the higher fuel surcharge in 2003 to offset the 90 Canadian National Railway Company Canadian GAAP Management’s Discussion and Analysis significant increase in fuel costs and new traffic through the Port of Vancouver. Partially offsetting these gains was reduced traffic in the domestic segment due to the closure of smaller terminal facilities in the U.S. Revenue per revenue ton mile decreased by 2% from 2002 due to the translation impact of the stronger Canadian dollar and an increase in the average length of haul, partially offset by the higher fuel surcharge. Automotive Revenues (millions) RTMs (millions) Revenue/RTM (cents) Year ended December 31, 2003 $525 3,225 16.28 2002 % Change $591 3,281 18.01 (11%) (2%) (10%) Revenues for the year ended December 31, 2003 decreased by $66 mil- lion, or 11%, from 2002. The decrease was primarily due to the transla- tion impact of the stronger Canadian dollar, weaker North American vehicle sales and production, and a change in shipping patterns for a significant customer. Revenue per revenue ton mile decreased by 10% from 2002 mainly due to the translation impact of the stronger Canadian dollar and a significant increase in the average length of haul. Operating expenses Operating expenses amounted to $4,516 million in 2003 compared to $5,012 million in 2002. The decrease was mainly due to the charges recorded in the fourth quarter of 2002 for personal injury and other claims and workforce reductions, and the translation impact of the stronger Canadian dollar on U.S. dollar denominated expenses. Partly offsetting these decreases were higher casualty and other expenses and higher fuel costs. In millions Year ended December 31, 2003 2002 Labor and fringe benefits Purchased services and material Depreciation and amortization Fuel Equipment rents Casualty and other Total Amount $1,929 879 472 471 299 466 % of revenue 32.8% 15.0% 8.0% 8.0% 5.1% 7.9% Amount $2,069 908 499 459 353 724 $4,516 76.8% $5,012 % of revenue 33.9% 14.9% 8.1% 7.5% 5.8% 11.8% 82.0% Labor and fringe benefits: Labor and fringe benefits expenses in 2003 decreased by $140 million, or 7%, as compared to 2002. The decrease was mainly due to the workforce reduction charge of $120 million recorded in the fourth quarter of 2002, the effects of a reduced work- force and the translation impact of the stronger Canadian dollar. Higher wages and employee benefits, including increased costs for pensions resulting from a change in management’s assumption for the expected long-term rate of return on pension plan assets from 9% to 8%, partly offset the decrease. In 2002, the Company had recorded a workforce reduction charge of $120 million in a renewed drive to improve productivity across all its corporate and operating functions. Reductions relating to this ini- tiative and the 2001 workforce reduction charge of $98 million were completed in 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: Purchased services and material expenses in 2003 decreased by $29 million, or 3%, as compared to 2002. The decrease was mainly due to lower expenses for consulting and professional services, lower discretionary spending (courier, com- munication charges, occupancy costs, etc.), reflecting the Company’s continued focus on cost containment, and the translation impact of the stronger Canadian dollar. Higher repair expenses for rolling stock partly offset the decrease. Depreciation and amortization: Depreciation and amortization expenses in 2003 decreased by $27 million, or 5%, as compared to 2002, mainly due to the translation impact of the stronger Canadian dollar. Fuel: Fuel expense in 2003 increased by $12 million, or 3%, as com- pared to 2002. The increase was mainly due to a higher average price per gallon, net of the impact of the hedging program, and higher vol- umes. These increases were partly offset by the translation impact of the stronger Canadian dollar. Equipment rents: Equipment rents in 2003 decreased by $54 million, or 15%, as compared to 2002. The decrease was due to the Company’s continued focus on asset utilization, which resulted in lower lease expense for freight cars and locomotives and a reduction in net car hire expense. Also contributing to the decrease was the translation impact of the stronger Canadian dollar and a reduction in intermodal car hire rates. Casualty and other: Casualty and other expenses in 2003 decreased by $258 million, or 36%, as compared to 2002, which included a fourth quarter charge of $281 million to increase the provision for U.S. per- sonal injury and other claims. Excluding this charge, the increase was mainly due to higher expenses for personal injury claims and increased insurance premiums. Partly offsetting the increase were lower travel- related expenses and lower provincial capital taxes. Canadian GAAP Canadian National Railway Company 91 Management’s Discussion and Analysis Other Interest expense: Interest expense decreased by $36 million to $317 mil lion for the year ended December 31, 2003 as compared to 2002. The decrease was mainly due to the translation impact of the stronger Canadian dollar and lower interest rates on new debt to replace matured debt. Other income: In 2003, the Company recorded other income of $21 mil- lion compared to $76 million in 2002. The decrease was mainly due to lower right of way fees due to the termination of a contract in late 2002, lower income from the Company’s equity investments, and real- ized foreign exchange losses in 2003. Summary of quarterly financial data – unaudited In millions, except per share data Income tax expense: The Company recorded income tax expense of $338 million for the year ended December 31, 2003 compared to $268 mil- lion in 2002. The effective tax rate for the year ended December 31, 2003 was 31.5% compared to 32.6% in 2002. The decrease was mainly due to net favorable adjustments relating to the resolution of matters pertain- ing to prior years’ income taxes of $44 million and lower corporate income tax rates in Canada. Partly offsetting the decrease was a $33 mil- lion deferred income tax expense recorded in the fourth quarter of 2003 resulting from the enactment of higher corporate tax rates in the province of Ontario. Revenues Operating income Net income Basic earnings per share Diluted earnings per share Dividend declared per share 2004 Fourth Third Second $1,736 $÷«620 $÷«373 $÷1.31 $÷1.28 $1,709 $÷«609 $÷«367 $÷1.28 $÷1.26 $1,665 $÷«592 $÷«338 $÷1.19 $÷1.17 $0.195 $0.195 $0.195 First $1,438 $÷«409 $÷«219 $÷0.77 $÷0.76 $0.195 2003 Third Second $1,413 $÷«329 $÷«208 $÷0.73 $÷0.72 $1,463 $÷«335 $÷«177 $÷0.62 $÷0.61 Fourth $1,512 $÷«363 $÷«169 $÷0.60 $÷0.59 $0.167 $0.167 $0.167 First $1,496 $÷«341 $÷«180 $÷0.61 $÷0.61 $0.167 The volume of goods and commodities transported by the Company during the year is influenced by seasonal weather conditions, general economic conditions, cyclical demand for rail transportation, and competitive forces in the transportation marketplace. Operating expenses reflect the impact of freight volumes, seasonal weather conditions, labor costs, fuel prices, and the Company’s productivity initiatives. The Company’s quarterly results include items that affect the quarter-over-quarter comparability of the results of operations. The Company’s results of operations for 2004 included GLT as of May 10, 2004 and BC Rail as of July 14, 2004. First-quarter 2004 results were affected by the month-long CAW strike, which negatively impacted operating income and net income by $35 million and $24 million, respectively. Fourth-quarter 2003 included a deferred income tax expense of $33 million resulting from the enactment of higher corporate tax rates in the province of Ontario. Also affecting comparability was the significant appreciation in the Canadian dollar relative to the U.S. dollar which has impacted the conversion of the Company’s U.S. dollar denominated revenues and expenses and resulted in a reduction in net income of approximately $45 million for 2004, particularly in the first quarter. Liquidity and capital resources The Company’s principal source of liquidity is cash generated from operations. The Company also has the ability to fund liquidity require- ments through its revolving credit facility, the issuance of debt and/or equity, and the sale of a portion of its accounts receivable through a 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 $2,139 million for the year ended December 31, 2004 compared to $1,500 million for 2003. Net cash receipts from customers and others were $6,501 million for the year ended December 31, 2004 compared to $6,022 million in 2003. In 2004, payments for employee services, suppliers and other expenses were $3,628 million, a decrease of $108 million when compared to 2003. Also consuming cash in 2004 were payments for interest, workforce reductions and personal injury and other claims of $282 million, $93 million and $106 million, respectively, compared to $327 million, $155 million and $126 million, respectively, in 2003. In 2004, pension contributions and payments for income taxes were $161 million and $92 million, respectively, compared to $92 million and $86 million, respectively, in 2003. The Company 92 Canadian National Railway Company Canadian GAAP Management’s Discussion and Analysis increased the level of accounts receivable sold under its accounts receiv- able securitization program by $12 million in 2004 and $132 million in 2003. Payments in 2005 for workforce reductions are expected to be $90 million while pension contributions are expected to be approxi- mately $120 million. As at December 31, 2004, the Company had outstanding informa- tion technology service contracts of $18 million. Investing activities: Cash used by investing activities in 2004 amounted to $2,411 million compared to $599 million in 2003. The Company’s investing activities in 2004 included $984 million related to the acquisi- tion of BC Rail and $547 million related to the acquisition of GLT, net proceeds of $141 million from the EWS capital reorganization and $52 million from the sale of its Canac Inc. and Beltpack subsidiaries. Net capital expenditures for the year ended December 31, 2004 amounted to $1,072 million, an increase of $489 million over 2003, mainly result- ing from the change in property capitalization. The following table details capital expenditures for 2004 and 2003. In millions Year ended December 31, Rail infrastructure Rolling stock Information technology and other Less: capital leases Net capital expenditures 2004 $÷«769 253 210 1,232 160 2003 $373 97 160 630 47 $1,072 $583 The Company expects that its capital expenditures will increase in 2005 due to the acquisition of rolling stock and increased expenditures required for ongoing renewal of the basic plant and other acquisitions and investments required to improve the Company’s operating effi- ciency and customer service. As at December 31, 2004, the Company had commitments to acquire railroad ties, rail, freight cars, locomotives and other equipment at an aggregate cost of $194 million ($211 million at December 31, 2003). Dividends: During 2004, the Company paid dividends totaling $222 mil- lion to its shareholders at the quarterly rate of $0.195 per share com- pared to $191 million at the rate of $0.167 per share, in 2003. Free cash flow The Company generated $1,025 million of free cash flow for the year ended December 31, 2004, compared to $578 million in 2003. Free cash flow does not have any standardized meaning prescribed by GAAP and may, therefore, not be comparable to similar measures presented by other companies. The Company believes that free cash flow is a useful measure of performance as it demonstrates the Company’s ability to generate cash after the payment of capital expenditures and dividends. The Company defines free cash flow as cash provided from operating activities, exclud- ing changes in the level of accounts receivable sold under the securitiza- tion program, less investing activities and dividends paid, and adjusted for significant acquisitions as they are not indicative of normal day-to-day investments in the Company’s asset base, calculated as follows: In millions Year ended December 31, 2004 2003 Cash provided from operating activities $«2,139 $1,500 Less: Investing activities Dividends paid Cash provided (used) before financing activities Adjustments: Change in accounts receivable sold Acquisition of BC Rail & GLT Free cash flow (2,411) (222) (494) (599) (191) 710 (12) 1,531 $«1,025 (132) – $÷«578 Financing activities: Cash provided from financing activities totaled $511 million for the year ended December 31, 2004 compared to cash used by financing activities of $605 million in 2003. In July 2004, the Company issued U.S.$300 million (Cdn$395 million) of 4.25% Notes due 2009 and U.S.$500 million (Cdn$658 million) of 6.25% Debentures due 2034. In March 2004, the Company had repaid U.S.$266 million (Cdn$355 million) of 7.00% 10-year Notes with cash on hand and the proceeds received from the issuance of commercial paper. In May 2003, the Company had repaid U.S.$150 million (Cdn$207 million) of 6.625% 10-year Notes and U.S.$100 million (Cdn$138 million) of 6.75% 10-year Notes with the proceeds received in March 2003 from the issuance of U.S.$400 million (Cdn$586 million) 4.40% Notes due 2013. In 2004 and 2003, issuances and repayments of long-term debt related principally to the Company’s commercial paper and revolving credit facility. In 2004, the Company used $273 million to repurchase 4.0 million common shares under its current share repurchase program whereas in 2003, the Company used $656 million to repurchase the remaining 15.0 million common shares under its previous share repurchase pro- gram initiated in 2002. During 2004, the Company recorded $160 million in capital lease obligations ($47 million in 2003) related to new equipment and the exercise of purchase options on existing equipment. Canadian GAAP Canadian National Railway Company 93 Management’s Discussion and Analysis The Company has access to various financing arrangements: Revolving credit facility The Company has a U.S.$1,000 million three-year revolving credit facil- ity expiring in December 2005, which it intends to renew before such date. 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, with which the Company has been in compliance. The Company’s borrowings of U.S.$180 million (Cdn$233 million) outstanding at December 31, 2003 at an average interest rate of 1.49% were entirely repaid in the first quarter of 2004. As at December 31, 2004, the Company had borrowings under its revolving credit facility of U.S.$90 million (Cdn$108 million) at an average inter- est rate of 2.77% and letters of credit drawn of $342 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 $800 million, Contractual obligations or the U.S. dollar equivalent. As the revolving credit facility will mature within the next twelve months and the refinancing has not been renegotiated, the outstanding balance of U.S.$211 million (Cdn$254 million) of commercial paper at an average interest rate of 2.37% has been included in the current portion of long-term debt at December 31, 2004. The Company had no commercial paper out- standing at December 31, 2003. Shelf registration statement On July 9, 2004, the Company issued U.S.$300 million (Cdn$395 mil- lion) of 4.25% Notes due 2009 and U.S.$500 million (Cdn$658 million) of 6.25% Debentures due 2034. The debt offering was made under the Company’s shelf prospectus and registration statement filed in October 2003. Accordingly, the amount available under the shelf prospectus and registration statement has been reduced to U.S.$200 million. The Company used the net proceeds of U.S.$790 million to finance a portion of the acquisition costs of BC Rail and GLT. The Company’s access to current and alternate sources of financing at competitive costs is dependent on its credit rating. The Company is not currently aware of any adverse trend, event or condition that would affect the Company’s credit rating. In the normal course of business, the Company incurs contractual obligations. The following table sets forth the Company’s contractual obligations for the following items as at December 31, 2004: In millions Long-term debt obligations (a) Capital lease obligations (b) Operating lease obligations Purchase obligations (c) Total obligations Total $4,403 1,103 992 212 $6,710 2005 $÷«497 113 206 191 $1,007 2006 $308 106 194 10 $618 2007 $÷60 130 146 5 $341 2008 $207 52 116 3 $378 2009 $363 93 90 3 2010 and thereafter $2,968 609 240 – $549 $3,817 (a) Presented net of unamortized discounts, of which $838 million relates to non-interest bearing notes due in 2094 assumed as part of the BC Rail acquisition and excludes capital lease obligations of $761 million which are included in “Capital lease obligations.” (b) Includes $342 million of imputed interest on capital leases at rates ranging from approximately 2.23% to 13.13%. (c) Includes commitments for railroad ties, rail, freight cars, locomotives and other equipment and outstanding information technology service contracts. For 2005 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. 94 Canadian National Railway Company Canadian GAAP Management’s Discussion and Analysis Acquisitions BC Rail In November 2003, the Company entered into an agreement with British Columbia Railway Company, a corporation owned by the Government of the Province of British Columbia (Province), to acquire all the issued and outstanding shares of BC Rail Ltd. and all the part- nership units of BC Rail Partnership (collectively BC Rail), and the right to operate over BC Rail’s roadbed under a long-term lease, for a pur- chase price of $1 billion. On July 2, 2004, the Company reached a consent agreement with Canada’s Competition Bureau, allowing for the closing of the trans- action, whereby the Company reaffirmed its commitment to share merger efficiencies with BC Rail shippers and assure them competitive transportation options through its Open Gateway Rate and Service Commitment. The consent agreement also maintains competitive rates and service for grain shippers in the Peace River region. On July 14, 2004, the Company completed its acquisition of BC Rail and began a phased integration of the companies’ operations. The acquisition was financed by debt and cash on hand. The Company accounted for the acquisition using the purchase method of accounting as required by Section 1581, “Business Combinations,” and Section 3062, “Goodwill and Other Intangible Assets,” of the CICA. As such, the consolidated financial statements of the Company include the assets, liabilities and results of operations of BC Rail as of July 14, 2004, the date of acquisition. The Company’s cost to acquire BC Rail of $991 million includes purchase price adjustments and transaction costs. The preliminary purchase price allocation, based on the fair value of BC Rail’s assets acquired, owned and leased, and liabilities assumed at acquisition, as presented in Note 3 – Acquisitions, of the Company’s Annual Consolidated Financial Statements, is subject to a final valuation, the impact of which is not expected to have a material effect on the results of operations. Great Lakes Transportation LLC’s Railroads and Related Holdings In October 2003, the Company, through an indirect wholly owned subsidiary, entered into an agreement for the acquisition of GLT for a purchase price of U.S.$380 million. As of April 2004, the Company received all necessary regulatory approvals, including the U.S. Surface Transportation Board (STB) ruling rendered on April 9, 2004. On May 10, 2004, the Company completed its acquisition of GLT and began a phased integration of the companies’ operations. The acquisition was financed by debt and cash on hand. The Company accounted for the acquisition using the purchase method of accounting. As such, the consolidated financial statements of the Company include the assets, liabilities and results of operations of GLT as of May 10, 2004, the date of acquisition. The Company’s cost to acquire GLT of U.S.$395 million (Cdn$547 million) includes purchase price adjustments and transaction costs. The preliminary purchase price allocation, based on the fair value of GLT’s assets acquired and liabili- ties assumed at acquisition, as presented in Note 3 – Acquisitions, of the Company’s Annual Consolidated Financial Statements, is subject to a final valuation, the impact of which is not expected to have a mate- rial effect on the results of operations. These acquisitions involve the integration of two previously inde- pendent businesses to provide shippers enhanced rail services over a coordinated network. There can be no assurance that CN will be able to integrate its business with that of either BC Rail or GLT without encoun- tering operational difficulties or experiencing the loss of key employees or customers, or that the rail service levels and other efficiencies or syn- ergies expected from these acquisitions will be attained. Investment in English Welsh and Scottish Railway (EWS) – Capital reorganization On January 6, 2004, EWS shareholders approved a plan to reduce the EWS share capital to enable cash to be returned to the shareholders by offering them the ability to cancel a portion of their EWS shares. For each share cancelled, EWS shareholders would receive cash and 8% notes due in 2009, redeemable in whole or in part at any time by EWS, at their principal amount together with accrued but unpaid interest up to the date of repayment. The Company elected to have the maximum allowable number of shares cancelled under the plan, thereby reducing its ownership inter- est of EWS to approximately 31% on a fully diluted basis (13.7 million shares) compared to approximately 37% on a fully diluted basis (43.7 million shares) prior to the capital reorganization. In the first quarter of 2004, the Company received £57.7 million (Cdn$141 million) in cash and a note receivable of £23.9 million (Cdn$58 million) from EWS. Off balance sheet arrangements Accounts receivable securitization program The Company has an accounts receivable securitization program, expiring in June 2006, under which it may sell, on a revolving basis, a maximum of $450 million of eligible freight trade and other receivables outstanding at any point in time, to an unrelated trust. The Company has a contingent residual interest of approximately 10% of receivables sold, which is recorded in Other current assets. Canadian GAAP Canadian National Railway Company 95 Management’s Discussion and Analysis The Company is subject to customary reporting requirements for which failure to perform could result in termination of the program. In addition, the trust is subject to customary credit rating requirements, which if not met could also result in termination of the program. The Company monitors these reporting and credit rating requirements for any trends, events or conditions that could cause such termination. The accounts receivable securitization program provides the Company with readily available short-term financing for general corpo- rate uses. In the event the program is terminated before its scheduled maturity, the Company expects to meet its future payment obligations through its various sources of financing, including its revolving credit facility and commercial paper program, and/or access to capital markets. At December 31, 2004, pursuant to the agreement, $445 million had been sold compared to $448 million at December 31, 2003. Guarantees and indemnifications In the normal course of business, the Company, including certain of its subsidiaries, enters into agreements that may involve providing certain guarantees or indemnifications to third parties and others, which extend over the term of the agreement. These include, but are not limited to, residual value guarantees on operating leases, standby letters of credit and surety bonds, and indemnifications that are customary for the type of transaction or for the railway business. Effective January 1, 2003, the Company is required to disclose its obligations undertaken in issuing certain guarantees on the date the guarantee is issued or modified. Where the Company expects to make a payment in respect of a guarantee, a liability will be recognized to the extent that one has not yet been recognized. The nature of these guarantees or indemnifications, the maximum potential amount of future payments and the nature of any recourse provisions are disclosed in Note 19 – Major commitments and contin- gencies of the Company’s Annual Consolidated Financial Statements. Financial instruments The Company has limited involvement with derivative financial instru- ments and does not use them for trading purposes. Collateral or other security to support financial instruments subject to credit risk is usually not obtained. While the Company is exposed to counterparty credit risk in the event of non-performance, the credit standing of counterparties or their guarantors is regularly monitored, and losses due to counter- party non-performance are not anticipated. Fuel To mitigate the effects of fuel price changes on its operating margins and overall profitability, the Company has a systematic hedging pro- gram which calls for regularly entering into swap positions on crude and heating oil to cover a target percentage of future fuel consumption up to two years in advance. However, in the fourth quarter of 2004, the Company did not enter into any swap positions on crude and heating oil. At December 31, 2004, the Company had hedged approximately 50% of the estimated 2005 fuel consumption, representing approxi- mately 203 million U.S. gallons at an average price of U.S.$0.74 per U.S. gallon, and 17% of the estimated 2006 fuel consumption, representing 69 million U.S. gallons at an average price of U.S.$0.89 per U.S. gallon. Realized gains from the Company’s fuel hedging activities were $112 million, $49 million and $3 million for the years ended December 31, 2004, 2003 and 2002, respectively. As a result of fuel hedging activities, the Company had an unreal- ized gain of $92 million at December 31, 2004 compared to $38 million at December 31, 2003. Interest rate In the first quarter of 2004, in anticipation of future debt issuances, the Company had entered into treasury lock transactions for a notional amount of U.S.$380 million to fix the treasury component on these future debt issuances. Upon expiration in June 2004, these treasury rate locks were rolled into new contracts expiring in September 2004, at an average locked-in rate of 5.106%. The Company settled these treasury locks at a gain of U.S.$9 million (Cdn$12 million) upon the pricing of the U.S.$500 million 6.25% Debentures due 2034, subsequently issued on July 9, 2004 and recorded the gain immediately into income, as a reduction of interest expense. Common stock Share repurchase program On October 26, 2004, the Board of Directors of the Company approved a share repurchase program which allows for the repurchase of up to 14.0 million common shares between November 1, 2004 and October 31, 2005 pursuant to a normal course issuer bid, at prevailing market prices. As at December 31, 2004, 4.0 million common shares have been repurchased for $273 million, at an average price of $68.31 per share. Common stock split On January 27, 2004, the Board of Directors of the Company approved a three-for-two common stock split which was effected in the form of a stock dividend of one-half additional common share of CN payable for each share held. The stock dividend was paid on February 27, 2004, to shareholders of record on February 23, 2004. All equity-based ben- efit plans were adjusted to reflect the issuance of additional shares or options due to the declaration of the stock split. All share and per share data has been adjusted to reflect the stock split. Outstanding share data As at January 25, 2005, the Company had 283.1 million common shares outstanding. 96 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 claims, depreciation, pensions and other post-retirement benefits, and income taxes, based upon currently available information. Actual results could differ from these estimates. The following account- ing 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 information should be read in conjunction with the Company’s Annual 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 dis- closures 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’ com- pensation 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 not changed any of these assumptions. 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 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 set- tlements, has contributed to the significant increase in the Company’s personal injury expense in recent years. In view of the Company’s growing presence 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 Annual 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 expected cost for personal injury and property damage claims and asserted occupational disease claims, based on actuarial estimates of their ultimate cost. A liability for the minimum amount of unasserted occupational disease claims is also accrued to the extent they can be reasonably estimated. The amount recorded reflects a 25-year horizon as the Company expects that a large majority of these cases will be received over such period. 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 sever- ity would have the effect of changing the provision by approximately $23 million and the annual expense by approximately $8 million. In 2004, the Company’s expenses for personal injury and other claims, net of recoveries, were $149 million ($127 million in 2003 and $393 million in 2002) and payments for such items were $106 million ($126 million in 2003 and $156 million in 2002). As at December 31, 2004, the Company had aggregate reserves for personal injury and other claims of $642 million ($590 million at December 31, 2003). Environmental claims 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 compli- ance and capital costs, on an ongoing basis, associated with environ- mental regulatory compliance and clean-up requirements in its railroad operations and relating to its past and present ownership, operation or control of real property. Environmental expenditures that relate to cur- rent 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. Canadian GAAP Canadian National Railway Company 97 Management’s Discussion and Analysis Known existing environmental concerns The Company is subject to environmental clean-up and enforce- ment actions. In particular, the Federal Comprehensive Environmental Response, Compensation and Liability Act of 1980 (CERCLA), also known as the Superfund law, as well as similar state laws generally impose joint and several liability for clean-up and enforcement costs on current and former owners and operators of a site without regard to fault or the legality of the original conduct. The Company has been notified that it is a potentially responsible party for study and clean-up costs at approximately 17 Superfund sites for which investigation and remediation payments are or will be made or are yet to be determined and, in many instances, is one of several potentially responsible parties. 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 assessment conducted on a site-by-site basis. Cost scenarios established by external consultants based on extent of contamination and expected costs for remedial efforts are used by the Company to estimate the costs related to a particular site. A liability is initially recorded when environmental assessments and/or remedial efforts are likely, and when 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. Adjustments to initial estimates are recorded as additional information becomes available. Based on the informa- tion currently available, the Company considers its provisions to be adequate. At December 31, 2004, most of the Company’s properties not acquired through recent acquisitions have reached the final assessment stage and therefore costs related to such sites have been anticipated. For properties acquired through recent acquisitions, the Company obtains assessments from both external and internal consultants and a liability has been or will be accrued based on such assessments. Unknown existing environmental concerns 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. 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 period 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 dam- ages and compensatory or punitive damages relating to harm to individuals or property. In 2004, the Company’s expenses relating to environmental matters, net of recoveries, were $10 million ($6 million in both 2003 and 2002) and payments for such items were $8 million ($12 million in 2003 and $16 million in 2002). As at December 31, 2004, the Company had aggregate accruals for environmental costs of $113 million ($83 million as at December 31, 2003). The Company anticipates that the majority of the liability will be paid out over the next five years. Depreciation Railroad properties are carried at cost less accumulated depreciation including asset impairment write-downs. The Company follows the group method of depreciation for railroad properties 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 busi- ness, is charged to accumulated depreciation. Assessing the reasonableness of the estimated useful lives of prop- erties requires judgment and is based on currently available informa- tion, including periodic depreciation studies conducted by the Company. The Company’s U.S. properties are subject to comprehensive deprecia- tion studies conducted by external consultants as required by the STB. Depreciation studies for Canadian properties are not required by regula- tion 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. 98 Canadian National Railway Company Canadian GAAP Management’s Discussion and Analysis 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 composite 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 2004, the Company conducted a comprehensive study for its Canadian properties and U.S. rolling stock and equipment. The study did not have a signifi- cant effect on depreciation expense. In 2004, the Company recorded total depreciation and amortiza- tion expense of $521 million ($478 million in 2003 and $506 million in 2002). At December 31, 2004, the Company had Properties of $16,688 million, net of accumulated depreciation of $6,448 million ($15,158 mil- lion in 2003, net of accumulated depreciation of $6,265 million). Pensions and other post-retirement benefits The Company accounts for pensions and other post-retirement ben- efits 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 this standard. 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 Company has various pension plans, however, the following description pertaining to pen- sions relates generally to the Company’s main pension plan, the CN Pension Plan. 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, termina- tions or disability. Changes in these assumptions result in actuarial gains or losses which in accordance with CICA Handbook 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 12 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 dis- count rate of 5.75%, based on bond yields prevailing at December 31, 2004, was considered appropriate by the Company and is supported by reports issued by third party advisors. A one-percentage-point decrease in the discount rate would cause annual net periodic benefit cost to increase by approximately $33 million whereas a one-percentage-point increase would not have a material change in net periodic benefit cost as the Company amortizes actuarial gains and losses over the expected average remaining service life of the employee group covered by the plans, only to the extent they are in excess of 10% of the greater of the beginning of year balances of the projected benefit obligation or mar- ket-related value of plan assets. 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, the expected composition of the plans’ assets as well as the expected long-term market returns in the future. The Company has elected to use a market- related value of assets, whereby realized and unrealized gains/losses and appreciation/depreciation in the value of the investments are recog- nized over a period of five years, while investment income is recognized immediately. The Company follows a disciplined investment strategy, which limits concentration of investments by asset class, foreign cur- rency, sector or company. The Investment Committee of the Board of Directors has approved an investment policy that establishes long-term asset mix targets based on a review of historical returns achieved by worldwide investment markets. Investment managers may deviate from these targets but their performance is evaluated in relation to the mar- ket performance of the target mix. The Company does not anticipate the return on plan assets to fluctuate materially from related capital market indices. The Investment Committee reviews investments regularly with specific approval required for major investments in illiquid securities. The policy also permits the use of derivative financial instruments to implement asset mix decisions or to hedge existing or anticipated expo- sures. The Pension Plan does not invest in the securities of the Company or its subsidiaries. During the last ten years ended December 31, 2004, the CN Pension Plan earned an annual average rate of return of 9.8%. The actual and market-related value rates of return on plan assets for the last five years were as follows: Rates of return Actual Market-related value 2004 11.7% 6.3% 2003 9.6% 7.0% 2002 2001 2000 (0.3)% 7.4% (1.4)% 10.2% 10.5% 13.7% Canadian GAAP Canadian National Railway Company 99 Management’s Discussion and Analysis 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. In 2003, the Company had reduced the expected long-term rate of return on plan assets from 9% to 8% to reflect management’s view of long-term investment returns. The effect of this change in management’s assumption was 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, 2004, the plan assets are comprised of 56% in Canadian and foreign equities, 34% in debt securities, 3% in real estate assets and 7% in other assets. The long-term asset allocation percentages are not expected to differ materially from the current composition. The rate of compensation increase, 3.75% to determine both the benefit obligation and the net periodic benefit cost, is another signifi- cant assumption in the actuarial model for pension accounting and is determined 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 15% in the current year, and it is assumed that the rate will decrease gradually to 6% in 2013 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. For pension funding purposes, 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. The latest actuarial valuation of the CN Pension Plan was conducted as at December 31, 2003 and indicated a funding excess. Total con- tributions for all of the Company’s pension plans are expected to be approximately $120 million in each of 2005, 2006 and 2007 based on the plans’ current position. The assumptions discussed above are not expected to have a significant impact on the cash funding requirements of the pension plans. The Canadian Institute of Actuaries (CIA) has adopted a new standard that will be used to calculate the values that pension plan members are entitled to receive on termination of employ- ment. The new standard will impact the calculation of the pension plan liabilities under a solvency or wind-up scenario when the Company conducts an actuarial valuation for purposes of determining the fund- ing position of the Company’s Canadian pension plans. The standard is effective in February 2005 and may significantly impact future funding requirements. For pensions, the Company recorded consolidated net periodic ben- efit cost of $22 million and $49 million in 2004 and 2003, respectively, and no net periodic benefit cost in 2002. Consolidated net periodic ben- efit cost for other post-retirement benefits was $29 million, $33 million and $25 million in 2004, 2003 and 2002, respectively. At December 31, 2004, the Company’s accrued benefit cost for post-retirement benefits other than pensions was $309 million ($164 million at December 31, 2003). In addition, at December 31, 2004, the Company’s consolidated pension benefit obligation and accumulated post-retirement benefit obligation (APBO) were $13,137 million and $319 million, respectively ($12,020 million and $309 million at December 31, 2003). The Medicare Prescription Drug, Improvement, and Modernization Act of 2003 (the “Act”), signed into law in the United States in December 2003, provides for prescription drug benefits under Medicare, as well as a federal subsidy to sponsors of retiree health care benefit plans that provide prescription drug benefits that have been concluded to be actuarially equivalent to the Medicare benefit. Pursuant to guid- ance by the Financial Accounting Standards Board (FASB) in the United States, adopted on July 1, 2004, the Company evaluated and deter- mined the prescription drug benefits provided by its health care plans to be actuarially equivalent to the Medicare benefit under the Act. The Company measured the effects of the Act on the APBO as of January 1, 2004 and, as such, the APBO was reduced by $49 million. Net periodic benefit cost for the year ended December 31, 2004 was reduced by $7 million due to the effects of the Act. In 2004, with the acquisitions of GLT and BC Rail, the Company assumed two additional defined benefit plans. The following table provides the Company’s plan assets by category, benefit obligation at end of year and Company and employee contributions by major pension plan: In millions Plan assets by category Equity securities Debt securities Real estate Other Total Benefit obligation at end of year Company contributions in 2004 Employee contributions in 2004 December 31, 2004 CN Pension Plan BC Rail Pension Plan U.S. and Other Plans Total $÷6,812 3,888 348 1,208 $12,256 $12,172 $÷÷÷«74 $÷÷÷«55 $312 212 16 73 $613 $626 $÷20 $÷÷– $105 $÷7,229 54 1 24 $184 $339 $÷71 $÷÷– 4,154 365 1,305 $13,053 $13,137 $÷÷«165 $÷÷÷«55 100 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 tax- able 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 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, 2004, 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 assets are mainly composed of temporary differences related to accruals for workforce reductions, personal injury and other claims, environmental and other post-retire- ment 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 liabilities are mainly composed of temporary dif- ferences related to properties and prepaid benefit cost for pensions. The reversal of temporary 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/or 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 $19 million in 2004. In the fourth quarter of 2003, the Company had recorded an increase of $33 million to its net deferred income tax liability resulting from the enactment of higher corporate tax rates in the province of Ontario. For the year ended December 31, 2004, the Company recorded total income tax expense of $631 million ($338 million in 2003 and $268 million in 2002) of which $401 million was for deferred income taxes ($232 million in 2003 and $156 million in 2002). The Company’s net deferred income tax liability at December 31, 2004 was $3,198 mil- lion ($3,240 million at December 31, 2003). 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. Competition The Company faces significant competition from a variety of carriers, including Canadian Pacific Railway Company (CP) which operates the other major rail system in Canada, serving most of the same industrial and population centers as the Company, long distance trucking compa- nies and, in many markets, major U.S. railroads and other Canadian and U.S. railroads. Competition is generally based on the quality and reliabil- ity of services provided, price, and the condition and suitability of car- riers’ 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 competi- tion 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 materially adversely affect the demand for goods supplied by the sources served by the Company and, therefore, the Company’s volumes, revenues and profit margins. In addition to trucking competition, and to a greater degree than other rail carriers, the Company’s subsidiary, Illinois Central Railroad Company (ICRR), is vulnerable to barge competition 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. The significant consolidation of rail systems in the United States has resulted in larger rail systems that are able to offer seamless ser- vices in larger market areas and accordingly, compete effectively with the Company in certain markets. This requires the Company to consider transactions that would similarly enhance its own service, such as its acquisitions of BC Rail and the GLT carriers. There can be no assurance Canadian GAAP Canadian National Railway Company 101 Management’s Discussion and Analysis that the Company will be able to compete effectively against current and future competitors in the railroad industry and that further consolida- tion within the railroad industry will not adversely affect the Company’s competitive position. No assurance can be given that competitive pres- sures will not lead to reduced revenues, profit margins or both. Environmental matters The Company’s operations are subject to numerous federal, provin- cial, state, municipal and local environmental laws and regulations in Canada and the United States concerning, among other things, emis- sions 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 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 compli- ance and capital costs, on an ongoing basis, associated with environ- mental 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 for environmental matters in the next several years, based on known information, 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 railroad and related transportation operations, 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 relat- ing 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 envi- ronmental 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, 2004, 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 opera- tions in a particular quarter or fiscal year. Labor negotiations Canadian workforce Labor agreements covering approximately 97% of the Company’s Canadian unionized workforce expired on December 31, 2003. As of January 2005, the Company has successfully negotiated four collective agreements with the CAW, retroactive to January 1, 2004, covering the Company’s shopcraft forces, clerical workers, intermodal yard employ- ees and owner operators. Agreements were also reached with the Company’s Rail Traffic Controllers, Toronto Terminal employees and the Canadian Railway Police Association as well as a United Transportation Union (UTU) group that represents employees in the Company’s north- ern Quebec territory (CFIL). In addition, the Company has reached a tentative labor agreement with the United Steelworkers of America, rep- resenting approximately 2,250 track, bridges and structures employees, whose agreement also expired on December 31, 2003. The UTU, rep- resenting 2,520 brakemen and conductors, the Teamsters Canada Rail Conference (TCRC), which represents 1,750 locomotive engineers, and the 630-member International Brotherhood of Electrical Workers (IBEW), representing close to 40% of the unionized workforce in Canada, filed for conciliation in the fourth quarter and the negotiations have since been conducted with government assistance. On December 29, 2004, the Minister of Labour also referred to the Canadian Industrial Relations Board (CIRB) a question respecting the maintenance of essential ser- vices should there be a strike or lockout involving these groups. Until the Board renders its decision, the right to strike or lockout is sus- pended. In addition to the Board’s decision, at least 72 hours’ strike or lockout notice would be required prior to any legal strike or lockout. In the third quarter of 2004, the Company acquired BC Rail. At December 2004, the Company had reached implementing agreements for BC Rail employees with the Council of Trade Unions and its mem- bers, representing all unions, regarding the integration of the various collective agreements. 102 Canadian National Railway Company Canadian GAAP Management’s Discussion and Analysis In the first quarter of 2004, the Company’s shopcraft forces, cleri- cal workers and intermodal yard employees, represented by the CAW had rejected three tentative agreements signed by the CAW and the Company on January 23, 2004. The strike that ensued lasted one month and disrupted the Company’s operations and affected operating income by approximately $35 million in the first quarter of 2004. There can be no assurance that the Company will be able to have all its collective agreements renewed and ratified without any other strikes or lockouts, or that such strikes or lockouts or the resolution of these collective bargaining negotiations will not have a material adverse effect on the Company’s financial position or results of operations. 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 Wisconsin Central Transportation Corporation (WC), have bargained on a local basis rather than holding national, industry wide negotia- tions because it results in agreements that better address both the employees’ concerns and preferences, and the railways’ actual operat- ing 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 2005, the Company had in place agreements with bargaining units representing the entire unionized workforce at ICRR, GTW, DWP, CCP and GLT, and 93% of the unionized workforce at WC. Agreements in place 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 2005. Negotiations are ongoing with the bargaining units with which the Company does not have agreements or settlements. Until new agree- ments are reached or the processes of the Railway Labor Act have been exhausted, the terms and conditions of existing agreements or policies 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 there will not be any such work action and that the resolution of these negotiations 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 as to (i) economic regulation by the STB (the successor to the Interstate Commerce Commission) and (ii) safety by the Federal Railroad Administration. As such, various Company business transactions must gain prior regulatory approval, with attendant risks and uncertainties. The Company is also subject to a variety of health, safety, security, labor, environmental and other regulations, all of which can affect its com- petitive position and profitability. The CTA Review Panel, which was appointed by the federal govern- ment to carry out a comprehensive review of the Canadian transporta- tion 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 affecting all modes of transportation, including rail. On February 25, 2003, the Canadian Minister of Transport released its policy document Straight Ahead – A Vision for Transportation in Canada and tabled in the House of Commons Bill C-26 entitled An Act to Amend the Canada Transportation Act and the Railway Safety Act, to enact the VIA Rail Canada Act and to make consequential amendments to other Acts. Bill C-26 died on the Order Paper (was terminated) when Parliament was prorogued on November 12, 2003. No assurance can be given that any future legislative action by the federal government pursuant to the report’s recommendations and the policy document, or other future governmental initiatives will not materially adversely affect the Company’s financial position or results of operations. The U.S. Congress has had under consideration for several years various pieces of legislation that would increase federal economic regulation of the railroad industry. In addition, the STB is authorized by statute to commence regulatory proceedings if it deems them to be appropriate. No assurance can be given that any future regulatory initia- tives by the U.S. federal government will not materially adversely affect the Company’s operations, or its competitive and financial position. The Company is subject to statutory and regulatory directives in the United States addressing homeland security concerns. These include new border security arrangements, pursuant to an agreement the Company and CP entered into with U.S. Customs and Border Protection (CBP) and the Canada Border Services Agency (CBSA). These require- ments include advance electronic transmission of cargo information for U.S.-bound traffic and cargo screening (including gamma ray and radiation screening), as well as U.S. government imposed restrictions on the transportation into the United States of certain commodities. In the fourth quarter of 2003, the CBP issued regulations to extend advance notification requirements to all modes of transportation and the U.S. Food and Drug Administration promulgated interim final rules requir- ing advance notification by all modes for certain food imports into the United States. The Company has also worked with the Association of American Railroads to develop and put in place an extensive industry- wide security plan. While the Company will continue to work closely with the CBSA, CBP, and other Canadian and U.S. agencies, as above, no assurance can be given that future decisions by the U.S. and/or Canadian governments on homeland security matters, or joint decisions by the industry in response to threats to the North American rail net- work, will not materially adversely affect the Company’s operations, or its competitive and financial position. Canadian GAAP Canadian National Railway Company 103 Management’s Discussion and Analysis In October 2002, the Company became the first North American railroad to gain membership in the U.S. Customs Service‘s Customs- Trade Partnership Against Terrorism (C-TPAT). C-TPAT is a joint govern- ment-business initiative designed to build cooperative relationships that strengthen overall supply chain and border security on goods exported to the U.S. The Company is also designated as a low-risk carrier under the Customs Self-Assessment (CSA) program, a CBSA program designed to expedite the cross-border movement of goods of CSA-accredited importing companies for goods imported into Canada. The Company’s ownership of the former Great Lakes Transportation vessels is subject to regulation by the U.S. Coast Guard and the Department of Transportation, Maritime Administration, which regu- late the ownership and operation of vessels operating on the Great Lakes and in U.S. coastal waters. On February 4, 2004, the Maritime Administration and the U.S. Coast Guard issued a Joint Notice of Proposed Rulemaking, proposing modifications to the regulations gov- erning vessel documentation for lease financing for vessels engaged in the coastwise trade. In addition, the U.S. Congress has from time to time considered modifications to the legislation governing the United States coastwise trade. As a result of maritime legislation enacted in 2004, the regulations governing the Company’s acquisition of these vessels should not be affected. No assurance can be given that any future legislative or regulatory initiatives by the U.S. federal government will not materially adversely affect the Company’s operations, or its competitive and financial position. Business prospects and 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 commodi- ties carried by the Company experience cyclicality in demand. Many of the bulk commodities the Company transports move offshore and are affected more by global rather than North American economic condi- tions. The Company’s results of operations can be expected to reflect these conditions because of the significant fixed costs inherent in rail- road operations. Global, as well as North American trade 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 transportation infrastructure, including railway infrastructure in North America, and interfere with the free flow of goods. International conflicts can also have an impact on the Company’s markets. Although the Company conducts its business and receives rev- enues 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. Based on the Company’s current operations, the estimated annual impact on net income of a year-over-year one- cent change in the Canadian dollar relative to the U.S. dollar is approxi- mately $8 million. 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. 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 adversely affected. In addition to the inherent risks of the business cycle, the Company’s operations are occasionally susceptible to severe weather conditions, which can disrupt operations and service for the railroad as well as for the Company’s customers. Recent severe drought conditions in western Canada, for instance, significantly reduced bulk commodity revenues, principally grain. 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. 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-15(e) and 15d- 15(e)) as of December 31, 2004, 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. During the fourth quarter ending December 31, 2004, there was no change in the Company’s internal control over financial reporting that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting. Additional information, including the Company’s 2003 Annual Information Form and Form 40-F, may be found on SEDAR at www.sedar.com and on EDGAR at www.sec.gov/edgar.shtml, respectively. Montreal, Canada January 25, 2005 104 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 esti- mates and judgments. Financial information used elsewhere in the annual report is consistent with these 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 exten- sive 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 state- ments and annual report and recommends their approval by the Board of Directors. Also, the Audit, Finance and Risk Committee meets regu- larly 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, 2004 and 2003 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, 2004. 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 generally accepted auditing standards and with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform an audit to obtain reasonable assur- ance whether the financial statements are free of material misstate- ment. 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, 2004 and 2003, and the results of its operations and its cash flows for each of the years in the three-year period ended December 31, 2004, in accordance with Canadian generally accepted accounting principles. On January 25, 2005, 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. Claude Mongeau Executive Vice-President and Chief Financial Officer January 25, 2005 KPMG LLP Chartered Accountants Montreal, Canada January 25, 2005 Serge Pharand Vice-President and Corporate Comptroller January 25, 2005 Canadian GAAP Canadian National Railway Company 105 Consolidated Statement of Income In millions, except per share data Year ended December 31, 2004 2003 2002 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 Purchased services and material Depreciation and amortization Fuel Equipment rents Casualty and other (Note 2) Total operating expenses Operating income Interest expense (Note 14) Other income (loss) (Note 15) Income before income taxes Income tax expense (Note 16) Net income Basic earnings per share (Note 18) Diluted earnings per share (Note 18) $1,123 713 1,452 284 1,053 1,117 510 296 6,548 1,838 746 517 528 244 445 4,318 2,230 (282) (20) 1,928 (631) $1,297 $««4.55 $««4.48 $1,058 527 1,284 261 938 1,101 525 190 5,884 1,929 879 472 471 299 466 4,516 1,368 (317) 21 1,072 (338) $÷«734 $««2.56 $««2.52 $1,102 521 1,323 326 986 1,052 591 209 6,110 2,069 908 499 459 353 724 5,012 1,098 (353) 76 821 (268) $÷«553 $««1.85 $««1.82 See accompanying notes to consolidated financial statements. 106 Canadian National Railway Company Canadian GAAP Consolidated Balance Sheet In millions Assets Current assets: Cash and cash equivalents Accounts receivable (Note 4) Material and supplies Deferred income taxes (Note 16) Other Properties (Note 5) Intangible and other assets (Note 6) Total assets Liabilities and shareholders’ equity Current liabilities: Accounts payable and accrued charges (Note 8) Current portion of long-term debt (Note 10) Other Deferred income taxes (Note 16) Other liabilities and deferred credits (Note 9) Long-term debt (Note 10) Shareholders’ equity: Common shares (Note 11) Contributed surplus Currency translation Retained earnings December 31, 2004 2003 $÷÷«147 793 127 393 194 1,654 16,688 929 $19,271 $÷÷«130 529 120 125 188 1,092 15,158 900 $17,150 $÷1,605 578 76 $÷1,421 483 73 2,259 3,591 1,488 4,586 3,587 164 (80) 3,676 7,347 1,977 3,365 1,153 4,175 3,530 166 (38) 2,822 6,480 Total liabilities and shareholders’ equity $19,271 $17,150 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 107 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, 2001 Net income Stock options exercised (Notes 11, 12) Conversion of convertible 289.1 – 2.7 preferred securities (Note 11) Share repurchase program (Note 11) Currency translation Dividends ($0.57 per share) Dividends on convertible preferred securities Balances December 31, 2002 Net income Stock options exercised and other (Notes 11, 12) Share repurchase program (Note 11) Currency translation Dividends ($0.67 per share) Balances December 31, 2003 Net income Stock options exercised and other (Notes 11, 12) Share repurchase program (Note 11) Currency translation Dividends ($0.78 per share) Balances December 31, 2004 9.0 (4.5) – – – 296.3 – 2.9 (15.0) – – 284.2 – 2.9 (4.0) – – 283.1 6.9 – – (6.9) – – – – – – – – – – – – – – – – – $3,209 – 93 327 (53) – – – 3,576 – 136 (182) – – 3,530 – 107 (50) – – $«327 – – (327) – – – – – – – – – – – – – – – – $178 – – «$133 – – $2,514 553 – $6,361 553 93 – (3) – – – 175 – – (9) – – 166 – – (2) – – – – (1) – – 132 – – – (170) – (38) – – – (42) – – (147) – (170) (6) 2,744 734 – (465) – (191) 2,822 1,297 – (221) – (222) – (203) (1) (170) (6) 6,627 734 136 (656) (170) (191) 6,480 1,297 107 (273) (42) (222) $3,587 $÷÷«– $164 $«(80) $3,676 $7,347 See accompanying notes to consolidated financial statements. 108 Canadian National Railway Company Canadian GAAP Consolidated Statement of Cash Flows In millions Operating activities Net income Year ended December 31, 2004 2003 2002 $«1,297 $««««734 $««««553 Adjustments to reconcile net income to net cash provided from operating activities: Depreciation and amortization Deferred income taxes (Note 16) Equity in earnings of English Welsh and Scottish Railway (Note 15) Charge to increase U.S. personal injury and other claims liability (Note 2) Workforce reduction charge (Note 9) Other changes in: Accounts receivable Material and supplies Accounts payable and accrued charges Other net current assets and liabilities Other Cash provided from operating activities Investing activities Net additions to properties Acquisition of BC Rail (Note 3) Acquisition of GLT (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 Cash and cash equivalents, end of year Supplemental cash flow information Net cash receipts from customers and other Net cash payments for: Employee services, suppliers and other expenses Interest (Note 14) Workforce reductions (Note 9) Personal injury and other claims (Note 19) Pensions (Note 13) Income taxes (Note 16) Cash provided from operating activities See accompanying notes to consolidated financial statements. 521 401 4 – – (233) 10 5 21 113 2,139 (1,072) (984) (547) 192 (2,411) (222) 8,277 (7,579) 86 (273) 511 17 130 478 232 (17) – – 153 (3) (96) (27) 46 506 156 (33) 281 120 (80) – (154) (18) (158) 1,500 1,173 (583) – – (16) (599) (191) 4,109 (4,141) 83 (656) (605) 105 25 (571) – – 95 (476) (179) 3,146 (3,558) 69 (203) (546) (28) 53 $««««147 $««««130 $««««««25 $«6,501 $«6,022 $«6,285 (3,628) (282) (93) (106) (161) (92) (3,736) (327) (155) (126) (92) (86) (4,231) (390) (177) (156) (93) (65) $«2,139 $«1,500 $«1,173 Canadian GAAP Canadian National Railway Company 109 Notes to Consolidated Financial Statements Canadian National Railway Company (CN or the Company), directly and through its subsidiaries, is engaged in the rail and related 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 principles applied in the accompanying financial statements and those under United States generally accepted accounting principles (U.S. GAAP) are quantified and explained in Note 21 to the financial state- ments. 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 rev- enues 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 claims, depreciation, pensions and other post-retirement benefits, and income taxes, based upon currently avail- able information. Actual results could differ from these estimates. A. Principles of consolidation These consolidated financial statements include the accounts of all subsidiaries, including Great Lakes Transportation LLC’s railroads and related holdings (GLT) and BC Rail for which the Company acquired control and consolidated effective May 10, 2004 and July 14, 2004, respectively. 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-sustain- ing 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 dollars 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 designates the 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 approximates market value. E. Accounts receivable Accounts receivable are recorded at cost net of the provision for doubt- ful 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 dis- counted 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. 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 addi- tions are the costs of developing computer software for internal use. Maintenance costs are expensed as incurred. 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 held and used whenever events or changes in circumstances indicate that such carry- ing 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 recognized in income when the asset meets the criteria for classification as held for sale whereas losses resulting from aban- donment are recognized in income when the asset ceases to be used. Gains are recognized in income when they are realized. 110 Canadian National Railway Company Canadian GAAP Notes to Consolidated Financial Statements H. Depreciation The cost of properties, including those under capital leases, net of asset impairment write-downs, is depreciated on a straight-line basis over their estimated useful lives as follows: 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. Asset class Track and roadway Rolling stock Buildings Other Annual rate 2% 3% 6% 4% The Company follows the group method of depreciation for railroad properties and, as such, conducts comprehensive depreciation studies on a periodic basis to assess the reasonableness of the lives of proper- ties based upon current information and historical activities. Changes in estimated useful lives are accounted for prospectively. I. Intangible assets Intangible assets relate to customer contracts and relationships assumed through recent acquisitions and are being amortized on a straight-line basis over 40 to 50 years. J. Pensions Pension costs are determined using actuarial methods. Net periodic benefit cost is charged to income 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 cov- ered 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 balances 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. K. 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, and free rail travel benefits. L. Personal injury claims In Canada, the Company accounts for costs related to employee work- related injuries based on actuarially developed estimates of the ulti- mate cost associated with such injuries, including compensation, health care and administration costs. In the U.S., the Company accrues the expected cost for personal injury claims and asserted occupational disease claims, based on actuarial estimates of their ultimate cost. A liability for the minimum amount of unasserted occupational disease claims is also accrued to the extent they 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 opera- tions 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. 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 sub- stantively enacted tax rates expected to apply to taxable income in the years in which temporary differences are expected to be recov- ered or settled. O. Derivative financial instruments The Company uses derivative financial instruments in the manage- ment of its fuel exposure, and may use them from time to time, in the management 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 derivative financial instrument. Income and expense related to hedged derivative financial instruments are recorded in the same cat- egory as that generated by the underlying asset or liability. P. Stock-based compensation The Company follows the fair value based approach for stock option awards and retroactively applied this method of accounting to all awards of employee stock options granted, modified or settled on Canadian GAAP Canadian National Railway Company 111 Notes to Consolidated Financial Statements 1 Summary of significant accounting policies (continued) or after January 1, 2002 and restated the 2002 comparative period to reflect this change in accounting policy, as explained in Note 2 – Accounting changes. For awards of conventional and performance- based employee stock options granted before January 1, 2002, the Company did not record compensation cost, and any consideration paid by employees on the exercise of stock options was recorded as share capital. 2 Accounting changes 2004 Property capitalization Effective January 1, 2004, the Company changed its capitalization policy under Canadian GAAP, on a prospective basis, to conform with the Canadian Institute of Chartered Accountants (CICA) Handbook Section 3061, “Properties, Plant and Equipment.” The change was made in response to the CICA Handbook Section 1100, “Generally Accepted Accounting Principles,” issued in July 2003. This section provides new accounting guidance as to what constitutes GAAP in Canada and its sources, thereby codifying a GAAP hierarchy. The section also estab- lishes that when financial statements are prepared in accordance with regulatory or legislative requirements that are in conflict with the new GAAP hierarchy, they cannot be described as being in accordance with Canadian GAAP. The Company’s accounting for Properties under Canadian GAAP had been based on the rules and regulations of the Canadian Transportation Agency’s (CTA) Uniform Classification of Accounts, which for railways in Canada, were considered Canadian GAAP prior to the issuance of Section 1100. Under the CTA rules, the Company capitalized only the material component of track replacement costs, to the extent it met the Company’s minimum threshold for capitalization. In accor- dance with the CICA Handbook Section 3061, “Properties, Plant and Equipment,” the Company now capitalizes the cost of labor, material and related overhead associated with track replacement activities pro- vided they meet the Company’s minimum threshold for capitalization. Also, all major expenditures for work that extends the useful life and/or improves the functionality of bridges, other structures and freight cars, are capitalized. For the year ended December 31, 2004, net income increased by $312 million ($464 million before tax), as a result of the change in the capitalization policy. 2003 Stock-based compensation Effective January 1, 2003, the Company adopted the fair value based approach recommended by CICA Handbook Section 3870, “Stock-Based Compensation and Other Stock-Based Payments.” The Company retro- actively applied this method of accounting to all awards of employee stock options granted, modified or settled on or after January 1, 2002 and restated the 2002 comparative period to reflect this change in accounting policy. For the year ended December 31, 2002, the restate- ment had the effect of decreasing net income by $18 million ($0.06 per basic and diluted share), through increased labor and fringe benefits expense. The restatement also had the effect of increasing the book value of common shares and decreasing retained earnings by $18 mil- lion at December 31, 2002. In 2002, prior to the adoption of the fair value based approach, the Company had applied the intrinsic value method of accounting to its awards of conventional and performance-based employee stock options granted on or after January 1, 2002 and as a result, no compensation cost had been recognized for the year ended December 31, 2002 as no performance-based employee stock options were granted. For awards of conventional and performance-based employee stock options granted before January 1, 2002, the Company did not record compensation cost, and any consideration paid by employees on the exercise of stock options was recorded as share capital. The Company granted 3.0 million and 4.8 million stock options during 2003 and 2002, respectively, which will be expensed over their vesting period based on their estimated fair values on the date of grant, determined using the Black-Scholes option-pricing model. For the years ended December 31, 2003 and 2002, the Company recognized compen- sation cost of $50 million and $18 million, respectively. 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 dam- age, from a case-by-case approach to an actuarial-based approach. Consequently, for the year ended December 31, 2002, 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 expected cost for personal injury and property damage claims and asserted 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 unas- serted occupational disease claims was accrued to the extent they were reasonably estimable. 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. In 2002, the Company’s U.S. personal injury and other claims expense, including the above-mentioned charge, was $362 million. 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. 112 Canadian National Railway Company Canadian GAAP Notes to Consolidated Financial Statements 3 Acquisitions BC Rail In November 2003, the Company entered into an agreement with British Columbia Railway Company, a corporation owned by the Government of the Province of British Columbia (Province), to acquire all the issued and outstanding shares of BC Rail Ltd. and all the part- nership units of BC Rail Partnership (collectively BC Rail), and the right to operate over BC Rail’s roadbed under a long-term lease, for a pur- chase price of $1 billion. On July 2, 2004, the Company reached a consent agreement with Canada’s Competition Bureau, allowing for the closing of the trans- action, whereby the Company reaffirmed its commitment to share merger efficiencies with BC Rail shippers and assure them competitive transportation options through its Open Gateway Rate and Service Commitment. The consent agreement also maintains competitive rates and service for grain shippers in the Peace River region. On July 14, 2004, the Company completed its acquisition of BC Rail and began a phased integration of the companies’ operations. The acquisition was financed by debt and cash on hand. The Company accounted for the acquisition using the pur- chase method of accounting as required by Section 1581, “Business Combinations,” and Section 3062, “Goodwill and Other Intangible Assets,” of the CICA Handbook. As such, the accompanying consoli- dated financial statements include the assets, liabilities and results of operations of BC Rail as of July 14, 2004, the date of acquisition. The Company’s cost to acquire BC Rail of $991 million includes purchase price adjustments and transaction costs. The following table reflects the preliminary purchase price allocation, based on the fair value of BC Rail’s assets acquired, owned and leased, and liabilities assumed at acquisition, which is subject to a final valuation, the impact of which is not expected to have a material effect on the results of operations. In millions Current assets Deferred income taxes Properties Other assets Total assets acquired Current liabilities Other liabilities and deferred credits Long-term debt Total liabilities assumed Net assets acquired Great Lakes Transportation LLC’s Railroads and Related Holdings In October 2003, the Company, through an indirect wholly owned subsidiary, entered into an agreement for the acquisition of GLT for a purchase price of U.S.$380 million. As of April 2004, the Company received all necessary regulatory approvals, including the U.S. Surface Transportation Board (STB) ruling rendered on April 9, 2004. On May 10, 2004, the Company completed its acquisition of GLT and began a phased integration of the companies’ operations. The acquisition was financed by debt and cash on hand. The Company accounted for the acquisition using the purchase method of accounting. As such, the accompanying consolidated finan- cial statements include the assets, liabilities and results of operations of GLT as of May 10, 2004, the date of acquisition. The Company’s cost to acquire GLT of U.S.$395 million (Cdn$547 million) includes purchase price adjustments and transaction costs. The following table reflects the preliminary purchase price allocation, based on the fair value of GLT’s assets acquired and liabilities assumed at acquisition, which is subject to a final valuation, the impact of which is not expected to have a material effect on the results of operations. In millions Current assets Properties Intangible and other assets Total assets acquired Current liabilities Deferred income taxes Other liabilities and deferred credits Total liabilities assumed Net assets acquired 4 Accounts receivable In millions Freight Trade Accrued Non-freight May 10, 2004 $÷÷«67 977 87 1,131 64 290 230 584 $÷«547 December 31, 2004 2003 $414 93 356 863 (70) $793 $252 55 277 584 (55) $529 July 14, 2004 Provision for doubtful accounts $÷«202 397 620 3 1,222 76 142 13 231 $÷«991 The Company has an accounts receivable securitization program, expiring in June 2006, under which it may sell, on a revolving basis, a maximum of $450 million of eligible freight trade and other receivables outstanding at any point in time, to an unrelated trust. The Company has a contingent residual interest of approximately 10% of receivables sold, which is recorded in Other current assets. The Company has retained the responsibility for servicing, administering and collecting freight receivables sold. Other income (loss) included $9 million in each of 2004, 2003 and 2002, for costs related to the agreement, which fluctuate with changes in prevailing interest rates. At December 31, 2004, pursuant to the agreement, $445 million had been sold compared to $448 million at December 31, 2003. Canadian GAAP Canadian National Railway Company 113 Notes to Consolidated Financial Statements 5 Properties In millions Track, roadway and land Rolling stock Buildings Other Capital leases included in properties Track and roadway Rolling stock Buildings Other December 31, 2004 Accumulated depreciation $3,697 1,466 771 514 Cost $16,105 4,059 1,915 1,057 $23,136 $6,448 $÷÷«395 1,155 110 119 $÷÷÷«7 265 6 7 $÷1,779 $÷«285 Net $12,408 2,593 1,144 543 $16,688 $÷÷«388 890 104 112 $÷1,494 December 31, 2003 Accumulated depreciation $3,544 1,399 817 505 Cost $15,094 3,658 1,773 898 Net $11,550 2,259 956 393 $21,423 $6,265 $15,158 $÷÷÷«41 1,213 21 105 $÷÷÷«4 275 4 7 $÷÷÷«37 938 17 98 $÷1,380 $÷«290 $÷1,090 6 Intangible and other assets In millions December 31, Prepaid benefit cost (Note 13) Investments (A) Deferred receivables Intangible assets (B) Note receivable from EWS Unamortized debt issue costs Other (Cdn$141 million) in cash and a note receivable of £23.9 million (Cdn$58 million) from EWS. The note receivable is due in 2009, carries interest at 8% and is redeemable in whole or in part at any time by EWS, at the principal amount together with accrued but unpaid interest up to the date of repayment. B. Intangible assets Intangible assets relate to customer contracts and relationships assumed through the GLT acquisition. 2004 $515 166 77 69 57 35 10 $929 2003 $411 367 69 – – 35 18 $900 A. Investments As at December 31, 2004, the Company had $157 million ($356 million at December 31, 2003) of investments accounted for under the equity method and $9 million ($11 million at December 31, 2003) of invest- ments accounted for under the cost method. Investment in English Welsh and Scottish Railway (EWS) As at December 31, 2004, the Company owned approximately 32% of EWS, a company which provides most of the rail freight services in Great Britain and operates freight trains through the English Channel tunnel, and accounted for this investment using the equity method. At December 31, 2004, the excess of the Company’s share of the book value of EWS’ net assets over the carrying value of the investment was not significant. On January 6, 2004, EWS shareholders approved a plan to reduce the EWS share capital to enable cash to be returned to the shareholders by offering them the ability to cancel a portion of their EWS shares. For each share cancelled, EWS shareholders would receive a combination of cash and notes receivable. The Company elected to have the maximum allowable number of shares cancelled under the plan, thereby reducing its ownership interest in EWS to approximately 31% on a fully diluted basis (13.7 million shares) compared to approximately 37% on a fully diluted basis (43.7 million shares) prior to the capital reorganization. In the first quarter of 2004, the Company received £57.7 million 7 Credit facility The Company has a U.S.$1,000 million three-year revolving credit facil- ity expiring in December 2005, which it intends to renew before such date. 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. The Company has been in compliance with these financial covenants. The Company’s borrowings of U.S.$180 million (Cdn$233 million) outstanding at December 31, 2003 at an average interest rate of 1.49% were entirely repaid in the first quarter of 2004. At December 31, 2004, the Company had borrowings under its revolving credit facility of U.S.$90 million (Cdn$108 million) at an aver- age interest rate of 2.77% and letters of credit drawn of $342 million. The Company’s commercial paper program is backed by its revolv- ing credit facility. As at December 31, 2004, the Company had U.S.$211 million (Cdn$254 million) of commercial paper outstanding at an aver- age interest rate of 2.37%, compared to no commercial paper outstand- ing as at December 31, 2003. 114 Canadian National Railway Company Canadian GAAP Notes to Consolidated Financial Statements 8 Accounts payable and accrued charges (ii) Funded status In millions Trade payables Income and other taxes Payroll-related accruals Accrued charges Personal injury and other claims provision Accrued interest Workforce reduction provisions Other December 31, 2004 $÷«491 310 259 179 118 106 90 52 $1,605 2003 In millions December 31, $÷«444 Unfunded benefit obligation at end of year 270 205 131 123 94 89 65 Unrecognized net actuarial gain (loss) Unrecognized prior service cost Accrued benefit cost for post-retirement benefits other than pensions (including current portion) (iii) Components of net periodic benefit cost $1,421 In millions Year ended December 31, 9 Other liabilities and deferred credits In millions December 31, 2004 2003 Personal injury and other claims provision, net of current portion Workforce reduction provisions, net of current portion (A) Accrual for post-retirement benefits other than pensions (B) Accrued benefit cost for pensions (Note 13) Environmental reserve, net of current portion Deferred credits and other $÷«524 149 284 156 93 282 $1,488 $÷«467 136 139 126 62 223 Current service cost – employer portion Interest cost Plan amendments Actuarial loss (gain) on accrued benefit obligation Cost arising in the period Difference between cost arising in the period and cost recognized in the period in respect of: Actuarial loss (gain) Plan amendments Net periodic benefit cost 2004 $÷÷«8 17 (12) (111) (98) 112 15 $÷«29 2004 $319 6 (16) 2003 $«309 (112) (33) $309 $«164 2003 $÷«5 18 8 29 60 2002 $÷÷4 15 18 95 132 (22) (5) (92) (15) $«33 $÷25 $1,153 (iv) Weighted-average assumptions A. Workforce reduction provisions 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 retirement, the majority of which will be disbursed within the next five years. In 2004, liabilities assumed through recent acquisitions and other charges and adjustments increased the provisions by $107 million. Payments have reduced the provisions by $93 million for the year ended December 31, 2004 ($155 million for the year ended December 31, 2003). As at December 31, 2004, the aggregate provisions, including the current por- tion, amounted to $239 million ($225 million as at December 31, 2003). In 2002, the Company had 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. Reductions relating to this charge were completed in 2003. B. Post-retirement benefits other than pensions (i) Change in benefit obligation In millions Year ended December 31, Benefit obligation at beginning of year Acquisition of GLT and BC Rail Amendments Actuarial (gain) loss Interest cost Service cost Foreign currency changes Benefits paid Benefit obligation at end of year 2004 $«309 151 (12) (111) 17 8 (25) (18) $«319 2003 $311 – 8 29 18 5 (44) (18) $309 The Company uses a measurement date of September 30 for its U.S. plans and December 31 for its Canadian plans. December 31, 2004 2003 2002 To determine benefit obligation Discount rate Rate of compensation increase To determine net periodic benefit cost Discount rate Rate of compensation increase 5.90% 3.75% 6.00% 3.75% 6.69% 4.00% 6.00% 3.75% 6.69% 4.00% 7.14% 4.00% (v) For measurement purposes, increases in the per capita cost of cov- ered health care benefits were assumed to be 14% for 2005 and 15% for 2004. It is assumed that the rate will decrease gradually to 6% in 2013 and remain at that level thereafter. A one-percentage-point change in the assumed health care cost trend rates would have the following effect: In millions Effect on total service and interest costs Effect on benefit obligation One-percentage-point Increase Decrease $÷2 28 $÷(2) (24) The Medicare Prescription Drug, Improvement, and Modernization Act of 2003 (the “Act”), signed into law in the United States in December 2003, provides for prescription drug benefits under Medicare, as well as a federal subsidy to sponsors of retiree health care benefit plans that provide prescription drug benefits that have been concluded to be actuarially equivalent to the Medicare benefit. Pursuant to guidance by the Financial Accounting Standards Board (FASB) in the United States, adopted on July 1, 2004, the Company evaluated and determined the Canadian GAAP Canadian National Railway Company 115 Notes to Consolidated Financial Statements 9 Other liabilities and deferred credits (continued) prescription drug benefits provided by its health care plans to be actu- arially equivalent to the Medicare benefit under the Act. The Company measured the effects of the Act on the accumulated post-retirement benefit obligation (APBO) as of January 1, 2004 and, as such, the APBO was reduced by $49 million. Net periodic benefit cost for the year ended December 31, 2004 was reduced by $7 million due to the effects of the Act. (vi) The estimated future benefit payments for each of the next five years and the subsequent five-year period are as follows: In millions 2005 2006 2007 2008 2009 Years 2010 to 2014 $÷20 21 22 22 23 130 10 Long-term debt In millions Debentures and notes: (A) Canadian National series: 7.00% 10-year notes 6.45% Puttable Reset Securities (PURS) (B) 4.25% 5-year notes (C) 6.38% 10-year notes (C) 4.40% 10-year notes (C) 6.80% 20-year notes (C) 7.63% 30-year debentures 6.90% 30-year notes (C) 7.38% 30-year debentures (C) 6.25% 30-year notes (C) Illinois Central series: 7.75% 10-year notes 6.98% 12-year notes 6.63% 10-year notes 5.00% 99-year income debentures 7.70% 100-year debentures Wisconsin Central series: 6.63% 10-year notes BC Rail series: Currency in which payable Maturity Mar. 15, 2004 July 15, 2006 Aug. 1, 2009 Oct. 15, 2011 Mar. 15, 2013 July 15, 2018 May 15, 2023 July 15, 2028 Oct. 15, 2031 Aug. 1, 2034 May 1, 2005 July 12, 2007 June 9, 2008 Dec. 1, 2056 Sept. 15, 2096 April 15, 2008 U.S.$ 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.$ Non-interest bearing 90-year subordinated notes (D) July 14, 2094 CDN$ Total debentures and notes Other: Revolving credit facility (A) (Note 7) Commercial paper (E) (Note 7) Capital lease obligations and other (F) Total other Less: Current portion of long-term debt Net unamortized discount U.S.$ U.S.$ Various 116 Canadian National Railway Company Canadian GAAP December 31, 2004 2003 $÷«÷÷– $÷«344 301 361 482 482 241 181 572 241 602 120 60 24 9 151 181 4,008 843 4,851 108 254 805 1,167 6,018 578 854 1,432 324 – 518 518 259 194 615 259 – 129 65 26 10 162 194 3,617 – 3,617 233 – 822 1,055 4,672 483 14 497 $4,586 $4,175 Notes to Consolidated Financial Statements A. The Company’s debentures, notes and revolving credit facility 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 exer- cised, the imbedded put option is automatically triggered, resulting in the redemption 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 con- ditions then prevailing. 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. • H. The aggregate amount of debt payable in U.S. currency as at December 31, 2004 is U.S.$4,022 million (Cdn$4,845 million) and U.S.$3,273 million (Cdn$4,236 million) as at December 31, 2003. I. The Company has U.S.$200 million available under its currently effec- tive shelf prospectus and registration statement providing for the issu- ance of debt securities in one or more offerings. 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 D. The Company records these notes as a discounted debt of $5 million, using an imputed interest rate of 5.75%. The discount of $838 million is included in the net unamortized discount. E. The Company has a commercial paper program, which is backed by its revolving credit facility, enabling it to issue commercial paper up to a maximum aggregate principal amount of $800 million, or the U.S. dol- lar equivalent. At December 31, 2004, the amounts outstanding under both the revolving credit facility and the commercial paper program have been presented as short-term debt given the maturity in December 2005 of the revolving credit facility. During 2003, the commercial paper debt was due within one year but was 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. F. Interest rates for the capital leases range from approximately 2.23% to 13.13% with maturity dates in the years 2005 through 2025. The imputed interest on these leases amounted to $342 million as at December 31, 2004 and $395 million as at December 31, 2003. The capital lease obligations are secured by properties with a net carrying amount of $1,054 million as at December 31, 2004 and $1,091 million as at December 31, 2003. During 2004, the Company recorded $160 million in assets it acquired through the exercise of purchase options on existing leases and leases for new equipment ($47 million in 2003). An equivalent amount was recorded in debt. G. Long-term debt maturities, including repurchase arrangements and capital lease repayments on debt outstanding as at December 31, 2004, for the next five years and thereafter, are as follows: In millions 2005 2006 2007 2008 2009 2010 and thereafter $÷«578 376 154 230 427 3,399 B. Issued and outstanding common shares During 2004, the Company issued 2.9 million shares (2.9 million shares in 2003 and 2.7 million shares in 2002) related to stock options exer- cised. The total number of common shares issued and outstanding was 283.1 million as at December 31, 2004. In 2002, the Company issued 9.0 million common shares related to the conversion of the Company’s convertible preferred securities. 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 had 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.$25.65 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 9.0 million common shares of the Company. In 1999, the Company had issued 6.9 million 5.25% Securities due on June 30, 2029, at U.S.$33.33 per Security. These Securities were sub- ordinated securities convertible into common shares of CN at the option of the holder at an original conversion price of U.S.$25.65 per common share, representing an original conversion rate of 1.2995 common shares for each Security. D. Share repurchase program On October 26, 2004, the Board of Directors of the Company approved a share repurchase program which allows for the repurchase of up to 14.0 million common shares between November 1, 2004 and October 31, 2005 pursuant to a normal course issuer bid, at prevailing market prices. As at December 31, 2004, 4.0 million common shares have been repurchased for $273 million, at an average price of $68.31 per share. Canadian GAAP Canadian National Railway Company 117 Notes to Consolidated Financial Statements 11 Capital stock and convertible preferred securities (continued) The Company’s previous share repurchase program initiated in 2002 allowed for the repurchase of up to 19.5 million common shares between October 25, 2002 and October 24, 2003 pursuant to a normal course issuer bid, at prevailing market prices. By October 2003, the Company had completed its program, repurchasing 19.5 million com- mon shares for $859 million, at an average price of $44.04 per share (15.0 million and 4.5 million shares in 2003 and 2002, respectively). E. Common stock split On January 27, 2004, the Board of Directors of the Company approved a three-for-two common stock split which was effected in the form of a stock dividend of one-half additional common share of CN payable for each share held. The stock dividend was paid on February 27, 2004, to shareholders of record on February 23, 2004. All equity-based ben- efit plans were adjusted to reflect the issuance of additional shares or options due to the declaration of the stock split. All share and per share data has been adjusted to reflect the stock split. 12 Stock plans The Company has various stock-based incentive plans for eligible employees. A description of the Company’s major plans is provided below: Employee share investment plan The Company has an Employee Share Investment Plan (ESIP) giving eligible employees the opportunity to subscribe for up to 10% (6% prior to 2003) 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, up to 6% of their gross salaries. Participation at December 31, 2004 was 10,073 employees (8,894 at December 31, 2003 and 8,911 at December 31, 2002). The total number of ESIP shares purchased on behalf of employees, including the Company’s contributions, was 723,663 in 2004, 855,210 in 2003 and 746,189 in 2002, resulting in a pre-tax charge to income of $11 million, $8 million and $9 million for the years ended December 31, 2004, 2003 and 2002, respectively. Stock-based plans Compensation cost for awards under all stock-based plans was $84 million, $50 million and $18 million for the years ended December 31, 2004, 2003 and 2002, respectively. A. Restricted share units In 2004, the Company granted approximately 1.2 million restricted share units (RSUs) to designated management employees entitling them to receive payout in cash based on the Company’s share price. The RSUs granted are generally scheduled for payout after three years and vest upon the attainment of targets relating to return on invested capital over the three-year period and to the Company’s share price during the three-month period ending December 31, 2006. If specified targets related to the Company’s 20-day average share price are attained during any period ending on or after December 31, 2005, payout can be accelerated. For the year ended December 31, 2004, the Company recorded compensation cost of $36 million for RSUs. B. Mid-term incentive share unit plan The mid-term incentive share unit plan, approved by the Board of Directors in 2001, entitled designated senior management employees to receive payout on June 30, 2004. The share units vested conditionally upon the attainment of targets relating to the Company’s share price during the six-month period ending June 30, 2004. On June 30, 2004, upon the partial attainment of these targets, the Company recorded additional compensation cost of $13 million based on the number of share units vested multiplied by the Company’s share price on such date. For the year ended December 31, 2003, the Company recorded compensation cost of $7 million related to the plan and no compen- sation cost was recorded for 2002. C. Voluntary incentive deferral plan The Company has a voluntary incentive deferral plan (VIDP), provid- ing eligible senior management employees the opportunity to elect to receive their annual incentive bonus payment and other eligible incen- tive payments in deferred share units (DSUs). For each participant, the Company will grant 25% of DSUs, which will vest over a period of four years. A DSU is equivalent to a common share of the Company and also earns dividends when normal cash dividends are paid on common shares. The number of DSUs received by each participant is established using the average closing price for the 20 trading days prior to and including the date of the incentive payment. The value of each partici- pant’s DSUs is payable in cash at the time of cessation of employment. At December 31, 2004, the total liability under the VIDP was $22 million, representing 354,745 units outstanding under the plan. For the year ended December 31, 2004, the Company recognized an expense of $7 million related to the plan. 118 Canadian National Railway Company Canadian GAAP Notes to Consolidated Financial Statements D. 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 contin- uous employment. Options are not generally exercisable during the first 12 months after the date of grant. At December 31, 2004, an additional 1.2 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, performance options, which vest upon the attainment of Company targets relating to the operating ratio and unlevered return on investment, and performance-accelerated options, which vest on the sixth anniversary of the grant or prior if certain Company targets relating to return on investment and revenues are attained. The total conventional, performance, and performance- accelerated options outstanding at December 31, 2004 were 8.9 million, 1.3 million and 2.9 million, respectively. Changes in the Company’s stock options are as follows: Outstanding at December 31, 2001 (1) Granted Canceled and expired Exercised Outstanding at December 31, 2002 (1) Granted Canceled and expired Exercised Outstanding at December 31, 2003 (1) Granted Canceled and expired Exercised Outstanding at December 31, 2004 (1) Weighted- average exercise price Number of options In millions 14.9 4.8 (0.3) (2.7) 16.7 3.0 (0.6) (2.9) 16.2 – (0.2) (2.9) 13.1 $29.08 $51.19 $37.99 $26.11 $35.67 $40.95 $45.11 $26.60 $37.16 – $42.58 $28.70 $38.85 Stock options outstanding and exercisable as at December 31, 2004 were as follows: (1) Includes IC and WC converted stock options translated to Canadian dollars using the foreign exchange rate in effect at the balance sheet date. Range of exercise prices $ 9.00–$16.02 $18.13–$27.08 $27.31–$33.35 $37.17–$49.21 $51.05–$58.44 Balance at December 31, 2004 (1) Options outstanding Options exercisable Number of options In millions 0.2 1.6 4.1 3.1 4.1 13.1 Weighted- average years to expiration Weighted- average exercise price 1 4 5 8 7 6 $15.40 $23.33 $32.10 $40.98 $51.19 $38.85 Weighted- average exercise price Number of options In millions 0.2 1.6 3.3 1.1 2.0 8.2 $15.40 $23.33 $31.82 $41.03 $51.20 $35.55 (1) Includes IC and WC converted stock options translated to Canadian dollars using the foreign exchange rate in effect at the balance sheet date. At December 31, 2003 and 2002, the Company had 7.5 million and 7.4 million options exercisable at a weighted-average exercise price of $31.39 and $29.34, respectively. Compensation cost for awards of employee stock options granted, modified or settled on or after January 1, 2002 was determined using the fair value based approach in accordance with the CICA Handbook Section 3870, “Stock-Based Compensation and Other Stock-Based Payments,” as explained in Note 2 – Accounting changes. Compensation cost recognized for stock option awards was $28 million, $43 million and $18 million in 2004, 2003 and 2002, respectively. Compensation cost related to stock option awards under the fair value based approach was calculated using the Black-Scholes option- pricing model with the following assumptions: Year ended December 31, 2004 (1) 2003 Expected option life (years) Risk-free interest rate Expected stock price volatility Average dividend per share – – – – 2002 7.0 5.0 4.12% 5.79% 30% 30% $÷0.67 $÷0.57 Year ended December 31, 2004 (1) 2003 2002 Weighted average fair value of options granted $«– $11.88 $20.65 (1) The Company did not grant any stock option awards in 2004. Canadian GAAP Canadian National Railway Company 119 Notes to Consolidated Financial Statements 13 Pensions The Company has various retirement benefit plans under which sub- stantially all of its employees are entitled to benefits at retirement age, generally based on compensation and length of service and/or contributions. The information in the tables that follow pertains to all such plans. However, the following descriptions relate solely to the Company’s main pension plan, the CN Pension Plan (the Pension Plan), unless otherwise specified. Description of Pension 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. The Company utilizes a measurement date of December 31 for the Pension Plan. Funding policy Employee contributions to the Pension Plan are determined by the plan rules. Company contributions are in accordance with the require- ments of the Government of Canada legislation, The Pension Benefits Standards Act, 1985, and are determined by actuarial valuations con- ducted at least on a triennial basis. These valuations are made in accor- dance with legislative 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, 2003 and indicated a funding excess. Total contributions for all of the Company’s pension plans are expected to be approxi- mately $120 million in each of 2005, 2006 and 2007 based on the plans’ current position. All of the Company’s contributions are expected to be in the form of cash. 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. The assets of the Pension Plan have a fair market value of $12,256 million as at December 31, 2004 ($11,573 million at December 31, 2003). The Pension Plan’s target percentage allocation and weighted-average asset allocations as at December 31, 2004 and 2003, by asset category are as follows: Plan assets by category Equity securities Debt securities Real estate Other Target Allocation December 31, 2003 2004 53% 40% 4% 3% 100% 56% 34% 3% 7% 100% 56% 38% 3% 3% 100% The Company follows a disciplined investment strategy, which limits concentration of investments by asset class, foreign currency, sector or company. The Investment Committee of the Board of Directors has approved an investment policy that establishes long-term asset mix targets based on a review of historical returns achieved by worldwide investment markets. Investment managers may deviate from these targets but their performance is evaluated in relation to the market performance of the target mix. The Company does not anticipate the return on plan assets to fluctuate materially from related capital market indices. The Investment Committee reviews investments regularly with specific approval required for major investments in illiquid securities. The policy also permits the use of derivative financial instruments to implement asset mix decisions or to hedge existing or anticipated expo- sures. The Pension Plan does not invest in the securities of the Company or its subsidiaries. Weighted-average assumptions December 31, 2004 2003 2002 To determine benefit obligation Discount rate Rate of compensation increase To determine net periodic benefit cost Discount rate Rate of compensation increase Expected return on plan assets 5.75% 3.75% 6.00% 3.75% 6.50% 4.00% 6.00% 3.75% 8.00% 6.50% 4.00% 8.00% 6.50% 4.00% 9.00% 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, the expected composition of the plans’ assets as well as the expected long-term market returns in the future. The Company has elected to use a market- related value of assets, whereby realized and unrealized gains/losses and appreciation/depreciation in the value of the investments are recognized over a period of five years, while investment income is recognized immediately. Information about the Company’s defined benefit pension plans: (a) Change in benefit obligation In millions Year ended December 31, 2004 2003 Benefit obligation at beginning of year Acquisition of GLT and BC Rail Interest cost Actuarial loss Service cost Plan participants’ contributions Foreign currency changes Benefit payments and transfers Benefit obligation at end of year $12,020 684 733 349 124 55 (23) (805) $13,137 $11,376 – 720 482 103 60 (26) (695) $12,020 120 Canadian National Railway Company Canadian GAAP Notes to Consolidated Financial Statements (b) Change in plan assets (f) Estimated future benefit payments In millions Year ended December 31, 2004 2003 The estimated future benefit payments for each of the next five years and the subsequent five-year period are as follows: $11,671 611 165 55 (15) 1,371 (805) $13,053 $11,182 – 90 60 (15) 1,049 (695) $11,671 In millions 2005 2006 2007 2008 2009 Years 2010 to 2014 Fair value of plan assets at beginning of year Acquisition of GLT and BC Rail Employer contributions Plan participants’ contributions Foreign currency changes Actual return on plan assets Benefit payments and transfers Fair value of plan assets at end of year (c) Funded status In millions Deficiency of fair value of plan assets over benefit obligation at end of year (1) Unrecognized net actuarial loss (1) Unrecognized prior service cost Net amount recognized December 31, 2004 2003 14 Interest expense In millions Year ended December 31, Interest on debt and capital leases Interest income $«(84) 368 75 $359 $(349) 540 94 $«285 (1) Subject to future reduction for gain sharing under the terms of the plan. Cash interest payments (d) Amount recognized in the Consolidated Balance Sheet 15 Other income (loss) In millions December 31, Prepaid benefit cost (Note 6) Accrued benefit cost (Note 9) Net amount recognized 2004 $«515 (156) $«359 2003 $«411 (126) $«285 The accumulated benefit obligation for all defined benefit pension plans was $12,450 million and $11,381 million at December 31, 2004, and 2003, respectively. In millions Year ended December 31, Gain on disposal of properties Investment income Foreign exchange gain (loss) Equity in earnings of English Welsh and Scottish Railway (Note 6) Net real estate costs Other $÷«957 821 845 869 893 4,760 2002 $353 – $353 $390 2002 $«41 18 12 33 (15) (13) 2003 $318 (1) $317 $327 2003 $«56 1 (3) 17 (19) (31) $«21 $«76 2004 $282 – $282 $282 2004 $«32 5 (2) (4) (18) (33) $(20) (e) Components of net periodic benefit cost In millions Year ended December 31, Current service cost – employer portion Interest cost Actual return on plan assets Actuarial loss (gain) on accrued benefit obligation Cost arising in the period Difference between cost arising in the period and cost recognized in the period in respect of: Return on plan assets Actuarial loss (gain) Transition obligation Plan amendments Net periodic benefit cost 2004 $«÷«124 733 (1,371) 349 (165) 514 (346) – 19 $÷÷÷22 2003 2002 16 Income taxes $÷÷103 $«108 720 (1,049) 482 256 230 (478) 19 22 722 39 (86) 783 (913) 88 20 22 $÷÷÷49 $÷÷«– 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, Federal tax rate Income tax expense at the statutory Federal tax rate Income tax (expense) recovery resulting from: Provincial and other taxes Deferred income tax adjustments due to rate enactments Gain on disposals and dividends Adjustments to prior years’ income taxes (1) Other Income tax expense Cash payments for income taxes 2004 22.1% 2003 2002 24.1% 26.1% $÷«(426) $÷«(258) $÷«(219) (272) (144) (97) 2 10 11 44 $÷«(631) $÷«÷«92 (33) 11 44 42 – 6 – 42 $÷«(338) $÷«(268) $÷«÷«86 $÷«÷«65 (1) Adjustments relating mainly to the resolution of matters pertaining to prior years’ income taxes. Canadian GAAP Canadian National Railway Company 121 Notes to Consolidated Financial Statements 16 Income taxes (continued) 17 Segmented information The following table provides tax information for Canada and the United States: The Company operates in one business segment with operations in Canada and the United States. In millions Year ended December 31, 2004 2003 2002 Information on geographic areas $1,552 376 $1,928 $÷(222) (8) $÷(230) $÷(279) (122) $÷(401) $1,052 20 $1,072 $«882 (61) $«821 $÷÷(94) $(130) (12) 18 $÷(106) $(112) $÷(244) $(161) 12 5 $÷(232) $(156) In millions Revenues Canada U.S. In millions Properties Canada U.S. Year ended December 31, 2004 2003 2002 $4,126 2,422 $6,548 $3,707 $3,726 2,177 2,384 $5,884 $6,110 December 31, 2004 2003 $÷7,449 9,239 $16,688 $÷6,376 8,782 $15,158 Significant components of deferred income tax assets and liabilities 18 Earnings per share December 31, 2004 2003 Basic earnings per share Diluted earnings per share Year ended December 31, 2004 $4.55 $4.48 2003 2002 $2.56 $2.52 $1.85 $1.82 $÷÷«86 190 115 278 669 121 3,746 3,867 $3,198 $÷«644 2,554 $3,198 $3,198 393 $3,591 $÷÷«81 252 61 81 475 102 3,613 3,715 $3,240 $÷«630 2,610 $3,240 $3,240 125 $3,365 The following table provides a reconciliation between basic and diluted earnings per share: In millions Net income Year ended December 31, Dividends on convertible preferred securities (Note 11) Weighted-average shares outstanding Effect of dilutive securities and stock options Weighted-average diluted shares outstanding 2004 $1,297 – $1,297 285.1 4.5 289.6 2003 $734 2002 $553 – 6 $734 $547 286.8 3.9 290.7 295.0 9.2 304.2 For the years ended December 31, 2004, 2003 and 2002, the weighted-average number of stock options that were not included in the calculation of diluted earnings per share, as their inclusion would have had an anti-dilutive impact, was 0.2 million, 6.8 million and 4.8 million, respectively. The 2003 and 2002 figures have been adjusted for the three-for-two common stock split (see Note 11(E)). Income before income taxes Canada U.S. Current income taxes Canada U.S. Deferred income taxes Canada U.S. are as follows: In millions Deferred income tax assets Workforce reduction provisions Personal injury claims and other reserves Post-retirement benefits Losses and tax credit carryforwards Deferred income tax liabilities Net prepaid benefit cost for pensions Properties and other Total net deferred income tax liability Total net deferred income tax liability Canada U.S. Total net deferred income tax liability Net current deferred income tax asset Long-term deferred income tax liability It is more likely than not that the Company will realize its deferred income tax assets from the generation of future taxable income, as the payments for provisions, reserves and accruals are made and losses and tax credit carryforwards are utilized. At December 31, 2004, the Company had $794 million of operating loss carryforwards, mainly resulting from the BC Rail acquisition, available to reduce future taxable income expiring between 2005 and 2023. The Company recognized tax credits of $4 million in 2004 for research and development expenditures ($15 million in 2003 and $9 million in 2002) not previously recognized, which reduced the cost of properties. 122 Canadian National Railway Company Canadian GAAP Notes to Consolidated Financial Statements 19 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, 2004, the Company’s commitments under operating and capital leases were $992 million and $1,103 million, respectively. Minimum lease payments in each of the next five years and thereafter are as follows: In millions 2005 2006 2007 2008 2009 2010 and thereafter Less: imputed interest on capital leases at rates ranging from approximately 2.23% to 13.13% Present value of minimum lease payments included in debt Operating Capital $206 $÷«113 194 146 116 90 240 106 130 52 93 609 $992 1,103 342 $÷«761 Rent expense for operating leases was $242 million, $230 million and $269 million for the years ended December 31, 2004, 2003 and 2002, respectively. Contingent rentals and sublease rentals were not significant. B. Other commitments As at December 31, 2004, the Company had commitments to acquire railroad ties, rail, freight cars, locomotives and other equipment at an aggregate cost of $194 million. Furthermore, as at December 31, 2004, the Company had outstanding information technology service contracts of $18 million and agreements with fuel suppliers to purchase approxi- mately 56% of its anticipated 2005 volume, 19% of its anticipated 2006 volume, and 2% of its anticipated 2007 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’ com- pensation 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), which requires either the finding of fault through the U.S. jury system or individual settlements, and represent a major expense for the railroad industry. The Company follows an actuarial-based approach and accrues the expected cost for personal injury and property damage claims and asserted occupational disease claims, based on actuarial estimates of their ultimate cost. A liability for the minimum amount of unasserted occupational disease claims is also accrued to the extent they can be reasonably estimated. The amount recorded reflects a 25-year horizon as the Company expects that a large majority of these cases will be received over such period. In 2004, the Company’s expenses for personal injury and other claims, net of recoveries, were $149 million ($127 million in 2003 and $393 million in 2002) and payments for such items were $106 million ($126 million in 2003 and $156 million in 2002). As at December 31, 2004, the Company had aggregate reserves for personal injury and other claims of $642 million ($590 million at December 31, 2003). 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, 2004, 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, 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, treat- ment 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 potential environmental concerns that may be associated with its prop- erties may lead to future environmental investigations, which may result in the identification of additional environmental costs and liabilities. The Canadian GAAP Canadian National Railway Company 123 Notes to Consolidated Financial Statements 19 Major commitments and contingencies (continued) magnitude of such additional liabilities and the costs of complying with environmental laws and containing or remediating contamination can- not 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 operat- ing 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. In 2004, the Company’s expenses relating to environmental matters, net of recoveries, were $10 million ($6 million in both 2003 and 2002) and payments for such items were $8 million ($12 million in 2003 and $16 million in 2002). As at December 31, 2004, the Company had aggre- gate accruals for environmental costs of $113 million ($83 million as at December 31, 2003). The Company anticipates that the majority of the liability at December 31, 2004 will be paid out over the next five years. In addition, related environmental capital expenditures were $13 million in 2004, $23 million in 2003 and $19 million in 2002. The Company expects to incur capital expenditures relating to environmen- tal matters of approximately $20 million in 2005, $17 million in 2006 and $16 million in 2007. E. Guarantees and indemnifications In the normal course of business, the Company, including certain of its subsidiaries, enters into agreements that may involve providing certain guarantees or indemnifications to third parties and others, which extend over the term of the agreement. These include, but are not limited to, residual value guarantees on operating leases, standby letters of credit and surety bonds, and indemnifications that are customary for the type of transaction or for the railway business. Effective January 1, 2003, the Company is required to disclose its obligation undertaken in issuing certain guarantees on the date the guarantee is issued or modified. In addition, where the Company expects to make a payment in respect of a guarantee, a liability will be recognized to the extent that one has not yet been recognized. 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 2005 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. At December 31, 2004, the maximum exposure in respect of these guar- antees was $97 million, of which $6 million has been recorded. The Company has issued guarantees for which the fair value at December 31, 2004 was $2 million. There are no recourse provisions to recover any amounts from third parties. Other guarantees The Company, including certain of its subsidiaries, has granted irrevo- cable standby letters of credit and surety bonds, issued by highly rated financial institutions, to third parties to indemnify them in the event the Company does not perform its contractual obligations. As at December 31, 2004, the maximum potential liability under these guarantees was $439 million of which $359 million was for workers’ compensation and other employee benefits and $80 million was for equipment under leases and other. As at December 31, 2004, the Company had not recorded any additional liability with respect to these guarantees, as the Company does not expect to make any additional payments associated with these guarantees. The guarantee instruments mature at various dates between 2005 and 2007. CN Pension Plan, CN 1935 Pension Plan and BC Rail Ltd Pension Plan The Company has indemnified and held harmless the current trustee and the former trustee of the Canadian National Railways Pension Trust Funds, the trustee of the BC Rail Ltd Pension Trust Fund, 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, 2004, the Company had not recorded a liability associated with these indemnifications, as the Company does not expect to make any pay- ments pertaining to these indemnifications. 124 Canadian National Railway Company Canadian GAAP Notes to Consolidated Financial Statements 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 indemnifi- cation 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 prop- erty owned by third parties 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) con- tracts for the sale of assets and securitization of accounts receivable; (d) contracts for the acquisition of services; (e) financing agreements; (f) trust indentures, fiscal agency agreements, underwriting agree- ments 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; (h) trust agreements relating to pension plans and other plans, including those establishing trust funds to secure payment to certain officers and senior employees of special retirement compensa- tion arrangements; (i) master agreements with financial institutions governing derivative transactions; and (j) settlement agreements with insurance companies or other third parties whereby such insurer or third party has been indemnified for any present or future claims relat- ing to insurance policies, incidents or events covered by the settlement agreements. 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, such exposure cannot be determined with certainty. In 2004 and 2003, the Company entered into various indemnifica- tion contracts with third parties for which the maximum exposure for future payments cannot be determined with certainty. As a result, the Company was unable to determine the fair value of these guarantees. For guarantees for which the fair value was estimable, it was deter- mined to be $1 million. There are no recourse provisions to recover any amounts from third parties. 20 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 condition of its customers and reviews the credit history of each new customer. The Company is exposed to credit risk in the event of non-per- formance 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-perfor- mance are not anticipated. The total risk associated with the Company’s counterparties was immaterial at December 31, 2004. 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 pro- gram which calls for regularly entering into swap positions on crude and heating oil to cover a target percentage of future fuel consumption up to two years in advance. However, in the fourth quarter of 2004, the Company did not enter into any swap positions on crude and heating oil. At December 31, 2004, the Company had hedged approximately 50% of the estimated 2005 fuel consumption, representing approxi- mately 203 million U.S. gallons at an average price of U.S.$0.74 per U.S. gallon, and 17% of the estimated 2006 fuel consumption, representing 69 million U.S. gallons at an average price of U.S.$0.89 per U.S. gallon. Realized gains from the Company’s fuel hedging activities, which are recorded in fuel expense, were $112 million, $49 million, and $3 million for the years ended December 31, 2004, 2003 and 2002, respectively. As a result of fuel hedging activities, the Company had an unrealized gain of $92 million at December 31, 2004 compared to $38 million at December 31, 2003. (iii) Interest rate In the first quarter of 2004, in anticipation of future debt issuances, the Company had entered into treasury lock transactions for a notional amount of U.S.$380 million to fix the treasury component on these future debt issuances. Upon expiration in June 2004, these treasury rate locks were rolled into new contracts expiring in September 2004, at an average locked-in rate of 5.106%. The Company settled these treasury locks at a gain of U.S.$9 million (Cdn$12 million) upon the pricing of the U.S.$500 million 6.25% Debentures due 2034, subsequently issued on July 9, 2004 and recorded the gain into income, as a reduction of interest expense. (iv) 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. Canadian GAAP Canadian National Railway Company 125 Notes to Consolidated Financial Statements 20 Financial instruments (continued) 21 Reconciliation of Canadian and United States generally 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 designates the 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. (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, Other current assets, Accounts payable and accrued charges, and Other current liabilities: The carrying amounts approximate fair value because of the short maturity of these instruments. (ii) Other assets: Investments: The Company has various debt and equity investments for which the carrying value approximates the fair value, with the excep- tion 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. The following table presents the carrying amounts and estimated fair values of the Company’s financial instruments as at December 31, 2004 and 2003 for which the carrying values on the Consolidated Balance Sheet are different from their fair values: In millions December 31, 2004 December 31, 2003 Carrying amount Fair value Carrying amount Fair value accepted accounting principles The Consolidated Financial Statements of the Company are expressed in Canadian dollars and are prepared in accordance with Canadian GAAP which conform, in all material respects, with U.S. GAAP except as follows: 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, Net income – Canadian GAAP Adjustments in respect of: Property capitalization, net of depreciation Stock-based compensation cost Interest expense Income tax rate enactments Interest on convertible preferred securities Income tax (expense) recovery on current year U.S. GAAP adjustments Income before cumulative effect of change in accounting policy Cumulative effect of change in accounting policy (net of applicable taxes) Net income – U.S. GAAP 2004 $1,297 2003 2002 $÷«734 $«553 (81) 19 (12) 3 – 32 384 27 – (46) – 363 9 – – (9) (133) (116) 1,258 966 800 – $1,258 48 – $1,014 $«800 (i) Property capitalization Effective January 1, 2004, the Company changed its capitalization policy under Canadian GAAP, on a prospective basis, to conform with the CICA Handbook Section 3061, “Properties, Plant and Equipment.” The change was made in response to the CICA Handbook Section 1100, “Generally Accepted Accounting Principles,” issued in July 2003, as explained in Note 2 – Accounting changes. The Company’s accounting for Properties under Canadian GAAP had been based on the rules and regulations of the Canadian Transportation Agency’s (CTA) Uniform Classification of Accounts, which for railways in Canada, were considered Canadian GAAP prior to the issuance of Section 1100. Under the CTA rules, the Company capitalized only the material component of track replacement costs, to the extent it met the Company’s minimum threshold for capitalization. In accor- dance with the CICA Handbook Section 3061, “Properties, Plant and Equipment,” the Company now capitalizes the cost of labor, material and related overhead associated with track replacement activities pro- vided they meet the Company’s minimum threshold for capitalization. Also, all major expenditures for work that extends the useful life and/or improves the functionality of bridges, other structures and freight cars, are capitalized. Financial assets Investments Financial liabilities Long-term debt (including current portion) $÷«166 $÷«220 $÷«367 $÷«420 This change effectively harmonizes the Company’s Canadian and $5,164 $5,857 $4,658 $5,128 U.S. GAAP capitalization policy. However, since the change was applied prospectively, there continues to be a difference in depreciation and amortization expense between Canadian and U.S. GAAP relating to the difference in the amounts previously capitalized under Canadian and U.S. GAAP as at January 1, 2004. 126 Canadian National Railway Company Canadian GAAP Notes to Consolidated Financial Statements (ii) Interest expense In the first quarter of 2004, in anticipation of future debt issuances, the Company had entered into treasury lock transactions for a notional amount of U.S.$380 million to fix the treasury component on these future debt issuances. Under U.S. GAAP, these derivatives were accounted for as cash flow hedges whereby the cumulative change in the market value of the derivative instruments was recorded in Other comprehen- sive loss. On July 9, 2004, upon the pricing and subsequent issuance of U.S.$500 million 6.25% Debentures due 2034, the Company settled these treasury-rate locks and realized a gain of $12 million. Under U.S. GAAP, this gain was recorded in Other comprehensive loss and will be amortized and recorded into income, as a reduction of interest expense, over the term of the debt based on the interest payment schedule. Under Canadian GAAP, this gain was recorded immediately into income, as a reduction of interest expense. (iii) Stock-based compensation cost As explained in Note 2, effective January 1, 2003, the Company adopted the fair value based approach of the CICA’s Handbook Section 3870, “Stock-Based Compensation and Other Stock-Based Payments.” The Company retroactively applied the fair value method of accounting to all awards of employee stock options granted, modified or settled on or after January 1, 2002 and restated the 2002 comparative period to reflect this change in accounting policy. Under U.S. GAAP, effective January 1, 2003, the Company voluntarily adopted the recommenda- tions of Statement of Financial Accounting Standards (SFAS) No. 123, “Accounting for Stock-Based Compensation,” and applied the fair value based approach prospectively to all awards of employee stock options granted, modified or settled on or after January 1, 2003. Compensation cost attributable to employee stock options granted prior to January 1, 2003 continues to be a reconciling difference. (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 interest on the Securities until July 3, 2002 was treated as a divi- dend for Canadian GAAP but as interest expense for U.S. GAAP. (v) Income tax expense The provincial and federal governments enact new corporate tax rates resulting in either lower or higher tax liabilities under both U.S. and Canadian GAAP. The difference in the deferred income tax expense or recovery recorded is a function of the net deferred income tax liability position, which is larger under U.S. GAAP due essentially to the dif- ference in the property capitalization policy prior to 2004. In addition, under U.S. GAAP, the resulting deferred income tax expense or recovery is recorded when the rates are enacted, whereas under Canadian GAAP, when they are substantively enacted. In 2004, under U.S. GAAP, the Company recorded a decrease to its net deferred income tax liability of $5 million resulting from the enactment of lower corporate tax rates in the province of Alberta, with the corresponding decrease of $2 million under Canadian GAAP. In 2003, under U.S. GAAP, the Company recorded an increase to its net deferred income tax liability resulting from the enactment of higher corporate tax rates in the province of Ontario. As a result, the Company recorded deferred income tax expense of $79 million and $2 million in income and Other comprehensive loss, respectively. For Canadian GAAP, the corresponding increase to the net deferred income tax liability was $33 million. (vi) Cumulative effect of change in accounting policy In 2003, under U.S. GAAP, in accordance with SFAS No. 143, “Accounting for Asset Retirement Obligations,” the Company changed its accounting policy for certain track structure assets to exclude removal costs as a component of depreciation expense where the inclusion of such costs would result in accumulated depreciation balances exceeding the historical cost basis of the assets. As a result, a cumulative benefit of $75 million, or $48 million after tax, was recorded for the amount of removal costs accrued in accumulated depreciation on certain track structure assets at January 1, 2003. Under Canadian GAAP, the recom- mendations of Handbook Section 3110, “Asset Retirement Obligations,” which are similar to those under SFAS No. 143 (U.S. GAAP), were effec- tive for the Company’s fiscal year beginning January 1, 2004 and did not have an impact on the Canadian GAAP financial statements since removal costs, as a component of depreciation expense, have not resulted in accumulated depreciation balances exceeding the historical cost basis of the assets. B. Earnings per share The earnings per share calculation under Canadian GAAP differs from U.S. GAAP essentially due to differences in the earnings figures: (i) Basic earnings per share Year ended December 31, 2004 2003 2002 Income before cumulative effect of change in accounting policy – U.S. GAAP Cumulative effect of change in accounting policy Net income – U.S. GAAP $4.41 – $4.41 $3.38 0.16 $3.54 $2.71 – $2.71 Weighted-average number of common shares outstanding (millions) – U.S. GAAP 285.1 286.8 295.0 (ii) Diluted earnings per share Year ended December 31, 2004 2003 2002 Income before cumulative effect of change in accounting policy – U.S. GAAP Cumulative effect of change in accounting policy Net income – U.S. GAAP $4.34 – $4.34 $3.33 0.16 $3.49 $2.65 – $2.65 Weighted-average number of common shares outstanding (millions) – U.S. GAAP 289.9 290.7 304.2 Canadian GAAP Canadian National Railway Company 127 Notes to Consolidated Financial Statements 21 Reconciliation of Canadian and United States generally accepted accounting principles (continued) C. Reconciliation of significant balance sheet items In millions Current assets – Canadian GAAP Derivative instruments Deferred income taxes related to derivative instruments Other Current assets – U.S. GAAP Properties – Canadian GAAP Property capitalization, net of depreciation Cumulative effect of change in accounting policy Properties – U.S. GAAP Intangible and other assets – Canadian GAAP Derivative instruments Intangible and other assets – U.S. GAAP Deferred income tax liability – Canadian GAAP Cumulative effect of prior years’ adjustments to income Income taxes on current year U.S. GAAP adjustments to income Income taxes on cumulative effect of change in accounting policy Income taxes on translation of Canadian to U.S. GAAP adjustments Income taxes on minimum pension liability adjustment Income taxes on derivative instruments Income taxes on settlement of interest rate swaps recorded in Other comprehensive loss Income tax rate enactments Other Deferred income tax liability – U.S. GAAP Other liabilities and deferred credits – Canadian GAAP Stock-based compensation Minimum pension liability Other Other liabilities and deferred credits – U.S. GAAP Common shares – Canadian GAAP Capital reorganization Stock-based compensation Foreign exchange loss on convertible preferred securities Costs related to the sale of shares Share repurchase program Common shares – U.S. GAAP Contributed surplus – Canadian GAAP 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 Capital reorganization Contributed surplus – U.S. GAAP December 31, 2004 $÷1,654 81 (29) 4 $÷1,710 $16,688 2,952 75 $19,715 $÷÷«929 11 $÷÷«940 $÷3,591 1,204 (32) 27 (28) (7) 1 4 (41) 4 $÷4,723 $÷1,488 – 22 3 $÷1,513 $÷3,587 1,300 18 12 (33) (178) $÷4,706 $÷÷«164 248 33 18 26 (489) $÷÷÷÷«– 2003 $÷«1,092 33 – 2 $÷1,127 $15,158 3,072 75 $18,305 $÷÷«900 5 $÷«÷905 $÷3,365 1,071 133 27 (15) (10) 12 – (38) 5 $÷4,550 $÷1,153 20 30 – $÷1,203 $÷3,530 1,300 17 12 (33) (162) $÷4,664 $÷÷«166 248 33 18 24 (489) $÷÷÷÷«– 128 Canadian National Railway Company Canadian GAAP Notes to Consolidated Financial Statements In millions Currency translation – Canadian GAAP Unrealized foreign exchange loss on translation of Canadian to U.S. GAAP adjustments, net of applicable taxes December 31, Derivative instruments, net of applicable taxes Unamortized gain on settlement of interest rate swaps, net of applicable taxes Income tax rate enactments Minimum pension liability adjustment, net of applicable taxes Accumulated other comprehensive loss – U.S. GAAP Retained earnings – Canadian GAAP Cumulative effect of prior years’ adjustments to income Cumulative effect of change in accounting policy Current year adjustments to net income Share repurchase program Cumulative dividend on convertible preferred securities Capital reorganization Dividend in kind with respect to land transfers Other transactions and related income tax effect Retained earnings – U.S. GAAP (i) Shareholders’ equity As permitted under Canadian GAAP, the Company eliminated its accu- mulated deficit of $811 million as of June 30, 1995 through a reduc- tion 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 Common shares. Under Canadian GAAP, the cost resulting from the repurchase of shares was allocated first to Common shares, then to Contributed sur- plus and finally to Retained earnings. Under U.S. GAAP, the cost would have been allocated to Common shares followed by Retained earnings. For Canadian and U.S. GAAP purposes, the Company designates the U.S. dollar denominated long-term debt of the parent company as a foreign exchange hedge of its net investment in U.S. subsidiaries. Under Canadian GAAP, the resulting net unrealized foreign exchange loss from the date of designation, has been included in Currency translation. For U.S. GAAP purposes, the resulting net unrealized foreign exchange loss has been included as part of Accumulated other comprehensive loss, a separate component of Shareholders’ equity, as required under SFAS No. 130, “Reporting Comprehensive Income.” 2004 $÷÷÷(80) (89) 62 8 (34) (15) $÷÷(148) $÷3,676 1,928 48 (39) 152 38 (811) (248) (18) $÷4,726 2003 $÷÷÷(38) (63) 26 – (34) (20) $÷÷(129) $÷2,822 1,696 48 232 138 38 (811) (248) (18) $÷3,897 (ii) Minimum pension liability adjustment At each measurement date, if the Company’s pension plans have an accumulated benefit obligation in excess of the fair value of the plan assets, under U.S. GAAP, this gives rise to an additional minimum pen- sion liability. As a result, an intangible asset is recognized up to the amount of the unrecognized prior service cost and the difference is recorded in Accumulated other comprehensive loss, a separate compo- nent of Shareholders’ equity. There are no requirements under Canadian GAAP to record a minimum pension liability adjustment. (iii) Derivative instruments Under U.S. GAAP, pursuant to 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,” the Company records in its balance sheet the fair value of derivative instruments used in its hedging activities. Changes in the market value of these derivative instruments have been recorded in Accumulated other comprehensive loss, 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 amortization, which were previously deferred and amortized for U.S. GAAP, have since been reclassified to equity. 22 Comparative figures Certain figures, previously reported for 2003 and 2002, have been reclassified to conform with the basis of presentation adopted in the current year. Canadian GAAP Canadian National Railway Company 129 Non-GAAP Measures – unaudited The Company makes reference to non-GAAP measures in this Annual Report that do not have any standardized meaning prescribed by U.S. GAAP and are, therefore, not necessarily comparable to similar measures presented by other companies and, as such, should not be considered in isola- tion. Management believes that non-GAAP measures such as adjusted net income and the resulting adjusted performance measures for such items as operating income, operating ratio and per share data are useful measures of performance that can facilitate period-to-period comparisons as they exclude items that do not arise as part of the normal day-to-day operations or that could potentially distort the analysis of trends in business performance. The exclusion of specified items in the adjusted measures below does not imply that they are necessarily non-recurring. The Company also believes free cash flow to be a useful measure of performance as it demonstrates the Company’s ability to generate cash after the payment of capital expenditures and dividends. A reconciliation of the various non-GAAP measures presented in this Annual Report to their comparable U.S. GAAP measures is provided herein: Reconciliation of adjusted performance measures 2001-2002 In millions, except per share data, or unless otherwise indicated Year ended December 31, Revenues Operating expenses Operating income Interest expense Other income Income before income taxes Income tax expense Net income Operating ratio Basic earnings per share Diluted earnings per share 2001 2002 Reported Adjustments(1) Adjusted Reported Adjustments(2) Adjusted $«5,652 3,970 $÷÷«– (98) $«5,652 3,872 $«6,110 4,641 $÷÷«– (401) $«6,110 4,240 1,682 98 1,780 1,469 401 1,870 (327) 65 1,420 (380) – (2) 96 (158) (327) 63 1,516 (538) (361) 76 1,184 (384) – – 401 (149) (361) 76 1,585 (533) $1,040 $÷(62) $÷««978 $÷««800 $«252 $«1,052 70.2% $÷3.61 $÷3.49 68.5% $÷«3.39 $÷«3.28 76.0% $÷«2.71 $÷«2.65 69.4% $÷«3.57 $÷«3.48 (1) Operating expenses include a charge of $98 million ($62 million after tax) for workforce reductions. Other income includes a gain of $101 million ($73 million after tax) from the sale of the Company’s 50 per cent interest in the Detroit River Tunnel Company and a charge of $99 million ($71 million after tax) to write down the Company’s net investment in 360networks Inc. 2001 also includes a deferred income tax recovery of $122 million resulting from the enactment of lower corporate tax rates in Canada. (2) Includes a fourth-quarter charge of $281 million ($173 million after tax) to increase the Company’s U.S. personal injury and other claims liability and a workforce reduction charge of $120 million ($79 million after tax). 130 Canadian National Railway Company Non-GAAP Measures – unaudited Free cash flow 2000-2004 In millions Cash provided from operating activities Less: Investing activities Dividends paid Cash provided (used) before financing activities Adjustments: Change in level of accounts receivable sold (1) Acquisitions (2) Free cash flow 2000 2001 2002 2003 2004 $1,506 $«1,621 $1,612 $«1,976 $«2,139 (981) (136) 389 (2,173) (150) (702) (924) (170) 518 (1,075) (191) 710 (2,411) (222) (494) (3) – (133) 1,278 (5) – (132) – (12) 1,531 $÷«386 $«÷«443 $÷«513 $÷««578 $«1,025 (1) Changes in the level of accounts receivable sold under the Company’s accounts receivable securitization program are considered a financing activity. (2) Significant acquisitions, WC in 2001 and BC Rail and GLT in 2004, are excluded as they are not indicative of normal day-to-day investments in the Company’s asset base. Canadian National Railway Company 131 Corporate Governance CN is committed to being a good corporate citizen. At CN, sound corporate citizenship touches nearly every aspect of what we do, from governance to business ethics, from safety to environmental protection. Central to this comprehensive approach is our strong belief that good corporate citizenship is simply good business. CN has always recognized the importance of good governance. As it evolved from a Canadian institution to a North American publicly traded company, CN voluntarily followed certain corporate governance requirements that, as a company based in Canada, it was not technically compelled to follow. We continue to do so today. Since many of our peers – and shareholders – are based in the United States, we want to provide the same assurances of sound practices as our U.S. competitors. Hence, we adopt and adhere to corporate governance practices that either meet or exceed applicable Canadian and U.S. corporate governance standards. As a Canadian reporting issuer with securi- ties listed on the Toronto Stock Exchange and the New York Stock Exchange (NYSE), CN complies with applicable rules adopted by the Canadian Securities Administrators and the rules of the U.S. Securities and Exchange Commission giving effect to the provisions of the U.S. Sarbanes Oxley Act of 2002. On October 29, 2004, the Canadian Securities Administrators (CSA) published for comment proposed National Policy 58-201 “Corporate Governance Guidelines” and proposed National Instrument 58-101 “Disclosure of Corporate Governance Practices.” Our governance prac- tices are already substantially in compliance with the proposed CSA guidelines. When these guidelines will be finalized, the board intends to reassess its governance practices in order to improve them further. As a Canadian company, we are not required to comply with many of the NYSE corporate governance rules, and instead may comply with Canadian governance practices. However, except as summarized on our Web site (www.cn.ca/cngovernance), our governance practices comply with the NYSE corporate governance rules in all significant respects. Consistent with the belief that ethical conduct goes beyond com- pliance and resides in a solid governance culture, the governance sec- tion on the CN Web site contains CN’s Corporate Governance Manual (including the charters of our Board and of our Board committees) and CN’s Code of Business Conduct. Printed versions of these documents are also available upon request to CN’s Corporate Secretary. Because it is important to CN to uphold the highest standards in corporate governance and that any potential or real wrongdoings be reported, CN has also adopted methods allowing employees and third parties to report accounting, auditing and other concerns, as more fully described on our Web site. We are proud of our corporate governance practices. For more information on these practices, please refer to our Web site and to our proxy circular which has been mailed to all shareholders and which is also available on our Web site. 132 Canadian National Railway Company 2004 President’s Awards for Excellence The accomplishments of these employees not only reinforced the five principles that are the foundation of CN's industry-leading railroad but also won them the President’s Award for Excellence for their outstanding contributions in 2004 in the areas of Service, Cost Control, Asset Utilization, Safety and People. These individuals and teams were singled out for their exceptional effort, dedication and performance. Category: Service Winner: Rolland Miron – Saskatoon, SK Winners: Eastern Canada Engineering Team Steve Tselios, Montreal, QC; George Nowak, Edmonton, AB; Mario Ruel, Montreal, QC; Rocco Cacchiotti, Montreal, QC; Denis Bourque, Charny, QC; Roméo Morin, Montreal, QC; Alain Martineau, Charny, QC; Réjean Martel, Montreal, QC When disaster struck in Montmagny, Quebec, in February 2004, this team snapped into action to minimize disruptions. With a steel railway bridge lit- erally destroyed due to a major derailment, they wasted no time in building a temporary rail line around the existing crossing – which had traffic moving again in just three days. They restored full service within a mere 22 days. Winners: Mainframe Install Team Ron Hewitt, Ron Dubois, Bruno Michaud, John Hillier, John Ferrari, Kevin Whelan, all from Montreal, QC CN’s three mainframe computers had to be replaced with two newer model mainframes, translating into $1.9 million in savings in 2004 alone. Aware that any outages of the mainframe computers that host CN’s most critical applications would hurt operations of the railroad, this team used care and professionalism in tackling this complex and highly technical task on week- ends over a five-week period, avoiding any disruptions to operations. Category: Cost Control Winner: Gary Petersen – Kamloops, BC Gary’s suggestion of a new process for stocking and delivering sand needed for locomotive traction resulted in substantial savings. With the new method, sand is trucked to the site and elevated using the compressor on the delivery truck, eliminating the need for a sand car. The 100-hp compressor was replaced with a 50-hp compressor, which has resulted in additional savings of $31,000 a year. Winner: Glen Becker – Winnipeg, MB Glen undertook a thorough review of material purchased by CN to repair and service its work equipment. The review of 21 items shows an annual savings of well over $100,000 in materials, and that amount is expected to increase significantly. Additional benefits include reduced repair times, improved inventory management and identification of duplicate parts. Rolland undertook a thorough review of intermodal operations in Saskatoon and implemented important modifications. He was able to adjust the work schedule and operations without having an impact on service, which helped the company’s efficiency and reduced costs by about $5.00 for every lift. Category: Safety Winners: Alberta WCB Disability Team Don Penney, Brian Kalin, Tom Brown, Joseph Slavin, Randy Roach, all from Edmonton, AB Besides promoting safety for the prevention of injuries, this team also improved disability management for early return to work and modified duties as well as for on-time reporting of injuries to the Workers’ Compen- sa tion Board. Their hard work resulted in a better-than-target injury ratio and a 50 per cent reduction in lost time days compared to 2003, in addition to a substantial rebate to CN from the Workers’ Compensation Board. Category: People Winners: Mike Cater – Surrey, BC; Jim Halberg – Kamloops, BC Alert to the possibility of bringing a new client on board, Jim referred a friend in the propane business to Mike, who jumped at the opportunity to explain the benefits of shipping this traffic from Edmonton to Vancouver by CN instead of by truck. As a result, a new rail facility was built by Canwest Propane on property adjacent to CN’s Thornton Yard, with all inbound traffic committed to CN over a five-year period. Winners: Susan Seebeck, Kathy McDonald and Julie O’Halloran – Montreal, QC In order to promote and support culture change throughout CN, these employees created a variety of learning and tutorial materials that focused on CN’s five principles, including the “How We Work and Why” Web site and book, as well as the ABC Field Toolbook and Leadership and Process Improvement Cards. The written materials have been used by employees across the system, and the Web site has registered hundreds of thousands of hits, helping employees better understand and implement CN’s principles. Winner: William Moss – Brandon, MS Special Award Bill designed and implemented a system to remotely monitor the position of the automatic drawbridge at Manchac, Louisiana. This not only verifies proper bridge operation, but also increases the energy efficiency and reliability of the bridge operating motors. Category: Asset Utilization Winners: Paul Zastre and Tim Schick – Winnipeg, MB Using materials and assets they had on hand, Paul and Tim designed a pro- totype Plate F box car – a large car that can haul up to 286,000 pounds of paper and stands 17 feet tall from the rail. They then fabricated all the fix- tures to duplicate the prototype. Their inventiveness resulted in the building of 199 Plate F’s, which was accomplished at the rate of two cars a day. Winners: Paul Kirk – Homewood, IL; James Reed – Jackson, MS; Sam Cook – Jackson, MS When a runaway train was speeding toward a head-on collision with their train, this crew worked with their dispatcher to prevent disaster. Dispatcher Paul Kirk contacted engineer James Reed and conductor Sam Cook by radio and advised them to stop their train. After a quick discussion of options, the dispatcher and the crew decided to attempt to intercept the runaway. Sam got off the train and ran towards the runaway to give James an estimate of how fast it was rolling. As the runaway got closer to him, James backed up at a speed to match the velocity of the runaway, skillfully coupled up and brought both trains to a stop. Canadian National Railway Company 133 Board of Directors (at December 31, 2004) Committees: 1 Audit, ﬁ nance 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 David G.A. McLean, O.B.C., LL.D. Chairman of the Board Canadian National Railway Company Chairman of the Board and Chief Executive Ofﬁ cer The McLean Group Committees: 2*, 3, 4, 5, 6, 7 E. Hunter Harrison President and Chief Executive Ofﬁ cer Canadian National Railway Company Committees: 3*, 7 Ambassador Gordon D. Gifﬁ n Senior Partner McKenna Long & Aldridge Committees: 2, 5, 7 Hugh J. Bolton, F.C.A. Chairman of the Board EPCOR Utilities Inc. Committees: 1, 2, 4, 7 Robert Pace President and Chief Executive Ofﬁ cer The Pace Group Committees: 1*, 2, 6, 7 Michael R. Armellino Retired Partner The Goldman Sachs Group Committees: 1, 2, 4, 6, 7* Purdy Crawford, O.C., Q.C., LL.D. Counsel Osler, Hoskin & Harcourt Committees: 2, 5*, 6, 7 134 Canadian National Railway Company J.V. Raymond Cyr, O.C., LL.D. Chairman of the Board Polyvalor Inc. Committees: 1, 4*, 5, 6, 7 Gilbert H. Lamphere Private Investor 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 President GM Latin America, Africa and Middle East Committees: 4, 6, 7 James K. Gray, O.C., A.O.E., LL.D. Corporate Director Former Chairman and Chief Executive Ofﬁ cer Canadian Hunter Exploration Ltd. Committees: 1, 2, 4, 7 Edith E. Holiday Corporate Director and Trustee Former General Counsel United States Treasury Department Secretary of the Cabinet The White House Committees: 1, 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 Ofﬁ cer Assumption Life Committees: 1, 4, 5, 6, 7 A. Charles Baillie, LL.D. Former Chairman and Chief Executive Ofﬁ cer The Toronto-Dominion Bank Committees: 1, 2, 5, 7 Canadian National Railway Company 135 Chairman of the Board and Executive Officers of the Company David G.A. Mc Lean Chairman of the Board E. Hunter Harrison President and Chief Executive Officer Tullio Cedraschi President and Chief Executive Officer CN Investment Division Keith E. Creel Senior Vice-President Eastern Canada Region 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 Fred R. Grigsby Senior Vice-President and Chief Information Officer Edmond L. Harris Senior Vice-President Operations Peter Marshall Senior Vice-President Western Canada Region Claude Mongeau Executive Vice-President and Chief Financial Officer Robert E. Noorigian Vice-President Investor Relations Gordon T. Trafton Senior Vice-President United States Region 136 Canadian National Railway Company Shareholder and investor information Annual meeting The annual meeting of shareholders will be held at 10:00 am (local time) on Thursday, April 21, 2005, at Fairmont The Queen Elizabeth Hotel, 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 CN 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 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 www.computershare.com 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 Dividend payment options Shareholders wishing to receive dividends by Direct Deposit or in U.S. dollars may obtain detailed information by communicating with: Computershare Trust Company of Canada Telephone: 1-800-332-0095 Shareholder services Shareholders having inquiries concerning their shares or wishing to obtain information about CN should contact: 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: service@computershare.com Head office Canadian National Railway Company 935 de La Gauchetière Street West Montreal, Quebec H3B 2M9 P.O. Box 8100 Montreal, Quebec H3C 3N4 Additional copies of this report are available from: CN Public Affairs 935 de La Gauchetière Street West Montreal, Quebec H3B 2M9 Telephone: 1-888-888-5909 Email: contact@cn.ca La version française du présent rapport est disponible à l’adresse suivante : Affaires publiques CN 935, rue de La Gauchetière Ouest Montréal (Québec) H3B 2M9 Téléphone : 1 888 888-5909 Courriel : contact@cn.ca This report has been printed on recycled paper. 935 de La Gauchetière Street West, Montreal, Quebec H3B 2M9 www.cn.ca

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