Canadian National Railway Company
Annual Report 2012

Plain-text annual report

A TRUE BACKBONE OF THE ECONOMY 2 0 1 2 a n n u a l r e p o r t 935 de La Gauchetière Street West Montreal, Quebec H3B 2M9 www.cn.ca 2 0 1 2 a n n u a l r e p o r t Contents 1 A message from the Chairman 2 A message from Claude Mongeau 4 A true backbone of the economy: Innovation that fosters prosperity 6 Board of Directors 7 Financial Section (U.S. GAAP) 87 Corporate Governance – Delivering Responsibly 88 Shareholder and Investor Information Except where otherwise indicated, all financial information reflected in this document is expressed in Canadian dollars and determined on the basis of United States gener- ally accepted accounting principles (U.S. GAAP). Certain information included in this annual report constitutes “forward-looking statements” within the meaning of the United States Private Securities Litigation Reform Act of 1995 and under Canadian securities laws. CN cautions that, by their nature, these forward-looking statements involve risks, uncertainties and assumptions. The Company cautions that its assumptions may not materialize and that current economic conditions render such assumptions, although reasonable at the time they were made, subject to greater uncertainty. Such forward-looking statements are not guarantees of future performance and involve known and unknown risks, uncertainties and other factors which may cause the actual results or performance of the Company or the rail industry to be materially different from the outlook or any future results or performance implied by such statements. Important risk factors that could affect the forward-looking statements include, but are not limited to, the effects of general economic and business conditions, industry competition, inflation, currency and interest rate fluctuations, changes in fuel prices, legislative and/or regulatory developments, compliance with environmental laws and regulations, actions by regulators, various events which could disrupt operations, including natural events such as severe weather, droughts, floods and earthquakes, labor negotiations and disruptions, environmental claims, uncertainties of investigations, proceedings or other types of claims and litigation, risks and liabilities arising from derailments, and other risks detailed from time to time in reports filed by CN with securities regulators in Canada and the United States. Reference should be made to “Manage- ment’s Discussion and Analysis” in CN’s annual and interim reports, Annual Information Form and Form 40-F filed with Canadian and U.S. securities regulators, available on CN’s website (www.cn.ca), for a summary of major risks. CN assumes no obligation to update or revise forward-looking statements to reflect future events, changes in circum- stances, or changes in beliefs, unless required by applicable Canadian securities laws. In the event CN does update any forward-looking statement, no inference should be made that CN will make additional updates with respect to that state- ment, related matters, or any other forward-looking statement. As used herein, the word “Company” or “CN” means, as the context requires, Canadian National Railway Company and/ or its subsidiaries. This annual report is printed on 100 % post-consumer paper. A message from the Chairman Dear fellow shareholders When I look at CN’s performance in 2012, I see a Company that is on top of its game. A Company that continues to deliver value to our customers by reaching out to improve our service in unprecedented ways. Claude Mongeau and his very skilled Leadership Team continue to develop and maintain a positive culture. This enables all employees to work and flourish, in a way that best ensures CN will continue to grow and prosper in the future. “ We strived to create value for our customers and help them win in markets in North America and throughout the world.” The Company’s 2012 results demonstrate that CN management delivered some of the best performance in the railroad’s history. We strived to create value for our customers and help them win in markets in North America and throughout the world. CN is very aware of the importance of transporting goods in an environmentally sustainable manner. The company for the fourth straight year was named to the Dow Jones Sustainability Index. The railroad continues to run efficiently and safely. CN is very committed to improving both efficiency and safety. This is something we will never take for granted. CN’s Board has been very focused on Board Renewal as several Directors will retire in the next few years. The Board has developed and implemented a succession plan for the Board that will see a number of new Board members being nominated in the next two years. The Company is in great condition from every perspective. The Board remains committed to ensuring the Company is well positioned to continue to deliver both customer and shareholder value for many years to come. Sincerely, David McLean, O.B.C., LL.D. Chairman of the Board Canadian National Railway Company 2012 Annual Report 1 A message from Claude Mongeau A TRUE BACKBONE OF THE ECONOMY Dear fellow shareholders What do we do for an encore? That’s the type of question we frequently get asked at CN. Our answer is simple: continue our remarkable transformational journey with the same sense of urgency and commitment we’ve displayed since our privatization in 1995. In 2012, we continued to build on our strengths and address areas where we need to improve. And our results reflect how well we’ve met the challenges we were compelled to face and those we set for ourselves. We’ve been able to grow faster than the global and North American economies, increasing our revenues by 10 per cent over 2011. Thanks to our outstanding team of railroaders and our focus on Operational and Service Excellence, we were able to grow the business and attain an operating ratio of 62.9 per cent, thereby increasing earnings by a full 16 per cent on an adjusted basis compared to the year before, while generating free cash flow of $1,006 million in 2012. And best of all, we improved our safety performance, including CN’s lowest Transportation Safety Board of Canada main-track accident ratio on record. By growing the business and delivering solid financial results, CN has reinforced its role as a true backbone of the economy and a key part of the solution in fostering the prosperity of the North American markets we serve. CN handles approximately $250 billion in goods in a year and more than 300 million tons of cargo, serving exporters, importers, retailers, farmers and touching the lives of millions of people every day. With a true transcontinental rail network extending from Halifax on the east coast of Canada to Vancouver and Prince Rupert on the west coast, and all the way down the heartland of the United States through Chicago and Memphis and to the Gulf Coast, CN has a resource-rich, manufacturing-intensive franchise, that reaches 75 per cent of consumers across North America. “ ...CN has a resource-rich, manufacturing- intensive fran- chise, that reaches 75 per cent of consumers across North America.” 2 2012 Annual Report Canadian National Railway Company CN makes its customers more competitive Of all the innovative services and products that CN has initiated over the years, perhaps none can be more impactful than those that flow from our bold agenda of supply chain collaboration. We are an engine of supply chain capability that helps grow markets, and ultimately helps our customers succeed. We know that the next great step in expanding our role as a backbone of the economy is to look at what we offer customers not just as a great railroad but from end to end, with a view to improving efficiency for the entire process. “ ...better end-to- end service for our customers so that we can help them become more competitive.” It’s really a new paradigm, driving end-to-end service for the benefit of those that are using our supply chain. And the key word is collaboration. We galvanize all the players in a supply chain to move away from a silo mentality, to daily engagement, information sharing, problem solving, and execution, and it’s driving exceptional results. Supply Chain Agreements with ports, terminal operators and customers are used to measure success as a team, not just as the individual components of the supply chain. CN gets products to market faster and more reliably CN has long been an indispensable transportation supplier for many key sectors in North America, from grain and forest products to chemicals and the automotive sector, moving raw materials and finished products to market. With some of the best transit times in the North American railroad industry, and serving ports on both Canadian coasts that are closest to key Asian and European destinations, we can help our customers win in the markets where they compete. But to play our role as a true backbone, we’ve been going beyond hub-to-hub speed and reliability, to focus on the first and last miles of our service. That includes better car order fulfilment and better switch window compliance for merchandise traffic, and better spotting reliability for grain. It also includes improving how we communicate with customers about what’s coming at them or advising them promptly if we can’t deliver as scheduled. It’s an intense focus on every detail of the receiving and origination part of our journey, with one outcome in mind: better end-to-end service for our customers so that we can help make them become more competitive. What will CN do for an encore in 2013? Well, we’ll continue to innovate… continue to improve safety and drive better service and efficiency… and continue to compete as if we still had everything to prove. We are determined to keep delivering because we are committed to ensuring that CN’s transformation journey continues. Claude Mongeau President and CEO Canadian National Railway Company 2012 Annual Report 3 INNOVATION THAT FOSTERS PROSPERITY A TRUE BACKBONE OF THE ECONOMY: Grain: from innovation in the supply the farmers’ product to market. From chain to cereal at the breakfast table moving the fertilizers that help grow CN has been moving record volumes the crops to delivering the grain of grain for the last three years destined for overseas markets or for since initiating our new scheduled North American processors, CN’s grain model in 2010. Not long ago, role enables this sector to thrive and we were measuring our spotting of feed people around the world. It’s cars on the week; now we measure something to think about as you have ourselves to the day, and in 2012 your breakfast cereal in the morning we achieved 82  per cent, while and grain-fed poultry for dinner. we spotted 7  per cent more cars than in 2011. This demonstrates Opening new markets for crude oil that when we work together with CN is playing an increasing role in the the other players, looking at the energy sector, in traditional and non- supply chain from end to end, we traditional areas. We started to test can achieve surprising results. We the transportation of crude oils of have seen some reasonably good various types to markets in Canada crops, especially in Canada, but the and the U.S. in 2010. In 2011, CN supply chain collaboration and the moved approximately 5,000 carloads innovation that CN has brought to of crude. In 2012, CN moved more the table is allowing the company, in than 30,000 carloads to various North partnership with the grain elevators American markets, and believes it has at the ports and the countryside grain the potential to double this business shippers, to increase the throughput in 2013. Our unique network reach capability of the system, to levels that gives crude producers and marketers a few years ago would not have been access to places not well served by thought possible. pipelines today, including markets The end-to-end visibility and the on the U.S. Gulf Coast, in the U.S. daily engagement that occurs on Midwest, California, or into Eastern the ground, every day between CN, and Western Canada.  CN connects terminal operators and the grain heavy oil in northern Alberta as well companies, is translating into greater as Bakken light crude with existing success for all of us, getting more of and new markets. 4 2012 Annual Report Canadian National Railway Company Rail is a safe and environmentally operators in Canada and significant friendly transportation mode that improvements in end-to-end service is complementary to pipelines for have also generated major growth. the shipping of crude. It opens new West Coast volumes have increased markets and provides significant 65 per cent over the past three flexibility now and in the future to years, well beyond the growth of the energy suppliers across our network. economy. The quality of our transit Once you’re on the rail network time, the focus on container dwell, you’re not tied down, so you can our system of collaboration and our ship to the most profitable market daily engagement have allowed us to of the moment. Shipping oil with attract more business. For example, CN is scalable, giving customers with our terminal partners, container the flexibility to start small and in- dwell time on the West Coast was crease volumes incrementally as reduced by 15 per cent in 2012 and required. And because in most we have dramatically improved end- cases rail projects use existing track to-end reliability. Our approach and and roadway infrastructure, long- the cooperation we establish when term capital is not required to start we talk to shipping lines and terminal shipping the product on rail. CN operators add up to progress on the sees continued opportunities for ground every day, for the benefit of growth in its crude oil business, by all those involved. continuing to supplement existing and new pipelines and thereby help bolster the energy sector’s potential. Whether it’s Intermodal or a wide range of commodities and streams Intermodal: pushing the frontier of business, we serve customers Intermodal growth is being fuelled by today in a different way, with trade with China and Asia, where the different service outcomes and CN advantage through Prince Rupert meaningful commercial benefits. and CN’s service for Vancouver are Whether it’s service or efficiency, resulting in record numbers. But that’s CN’s contribution to its customers’ only part of the story. Agreements success continues to reinforce its role with all major ports and terminal as a true backbone of the economy. Canadian National Railway Company 2012 Annual Report 5 Board of Directors As at February 19, 2013 David G.A. McLean, O.B.C., LL.D. Chairman of the Board Canadian National Railway Company Chairman of the Board The McLean Group Committees: 2, 3, 4, 6, 7, 8 Donald J. Carty, O.C., LL.D. Retired Chairman and CEO American Airlines and Retired Vice-Chairman Dell, Inc. Committees: 1, 2, 3, 7 Claude Mongeau President and Chief Executive Officer Canadian National Railway Company Committees: 4*, 7 Michael R. Armellino, CFA Retired Partner The Goldman Sachs Group, LP Committees: 2, 3*, 5, 6, 7, 8 A. Charles Baillie, O.C., LL.D. Former Chairman and Chief Executive Officer The Toronto-Dominion Bank Committees: 2*, 3, 6, 7, 8 Hugh J. Bolton, FCA Chairman of the Board EPCOR Utilities Inc. Committees: 1, 5, 6, 7*, 8 Ambassador Gordon D. Giffin Senior Partner McKenna Long & Aldridge Committees: 2, 4, 5, 7, 8 Edith E. Holiday Corporate Director and Trustee Former General Counsel United States Treasury Department Secretary of the Cabinet The White House Committees: 2, 3, 6, 7, 8 V. Maureen Kempston Darkes, O.C., D.Comm., LL.D. Retired Group Vice-President General Motors Corporation and President GM Latin America, Africa and Middle East Committees: 1, 5*, 6, 7, 8 The Honourable Denis Losier, C.M., P.C., LL.D. President and Chief Executive Officer Assumption Life Committees: 1*, 4, 5, 6, 7 The Honourable Edward C. Lumley, P.C., LL.D. Vice-Chairman BMO Capital Markets Committees: 2, 3, 6, 7, 8* James E. O’Connor Former Chairman and Chief Executive Officer Republic Services Inc. Committees: 1, 2, 5, 7 Robert Pace President and Chief Executive Officer The Pace Group Committees: 1, 3, 6*, 7, 8 Directors Emeritus Purdy Crawford J.V. Raymond Cyr James K. Gray Cedric Ritchie Committees: 1 Audit 2 Finance 3 Corporate governance and nominating 4 Donations and sponsorships 5 Environment, safety and security 6 Human resources and compensation 7 Strategic planning 8 Investment * denotes chairman of the committee Chairman of the Board and Select Senior Officers of the Company As at February 19, 2013 David G.A. Mc Lean Chairman of the Board Claude Mongeau President and Chief Executive Officer Sean Finn Executive Vice-President Corporate Services and Chief Legal Officer Mike Cory Senior Vice-President Western Region Kimberly A. Madigan Vice-President Human Resources Luc Jobin Executive Vice-President and Chief Financial Officer Sameh Fahmy Senior Vice-President Engineering, Mechanical and Supply Management Janet Drysdale Vice-President Investor Relations Jean-Jacques Ruest Executive Vice-President and Chief Marketing Officer Jeff Liepelt Senior Vice-President Eastern Region Russell Hiscock President and Chief Executive Officer CN Investment Division Jim Vena Executive Vice-President and Chief Operating Officer 6 2012 Annual Report Canadian National Railway Company Financial Section (U.S. GAAP) Contents 8 Selected Railroad Statistics 9 Management’s Discussion and Analysis 50 Management’s Report on Internal Control over Financial Reporting 50 Report of Independent Registered Public Accounting Firm 51 Report of Independent Registered Public Accounting Firm 52 Consolidated Statement of Income 53 Consolidated Statement of Comprehensive Income 54 Consolidated Balance Sheet 55 Consolidated Statement of Changes in Shareholders’ Equity 56 Consolidated Statement of Cash Flows Notes to Consolidated Financial Statements 57 1 Summary of significant accounting policies 59 2 Accounting changes 59 3 Accounts receivable 60 4 Properties 62 5 Intangible and other assets 62 6 Accounts payable and other 62 7 Other liabilities and deferred credits 63 8 Long-term debt 65 9 Capital stock 65 10 Stock plans 70 11 Pensions and other postretirement benefits 76 12 Other income 77 13 Income taxes 78 14 Segmented information 79 15 Earnings per share 79 16 Major commitments and contingencies 84 17 Financial instruments 86 18 Accumulated other comprehensive loss Canadian National Railway Company 2012 Annual Report 7 Selected Railroad Statistics Statistical operating data Rail freight revenues ($ millions) Gross ton miles (GTM) (millions) Revenue ton miles (RTM) (millions) Carloads (thousands) Route miles (includes Canada and the U.S.) (1) Employees (end of year) Employees (average for the year) Productivity Operating ratio (%) Rail freight revenue per RTM (cents) Rail freight revenue per carload ($) Operating expenses per GTM (cents) Labor and fringe benefits expense per GTM (cents) GTMs per average number of employees (thousands) Diesel fuel consumed (US gallons in millions) Average fuel price ($/US gallon) GTMs per US gallon of fuel consumed Safety indicators Injury frequency rate per 200,000 person hours (2) Accident rate per million train miles (2) (1) Rounded to the nearest hundred miles. (2) Based on Federal Railroad Administration (FRA) reporting criteria. Year ended December 31, 2012 2011 2010 8,938 8,111 7,417 383,754 357,927 341,219 201,496 187,753 179,232 5,059 4,873 4,696 20,100 20,000 20,600 23,430 23,339 22,444 23,466 23,079 22,055 62.9 4.44 63.5 4.32 63.6 4.14 1,767 1,664 1,579 1.62 0.51 1.60 0.51 1.55 0.51 16,354 15,509 15,471 388.7 367.7 355.7 3.47 987 1.31 2.10 3.39 973 1.55 2.25 2.64 959 1.72 2.23 Certain of the 2011 and 2010 comparative figures have been restated to conform with the 2012 presentation. Such statistical data and related productivity measures are based on estimated data available at such time and are subject to change as more complete information becomes available. 8 2012 Annual Report U.S. GAAP Canadian National Railway Company Management’s Discussion and Analysis Management’s discussion and analysis (MD&A) relates to the financial position and results of operations of Canadian National Railway Company, together with its wholly-owned subsidiaries, collectively “CN” or “the Company.” Canadian National Railway Company’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’s objective is to provide meaningful and relevant information reflecting the Company’s financial position 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. The reader is advised to read all information provided in the MD&A in conjunction with the Company’s 2012 Annual Consolidated Financial Statements and Notes thereto. Business profile Strategy overview CN is engaged in the rail and related transportation business. CN’s CN’s focus is on running a safe and efficient railroad. While network of approximately 20,100 route miles of track spans remaining at the forefront of the rail industry, CN’s goal is to be Canada and mid-America, connecting three coasts: the Atlantic, internationally regarded as one of the best-performing transpor- the Pacific and the Gulf of Mexico. CN’s extensive network, and its tation companies. co-production arrangements, routing protocols, marketing alli- CN’s commitment is to create value for both its customers and ances, and interline agreements, provide CN customers access to shareholders. By deepening customer engagement, leveraging all three North American Free Trade Agreement (NAFTA) nations. the strength of its franchise, and delivering operational and CN’s freight revenues are derived from seven commodity service excellence, the Company seeks to provide quality and groups representing a diversified and balanced portfolio of goods cost-effective service that creates value for its customers. transported between a wide range of origins and destinations. CN’s corporate goals are generally based on five key financial This product and geographic diversity better positions the performance targets: revenues, operating income, earnings per Company to face economic fluctuations and enhances its poten- share, free cash flow and return on invested capital, as well as var- tial for growth opportunities. In 2012, no individual commodity ious key operating and customer service metrics that the Company group accounted for more than 20% of revenues. From a geo- focuses on to measure efficiency, safety and quality of service. By graphic standpoint, 17% of revenues relate to United States (U.S.) striving for sustainable financial performance through profitable domestic traffic, 29% transborder traffic, 22% Canadian domes- growth, adequate free cash flow and return on invested capital, CN tic traffic and 32% overseas traffic. The Company is the originat- seeks to deliver increased shareholder value. For 2012, the ing carrier for approximately 85% of traffic moving along its Company’s Board of Directors approved share repurchase programs network, which allows it both to capitalize on service advantages funded mainly from cash generated from operations. The first share and build on opportunities to efficiently use assets. repurchase program, which was approved on October 24, 2011, Corporate organization allowed for the repurchase of up to 17.0 million common shares between October 28, 2011 and October 27, 2012. The Company The Company manages its rail operations in Canada and the U.S. purchased a total of 16.7 million common shares under this share as one business segment. Financial information reported at this repurchase program. On October 22, 2012, the Company’s Board level, such as revenues, operating income and cash flow from of Directors approved a new share repurchase program, which operations, is used by the Company’s corporate management in allows for the repurchase of up to $1.4 billion in common shares, evaluating financial and operational performance and allocating not to exceed 18.0 million common shares, between October 29, resources across CN’s network. The Company’s strategic initiatives, 2012 and October 28, 2013. Share repurchases are made pursuant which drive its operational direction, are developed and managed to a normal course issuer bid at prevailing market prices, plus bro- centrally by corporate management and are communicated to its kerage fees, or such other prices as may be permitted by the regional activity centers (the Western Region, Eastern Region and Toronto Stock Exchange. In addition, the Company’s Board of Southern Region), whose role is to manage the day-to-day service Directors approved an increase of 15% to the quarterly dividend to requirements of their respective territories, control direct costs common shareholders, from $0.375 in 2012 to $0.430 in 2013. incurred locally, and execute the corporate strategy and operating CN’s business model is anchored on five core principles: providing plan established by corporate management. quality service, controlling costs, focusing on asset utilization, commit- See Note 14 – Segmented information to the Company’s 2012 ting to safety and sustainability, and developing people. Precision Annual Consolidated Financial Statements for additional informa- Railroading is at the core of CN’s business model. It is a highly disci- tion on the Company’s corporate organization, as well as selected plined process whereby CN handles individual rail shipments accord- financial information by geographic area.  ing to a specific trip plan and manages all aspects of railroad operations to meet customer commitments efficiently and profitably. Precision Railroading demands discipline to execute the trip plan, the relentless measurement of results, and the use of such results to Canadian National Railway Company U.S. GAAP 2012 Annual Report 9 Management’s Discussion and Analysis generate further execution improvements in the service provided to equipped with distributed power capability, which allows the customers. Precision Railroading aims to increase velocity, improve Company to run longer, more efficient trains, particularly in cold reliability, lower costs, enhance asset utilization and, ultimately, help weather conditions, while improving train handling, reducing train the Company to grow the top line. It has been a key contributor to separations and improving the overall safety of operations. These CN’s earnings growth and improved return on invested capital. The initiatives, combined with CN’s investments in longer sidings over the success of the business model is dependent on commercial principles years, offer train-mile savings, allow for efficient long-train opera- and a supportive regulatory environment, both of which are key to an tions and reduce wear on rail and wheels. Yard throughput is being effective rail transportation marketplace throughout North America. improved through SmartYard, an innovative use of real-time traffic information to sequence cars effectively and get them out on the Providing quality service, controlling costs and focusing on line more quickly in the face of constantly changing conditions. In asset utilization Engineering, the Company is continuously working to increase the The basic driver of the Company’s business is demand for reliable, productivity of its field forces, through better use of traffic informa- efficient, and cost effective transportation. As such, the Company’s tion and the optimization of work scheduling and as a result, better focus is the pursuit of its long-term business plan, providing a high management of its engineering forces on the track. The Company level of service to customers, operating safely and efficiently, and also intends to continue focusing on the reduction of accidents and meeting short- and long-term financial commitments. related costs, as well as costs for legal claims and health care. In 2012, the Company benefited from a modest increase in North CN’s capital expenditure programs support the Company’s com- American industrial production, a significant increase in U.S. housing mitment to its core principles and strategy and its ability to grow the starts and moderate growth in U.S. automotive sales. In 2013, the business profitably. In 2013, CN plans to invest approximately Company expects North American industrial production to increase $1.9 billion on capital programs, of which over $1.0 billion is tar- by approximately 2%, U.S. housing starts to continue to increase geted towards track infrastructure to continue operating a safe significantly, and U.S. automotive sales to further increase modestly. railway and improve the productivity and fluidity of the network; Canadian grain production for the 2012/2013 crop year was slightly and includes the replacement of rail, ties, and other track materials, above the 5-year average whereas U.S. grain production for the bridge improvements, as well as rail-line improvements for the 2012/2013 crop year was below the 5-year average. The Company Elgin, Joliet and Eastern railway property. This amount also includes expects Canadian and U.S. grain production for the 2013/2014 crop funds for strategic initiatives and additional enhancements to the year to be in-line with their respective 5-year averages. track infrastructure in western and eastern Canada as well as in the To meet its business plan objectives, the Company’s priority is to U.S. In 2013, CN’s equipment capital expenditures are targeted to grow the business at low incremental cost. The Company’s strategy reach approximately $200 million, allowing the Company to tap to pursue deeper customer engagement and service improvements growth opportunities and improve the quality of the fleet. In order is expected to continue to drive growth. Improvements are to handle expected traffic increase and improve operational effi- expected to come from several key thrusts including “first mile-last ciency, CN took delivery in 2012 of 25 new high-horsepower loco- mile” initiatives that improve customer service at origin and desti- motives and 123 second-hand high-horsepower locomotives. In nation, and a supply chain perspective that emphasizes collabora- addition, CN expects to take delivery of 40 new high-horsepower tion and better end-to-end service. The Company sees opportunities locomotives and 37 second-hand high-horsepower locomotives for growth across most markets, led by commodities related to oil within the next 24 months. CN also expects to spend approximately and gas, particularly crude oil; by overseas container traffic; by $700 million on facilities to grow the business including transloads, market share gains against truck in domestic intermodal; and a distribution centers, the recently announced Joliet Intermodal continued recovery in the U.S. lumber market. Longer term, the Terminal in Illinois, and the completion of its Calgary Logistics Park Company also expects continued growth in offshore export markets project; on information technology to improve service and operat- including metallurgical and thermal coal as well as potash. ing efficiency; and on other projects to increase productivity. To grow the business at low incremental cost and to operate To meet short- and long-term financial commitments, the efficiently and safely while maintaining a high level of customer Company pursues a solid financial policy framework with the goal service, the Company continues to invest in capital programs to of maintaining a strong balance sheet by monitoring its credit maintain a safe and fluid railway and pursue strategic initiatives to ratios and preserving an investment-grade credit rating to be able improve its franchise, as well as undertake productivity initiatives to to maintain access to public financing. The Company’s principal reduce costs and leverage its assets. Opportunities to improve pro- source of liquidity is cash generated from operations, which can be ductivity extend across all functions in the organization. Train pro- supplemented by its commercial paper program to meet short- ductivity is being improved through the acquisition of locomotives term liquidity needs. The Company’s primary uses of funds are for that are more fuel-efficient than the ones they replace, which will working capital requirements, including income tax installments, also improve service reliability for customers and reduce greenhouse pension contributions, contractual obligations, capital expenditures gas emissions. In addition, the Company’s locomotives are being relating to track infrastructure and other, acquisitions, dividend 10 2012 Annual Report U.S. GAAP Canadian National Railway Company Management’s Discussion and Analysis payouts, and the repurchase of shares through share buyback Developing people programs, when applicable. The Company sets priorities on its uses CN’s ability to develop the best railroaders in the industry has been of available funds based on short-term operational requirements, a key contributor to the Company’s success. CN recognizes that expenditures to continue to operate a safe railway and pursue without the right people – no matter how good a service plan or strategic initiatives, while also considering its long-term contractual business model a company may have – it will not be able to fully obligations and returning value to its shareholders. execute. The Company is focused on recruiting the right people, Delivering responsibly developing employees with the right skills, motivating them to do the right thing, and training them to be the future leaders of the The Company’s commitment to safety is reflected in the wide Company. In 2014, CN expects to open two new state-of-the-art range of initiatives that CN is pursuing and in the size of its capital training centres located in Winnipeg, Manitoba and suburban programs. Comprehensive plans are in place to address safety, Chicago, Illinois as part of a new revitalized company-wide training security, employee well-being and environmental management. program aimed at preparing railroaders to be highly skilled, safety CN’s Safety Management Plan is the framework for putting safety conscious and confident in their work environment. The Company at the center of its day-to-day operations. This proactive plan is continues to address changes in employee demographics that will designed to minimize risk and drive continuous improvement in span multiple years. The Human Resources and Compensation the reduction of injuries and accidents, and engages employees at Committee of the Board of Directors reviews the progress made in all levels of the organization. developing current and future leaders through the Company’s The Company has made sustainability an integral part of its leadership development programs. These programs and initiatives business strategy by aligning its sustainability agenda with its provide a solid platform for the assessment and development of business model. As part of the Company’s comprehensive sustain- the Company’s talent pool. The leadership development programs ability action plan and to comply with the CN Environmental are tightly integrated with the Company’s business strategy. Policy, the Company engages in a number of initiatives, including the use of fuel-efficient locomotives that reduce greenhouse gas The forward-looking statements discussed in this MD&A are sub- emissions; increasing operational and building efficiencies; invest- ject to risks and uncertainties that could cause actual results or ing in virtualization technologies, energy-efficient data centers performance to differ materially from those expressed or implied and recycling programs for information technology systems; in such statements and are based on certain factors and assump- reducing, recycling and reusing waste at its facilities and on its tions which the Company considers reasonable, about events, network; engaging in modal shift agreements that favor low emis- developments, prospects and opportunities that may not materi- sion transport services; and participating in the Carbon Disclosure alize or that may be offset entirely or partially by other events and Project to gain a more comprehensive view of its carbon footprint. developments. See the section of this MD&A entitled Forward- The CN Environmental Policy aims to minimize the impact of looking statements for assumptions and risk factors affecting such the Company’s activities on the environment. The Company strives forward-looking statements. to contribute to the protection of the environment by integrating environmental priorities into the Company’s overall business plan Impact of foreign currency translation on reported results and through the specific monitoring and measurement of such Although the Company conducts its business and reports its earn- priorities against historical performance and in some cases, specific ings in Canadian dollars, a large portion of revenues and expenses targets. All employees must demonstrate commitment to the CN is denominated in US dollars. As such, the Company’s results are Environmental Policy at all times and it is the Environment, Safety affected by exchange rate fluctuations. and Security Committee of the Board of Directors that has the Management’s discussion and analysis includes reference to responsibility of overseeing this policy. This committee is composed “constant currency,” which allows the financial results to be of CN Directors and its responsibilities, powers and operation are viewed without the impact of fluctuations in foreign exchange further described in the charter of such committee, which is rates, thereby facilitating period-to-period comparisons in the included in the Company’s Corporate Governance Manual avail- analysis of trends in business performance. Financial results at able on CN’s website. Certain risk mitigation strategies, such as constant currency are obtained by translating the current period periodic audits, employee training programs and emergency plans results denominated in US dollars at the foreign exchange rate of and procedures, are in place to minimize the environmental risks to the comparable period of the prior year. The average foreign the Company. The CN Environmental Policy, the Company’s exchange rate for the year ended December 31, 2012 was $1.00 Carbon Disclosure Project report, and the Corporate Citizenship per US$1.00 compared to $0.99 per US$1.00 for 2011. Measures Report “Delivering Responsibly” are available on CN’s website. In at constant currency are considered non-GAAP measures and do 2012, the Company’s sustainability practices have earned it a place not have any standardized meaning prescribed by GAAP and on the Dow Jones Sustainability Index (DJSI) North America for the therefore may not be comparable to similar measures presented fourth year in a row and, for the first time, on the DJSI World Index. by other companies. Canadian National Railway Company U.S. GAAP 2012 Annual Report 11 Management’s Discussion and Analysis Forward-looking statements Certain information included in this MD&A are “forward-looking statements” within the meaning of the United States Private Securities Litigation Reform Act of 1995 and under Canadian securities laws. CN cautions that, by their nature, forward-looking statements involve risks, uncertainties and assumptions. The Company cautions that its assumptions may not materialize and that current economic conditions render such assumptions, although reasonable at the time they were made, subject to greater uncertainty. These forward-looking state- ments include, but are not limited to, statements with respect to growth opportunities; statements that the Company will benefit from growth in North American and global economies; the anticipation that cash flow from operations and from various sources of financing will be sufficient to meet debt repayments and future obligations in the foreseeable future; statements regarding future payments, including income taxes and pension contributions; as well as the projected capital spending program. Forward-looking statements could further be identified by the use of terminology such as the Company “believes,” “expects,” “anticipates” or other similar words. Such forward-looking statements are not guarantees of future performance and involve known and unknown risks, uncertainties and other factors which may cause the actual results or performance of the Company or the rail industry to be materially different from the outlook or any future results or performance implied by such statements. Key assumptions used in determining forward-looking information are set forth below. Forward-looking statements Key assumptions or expectations Statements relating to general economic • North American and global economic growth and business conditions, including those • Long-term growth opportunities being less affected by current economic referring to revenue growth opportunities conditions • Year-over-year carload growth Statements relating to the Company’s ability • North American and global economic growth to meet debt repayments and future • Adequate credit ratios obligations in the foreseeable future, including • Investment grade credit rating income tax payments, and capital spending • Access to capital markets • Adequate cash generated from operations Statements relating to pension contributions • Adequate cash generated from operations and other sources of financing • Adequate long-term return on investment on pension plan assets • Level of funding as determined by actuarial valuations, particularly influenced by discount rates for funding purposes Important risk factors that could affect the forward-looking statements include, but are not limited to, the effects of general economic and business conditions; industry competition; inflation, currency and interest rate fluctuations; changes in fuel prices; legislative and/or regula- tory developments; compliance with environmental laws and regulations; actions by regulators; various events which could disrupt opera- tions, including natural events such as severe weather, droughts, floods and earthquakes; labor negotiations and disruptions; environmental claims; uncertainties of investigations, proceedings or other types of claims and litigation; risks and liabilities arising from derailments; and other risks detailed from time to time in reports filed by CN with securities regulators in Canada and the U.S. See the section of this MD&A entitled Business risks for detailed information on major risk factors. CN assumes no obligation to update or revise forward-looking statements to reflect future events, changes in circumstances, or changes in beliefs, unless required by applicable Canadian securities laws. In the event CN does update any forward-looking statement, no inference should be made that CN will make additional updates with respect to that statement, related matters, or any other forward-looking statement. Financial outlook During the year, the Company issued and updated its financial outlook. The 2012 actual results are in line with the latest financial outlook as disclosed by the Company. 12 2012 Annual Report U.S. GAAP Canadian National Railway Company Management’s Discussion and Analysis Financial and statistical highlights $ in millions, except per share data, or unless otherwise indicated 2012 2011 2010 2012 vs. 2011 2011 vs. 2010 Change Favorable/(Unfavorable) Financial results Revenues Operating income Net income (1) (2) (3) Operating ratio Basic earnings per share (1) (2) (3) Diluted earnings per share (1) (2) (3) Dividend declared per share Financial position Total assets Total long-term liabilities $ 9,920 $ 9,028 $ 8,297 $ 3,685 $ 3,296 $ 3,024 $ 2,680 $ 2,457 $ 2,104 10% 12% 9% 9% 9% 17% 62.9% 63.5% 63.6% 0.6-pts 0.1-pts $ $ $ 6.15 6.12 1.50 $ $ $ 5.45 5.41 1.30 $ $ $ 4.51 4.48 1.08 $ 26,659 $ 26,026 $ 25,206 $ 13,438 $ 13,631 $ 12,016 13% 13% 15% 2% 1% 2% 5% 1% 21% 21% 20% 3% (13%) 5% - 1% Statistical operating data and productivity measures (4) Employees (average for the year) 23,466 23,079 22,055 Gross ton miles (GTM) per average number of employees (thousands) 16,354 15,509 15,471 GTMs per US gallon of fuel consumed 987 973 959 (1) The 2012 figures include a gain on disposal of a segment of the Bala and a segment of the Oakville subdivisions of $281 million, or $252 million after-tax ($0.57 per basic or diluted share); and a net income tax expense of $28 million ($0.06 per basic or diluted share) consisting of a $35 million income tax expense resulting from the enactment of higher provincial corporate income tax rates that was partly offset by a $7 million income tax recovery resulting from the recapitalization of a foreign investment. (2) The 2011 figures include gains on disposal of substantially all of the assets of IC RailMarine Terminal Company of $60 million, or $38 million after-tax ($0.08 per basic or diluted share) and of a segment of the Kingston subdivision known as the Lakeshore East of $288 million, or $254 million after-tax ($0.55 per basic or diluted share). The 2011 figures also included a net income tax expense of $40 million ($0.08 per basic or diluted share) resulting from the enactment of state corporate income tax rate changes and other legislated state tax revisions and an income tax recovery of $11 million ($0.02 per basic or diluted share) relating to certain fuel costs attributed to various wholly-owned subsidiaries’ fuel consumption in prior periods. (3) The 2010 figures include a gain on disposal of a portion of the property known as the Oakville subdivision of $152 million, or $131 million after-tax ($0.28 per basic or diluted share). (4) Based on estimated data available at such time and subject to change as more complete information becomes available. Financial results 2012 compared to 2011 In 2012, net income was $2,680 million, an increase of $223 mil- Foreign exchange fluctuations continue to have an impact on lion, or 9%, when compared to 2011, with diluted earnings per the comparability of the results of operations. The fluctuation of share increasing 13% to $6.12. the Canadian dollar relative to the US dollar, which affects the Included in the 2012 figures was a gain on disposal of a segment conversion of the Company’s US dollar-denominated revenues of the Bala and a segment of the Oakville subdivisions (collectively the and expenses, has resulted in a positive impact to net income of “Bala-Oakville”) of $281 million, or $252 million after-tax ($0.57 per $11 million ($0.03 per basic or diluted share) in 2012. basic or diluted share); and a net income tax expense of $28 million Revenues for the year ended December 31, 2012 increased by ($0.06 per basic or diluted share) consisting of a $35 million income $892 million, or 10%, to $9,920 million, mainly attributable to tax expense resulting from the enactment of higher provincial corpo- higher freight volumes, due in part to growth in North American rate income tax rates that was partly offset by a $7 million income tax and Asian economies, and the Company’s performance above recovery resulting from the recapitalization of a foreign investment. market conditions in a number of segments, as well as increased Included in the 2011 figures were gains on disposal of substantially volumes in the second quarter as a result of a labor disruption at a all of the assets of IC RailMarine Terminal Company (“IC RailMarine”) key competitor; freight rate increases; the impact of a higher fuel of $60 million, or $38 million after-tax ($0.08 per basic or diluted surcharge as a result of year-over-year increases in applicable fuel share) and of a segment of the Kingston subdivision known as the prices and higher volumes; and the positive translation impact of Lakeshore East of $288 million, or $254 million after-tax ($0.55 per the weaker Canadian dollar on US dollar-denominated revenues. basic or diluted share). The 2011 figures also included a net income Operating expenses for the year ended December  31, 2012 tax expense of $40 million ($0.08 per basic or diluted share) resulting increased by $503 million, or 9%, to $6,235 million, mainly due from the enactment of state corporate income tax rate changes and to higher labor and fringe benefits expense, increased purchased other legislated state tax revisions and an income tax recovery of services and material expense, as well as increased fuel costs. $11 million ($0.02 per basic or diluted share) relating to certain fuel The operating ratio, defined as operating expenses as a per- costs attributed to various wholly-owned subsidiaries’ fuel consump- centage of revenues, was 62.9% in 2012, compared to 63.5% in tion in prior periods. 2011, a 0.6-point improvement. Canadian National Railway Company U.S. GAAP 2012 Annual Report 13 Management’s Discussion and Analysis Revenues Petroleum and chemicals In millions, unless otherwise indicated Year ended December 31, 2012 2011 % Change % Change at constant currency Rail freight revenues $ 8,938 $ 8,111 10% 10% Other revenues Total revenues 982 917 7% $ 9,920 $ 9,028 10% 6% 9% Rail freight revenues Petroleum and chemicals $ 1,640 $ 1,420 15% 15% Metals and minerals 1,133 1,006 13% 12% Forest products 1,331 1,270 5% 4% Coal 712 618 15% 15% Grain and fertilizers 1,590 1,523 4% 4% Intermodal Automotive 1,994 1,790 11% 11% 538 484 11% 10% Total rail freight revenues $ 8,938 $ 8,111 10% 10% Revenue ton miles (RTM) (millions) 201,496 187,753 7% Rail freight revenue/RTM (cents) Carloads 4.44 4.32 (thousands) 5,059 4,873 Rail freight revenue/carload (dollars) 1,767 1,664 3% 4% 6% 7% 2% 4% 6% Revenues for the year ended December  31, 2012 totaled $9,920 million compared to $9,028 million in 2011. The increase of $892 million, or 10%, was mainly attributable to higher freight volumes, due in part to growth in North American and Asian economies, and the Company’s performance above market condi- tions in a number of segments, as well as increased volumes in the second quarter as a result of a labor disruption at a key competi- tor; freight rate increases; the impact of a higher fuel surcharge, in the range of $140 million, as a result of year-over-year increases in applicable fuel prices and higher volumes; and the positive Year ended December 31, 2012 2011 % Change % Change at constant currency Revenues (millions) $ 1,640 $ 1,420 15% 15% RTMs (millions) 37,449 32,962 14% 14% Revenue/RTM (cents) 4.38 4.31 2% 1% The petroleum and chemicals commodity group comprises a wide range of commodities, including chemicals, sulfur, plastics, petro- leum products and liquefied petroleum gas products. The primary markets for these commodities are within North America, and as such, the performance of this commodity group is closely cor- related with the North American economy. Most of the Company’s petroleum and chemicals shipments originate in the Louisiana petrochemical corridor between New Orleans and Baton Rouge; in northern Alberta, which is a major center for natural gas feed- stock and world-scale petrochemicals and plastics; and in eastern Canadian regional plants. For the year ended December 31, 2012, revenues for this commodity group increased by $220 million, or 15%, when compared to 2011. The increase was mainly due to higher shipments of crude oil, propane, condensate, petroleum lubricants, and asphalt; freight rate increases; a higher fuel sur- charge; and the positive translation impact of a weaker Canadian dollar. These gains were partly offset by lower volumes of molten sulfur to the U.S. market and reduced shipments of gasoline and diesel. Revenue per revenue ton mile increased by 2% in 2012, mainly due to freight rate increases, a higher fuel surcharge and the positive translation impact of a weaker Canadian dollar, partly offset by a significant increase in the average length of haul. Percentage of revenues Carloads (thousands) 46% Chemicals and plastics Year ended December 31, 32% Refined petroleum products 14% Crude and condensate 2010 549 2011 560 2012 594 translation impact of the weaker Canadian dollar on US dollar- 8% Sulfur denominated revenues. In 2012, revenue ton miles (RTM), measuring the relative 46% 32% weight and distance of rail freight transported by the Company, increased by 7% relative to 2011. Rail 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 3% when compared to 2011, driven by freight rate increases, the impact of a higher fuel surcharge, and the positive translation impact of the weaker Canadian dollar. These factors were partly offset by an increase in the average length of haul. 14% 8% 14 2012 Annual Report U.S. GAAP Canadian National Railway Company Management’s Discussion and Analysis Metals and minerals Year ended December 31, 2012 2011 % Change % Change at constant currency Revenues (millions) $ 1,133 $ 1,006 13% 12% RTMs (millions) 20,236 18,899 Revenue/RTM (cents) 5.60 5.32 7% 5% 7% 4% The metals and minerals com- Forest products modity group consists primarily of non-ferrous base metals and ores, concentrates, iron ore, steel, construction materials, Year ended December 31, 2012 2011 % Change % Change at constant currency machinery and dimensional RTMs (millions) (large) loads. The Company pro- Revenue/RTM (cents) 29,674 29,336 4.49 4.33 Revenues (millions) $ 1,331 $ 1,270 5% 1% 4% 4% 1% 3% vides unique rail access to alu- minum, mining, steel and iron ore producing regions, which are among the most important in North America. This access, coupled with the Company’s transload and port facilities, has made CN a leader in the trans- portation of copper, lead, zinc, concentrates, iron ore, refined metals and aluminum. Mining, oil and gas development and non-residential construction are the key drivers for metals and minerals. For the year ended December  31, 2012, revenues for this commodity group increased by $127 million, or 13%, when compared to 2011. The increase was mainly due to greater ship- ments of materials supporting oil and gas development, increased volumes of machinery and dimensional loads, steel products, and industrial materials; freight rate increases; a higher fuel surcharge; and the positive translation impact of a weaker Canadian dollar. These gains were partly offset by lower volumes of non-ferrous metals and iron ore. Revenue per revenue ton mile increased by 5% in 2012, mainly due to freight rate increases, a higher fuel surcharge, and the positive translation impact of a weaker Canadian dollar, partly offset by an increase in the average length of haul. The forest products commodity group includes various types of lumber, panels, paper, wood pulp and other fibers such as logs, recycled paper, wood chips, and wood pellets. The Company has extensive rail access to the western and eastern Canadian fiber-producing regions, which are among the largest fiber source areas in North America. In the U.S., the Company is strategically located to serve both the Midwest and southern U.S. corridors with interline connections to other Class I railroads. The key driv- ers for the various commodities are: for newsprint, advertising lineage, non-print media and overall economic conditions, primar- ily in the U.S.; for fibers (mainly wood pulp), the consumption of paper, pulpboard and tissue in North American and offshore mar- kets; and for lumber and panels, housing starts and renovation activities primarily in the U.S. For the year ended December  31, 2012, revenues for this commodity group increased by $61 mil- lion, or 5%, when compared to 2011. The increase was mainly due to freight rate increases, a higher fuel surcharge, the positive translation impact of a weaker Canadian dollar and increased shipments of lumber and panels to the U.S. market. These factors were partly offset by reduced paper shipments due to mill closures and curtailments, as well as decreased shipments of lumber for offshore export. Revenue per revenue ton mile increased by 4% in 2012, mainly due to freight rate increases, a higher fuel surcharge, and the positive translation impact of a weaker Canadian dollar. Percentage of revenues Carloads (thousands) 57% Pulp and paper Year ended December 31, Percentage of revenues Carloads (thousands) 43% Lumber and panels 41% Metals 41% Minerals 18% Iron ore 41% 41% 18% Year ended December 31, 2010 990 2011 1,013 2012 1,024 57% 43% 2010 423 2011 443 2012 445 Canadian National Railway Company U.S. GAAP 2012 Annual Report 15 Management’s Discussion and Analysis Coal Grain and fertilizers Year ended December 31, 2012 2011 % Change % Change at constant currency Year ended December 31, 2012 2011 % Change % Change at constant currency Revenues (millions) $ 712 $ 618 15% 15% Revenues (millions) $ 1,590 $ 1,523 RTMs (millions) 23,570 19,980 18% 18% RTMs (millions) 45,417 45,468 Revenue/RTM (cents) 3.02 3.09 (2%) (3%) Revenue/RTM (cents) 3.50 3.35 4% - 4% 4% - 4% The coal commodity group con- The grain and fertilizers commodity group depends primarily on sists of thermal grades of bitumi- crops grown and fertilizers processed in western Canada and the nous coal, metallurgical coal and U.S. Midwest. The grain segment consists of three primary seg- petroleum coke. Canadian thermal ments: food grains (mainly wheat, oats and malting barley), feed and metallurgical coal are largely grains and feed grain products (including feed barley, feed wheat, exported via terminals on the west peas, corn, ethanol and dried distillers grains), and oilseeds and coast of Canada to offshore mar- oilseed products (primarily canola seed, oil and meal, and soy- kets. In the U.S., thermal coal is beans). Production of grain varies considerably from year to year, transported from mines served in affected primarily by weather conditions, seeded and harvested southern Illinois, or from western acreage, the mix of grains produced and crop yields. Grain exports U.S. mines via interchange with are sensitive to the size and quality of the crop produced, interna- other railroads, to major utilities in tional market conditions and foreign government policy. The the Midwest and southeast U.S., majority of grain produced in western Canada and moved by CN as well as offshore markets via is exported via the ports of Vancouver, Prince Rupert and Thunder terminals in the Gulf and the Port Bay. Certain of these rail movements are subject to government of Prince Rupert. For the year regulation and to a revenue cap, which effectively establishes a ended December  31, 2012, reve- maximum revenue entitlement that railways can earn. In the U.S., nues for this commodity group grain grown in Illinois and Iowa is exported as well as transported increased by $94 million, or 15%, to domestic processing facilities and feed markets. The Company when compared to 2011. The also serves major producers of potash in Canada, as well as pro- increase was mainly due to higher ducers of ammonium nitrate, urea and other fertilizers across volumes of U.S. thermal coal to Canada and the U.S. For the year ended December  31, 2012, the Gulf and west coast ports, revenues for this commodity group increased by $67 million, or Canadian petroleum coke and metallurgical coal for offshore 4%, when compared to 2011. The increase was mainly due to export; freight rate increases; a higher fuel surcharge; and the freight rate increases; a higher fuel surcharge; higher volumes of positive translation impact of a weaker Canadian dollar. These Canadian wheat exports, U.S. soybean product exports to the factors were partly offset by reduced volumes of thermal coal to Gulf, and Canadian barley to the U.S.; and the positive translation U.S. utilities. Revenue per revenue ton mile decreased by 2% in impact of a weaker Canadian dollar. These gains were partly offset 2012, due to a significant increase in the average length of haul, by lower volumes of corn, peas, and ethanol. Revenue per reve- partly offset by freight rate increases, a higher fuel surcharge and nue ton mile increased by 4% in 2012, mainly due to freight rate the positive translation impact of a weaker Canadian dollar. increases, a higher fuel surcharge and the positive translation Percentage of revenues Carloads (thousands) 85% Coal Year ended December 31, Percentage of revenues Carloads (thousands) impact of a weaker Canadian dollar. 15% Petroleum coke 15% 85% 2010 499 2011 464 2012 435 32% Oilseeds 27% Food grains 22% Feed grains 19% Fertilizers 32% 27% 19% 22% Year ended December 31, 2010 579 2011 592 2012 597 16 2012 Annual Report U.S. GAAP Canadian National Railway Company Management’s Discussion and Analysis Automotive Year ended December 31, 2012 2011 % Change % Change at constant currency Revenues (millions) $ 538 $ 484 11% 10% RTMs (millions) Revenue/RTM (cents) 2,754 2,545 19.54 19.02 8% 3% 8% 2% The automotive commodity group moves both finished vehicles and parts throughout North America, providing rail access to cer- tain vehicle assembly plants in Canada, and Michigan and Mississippi in the U.S. The Intermodal Year ended December 31, 2012 2011 % Change % Change at constant currency Revenues (millions) $ 1,994 $ 1,790 11% 11% RTMs (millions) 42,396 38,563 10% 10% Revenue/RTM (cents) 4.70 4.64 1% 1% The intermodal commodity group is comprised of two segments: Company also serves vehicle distribution domestic and international. The domestic segment transports con- facilities in Canada and the U.S., as well as sumer products and manufactured goods, operating through both parts production facilities in Michigan and retail and wholesale channels, within domestic Canada, domestic Ontario. The Company serves shippers of U.S., Mexico and transborder, while the international segment han- import vehicles via the ports of Halifax and dles import and export container traffic, directly serving the major Vancouver, and through interchange with ports of Vancouver, Prince Rupert, Montreal, Halifax and New other railroads. The Company’s automotive Orleans. The domestic segment is driven by consumer markets, with revenues are closely correlated to automo- growth generally tied to the economy. The international segment is tive production and sales in North America. driven by North American economic and trade conditions. For the For the year ended December  31, 2012, year ended December 31, 2012, revenues for this commodity group revenues for this commodity group increased by $54 million, or 11%, increased by $204 million, or 11%, when compared to 2011. The when compared to 2011. The increase was mainly due to higher increase was mainly due to higher shipments through the west volumes of imported finished vehicles via the Port of Vancouver and coast ports and increased volumes of domestic shipments of con- spot moves of military equipment; freight rate increases; a higher fuel sumer and industrial products; a higher fuel surcharge; freight rate surcharge; and the positive translation impact of a weaker Canadian increases; and the positive translation impact of a weaker Canadian dollar. Revenue per revenue ton mile increased by 3% in 2012, dollar. Revenue per revenue ton mile increased by 1% in 2012, mainly due to freight rate increases, a higher fuel surcharge and the mainly due to a higher fuel surcharge, freight rate increases and the positive translation impact of a weaker Canadian dollar, partly offset positive translation impact of a weaker Canadian dollar. by an increase in the average length of haul. Percentage of revenues Carloads (thousands) Percentage of revenues Carloads (thousands) Year ended December 31, 89% Finished vehicles Year ended December 31, 2010 1,455 2011 1,584 2012 1,742 11% Auto parts 11% 89% 2010 201 2011 217 2012 222 56% International 44% Domestic 56% 44% Other revenues Year ended December 31, 2012 2011 % Change % Change at constant currency Revenues (millions) $ 982 $ 917 7% 6% Percentage of revenues 52% Other non-rail services 29% Vessels and docks 19% Interswitching and other revenues 52% 29% 19% Other revenues are largely derived from non-rail services that support CN’s rail business including vessels, docks, warehousing, Autoport logistic service and trucking as well as from other items which include interswitching and commuter train revenues. In 2012, Other revenues amounted to $982 million, an increase of $65 million, or 7%, when compared to 2011, mainly due to higher revenues from freight forwarding and transportation management, vessels and docks, intermodal trucking, and warehousing and distribution, partly offset by the loss of revenues due to the sale of IC RailMarine in August 2011 and lower commuter train revenues. Canadian National Railway Company U.S. GAAP 2012 Annual Report 17 Management’s Discussion and Analysis Operating expenses Operating expenses for the year ended December 31, 2012 amounted to $6,235 million, compared to $5,732 million in 2011. The increase of $503 million, or 9%, in 2012 was mainly due to higher labor and fringe benefits expense, increased purchased services and material expense, as well as increased fuel costs. In millions Year ended December 31, 2012 2011 % Change % Change at constant currency Percentage of revenues 2012 2011 Labor and fringe benefits Purchased services and material Fuel Depreciation and amortization Equipment rents Casualty and other Total operating expenses $ 1,952 1,248 1,524 924 249 338 $ 1,812 1,120 1,412 884 228 276 (8%) (11%) (8%) (5%) (9%) (7%) 19.7% (11%) 12.6% (7%) (4%) (8%) 15.4% 9.3% 2.5% (22%) (22%) 3.4% 20.1% 12.4% 15.6% 9.8% 2.5% 3.1% $ 6,235 $ 5,732 (9%) (8%) 62.9% 63.5% Labor and fringe benefits: Labor and fringe benefits expense Fuel: Fuel expense includes fuel consumed by assets, including includes wages, payroll taxes, and employee benefits such as locomotives, vessels, vehicles and other equipment as well as incentive compensation, including stock-based compensation; federal, provincial and state fuel taxes. These expenses increased health and welfare; and pensions and other postretirement bene- by $112 million, or 8%, in 2012 when compared to 2011. The fits. Certain incentive and stock-based compensation plans are increase was primarily due to higher freight volumes and a higher based on financial and market performance targets and the average price for fuel, which were partly offset by productivity related expense is recorded in relation to the attainment of such improvements. targets. These expenses increased by $140 million, or 8%, in 2012 when compared to 2011. The increase was primarily a result of Depreciation and amortization: Depreciation and amortization the impact of a higher workforce level due to volume growth, and expense relates to the Company’s rail and related operations. general wage increases; and increased pension expense; which Depreciation expense is affected by capital additions, railroad were offset by the recognition of a net settlement gain from the property retirements from disposal, sale and/or abandonment and termination of the former Chief Executive Officer’s retirement other adjustments including asset impairment write-downs. These benefit plan in the fourth quarter of 2012. expenses increased by $40 million, or 5%, in 2012 when com- pared to 2011. The increase was mainly due to the impact of net Purchased services and material: Purchased services and material capital additions. expense primarily includes the costs of services purchased from outside contractors; materials used in the maintenance of the Equipment rents: Equipment rents expense includes rental expense Company’s track, facilities and equipment; transportation and for the use of freight cars owned by other railroads or private lodging for train crew employees; utility costs; and the net costs companies and for the short- or long-term lease of freight cars, of operating facilities jointly used by the Company and other rail- locomotives and intermodal equipment, net of rental income from roads. These expenses increased by $128 million, or 11%, in 2012 other railroads for the use of the Company’s cars and locomotives. when compared to 2011. The increase was mainly due to higher These expenses increased by $21 million, or 9%, in 2012 when expenses for contracted services and for third-party non-rail trans- compared to 2011. The increase was due to increased lease portation services as a result of higher volumes; as well as higher expenses on account of volume increases, as well as higher car maintenance expenses for track, rolling stock and other equip- hire expenses. ment. These factors were partly offset by lower accident-related expenses; as well as reduced expenses for snow removal and utilities, primarily as a result of milder winter conditions at the beginning of the year. 18 2012 Annual Report U.S. GAAP Canadian National Railway Company Management’s Discussion and Analysis Casualty and other: Casualty and other expense includes expenses 2011 compared to 2010 for personal injuries, environmental, freight and property damage, In 2011, net income was $2,457 million, an increase of $353 mil- insurance, bad debt, operating taxes, and travel expenses. These lion, or 17%, when compared to 2010, with diluted earnings per expenses increased by $62 million, or 22%, in 2012 when com- share rising 21% to $5.41. pared to 2011. The increase was mainly due to increased provi- Included in the 2011 figures were gains on disposal of sub- sions for environmental and legal expenses, higher property taxes stantially all of the assets of IC RailMarine of $60 million, or and workers’ compensation expenses pursuant to an actuarial $38 million after-tax ($0.08 per basic or diluted share) and of the study, which were partly offset by lower expenses for loss and Lakeshore East of $288 million, or $254 million after-tax damage claims. Other ($0.55 per basic or diluted share). The 2011 figures also include a net income tax expense of $40 million ($0.08 per basic or diluted share) resulting from the enactment of state corporate income tax Interest expense: In 2012, interest expense was $342 million com- rate changes and other legislated state tax revisions, and an pared to $341 million in 2011. The increase was mainly due to the income tax recovery of $11 million ($0.02 per basic or diluted issuance of a higher level of debt with a lower interest rate and share) relating to certain fuel costs attributed to various wholly- the negative translation impact of the weaker Canadian dollar on owned subsidiaries’ fuel consumption in prior periods. Included US dollar-denominated interest expense, which were offset by a in the 2010 figures was a gain on disposal of a portion of the repayment of debt with a higher interest rate. property known as the Oakville subdivision of $152 million, or $131 million after-tax ($0.28 per basic or diluted share). Other income: In 2012, the Company recorded Other income of Foreign exchange fluctuations continue to have an impact on $315 million compared to $401 million in 2011. Included in Other the comparability of the results of operations. The fluctuation of income for 2012 was a gain on disposal of the Bala-Oakville of the Canadian dollar relative to the US dollar, which affects the $281 million compared to gains on disposal of substantially all of conversion of the Company’s US dollar-denominated revenues the assets of IC RailMarine of $60 million and the Lakeshore East and expenses resulted in a negative impact of $39 million of $288 million in 2011. ($0.09 per basic or diluted share) in 2011. Revenues for the year ended December 31, 2011 increased by Income tax expense: The Company recorded income tax expense $731 million, or 9%, to $9,028 million, mainly attributable to of $978 million for the year ended December 31, 2012 compared higher freight volumes, due in part to modest improvements in to $899 million in 2011. The 2012 figure includes a net income North American and global economies and to the Company’s tax expense of $28 million, which consisted of a $35 million performance above market conditions in a number of segments; income tax expense resulting from the enactment of higher pro- the impact of a higher fuel surcharge as a result of year-over-year vincial corporate income tax rates that was partly offset by a increases in applicable fuel prices and higher volumes; and freight $7 million income tax recovery resulting from the recapitalization rate increases. These factors were partly offset by the negative of a foreign investment. Included in the 2011 figure was a net translation impact of the stronger Canadian dollar on US dollar- income tax expense of $40 million, resulting from the enactment denominated revenues in the first nine months of the year. of state corporate income tax rate changes and other legislated Operating expenses for the year ended December  31, 2011, state tax revisions, and an income tax recovery of $11 million increased by $459 million, or 9%, to $5,732 million, mainly due relating to certain fuel costs attributed to various wholly-owned to higher fuel costs, purchased services and material expense as subsidiaries’ fuel consumption in prior periods. The effective tax well as higher labor and fringe benefits expense. These factors rate for 2012 was 26.7% compared to 26.8% in 2011. were partially offset by the positive translation impact of the stron- ger Canadian dollar on US dollar-denominated expenses, particu- larly in the first nine months of 2011, and lower casualty and other expense. The operating ratio, defined as operating expenses as a per- centage of revenues, was 63.5% in 2011, compared to 63.6% in 2010, a 0.1-point improvement. Canadian National Railway Company U.S. GAAP 2012 Annual Report 19 Management’s Discussion and Analysis Revenues In millions, unless otherwise indicated Year ended December 31, 2011 2010 % Change % Change at constant currency Rail freight revenues $ 8,111 $ 7,417 Other revenues Total revenues 917 880 $ 9,028 $ 8,297 9% 4% 9% 12% 6% 11% Rail freight revenues Petroleum and chemicals $ 1,420 $ 1,322 7% 10% Metals and minerals 1,006 861 17% 20% Forest products 1,270 1,183 Coal 618 600 Grain and fertilizers 1,523 1,418 7% 3% 7% 10% 5% 10% 2010. The increase was mainly due to higher shipments, particu- larly chemicals products, as a result of improvements in industrial production, new crude oil business, particularly in the fourth quarter of 2011, and refined petroleum products; the impact of a higher fuel surcharge; and freight rate increases. These factors were partly offset by the negative translation impact of the stron- ger Canadian dollar and lower volumes of condensate in the first half of 2011. Revenue per revenue ton mile increased by 2% in 2011, mainly due to the impact of a higher fuel surcharge and freight rate increases that were partly offset by the negative trans- lation impact of the stronger Canadian dollar and an increase in the average length of haul. Metals and minerals Intermodal Automotive 1,790 1,576 14% 15% Total rail freight revenues $ 8,111 $ 7,417 484 457 6% 9% 9% 12% Year ended December 31, 2011 2010 % Change % Change at constant currency Revenue ton miles (RTM) (millions) 187,753 179,232 5% Rail freight revenue/RTM (cents) Carloads 4.32 4.14 (thousands) 4,873 4,696 Rail freight revenue/carload (dollars) 1,664 1,579 4% 4% 5% 5% 7% 4% 8% Revenues for the year ended December  31, 2011 totaled $9,028 million compared to $8,297 million in 2010. The increase of $731 million was mainly attributable to higher freight volumes, due in part to modest improvements in North American and global economies and to the Company’s performance above mar- ket conditions in a number of segments; the impact of a higher fuel surcharge, in the range of $315 million, as a result of year- over-year increases in applicable fuel prices and higher volumes; and freight rate increases. These factors were partly offset by the negative translation impact of the stronger Canadian dollar on US dollar-denominated revenues in the first nine months of 2011. In 2011, revenue ton miles increased by 5% relative to 2010. Rail freight revenue per revenue ton mile increased by 4% when Revenues (millions) $ 1,006 $ 861 17% 20% RTMs (millions) 18,899 16,443 15% 15% Revenue/RTM (cents) 5.32 5.24 2% 5% For the year ended December  31, 2011, revenues for this com- modity group increased by $145 million, or 17%, when compared to 2010. The increase was mainly due to greater shipments, par- ticularly of commodities related to oil and gas development, steel-related products and non-ferrous ore; the impact of freight rate increases; and a higher fuel surcharge. These gains were partly offset by the negative translation impact of the stronger Canadian dollar. Revenue per revenue ton mile increased by 2% in 2011, mainly due to the impact of freight rate increases and a higher fuel surcharge that were offset by the negative translation impact of the stronger Canadian dollar and a significant increase in the average length of haul. Forest products Year ended December 31, 2011 2010 % Change % Change at constant currency compared to 2010, driven by the impact of a higher fuel sur- Revenues (millions) $ 1,270 $ 1,183 charge and freight rate increases. These were partly offset by the RTMs (millions) 29,336 28,936 negative translation impact of the stronger Canadian dollar. Revenue/RTM (cents) 4.33 4.09 7% 1% 6% 10% 1% 9% Petroleum and chemicals Year ended December 31, 2011 2010 % Change % Change at constant currency Revenues (millions) $ 1,420 $ 1,322 RTMs (millions) 32,962 31,190 Revenue/RTM (cents) 4.31 4.24 7% 6% 2% 10% 6% 4% For the year ended December  31, 2011, revenues for this com- modity group increased by $98 million, or 7%, when compared to For the year ended December  31, 2011, revenues for this com- modity group increased by $87 million, or 7%, when compared to 2010. The increase was attributable to the impact of a higher fuel surcharge; freight rate increases; higher lumber and wood pellet shipments to offshore markets, and increased panel shipments to the U.S., particularly in the fourth quarter of 2011. These factors were partly offset by the negative translation impact of the stron- ger Canadian dollar and reduced volumes of woodpulp in the second half of 2011 due to extended maintenance at various mills. Revenue per revenue ton mile increased by 6% in 2011, 20 2012 Annual Report U.S. GAAP Canadian National Railway Company Management’s Discussion and Analysis mainly due to the impact of a higher fuel surcharge, freight rate Intermodal increases and a decrease in the average length of haul. These factors were partly offset by the negative translation impact of the stronger Canadian dollar. Year ended December 31, 2011 2010 % Change % Change at constant currency Coal Year ended December 31, 2011 2010 % Change % Change at constant currency Revenues (millions) $ 618 $ 600 RTMs (millions) 19,980 19,766 Revenue/RTM (cents) 3.09 3.04 3% 1% 2% 5% 1% 4% Revenues (millions) $ 1,790 $ 1,576 14% 15% RTMs (millions) 38,563 35,803 Revenue/RTM (cents) 4.64 4.40 8% 5% 8% 6% For the year ended December  31, 2011, revenues for this com- modity group increased by $214 million, or 14%, when compared to 2010. The increase was mainly due to higher volumes of domestic traffic and shipments related to overseas markets; the impact of a higher fuel surcharge; and freight rate increases. For the year ended December  31, 2011, revenues for this com- These factors were partly offset by the negative translation impact modity group increased by $18 million, or 3%, when compared to of the stronger Canadian dollar. Revenue per revenue ton mile 2010. The increase was mainly due to the impact of a higher fuel increased by 5% in 2011, mainly due to the impact of a higher surcharge; freight rate increases; and new export thermal coal fuel surcharge and freight rate increases that were partly offset by shipments. These factors were partly offset by reduced volumes of the negative translation impact of the stronger Canadian dollar. thermal coal to North American utilities, export metallurgical coal and Canadian petroleum coke; and the negative translation Automotive impact of the stronger Canadian dollar. Revenue per revenue ton mile increased by 2% in 2011, primarily due to the impact of a higher fuel surcharge and freight rate increases that were partly Year ended December 31, 2011 2010 % Change % Change at constant currency offset by the negative translation impact of the stronger Canadian dollar and an increase in the average length of haul. Grain and fertilizers Year ended December 31, 2011 2010 % Change % Change at constant currency Revenues (millions) $ 1,523 $ 1,418 RTMs (millions) 45,468 44,549 Revenue/RTM (cents) 3.35 3.18 7% 2% 5% 10% 2% 8% Revenues (millions) $ 484 $ 457 RTMs (millions) 2,545 2,545 Revenue/RTM (cents) 19.02 17.96 6% - 6% 9% - 9% For the year ended December  31, 2011, revenues for this com- modity group increased by $27 million, or 6%, when compared to 2010. The increase was mainly due to higher volumes of domestic finished vehicles; freight rate increases; and the impact of a higher fuel surcharge. These gains were partly offset by the negative translation impact of the stronger Canadian dollar. Revenue per revenue ton mile increased by 6% in 2011, mainly due to freight For the year ended December  31, 2011, revenues for this com- rate increases, the impact of a higher fuel surcharge and a modity group increased by $105 million, or 7%, when compared decrease in the average length of haul that were partly offset by to 2010. The increase was mainly due to freight rate increases; the the negative translation impact of the stronger Canadian dollar. impact of a higher fuel surcharge; and higher volumes, including record shipments of canola to export markets and processed Other revenues canola products to the U.S., increased shipments of ethanol and dried distillers grains, and higher volumes of Canadian oats to U.S. millers. These factors were partly offset by the negative translation Year ended December 31, 2011 2010 % Change % Change at constant currency impact of the stronger Canadian dollar; reduced volumes of U.S. soybean and corn exports, mainly in the fourth quarter of 2011, Revenues (millions) $ 917 $ 880 4% 6% and lower volumes of Canadian wheat for export markets, partic- In 2011, Other revenues amounted to $917 million, an increase ularly in the first half of 2011. Revenue per revenue ton mile of $37 million, or 4%, when compared to 2010, mainly due to increased by 5% in 2011, mainly due to freight rate increases and increased revenues from vessels and docks, trucking, and ware- the impact of a higher fuel surcharge that were partly offset by housing and distribution services, partly offset by lower interna- the negative translation impact of the stronger Canadian dollar. tional freight forwarding revenues, the negative translation impact of the stronger Canadian dollar, and lower commuter train revenues. Canadian National Railway Company U.S. GAAP 2012 Annual Report 21 Management’s Discussion and Analysis Operating expenses Operating expenses for the year ended December 31, 2011 amounted to $5,732 million, compared to $5,273 million in 2010. The increase of $459 million, or 9%, in 2011 was mainly due to higher fuel costs, purchased services and material expense, labor and fringe benefits expense as well as higher depreciation and amortization. These factors were partially offset by the positive translation impact of the stronger Canadian dollar on US dollar-denominated expenses, particularly in the first nine months of 2011 and lower casualty and other expense. In millions Year ended December 31, 2011 2010 % Change % Change at constant currency Percentage of revenues 2011 2010 Labor and fringe benefits Purchased services and material Fuel Depreciation and amortization Equipment rents Casualty and other Total operating expenses $ 1,812 1,120 $ 1,744 1,036 1,412 1,048 884 228 276 834 243 368 (4%) (8%) (35%) (6%) 6% (6%) 20.1% (10%) (40%) (7%) 3% 12.4% 15.6% 9.8% 2.5% 3.1% 21.0% 12.5% 12.6% 10.1% 2.9% 4.5% 25% 23% $ 5,732 $ 5,273 (9%) (11%) 63.5% 63.6% Labor and fringe benefits: Labor and fringe benefits expense Depreciation and amortization: Depreciation and amortization increased by $68 million, or 4%, in 2011 when compared to expense increased by $50 million, or 6%, in 2011 when com- 2010. The increase was primarily due to the impact of increased pared to 2010. The increase was mainly due to the impact of net freight volumes, including a higher workforce level, general wage capital additions and the effect of depreciation studies, which increases, higher health and welfare costs, as well as higher incen- were partly offset by the positive translation impact of the stron- tive compensation, particularly in the fourth quarter of 2011. ger Canadian dollar. These factors were partly offset by the positive translation impact of the stronger Canadian dollar and a higher income for pensions. Equipment rents: Equipment rents expense decreased by $15 mil- Purchased services and material: Purchased services and material primarily due to lower lease expense and to the positive transla- expense increased by $84 million, or 8%, in 2011 when compared tion impact of the stronger Canadian dollar partly offset by higher lion, or 6%, in 2011 when compared to 2010. The decrease was to 2010. The increase was mainly due to higher repair and mainte- car hire expense. nance expenses for track, rolling stock and other equipment, higher accident-related expenses, increased contracted services Casualty and other: Casualty and other expense decreased by and material expense in the first nine months of 2011 as well as $92 million, or 25%, in 2011 when compared to 2010. The higher costs for snow removal and utilities, as a result of more decrease was mainly due to lower charges recorded in 2011 relat- difficult winter conditions in the first quarter of 2011. These factors ing to environmental matters, adjustments recorded on billings of were partly offset by the positive translation impact of the stronger certain cost recoveries recorded in 2010, lower general and Canadian dollar and lower expenses for third-party carriers. administrative expenses as well as a charge recorded in the first quarter of 2010 to increase the liability for personal injury claims Fuel: Fuel expense increased by $364 million, or 35%, in 2011 in Canada pursuant to an actuarial valuation. These factors were when compared to 2010. The increase was primarily due to a partially offset by increased employee travel costs and higher higher average price for fuel and higher freight volumes, which operating taxes. were partly offset by the positive translation impact of the stron- ger Canadian dollar and by productivity improvements. 22 2012 Annual Report U.S. GAAP Canadian National Railway Company Management’s Discussion and Analysis Other Income tax expense: The Company recorded income tax expense Interest expense: Interest expense decreased by $19 million, or of $899 million for the year ended December 31, 2011 compared 5%, for the year ended December 31, 2011, when compared to to $772 million in 2010. The 2011 figure includes a net income 2010, mainly due to the positive translation impact of the stronger tax expense of $40 million resulting from the enactment of state Canadian dollar on US dollar-denominated interest expense and corporate income tax rate changes and other legislated state tax the impact of a debt repayment in the fourth quarter of 2011. revisions, and an income tax recovery of $11 million relating to certain fuel costs attributed to various wholly-owned subsidiaries’ Other income: In 2011, the Company recorded Other income of fuel consumption in prior periods. The effective tax rate was $401 million, compared to $212 million in 2010. Included in Other 26.8% for both 2011 and 2010. income were gains on disposal of substantially all of the assets of IC RailMarine of $60 million and of the Lakeshore East for $288 million. The 2010 figures include $152 million for the sale of a portion of the property known as the Oakville subdivision. Summary of fourth quarter 2012 compared to corresponding quarter in 2011 – unaudited Fourth quarter 2012 net income was $610 million, an increase of $18 million, or 3%, when compared to the same period in 2011, with diluted earnings per share rising 7% to $1.41. The fourth-quarter 2011 figures include an item affecting the comparability of the results of operations. The 2011 figures include an income tax recovery of $11 million ($0.02 per basic or diluted share) relating to certain fuel costs attributed to various wholly-owned sub- sidiaries’ fuel consumption in prior periods. Foreign exchange fluctuations continued to have an impact on the comparability of the results of operations. The fluctuation of the Canadian dollar relative to the US dollar, which affects the conversion of the Company’s US dollar-denominated revenues and expenses, has resulted in a negative impact of $9 million ($0.02 per basic or diluted share) to fourth-quarter 2012 net income. Revenues for the fourth quarter of 2012 increased by $157 million, or 7%, to $2,534 million, when compared to the same period in 2011. The increase was attributable to higher freight volumes, due in part to modest improvements in North American and global econo- mies and to the Company’s performance above market conditions in a number of segments; freight rate increases; and the impact of a higher fuel surcharge as a result of year-over-year increases in applicable fuel prices and higher volumes. These gains were partly offset by the negative translation impact of the stronger Canadian dollar on US dollar-denominated revenues. Operating expenses for the fourth quarter of 2012 increased by $74 million, or 5%, to $1,612 million, when compared to the same period in 2011. The increase was primarily due to higher casualty and other expense, as well as increased expenses for purchased services and material. These factors were partly offset by lower labor and fringe benefits expense. The operating ratio was 63.6% in the fourth quarter of 2012 compared to 64.7% in the fourth quarter of 2011, a 1.1-point improvement. Canadian National Railway Company U.S. GAAP 2012 Annual Report 23 Management’s Discussion and Analysis Summary of quarterly financial data – unaudited In millions, except per share data 2012 Quarters 2011 Quarters Fourth Third Second First Fourth Third Second First Revenues Operating income Net income $ 2,534 $ 2,497 $ 2,543 $ 2,346 $ 2,377 $ 2,307 $ 2,260 $ 2,084 $ 922 $ 985 $ 985 $ 793 $ 839 $ 938 $ 874 $ 610 $ 664 $ 631 $ 775 $ 592 $ 659 $ 538 $ $ 645 668 Basic earnings per share $ 1.42 $ 1.53 $ 1.44 $ 1.76 $ 1.33 $ 1.47 $ 1.19 $ 1.46 Diluted earnings per share $ 1.41 $ 1.52 $ 1.44 $ 1.75 $ 1.32 $ 1.46 $ 1.18 $ 1.45 Dividend declared per share $ 0.375 $ 0.375 $ 0.375 $ 0.375 $ 0.325 $ 0.325 $ 0.325 $ 0.325 Revenues generated by the Company during the year are influenced by seasonal weather conditions, general economic conditions, cyclical demand for rail transportation, and competitive forces in the transportation marketplace (see the section of this MD&A entitled Business risks). Operating expenses reflect the impact of freight volumes, seasonal weather conditions, labor costs, fuel prices, and the Company’s productivity initiatives. The continued fluctuations in the Canadian dollar relative to the US dollar have also affected the conversion of the Company’s US dollar-denominated revenues and expenses and resulted in fluctuations in net income in the rolling eight quarters presented above. The Company’s quarterly results include items that impacted the quarter-over-quarter comparability of the results of operations as discussed below: In millions, except per share data 2012 Quarters 2011 Quarters Fourth Third Second First Fourth Third Second Income tax recoveries (expenses) (1) $ Gain on disposal of property (after-tax) (2) (3) (4) Impact on net income Impact on basic earnings per share Impact on diluted earnings per share $ $ $ - - - - - $ $ $ $ - - - - - $ (28) $ - (28) (0.06) (0.06) $ $ $ $ $ $ - 252 252 0.57 0.57 First - 254 $ 11 $ - $ 11 $ - 38 38 $ (40) $ - $ (40) $ 254 $ 0.02 $ 0.08 $ (0.08) $ 0.55 $ 0.02 $ 0.08 $ (0.08) $ 0.55 (1) Income tax recoveries (expenses) resulted mainly from the enactment of provincial and state corporate income tax rate changes and other legislated tax revisions in the U.S., the recapitalization of a foreign investment, and certain fuel costs attributed to various wholly-owned subsidiaries’ fuel consumption in prior periods. (2) The Company sold the Bala-Oakville for $311 million. A gain on disposal of $281 million ($252 million after-tax) was recognized in Other income. (3) The Company sold substantially all of the assets of IC RailMarine for proceeds of $70 million. A gain on disposal of $60 million ($38 million after-tax) was recognized in Other income. (4) The Company sold the Lakeshore East for $299 million. A gain on disposal of $288 million ($254 million after-tax) was recognized in Other income. 24 2012 Annual Report U.S. GAAP Canadian National Railway Company Management’s Discussion and Analysis Financial position The following tables provide an analysis of the Company’s balance sheet as at December 31, 2012 as compared to 2011. Assets and liabilities denominated in US dollars have been translated to Canadian dollars using the foreign exchange rate in effect at the balance sheet date. As at December 31, 2012 and 2011, the foreign exchange rate was $0.9949 per US$1.00 and $1.0170 per US$1.00, respectively. In millions As at December 31, 2012 2011 Foreign exchange impact Variance excluding foreign exchange Explanation of variance, other than foreign exchange impact Total assets Variance mainly due to: $ 26,659 $ 26,026 $ (235) $ 868 Restricted cash and cash equivalents $ 521 $ 499 Accounts receivable Deferred and receivable income taxes $ $ 831 43 $ $ 820 122 $ $ $ - (7) - $ $ $ 22 18 (79) Properties $ 24,541 $ 23,917 $ (220) $ 844 Intangible and other assets $ 249 $ 261 $ (2) $ (10) Total liabilities Variance mainly due to: $ 15,641 $ 15,346 $ (231) $ 526 Accounts payable and other $ 1,626 $ 1,580 $ (11) $ 57 Deferred income taxes $ 5,555 $ 5,333 $ (71) $ 293 Pension and other postretirement benefits, net of current portion $ 784 $ 1,095 $ (6) $ (305) Other liabilities and deferred credits $ 776 $ 762 $ (4) $ 18 Total long-term debt, including the current portion $ 6,900 $ 6,576 $ (140) $ 464 Increase due to additional amounts pledged as collateral related to letters of credit issued. Increase primarily due to higher revenues. Decrease primarily due to a reduction of income taxes receivable. Increase due to gross property additions of $1,825 million, partly offset by depreciation of $923 million and other items of $58 million. Decrease primarily due to the reduction of various deferred assets and long-term receivables. Increase due to higher income and other taxes of $167 million; partly offset by reductions in trade payables of $57 million, environmental provisions of $31 million, accrued interest of $18 million and other items of $4 million. Increase due to deferred income tax expense of $457 million recorded in net income, excluding recognized tax benefits, partly offset by a deferred income tax recovery of $127 million recorded in Other comprehensive loss and other items of $37 million. Decrease due to pension contributions of $833 million and pension income of $9 million adjusted for $123 million related to amortization components, partly offset by actuarial losses of $660 million. Increase primarily due to higher stock-based incentive liabilities. Increase due to debt issuances of $2,354 million, capital lease additions of $94 million and other items of $17 million, partly offset by debt repayments of $2,001 million. In millions As at December 31, 2012 2011 Variance Explanation of variance Total shareholders’ equity $ 11,018 $ 10,680 $ 338 Variance mainly due to: Common shares $ 4,108 $ 4,141 $ (33) Accumulated other comprehensive loss $ (3,257) $ (2,839) $ (418) Retained earnings $ 10,167 $ 9,378 $ 789 Decrease due to share repurchase programs of $161 million, partly offset by issuances of common shares of $128 million upon the exercise of stock options and other. Change in comprehensive loss due to after-tax amounts of $396 million to recognize the funded status of the Company’s pension and other postretirement benefit plans and $22 million for foreign exchange losses. Increase due to current year net income of $2,680 million partly offset by share repurchase programs of $1,239 million and dividends paid of $652 million. Canadian National Railway Company U.S. GAAP 2012 Annual Report 25 Management’s Discussion and Analysis Liquidity and capital resources The Company’s principal source of liquidity is cash generated from operations and is supplemented by borrowings in the money markets and capital markets. In addition, from time to time, the Company’s liquidity requirements can be supplemented by the disposal of surplus prop- erties and the monetization of assets. The strong focus on cash generation from all sources gives the Company increased flexibility in terms of its financing requirements. As part of its financing strategy, the Company regularly reviews its optimal capital structure, cost of capital, and the need for additional debt financing, and considers from time to time the feasibility of dividend increases and share repurchases. To meet short-term liquidity needs, the Company has a commercial paper program, which is backstopped by its revolving credit facility, expiring in May 2017. Access to commercial paper is dependent on market conditions. If the Company were to lose access to its commer- cial paper program for an extended period of time, the Company could rely on its $800 million revolving credit facility to meet its short-term liquidity needs. See the section of this MD&A entitled Available financing arrangements for additional information. The Company has at times had working capital deficits which are considered common in the rail industry because it is capital-intensive, and such deficits are not an indication of a lack of liquidity. The Company maintains adequate resources to meet daily cash requirements, and has sufficient financial capacity to manage its day-to-day cash requirements and current obligations. As at December 31, 2012 and December 31, 2011, the Company had cash and cash equivalents of $155 million and $101 million, respectively, restricted cash and cash equivalents of $521 million and $499 million, respectively, and a working capital deficit of $334 million and working capital of $133 million, respectively. The cash and cash equivalents pledged as collateral for a minimum term of one month pursuant to the Company’s bilateral letter of credit facilities are recorded as Restricted cash and cash equivalents. See the section of this MD&A entitled Available financing arrangements for additional information. There are currently no specific requirements relating to working capital other than in the normal course of business as discussed herein. The Company’s access to long-term funds in the debt capital markets depends on its credit rating and market conditions. The Company believes that it continues to have access to the long-term debt capital markets. If the Company were unable to borrow funds at acceptable rates in the long-term debt capital markets, the Company could borrow under its revolving credit facility, raise cash by disposing of surplus properties or otherwise monetizing assets, reduce discretionary spending or take a combination of these measures to assure that it has adequate funding for its business. The Company’s U.S. and other foreign subsidiaries hold cash to meet their respective operational requirements. The Company can decide to repatriate funds associated with either undistributed earnings or the liquidation of its foreign operations, including its U.S. and other foreign subsidiaries. Such repatriation of funds would not cause significant tax implications to the Company under the tax treaties currently in effect between Canada and the U.S. and other foreign tax jurisdictions. Therefore, the impact on liquidity resulting from the repatriation of funds held outside Canada would not be significant. Currently, the Company does not have any immediate plans to repatriate funds held outside Canada as the cash flows currently generated within each of the Company’s jurisdictions are sufficient to meet their respective financial obligations. Operating activities In millions Net cash receipts from customers and other Net cash payments for: Employee services, suppliers and other expenses Interest Personal injury and other claims Pensions Income taxes Net cash provided by operating activities Year ended December 31, 2012 2011 Variance $ 9,877 $ 8,995 $ 882 (5,241) (4,643) (364) (79) (844) (289) (329) (97) (468) (482) (598) (35) 18 (376) 193 $ 3,060 $ 2,976 $ 84 Net cash receipts from customers and other increased mainly due to higher revenues. Payments for employee services, suppliers and other expenses increased principally due to higher payments for labor and fringe benefits and for purchased services and material. Company contributions to its various pension plans are made in accordance with the applicable legislation in Canada and the U.S. and are determined by actuarial valuations. Actuarial valuations are required on an annual basis both in Canada and the U.S. The latest actuar- ial valuation of the CN Pension Plan for funding purposes was conducted as at December 31, 2011 and indicated a funding excess on a going-concern basis of approximately $1.1 billion and a funding deficit on a solvency basis of approximately $1.3 billion. The Company’s next actuarial valuation required as at December 31, 2012 will be performed in 2013. This actuarial valuation is expected to identify a going- concern surplus of approximately $1.4 billion, while on a solvency basis a funding deficit of approximately $2.0 billion is expected due to 26 2012 Annual Report U.S. GAAP Canadian National Railway Company Management’s Discussion and Analysis the level of interest rates applicable during that measurement period. The federal pension legislation requires funding deficits, as calculated under current pension regulations, to be paid over a number of years. In anticipation of its future funding requirements, the Company made voluntary contributions of $700 million in 2012 and $350 million in 2011 in excess of the required contributions mainly to strengthen the financial position of its main pension plan, the CN Pension Plan. These voluntary contributions can be treated as a prepayment against its required special solvency payments. As at December 31, 2012, the Company has $785 million of accumulated prepayments which remain available to offset deficit payments. The Company expects to use approximately $415 million of these prepayments to satisfy its 2013 required solvency deficit payment. Since 2010, the Company has made total voluntary contributions of $1.4 billion. The Company continuously monitors the various economic elements that affect the level of contribution it considers necessary to main- tain the financial health of its various pension plans. The Company’s cash contributions for 2013 are expected to be in the range of $135 mil- lion to $335 million, including a potential voluntary contribution of up to $200 million, for all the Company’s pension plans. Net income tax payments decreased mainly due to a reduction in the required installments for the 2012 fiscal year and no required final payment for the 2011 fiscal year typically due in the first quarter of 2012. This reduction was primarily caused by the Company’s voluntary contribution to the CN Pension Plan made in the first quarter of 2012. In 2013, net income tax payments are expected to be approximately $850 million. The Company expects cash from operations and its other sources of financing to be sufficient to meet its 2013 funding obligations. Investing activities In millions Year ended December 31, 2012 2011 Variance Net cash used in investing activities $ 1,421 $ 1,729 $ 308 The Company’s investing activities in 2012 included property additions of $1,731 million, an increase of $106 million when compared to 2011, and cash proceeds of $311 million from the disposal of the Bala-Oakville. Investing activities in 2011 included restricted cash and cash equivalents of $499 million related to the Company’s bilateral letter of credit facilities and cash proceeds of $369 million from the disposal of property of which $70 million was from the disposition of substantially all of the assets of IC RailMarine and $299 million was from the disposition of the Lakeshore East. See the section of this MD&A entitled Disposal of property. The following table details property additions for the years ture are generally planned and programmed in advance and car- ended December 31, 2012 and 2011: In millions Year ended December 31, 2012 2011 Track and roadway Rolling stock Buildings Information technology Other Gross property additions Less: Capital leases (1) Property additions $ 1,351 $ 1,185 206 66 125 77 195 72 135 125 1,825 1,712 94 87 $ 1,731 $ 1,625 (1) During 2012, the Company recorded $94 million in assets it acquired through equipment leases ($87 million in 2011), for which an equivalent amount was recorded in debt. On an ongoing basis, the Company invests in capital expendi- ture programs for the renewal of the basic track infrastructure, the acquisition of rolling stock and other investments to take advan- tage of growth opportunities and to improve the Company’s productivity and the fluidity of its network. Expenditures are generally capitalized if they meet a minimum level of activity, extend the life of the asset or provide future bene- fits such as increased revenue-generating capacity, functionality, or physical or service capacity. For Track and roadway properties, expenditures to replace and/or upgrade the basic track infrastruc- ried out by the Company’s engineering workforce. In both 2012 and 2011, approximately 90% of the Track and roadway capital expenditures were incurred to renew the basic track infrastructure. Expenditures relating to the Company’s properties that do not meet the Company’s capitalization criteria are considered normal repairs and maintenance and are expensed. In 2012, approxi- mately 20% of the Company’s total operating expenses were for such expenditures (approximately 20% in both 2011 and 2010). For Track and roadway properties, normal repairs and mainte- nance include but are not limited to spot tie replacement, spot or broken rail replacement, physical track inspection for detection of rail defects and minor track corrections, and other general main- tenance of track structure. For 2013, the Company expects to invest approximately $1.9 billion for its capital programs, of which over $1.0 billion is targeted towards track infrastructure to continue to operate a safe railway and to improve the productivity and fluidity of the network. Implementation costs associated with the U.S. federal government legislative requirement to implement positive train control (PTC) by 2015 will amount to approximately US$220 million, of which approximately US$40 million has been spent at the end of 2012, with the remainder to be spent over the next three years. Canadian National Railway Company U.S. GAAP 2012 Annual Report 27 Management’s Discussion and Analysis Free cash flow debt totaling $1,083 million related to the Company’s repayment of The Company generated $1,006 million of free cash flow for the year notes, commercial paper and capital lease obligations. ended December 31, 2012, compared to $1,175 million in 2011. Free Cash received from stock options exercised during 2012 and cash flow does not have any standardized meaning prescribed by 2011 was $101 million and $68 million, respectively, and the GAAP and may, therefore, not be comparable to similar measures related tax benefit realized upon exercise was $16 million and presented by other companies. The Company believes that free cash $9 million, respectively. flow is a useful measure of performance as it demonstrates the In 2012, the Company repurchased a total of 16.9 million com- Company’s ability to generate cash after the payment of capital expen- mon shares for $1,400 million (weighted-average price of $82.73 per ditures and dividends. The Company defines free cash flow as the sum share) under its share repurchase programs. In 2011, the Company of net cash provided by operating activities, adjusted for changes in repurchased a total of 19.9 million common shares for $1,420 million cash and cash equivalents resulting from foreign exchange fluctua- (weighted-average price of $71.33 per share) under its share repur- tions; and net cash used in investing activities, adjusted for changes in chase programs. See the section of this MD&A entitled Common restricted cash and cash equivalents, if any, the impact of major acqui- shares for the activity under the 2012 share repurchase programs, as sitions, if any; and the payment of dividends, calculated as follows: well as the share repurchase programs of the prior years. In millions Year ended December 31, 2012 2011 Net cash provided by operating activities Net cash used in investing activities $ 3,060 $ 2,976 (1,421) (1,729) Net cash provided before financing activities 1,639 1,247 Adjustments: Dividends paid Change in restricted cash and cash equivalents Effect of foreign exchange fluctuations on (652) 22 (585) 499 US dollar-denominated cash and cash equivalents (3) 14 Free cash flow $ 1,006 $ 1,175 Financing activities In millions Year ended December 31, 2012 2011 Variance During 2012, the Company paid quarterly dividends of $0.375 per share amounting to $652 million, compared to $585 million, at the rate of $0.325 per share, in 2011. Credit measures Management believes that the adjusted debt-to-total capitalization ratio is a useful credit measure that aims to show the true leverage of the Company. Similarly, the adjusted debt-to-adjusted earnings before interest, income taxes, depreciation and amortization (EBITDA) multiple is another useful credit measure because it reflects the Company’s ability to service its debt. The Company excludes Other income in the calculation of EBITDA. However, since these measures do not have any standardized meaning prescribed by GAAP, they may not be comparable to similar measures presented by other companies Net cash used in financing activities $ 1,582 $ 1,650 $ 68 and, as such, should not be considered in isolation. In 2012, the Company issued $1,861 million of commercial paper and made repayments of debt totaling $2,001 million related to the Company’s commercial paper and capital lease obligations. In Adjusted debt-to-total capitalization ratio December 31, 2012 2011 November 2012, under its shelf prospectus and registration state- Debt-to-total capitalization ratio (1) 38.5% 38.1% ment, the Company issued US$250 million (C$249 million) 2.25% Add: Present value of operating lease commitments (2) 1.9% 1.9% Notes due 2022 and US$250 million (C$249 million) 3.50% Notes Adjusted debt-to-total capitalization ratio 40.4% 40.0% due 2042 in the U.S. capital markets, which resulted in net proceeds of US$494 million (C$493 million), intended for general corporate Adjusted debt-to-adjusted EBITDA purposes, including the redemption and refinancing of outstanding $ in millions, unless otherwise indicated indebtedness. In 2011, the Company issued $659 million of commer- Year ended December 31, 2012 2011 cial paper. Issuances in 2011 also included US$300 million (C$305 mil- Debt $ 6,900 $ 6,576 lion) 1.45% Notes due 2016 and US$400 million (C$407 million) Add: Present value of operating lease commitments (2) 559 542 2.85% Notes due 2021 issued in the U.S. capital markets which Adjusted debt resulted in net proceeds of US$691 million (C$702 million). A portion of the proceeds was used to repay all of its then outstanding com- mercial paper and for general purposes, including the partial financ- ing of its share repurchase program. Also in 2011, the Company, Operating income Add: Depreciation and amortization EBITDA (excluding Other income) 7,459 7,118 3,685 3,296 924 884 4,609 4,180 Add: Deemed interest on operating leases 29 30 through a wholly-owned subsidiary, repurchased 76% of the 6.38% Adjusted EBITDA $ 4,638 $ 4,210 Notes due in October 2011 with a carrying value of US$303 million Adjusted debt-to-adjusted EBITDA 1.61 times 1.69 times pursuant to a tender offer for a total cost of US$304 million. The remaining 24% of the 6.38% Notes with a carrying value of US$97 million were repaid upon maturity. In 2011, repayments of (1) Debt-to-total capitalization is calculated as total long-term debt plus current portion of long-term debt, divided by the sum of total debt plus total shareholders’ equity. (2) The operating lease commitments have been discounted using the Company’s implicit interest rate for each of the periods presented. 28 2012 Annual Report U.S. GAAP Canadian National Railway Company Management’s Discussion and Analysis The increase in the Company’s adjusted debt-to-total capitaliza- lateral and recorded as Restricted cash and cash equivalents tion ratio at December  31, 2012, as compared to 2011, was on the Consolidated Balance Sheet. mainly due to net debt issuances. Higher operating income earned during 2012, partially offset by an increased debt level as at Accounts receivable securitization program December 31, 2012, resulted in an improvement in the Company’s On December 20, 2012, the Company entered into a three-year adjusted debt-to-adjusted EBITDA multiple, as compared to 2011. agreement, commencing on February 1, 2013, to sell an undi- Available financing arrangements Revolving credit facility vided co-ownership interest in a revolving pool of freight receiv- ables to unrelated trusts for maximum cash proceeds of $450 million. The trusts are multi-seller trusts and the Company is not the primary beneficiary. Funding for the acquisition of these On May 6, 2011, the Company entered into an $800 million four- assets is customarily through the issuance of asset-backed com- year revolving credit facility agreement with a consortium of lend- mercial paper notes. The notes are secured by, and recourse is ers. On March 23, 2012, the agreement was amended to extend limited to, the assets purchased using the proceeds of the notes. the term to May 5, 2017. The agreement, which contains custom- Upon commencement of the program in 2013, the Company ary terms and conditions, allows for increases in the facility amount, will account for the securitization program as secured borrowing. up to a maximum of $1,300 million, as well as the option to extend Upon transfers of receivables, an equivalent amount will be the term by an additional year at each anniversary date, subject to reflected as Long-term debt on the Consolidated Balance Sheet. the consent of individual lenders. The Company plans to use the credit facility for working capital and general corporate purposes, Shelf prospectus including backstopping its commercial paper program. As at As at December  31, 2012, the Company had used $1.2  billion December 31, 2012, the Company had no outstanding borrowings (US$1.2 billion) of its current shelf prospectus filed with Canadian under its revolving credit facility (nil as at December 31, 2011). securities regulators and its registration statement filed with the Commercial paper United States Securities and Exchange Commission (SEC), provid- ing for the issuance by CN of up to $2.5 billion of debt securities The Company has a commercial paper program, which is backed in the Canadian and U.S. markets. The shelf prospectus expires by its revolving credit facility, enabling it to issue commercial paper December  2013. Access to capital markets under the shelf is up to a maximum aggregate principal amount of $800 million, or dependent on market conditions at the time of pricing. the US dollar equivalent. As at December 31, 2012, the Company had no borrowings of commercial paper ($82 million (US$81 mil- All forward-looking information provided in this section is subject lion) at a weighted-average interest rate of 0.20% as at to risks and uncertainties and is based on assumptions about December  31, 2011) presented in Current portion of long-term events and developments that may not materialize or that may debt on the Consolidated Balance Sheet. be offset entirely or partially by other events and developments. See the section of this MD&A entitled Forward-looking statements Bilateral letter of credit facilities and Restricted cash and for a discussion of assumptions and risk factors affecting such cash equivalents forward-looking statements. On April 29, 2011, the Company entered into a series of three- year bilateral letter of credit facility agreements with various banks to support its requirements to post letters of credit in the ordinary course of business. On March 23, 2012, the agreements were amended to extend the maturity by one year to April 28, 2015 and an additional letter of credit agreement was signed with an additional bank. Under these agreements as amended, the Company has the option from time to time to pledge collateral in the form of cash or cash equivalents, for a minimum term of one month, equal to at least the face value of the letters of credit issued. As at December  31, 2012, the Company had letters of credit drawn of $551 million ($499 million as at December  31, 2011) from a total committed amount of $562 million ($520 mil- lion as at December  31, 2011) with the various banks. As at December  31, 2012, cash and cash equivalents of $521 million ($499 million as at December  31, 2011) were pledged as col- Canadian National Railway Company U.S. GAAP 2012 Annual Report 29 Management’s Discussion and Analysis 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, 2012: In millions Debt obligations (1) Interest on debt obligations Capital lease obligations (2) Operating lease obligations (3) Purchase obligations (4) Pension contributions (5) Other long-term liabilities reflected on the balance sheet (6) Other commitments (7) Total obligations Total 2013 2014 2015 2016 2017 $ 5,917 $ 4,929 1,232 676 735 1,284 807 280 $ 398 309 219 134 444 - 55 50 320 292 268 103 235 42 63 115 $ - $ 284 109 83 51 414 56 115 $ 545 277 296 61 2 414 40 - 246 265 144 49 1 414 38 - 2018 & thereafter $ 4,408 3,502 196 246 2 - 555 - $ 15,860 $ 1,609 $ 1,438 $ 1,112 $ 1,635 $ 1,157 $ 8,909 (1) Presented net of unamortized discounts, of which $834 million relates to non-interest bearing Notes due in 2094, and excludes capital lease obligations of $983 million which are included in “Capital lease obligations.” (2) Includes $983 million of minimum lease payments and $249 million of imputed interest at rates ranging from approximately 0.7% to 8.5%. (3) Includes minimum rental payments for operating leases having initial non-cancelable lease terms of one year or more. The Company also has operating lease agreements for its automotive fleet with one-year non-cancelable terms for which its practice is to renew monthly thereafter. The estimated annual rental payments for such leases are approximately $30 million and generally extend over five years. (4) Includes commitments for railroad ties, rail, freight cars, locomotives and other equipment and services, and outstanding information technology service contracts and licenses. (5) The Company’s pension contributions are based on actuarial funding valuations. The estimated minimum required payments for pension contributions, excluding current service cost, are based on actuarial funding valuations as at December 31, 2011 that were performed in 2012. As a result of the voluntary contributions made by the Company in 2011 and 2012 of $350 million and $700 million, respectively, mainly for the Company’s main pension plan, the CN Pension Plan, there are no minimum required payments for pension contributions, excluding current service cost required for 2013. Actuarial valuations are required annually and as such, future payments for pension contributions are subject to re-evaluation on an annual basis. See the section of this MD&A entitled Critical accounting policies – Pensions and other postretirement benefits as well as the section entitled Business risks, Other risks – Pensions. (6) Includes expected payments for workers’ compensation, workforce reductions, postretirement benefits other than pensions, net unrecognized tax benefits and environmental liabilities that have been classified as contractual settlement agreements. (7) The Company has remaining estimated commitments in relation to the acquisition of the principal lines of the former Elgin, Joliet and Eastern Railway Company of approximately $100 mil- lion (US$100 million) to be spent over the next few years for railroad infrastructure improvements, grade separation projects as well as commitments under a series of agreements with individual communities and a comprehensive voluntary mitigation program established to address surrounding municipalities’ concerns. The commitment for the grade separation projects is based on estimated costs provided by the Surface Transportation Board (STB) at the time of acquisition and could be subject to adjustment. In addition, remaining implementation costs associated with the U.S. federal government legislative requirement to implement positive train control (PTC) by 2015 are estimated to be approximately $180 million (US$180 million). For 2013 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. See the section of this MD&A entitled Forward-looking statements for a discussion of assumptions and risk factors affecting such forward-looking statements. Disposal of property 2012 Bala-Oakville 2011 IC RailMarine On August 1, 2011, the Company sold substantially all of the On March 23, 2012, the Company entered into an agreement assets of IC RailMarine Terminal Company (“IC RailMarine”), an with Metrolinx to sell a segment of the Bala and a segment of the indirect subsidiary of the Company, to Raven Energy, LLC, an affil- Oakville subdivisions in Toronto, Ontario, together with the rail iate of Foresight Energy, LLC (“Foresight”) and the Cline Group fixtures and certain passenger agreements (collectively the “Bala- (“Cline”), for cash proceeds of $70 million (US$73 million) before Oakville”), for cash proceeds of $311 million before transaction transaction costs. IC RailMarine is located on the east bank of the costs. Under the agreement, the Company obtained the perpetual Mississippi River and stores and transfers bulk commodities and right to operate freight trains over the Bala-Oakville at its then liquids between rail, ship and barge, serving customers in North current level of operating activity, with the possibility of increasing American and global markets. Under the sale agreement, the its operating activity for additional consideration. The transaction Company will benefit from a 10-year rail transportation agree- resulted in a gain on disposal of $281 million ($252 million after- ment with Savatran LLC, an affiliate of Foresight and Cline, to haul tax) that was recorded in Other income under the full accrual a minimum annual volume of coal from four Illinois mines to the method of accounting for real estate transactions. IC RailMarine transfer facility. The transaction resulted in a gain on disposal of $60 million ($38 million after-tax) that was recorded in Other income. 30 2012 Annual Report U.S. GAAP Canadian National Railway Company Management’s Discussion and Analysis Lakeshore East Stock plans On March 24, 2011, the Company entered into an agreement with The Company has various stock-based incentive plans for eligible Metrolinx to sell a segment of the Kingston subdivision known as employees. A description of the Company’s major plans is pro- the Lakeshore East in Pickering and Toronto, Ontario, together with vided in Note 10 – Stock plans to the Company’s 2012 Annual the rail fixtures and certain passenger agreements (collectively the Consolidated Financial Statements. The following table provides “Lakeshore East”), for cash proceeds of $299 million before trans- the total stock-based compensation expense for awards under all action costs. Under the agreement, the Company obtained the plans, as well as the related tax benefit recognized in income, for perpetual right to operate freight trains over the Lakeshore East at the years ended December 31, 2012, 2011 and 2010: its then current level of operating activity, with the possibility of increasing its operating activity for additional consideration. The transaction resulted in a gain on disposal of $288 million ($254 mil- lion after-tax) that was recorded in Other income under the full accrual method of accounting for real estate transactions. 2010 Oakville subdivision In millions Year ended December 31, 2012 2011 2010 Cash settled awards Restricted share unit plan $ 76 $ 81 $ 77 Voluntary Incentive Deferral Plan Stock option awards 19 95 10 21 102 10 18 95 9 Total stock-based compensation expense $ 105 $ 112 $ 104 On March 29, 2010, the Company entered into an agreement with Tax benefit recognized in income $ 25 $ 24 $ 27 Metrolinx to sell a portion of the property known as the Oakville subdivision in Toronto, Ontario, together with the rail fixtures and Financial instruments certain passenger agreements (collectively the “Oakville subdivi- In the normal course of business, the Company is exposed to vari- sion”), for proceeds of $168 million before transaction costs, of ous risks such as customer credit risk, commodity price risk, interest which $24 million was placed in escrow at the time of disposal and rate risk, foreign currency risk, and liquidity risk. To manage these was entirely released by December 31, 2010 in accordance with the risks, the Company follows a financial risk management frame- terms of the agreement. Under the agreement, the Company work, which is monitored and approved by the Company’s Finance obtained the perpetual right to operate freight trains over the Committee, with a goal of maintaining a strong balance sheet, Oakville subdivision at its then current level of operating activity, with optimizing earnings per share and free cash flow, financing its the possibility of increasing its operating activity for additional consid- operations at an optimal cost of capital and preserving its liquidity. eration. The transaction resulted in a gain on disposal of $152 million The Company has limited involvement with derivative financial ($131 million after-tax) that was recorded in Other income under the instruments in the management of its risks and does not use them full accrual method of accounting for real estate transactions. for trading purposes. At December 31, 2012, the Company did not Off balance sheet arrangements Guarantees and indemnifications have any significant derivative financial instruments outstanding. See Note 17 – Financial instruments to the Company’s 2012 Annual Consolidated Financial Statements for a discussion of such risks. In the normal course of business, the Company, including certain of its subsidiaries, enters into agreements that may involve provid- Payments for income taxes ing guarantees or indemnifications to third parties and others, The Company is required to make scheduled installment payments which may extend beyond the term of the agreements. These as prescribed by the tax authorities. In Canada, the Company’s include, but are not limited to, residual value guarantees on oper- domestic jurisdiction, tax installments in a given year are generally ating leases, standby letters of credit and surety and other bonds, based on the prior year’s pretax income whereas in the U.S., the and indemnifications that are customary for the type of transac- Company’s predominate foreign jurisdiction, they are based on tion or for the railway business. forecasted taxable income of that year. The Company is required to recognize a liability for the fair In 2012, net income tax payments to Canadian tax authorities value of the obligation undertaken in issuing certain guarantees were $138 million ($360 million in 2011) and net income tax on the date the guarantee is issued or modified. In addition, payments to U.S. tax authorities were $151 million ($122 million where the Company expects to make a payment in respect of a in 2011). For the 2013 fiscal year, the Company’s net income tax guarantee, a liability will be recognized to the extent that one has payments are expected to be approximately $850 million. Net not yet been recognized. income tax payments for 2012 and 2013 include the impact of The nature of these guarantees or indemnifications, the maxi- recent changes in tax laws. In 2012, U.S. tax payments reflected mum potential amount of future payments, the carrying amount the allowable 50% accelerated depreciation pursuant to the Tax of the liability, if any, and the nature of any recourse provisions are Relief, Unemployment Insurance Reauthorization and Job Creation disclosed in Note 16 – Major commitments and contingencies to Act of 2010. In 2013, U.S. tax payments will reflect the American the Company’s 2012 Annual Consolidated Financial Statements. Taxpayer Relief Act of 2012 which extended the allowable 50% Canadian National Railway Company U.S. GAAP 2012 Annual Report 31 Management’s Discussion and Analysis accelerated depreciation and the Railroad Track Maintenance Outstanding share data Credit until the end of 2013. As at February 1, 2013, the Company had 427.3 million common See the section of this MD&A entitled Forward-looking shares and 4.5 million stock options outstanding. statements for assumptions and risk factors affecting such forward-looking statement. Recent accounting pronouncements Common shares Share repurchase programs In June 2011, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2011-05, Presentation of Comprehensive Income, giving companies the option to present On October 24, 2011, the Board of Directors of the Company the components of net income and comprehensive income in either approved a share repurchase program which allowed for the one or two consecutive financial statements. ASU 2011-05 elimi- repurchase of up to 17.0 million common shares between nates the option to present the components of other comprehen- October 28, 2011 and October 27, 2012 pursuant to a normal sive income in the statement of changes in shareholders’ equity. course issuer bid at prevailing market prices plus brokerage fees, ASU 2011-05 also requires reclassification adjustments for each or such other prices as may be permitted by the Toronto Stock component of accumulated other comprehensive income (AOCI) in Exchange. The Company repurchased a total of 16.7 million com- both net income and other comprehensive income (OCI) to be mon shares under this share repurchase program. separately disclosed on the face of the financial statements. In On October 22, 2012, the Board of Directors of the Company December  2011, the FASB issued ASU 2011-12, Deferral of the approved a new share repurchase program which allows for the Effective Date for Amendments to the Presentation of Reclassi- repurchase of up to $1.4 billion in common shares, not to exceed fications of Items Out of Accumulated Other Comprehensive 18.0 million common shares, between October 29, 2012 and Income, which deferred the effective date to present reclassification October 28, 2013 pursuant to a normal course issuer bid at pre- adjustments in net income. The effective date of the deferral is vailing market prices plus brokerage fees, or such other prices as consistent with the effective date of ASU 2011-05 which becomes may be permitted by the Toronto Stock Exchange. effective for fiscal years beginning on or after December 15, 2011. The following table provides the activity under such share The FASB is re-evaluating the requirements, with a final decision repurchase programs as well as the share repurchase programs of expected in the first quarter of 2013. The Company has adopted the prior years: In millions, except per share data Year ended December 31, 2012 2011 2010 October 2012 – October 2013 program Number of common shares (1) 3.6 Weighted-average price per share (2) $ 84.23 Amount of repurchase $ 305 N/A N/A N/A October 2011 – October 2012 program Number of common shares (1) 13.3 3.4 Weighted-average price per share (2) $ 82.32 $ 75.08 Amount of repurchase $ 1,095 $ 256 January 2011 – December 2011 program Number of common shares (1) N/A 16.5 Weighted-average price per share (2) N/A $ 70.56 Amount of repurchase N/A $ 1,164 N/A N/A N/A N/A N/A N/A N/A N/A N/A January 2010 – December 2010 program Number of common shares (1) N/A Weighted-average price per share (2) N/A Amount of repurchase N/A N/A N/A N/A 15.0 $ 60.86 $ 913 Total for the year Number of common shares (1) 16.9 19.9 15.0 Weighted-average price per share (2) $ 82.73 $ 71.33 $ 60.86 Amount of repurchase $ 1,400 $ 1,420 $ 913 (1) Includes common shares purchased in the first and fourth quarters of 2012 and 2011 and in the second and third quarters of 2010 pursuant to private agreements between the Company and arm‘s-length third-party sellers. (2) Includes brokerage fees. the currently effective requirements of these ASUs. In May 2011, the FASB issued ASU 2011-04, Fair Value Measurement-Amendments to Achieve Common Fair Value Measurements and Disclosure Requirements. The update includes two types of amendments; those that clarify the application of existing fair value measurement and disclosure requirements and those that change a principle or requirement for measuring fair value or for disclosing information about fair value measurements. The update is effective for the Company beginning January  1, 2012 and did not have a significant impact on the Company’s consolidated financial statements. The Accounting Standards Board of the Canadian Institute of Chartered Accountants required all publicly accountable enter- prises to report under International Financial Reporting Standards (IFRS) for the fiscal years beginning on or after January 1, 2011. However, National Instrument 52-107 issued by the Ontario Securities Commission allows SEC issuers, as defined by the SEC, such as CN, to file with Canadian securities regulators financial statements prepared in accordance with U.S. GAAP. As such, the Company decided not to report under IFRS and continues to report under U.S. GAAP. The SEC is currently evaluating the impli- cations of incorporating IFRS into the U.S. financial reporting sys- tem. Should the SEC decide it will move forward, the Company will convert its reporting to IFRS when required. 32 2012 Annual Report U.S. GAAP Canadian National Railway Company Management’s Discussion and Analysis Critical accounting policies of the former CEO’s employment agreement. The Company has The preparation of financial statements in conformity with gener- filed legal proceedings in the United States District Court for the ally accepted accounting principles requires management to make Northern District of Illinois seeking, among other things, a decla- estimates and assumptions that affect the reported amounts of ration that the Company’s termination of the Benefits is valid. On revenues and expenses during the period, the reported amounts June 28, 2012, the former CEO was named President and CEO of assets and liabilities, and the disclosure of contingent assets and a member of the Board of Directors of the Company’s major and liabilities at the date of the financial statements. On an ongo- competitor in Canada. ing basis, management reviews its estimates based upon currently On December 21, 2012, the former CEO filed amended coun- available information. Actual results could differ from these esti- terclaims and affirmative defenses in the United States District mates. The Company’s policies for personal injury and other Court for the Northern District of Illinois to CN’s amended claims claims, environmental matters, depreciation, pensions and other in which the former CEO claims that CN failed to pay monthly postretirement benefits, and income taxes, require management’s retirement benefit installments due through June 28, 2012, the more significant judgments and estimates in the preparation of date on which the former CEO entered into an executive employ- the Company’s consolidated financial statements and, as such, are ment agreement with the Company’s major competitor in considered to be critical. The following information should be read Canada. The counterclaims seek affirmative damages from the in conjunction with the Company’s 2012 Annual Consolidated Company. The Company believes it has strong defenses and is Financial Statements and Notes thereto. vigorously defending those claims, but in any event, the Company Management discusses the development and selection of the believes the potential liability on the claims is not material. In Company’s critical accounting estimates with the Audit Committee addition, the former CEO made binding judicial admissions in of the Company’s Board of Directors, and the Audit Committee these court documents that he was not entitled to retirement has reviewed the Company’s related disclosures. benefits beyond June 28, 2012. As such, the Company, without Personal injury and other claims prejudice, has recorded a settlement gain of $20 million from the termination of the former CEO’s retirement benefit plan for the In the normal course of business, the Company becomes involved period beyond June 28, 2012 which is partially offset by the rec- in various legal actions seeking compensatory and occasionally ognition of past accumulated actuarial losses of $4 million. punitive damages, including actions brought on behalf of various The Company, without prejudice, has not recorded a gain of purported classes of claimants and claims relating to employee and approximately $18 million from the cancellation of the former third-party personal injuries, occupational disease and property CEO’s RSU payout and a settlement gain of $0.7 million associ- damage, arising out of harm to individuals or property allegedly ated with the former CEO’s 2012 retirement benefit liability caused by, but not limited to, derailments or other accidents. through June 28, 2012 pending a final resolution of the legal Proceedings against former CEO proceedings. The Company is also seeking to recover $3 million of retirement benefits paid to the former CEO as the Company In February 2012, the Company’s Board of Directors unanimously believes that the former CEO has failed to fulfill the terms of his voted to forfeit and cancel the RSU payout of approximately employment agreement as well as reasonable legal fees and $18 million, the $1.5 million annual retirement benefit, and other costs. The Company has not recognized the recovery of other benefits (collectively the “Benefits”) otherwise due to its these amounts. former CEO, after determining that the former CEO was likely in breach of his non-compete and non-disclosure of confidential Canada information conditions contained in the former CEO’s employ- Employee injuries are governed by the workers’ compensation ment agreement. The Company‘s determination was based on legislation in each province whereby employees may be awarded certain facts, including the former CEO’s active participation in either a lump sum or a future stream of payments depending on concert with the largest shareholder of the Company’s major the nature and severity of the injury. As such, the provision for competitor in Canada for the express purpose of installing the employee injury claims is discounted. In the provinces where the former CEO as Chief Executive Officer of the competitor; the Company is self-insured, costs related to employee work-related former CEO’s admission that he has taken a personal $5 million injuries are accounted for based on actuarially developed esti- stock position in the competitor; and statements by the former mates of the ultimate cost associated with such injuries, including CEO and the largest shareholder to the effect that the former compensation, health care and third-party administration costs. A CEO has developed a strategic plan for the operation of the comprehensive actuarial study is generally performed at least on a Company’s competitor to make it a stronger competitor to the triennial basis. For all other legal actions, the Company maintains, Company; the Company reasonably believes that any such strate- and regularly updates on a case-by-case basis, provisions for such gic plan would necessarily draw upon the Company’s confidential items when the expected loss is both probable and can be reason- information, which would constitute a clear and material breach ably estimated based on currently available information. Canadian National Railway Company U.S. GAAP 2012 Annual Report 33 Management’s Discussion and Analysis In 2012, the Company recorded an $18 million increase to its Due to the inherent uncertainty involved in projecting future provision for personal injuries and other claims as a result of a events, including events related to occupational diseases, which comprehensive actuarial study for employee injury claims as well include but are not limited to, the timing and number of actual as various other legal claims. claims, the average cost per claim and the legislative and judicial As at December  31, 2012, 2011 and 2010, the Company’s environment, the Company’s future payments may differ from provision for personal injury and other claims in Canada was as current amounts recorded. follows: In millions Balance January 1 Accruals and other Payments 2012 2011 2010 $ 199 $ 200 $ 178 55 (45) 31 (32) 59 (37) Balance December 31 $ 209 $ 199 $ 200 Current portion – Balance December 31 $ 39 $ 39 $ 39 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 information. Over the past three years, the Company has not significantly changed any of these assumptions. Changes in any of these assumptions could materially affect Casualty and other expense as reported in the Company’s results of operations. For all other legal claims in Canada, estimates are based on the specifics of the case, trends and judgment. United States Personal injury claims by the Company’s employees, including claims alleging occupational disease and work-related injuries, are subject to the provisions of the Federal Employers’ Liability Act (FELA). Employees are compensated under FELA for damages assessed based on a finding of fault through the U.S. jury system or In 2012, the Company recorded a $7 million increase to its provision for U.S. personal injury and other claims attributable to non-occupational disease and third-party claims, which was offset by a $6 million net reduction mainly attributable to occupational disease claims pursuant to the 2012 external actuarial studies. In previous years, external actuarial studies reflecting favorable claims development have supported net reductions to the Company’s provision for U.S. personal injury and other claims of $6 million and $19 million in 2011 and 2010, respectively. The previous years’ reductions were mainly attributable to decreases in the Company’s estimates of unasserted claims and costs related to asserted claims as a result of its ongoing risk mitigation strategy focused on reducing the frequency and severity of claims through injury prevention and containment; mitigation of claims; and lower settlements for existing claims. As at December  31, 2012, 2011 and 2010, the Company’s provision for personal injury and other claims in the U.S. was as follows: In millions Balance January 1 Accruals and other Payments 2012 2011 2010 $ 111 $ 146 $ 166 28 (34) 30 (65) 7 (27) Balance December 31 $ 105 $ 111 $ 146 Current portion – Balance December 31 $ 43 $ 45 $ 44 through individual settlements. As such, the provision is undis- For the U.S. personal injury and other claims liability, historical counted. With limited exceptions where claims are evaluated on a claim data is used to formulate assumptions relating to the case-by-case basis, the Company follows an actuarial-based expected number of claims and average cost per claim (severity) approach and accrues the expected cost for personal injury, includ- for each year. Changes in any one of these assumptions could ing asserted and unasserted occupational disease claims, and prop- materially affect Casualty and other expense as reported in the erty damage claims, based on actuarial estimates of their ultimate Company’s results of operations. For example, a 5% change in the cost. A comprehensive actuarial study is performed annually. asbestos average claim cost or a 1% change in the inflation trend For employee work-related injuries, including asserted occupa- rate would result in an increase or decrease of approximately tional disease claims, and third-party claims, including grade $2 million in the liability recorded for unasserted asbestos claims. crossing, trespasser and property damage claims, the actuarial valuation considers, among other factors, the Company’s histori- Environmental matters cal patterns of claims filings and payments. For unasserted occu- Known existing environmental concerns pational disease claims, the actuarial study includes the projection The Company has identified approximately 300 sites at which it is of the Company’s experience into the future considering the or may be liable for remediation costs, in some cases along with potentially exposed population. The Company adjusts its liability other potentially responsible parties, associated with alleged con- based upon management’s assessment and the results of the tamination and is subject to environmental clean-up and enforce- study. On an ongoing basis, management reviews and compares ment actions, including those imposed by the United States the assumptions inherent in the latest actuarial study with the Federal Comprehensive Environmental Response, Compensation current claim experience and, if required, adjustments to the lia- and Liability Act of 1980 (CERCLA), also known as the Superfund bility are recorded. law, or analogous state laws. CERCLA and similar state laws, in addition to other similar Canadian and U.S. laws, generally impose 34 2012 Annual Report U.S. GAAP Canadian National Railway Company Management’s Discussion and Analysis joint and several liability for clean-up and enforcement costs on The Company anticipates that the majority of the liability at current and former owners and operators of a site, as well as December  31, 2012 will be paid out over the next five years. those whose waste is disposed of at the site, without regard to However, some costs may be paid out over a longer period. The fault or the legality of the original conduct. The Company has Company expects to partly recover certain accrued remediation been notified that it is a potentially responsible party for study and costs associated with alleged contamination and has recorded a clean-up costs at approximately 10 sites governed by the receivable in Intangible and other assets for such recoverable Superfund law (and analogous state laws) for which investigation amounts. Based on the information currently available, the and remediation payments are or will be made or are yet to be Company considers its provisions to be adequate. determined and, in many instances, is one of several potentially As of December 31, 2012, most of the Company’s properties responsible parties. have reached the final assessment stage; therefore costs related to The ultimate cost of addressing these known contaminated such sites have been anticipated. The final assessment stage can sites cannot be definitely established given that the estimated span multiple years. environmental liability for any given site may vary depending on the nature and extent of the contamination; the nature of antici- Unknown existing environmental concerns pated response actions, taking into account the available clean-up While the Company believes that it has identified the costs likely techniques; evolving regulatory standards governing environmen- to be incurred for environmental matters in the next several years tal liability; and the number of potentially responsible parties and based on known information, the discovery of new facts, future their financial viability. As a result, liabilities are recorded based on changes in laws, the possibility of releases of hazardous materials the results of a four-phase assessment conducted on a site-by-site into the environment and the Company’s ongoing efforts to basis. A liability is initially recorded when environmental assess- identify potential environmental liabilities that may be associated ments occur, remedial efforts are probable, and when the costs, with its properties may result in the identification of additional based on a specific plan of action in terms of the technology to be environmental liabilities and related costs. The magnitude of such used and the extent of the corrective action required, can be rea- additional liabilities and the costs of complying with future envi- sonably estimated. The Company estimates the costs related to a ron mental laws and containing or remediating contamination particular site using cost scenarios established by external consul- cannot be reasonably estimated due to many factors, including: tants based on the extent of contamination and expected costs for (i) the lack of specific technical information available with respect remedial efforts. In the case of multiple parties, the Company to many sites; accrues its allocable share of liability taking into account the (ii) the absence of any government authority, third-party orders, Company’s alleged responsibility, the number of potentially or claims with respect to particular sites; responsible parties and their ability to pay their respective share of (iii) the potential for new or changed laws and regulations and for the liability. Adjustments to initial estimates are recorded as addi- development of new remediation technologies and uncer- tional information becomes available. tainty regarding the timing of the work with respect to partic- The Company’s provision for specific environmental sites is ular sites; and undiscounted and includes costs for remediation and restoration (iv) the determination of the Company’s liability in proportion to of sites, as well as monitoring costs. Environmental accruals, other potentially responsible parties and the ability to recover which are classified as Casualty and other in the Consolidated costs from any third parties with respect to particular sites. Statement of Income, include amounts for newly identified sites or contaminants as well as adjustments to initial estimates. Therefore, the likelihood of any such costs being incurred or Recoveries of environmental remediation costs from other parties whether such costs would be material to the Company cannot be are recorded as assets when their receipt is deemed probable. determined at this time. There can thus be no assurance that lia- As at December  31, 2012, 2011 and 2010, the Company’s bilities or costs related to environmental matters will not be provision for specific environmental sites was as follows: incurred in the future, or will not have a material adverse effect on In millions 2012 2011 2010 Balance January 1 Accruals and other Payments $ 152 $ 150 $ 103 (5) (24) 17 (15) 67 (20) Balance December 31 $ 123 $ 152 $ 150 Current portion – Balance December 31 $ 31 $ 63 $ 34 the Company’s financial position or results of operations in a par- ticular quarter or fiscal year, or that the Company’s liquidity will not be adversely impacted by such liabilities or costs, although management believes, based on current information, that the costs to address environmental matters will not have a material adverse effect on the Company’s financial position or liquidity. Costs related to any unknown existing or future contamination will be accrued in the period in which they become probable and reasonably estimable. Canadian National Railway Company U.S. GAAP 2012 Annual Report 35 Management’s Discussion and Analysis Future occurrences For all depreciable assets, the depreciation rate is based on the In railroad and related transportation operations, it is possible that estimated service lives of the assets. Assessing the reasonableness derailments or other accidents, including spills and releases of of the estimated service lives of properties requires judgment and hazardous materials, may occur that could cause harm to human is based on currently available information, including periodic health or to the environment. As a result, the Company may incur depreciation studies conducted by the Company. The Company’s costs in the future, which may be material, to address any such U.S. properties are subject to comprehensive depreciation studies harm, compliance with laws and other risks, including costs relat- as required by the Surface Transportation Board (STB) and are ing to the performance of clean-ups, payment of environmental conducted by external experts. Depreciation studies for Canadian penalties and remediation obligations, and damages relating to properties are not required by regulation and are therefore con- harm to individuals or property. Regulatory compliance ducted internally. Studies are performed on specific asset groups on a periodic basis. Changes in the estimated service lives of the assets and their related composite depreciation rates are imple- The Company may incur significant capital and operating costs mented prospectively. associated with environmental regulatory compliance and clean-up The studies consider, among other factors, the analysis of his- requirements, in its railroad operations and relating to its past and torical retirement data using recognized life analysis techniques, present ownership, operation or control of real property. and the forecasting of asset life characteristics. Changes in circum- Environmental expenditures that relate to current operations are stances, such as technological advances, changes to the Company’s expensed unless they relate to an improvement to the property. business strategy, changes in the Company’s capital strategy or Expenditures that relate to an existing condition caused by past changes in regulations can result in the actual service lives differ- operations and which are not expected to contribute to current or ing from the Company’s estimates. future operations are expensed. Operating expenses for environ- A change in the remaining service life of a group of assets, or mental matters amounted to $16 million in 2012, $4 million in their estimated net salvage value, will affect the depreciation rate 2011 and $23 million in 2010. For 2013, the Company expects to used to amortize the group of assets and thus affect depreciation incur operating expenses relating to environmental matters in the expense as reported in the Company’s results of operations. A same range as 2012. In addition, based on the results of its oper- change of one year in the composite service life of the Company’s ations and maintenance programs, as well as ongoing environ- fixed asset base would impact annual depreciation expense by mental audits and other factors, the Company plans for specific approximately $25 million. capital improvements on an annual basis. Certain of these Depreciation studies are a means of ensuring that the assump- improvements help ensure facilities, such as fuelling stations and tions used to estimate the service lives of particular asset groups waste water and storm water treatment systems, comply with are still valid and where they are not, they serve as the basis to environmental standards and include new construction and the establish the new depreciation rates to be used on a prospective updating of existing systems and/or processes. Other capital basis. The Company has undertaken depreciation studies of its expenditures relate to assessing and remediating certain impaired Canadian and U.S. track and roadway properties and expects to properties. The Company’s environmental capital expenditures finalize these studies by the first quarter of 2013. amounted to $13 million in 2012, $11 million in 2011 and In 2012, the Company recorded total depreciation expense of $14 million in 2010. For 2013, the Company expects to incur $923 million ($883 million in 2011 and $833 million in 2010). At capital expenditures relating to environmental matters in the same December 31, 2012, the Company had Properties of $24,541 mil- range as 2012. Depreciation lion, net of accumulated depreciation of $10,181 million ($23,917 million in 2011, net of accumulated depreciation of $9,904 million). Additional disclosures are provided in Note 4 – Properties are carried at cost less accumulated depreciation includ- Properties to the Company’s 2012 Annual Consolidated Financial ing asset impairment write-downs. The cost of properties, includ- Statements. ing those under capital leases, net of asset impairment write-downs, U.S. generally accepted accounting principles require the use is depreciated on a straight-line basis over their estimated service of historical cost as the basis of reporting in financial statements. lives, measured in years, except for rail which is measured in mil- As a result, the cumulative effect of inflation, which has signifi- lions of gross tons per mile. The Company follows the group cantly increased asset replacement costs for capital-intensive method of depreciation whereby a single composite depreciation companies such as CN, is not reflected in operating expenses. rate is applied to the gross investment in a class of similar assets, Depreciation charges on an inflation-adjusted basis, assuming that despite small differences in the service life or salvage value of indi- all operating assets are replaced at current price levels, would be vidual property units within the same asset class. The Company substantially greater than historically reported amounts. uses approximately 40 different depreciable asset classes. 36 2012 Annual Report U.S. GAAP Canadian National Railway Company Management’s Discussion and Analysis Pensions and other postretirement benefits At December 31, 2012 and 2011, the projected pension ben- The Company’s plans have a measurement date of December 31. efit obligation and accumulated other postretirement benefit The following table shows the Company’s pension liability and obligation were as follows: other postretirement benefits liability at December 31, 2012 and December 31, 2011: In millions Pension liability Other postretirement benefits liability In millions December 31, 2012 2011 Projected pension benefit obligation $ 16,335 $ 15,548 December 31, 2012 2011 Accumulated other postretirement benefit obligation $ 277 $ 284 $ 524 $ 277 $ 829 $ 284 Discount rate assumption The Company’s discount rate assumption, which is set annually at The descriptions in the following paragraphs pertaining to the end of each year, is used to determine the projected benefit pensions relate generally to the Company’s main pension plan, the obligation at the end of the year and the net periodic benefit cost CN Pension Plan, unless otherwise specified. for the following year. The discount rate is used to measure the single amount that, if invested at the measurement date in a Calculation of net periodic benefit cost (income) portfolio of high-quality debt instruments with a rating of AA or The Company accounts for net periodic benefit cost for pensions better, would provide the necessary cash flows to pay for pension and other postretirement benefits as required by FASB Accounting benefits as they become due. The discount rate is determined by Standards Codification 715 “Compensation – Retirement management with the aid of third-party actuaries. For the Benefits.” Under the standard, assumptions are made regarding Canadian pension and other postretirement benefit plans, future the valuation of benefit obligations and performance of plan expected benefit payments at each measurement date are dis- assets. In the calculation of net periodic benefit cost, the standard counted using spot rates from a derived AA corporate bond yield allows for a gradual recognition of changes in benefit obligations curve. The derived curve is based on observed rates for AA corpo- and fund performance over the expected average remaining ser- rate bonds with short-term maturities and a projected AA corpo- vice life of the employee group covered by the plans. rate curve for longer term maturities based on spreads between In accounting for pensions and other postretirement benefits, observed AA corporate bonds and AA provincial bonds. The assumptions are required for, among others, the discount rate, the derived curve is expected to generate cash flows that match the expected long-term rate of return on plan assets, the rate of com- estimated future benefit payments of the plans as the bond rate pensation increase, health care cost trend rates, mortality rates, for each maturity year is applied to the plans’ corresponding employee early retirements, terminations and disability. Changes in expected benefit payments of that year. A discount rate of 4.15%, these assumptions result in actuarial gains or losses, which are rec- based on bond yields prevailing at December 31, 2012 (4.84% at ognized in Other comprehensive income (loss). The Company December 31, 2011) was considered appropriate by the Company amortizes these gains or losses into net periodic benefit cost over to match the approximately 11-year average duration of esti- the expected average remaining service life of the employee group mated future benefit payments. The current estimate for the covered by the plans only to the extent that the unrecognized net expected average remaining service life of the employee group actuarial gains and losses are in excess of the corridor threshold, covered by the plans is approximately ten years. which is calculated as 10% of the greater of the beginning-of-year The Company amortizes net actuarial gains and losses over the balances of the projected benefit obligation or market-related value expected average remaining service life of the employee group of plan assets. The Company’s net periodic benefit cost for future covered by the plans, only to the extent they are in excess of the periods is dependent on demographic experience, economic condi- corridor threshold. For the year ended December  31, 2012, the tions and investment performance. Recent demographic experience Company amortized a net actuarial loss of $119 million related to has revealed no material net gains or losses on termination, retire- the accumulated actuarial losses of its pension plans as part of net ment, disability and mortality. Experience with respect to economic periodic benefit cost. The Company also recognized $8 million of conditions and investment performance is further discussed herein. actuarial losses related to settlements in its various pension plans, For the years ended December 31, 2012, 2011 and 2010, the and recorded a net actuarial loss of $671 million on its pension consolidated net periodic benefit cost (income) for pensions and plans increasing the net actuarial loss recognized in Accumulated other postretirement benefits were as follows: other comprehensive loss to $3,264 million ($2,720 million in In millions Year ended December 31, 2012 2011 2010 Net periodic benefit cost (income) for pensions $ (9) $ (80) $ (70) Net periodic benefit cost for other postretirement benefits $ 14 $ 19 $ 18 2011). The increase in the net actuarial loss was primarily due to the negative liability experience resulting from the decrease in the discount rate from 4.84% to 4.15%, partly offset by the differ- ence in the actual and expected return on plan assets for the year ended December 31, 2012. For the year ended December 31, 2012, a 0.25% decrease in the 4.15% discount rate used to determine the projected benefit Canadian National Railway Company U.S. GAAP 2012 Annual Report 37 Management’s Discussion and Analysis obligation would have resulted in a decrease of approximately Annually, the CN Investment Division, a division of the $490 million to the funded status for pensions and an increase of Company created to invest and administer the assets of the plans, approximately $30 million to the 2013 net periodic benefit cost. proposes a short-term asset mix target (Strategy) for the coming A 0.25% increase in the discount rate would have resulted in an year, which is expected to differ from the Policy, because of cur- increase of approximately $470 million to the funded status for rent economic and market conditions and expectations. The pensions and a decrease of approximately $30 million to the 2013 Investment Committee of the Board (Committee) regularly com- net periodic benefit cost. pares the actual asset mix to the Policy and Strategy asset mixes and evaluates the actual performance of the trust funds in relation Expected long-term rate of return assumption to the performance of the Policy, calculated using Policy asset mix To develop its expected long-term rate of return assumption used and the performance of the benchmark indices. in the calculation of net periodic benefit cost applicable to the The Committee’s approval is required for all major investments market-related value of assets, the Company considers multiple in illiquid securities. The SIPP allows for the use of derivative finan- factors. The expected long-term rate of return is determined cial instruments to implement strategies or to hedge or adjust based on expected future performance for each asset class and is existing or anticipated exposures. The SIPP prohibits investments weighted based on the current asset portfolio mix. Consideration in securities of the Company or its subsidiaries. During the last 10 is taken of the historical performance, the premium return gener- years ended December 31, 2012, the CN Pension Plan earned an ated from an actively managed portfolio, as well as current and annual average rate of return of 7.42%. future anticipated asset allocations, economic developments, The actual, market-related value, and expected rates of return inflation rates and administrative expenses. Based on these fac- on plan assets for the last five years were as follows: tors, the rate is determined by the Company. For 2012, the Company used a long-term rate of return assumption of 7.25% on the market-related value of plan assets to compute net peri- odic benefit cost. Effective January  1, 2013, the Company will reduce the expected long-term rate of return on plan assets from 7.25% to 7.00% to reflect management’s current view of long- term investment returns. The effect of this change in manage- ment’s assumption will be to increase 2013 net periodic benefit cost by approximately $20 million. The Company has elected to use a market-related value of assets, whereby realized and unreal- ized 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. If the Company had elected to use the market value of assets, which for the CN Rates of return 2012 2011 2010 2009 2008 Actual 7.7% Market-related value 2.3% 0.3% 3.0% 8.7% 4.8% 10.8% (11.0%) 6.5% 7.8% Expected 7.25% 7.50% 7.75% 7.75% 8.00% The Company’s expected long-term rate of return on plan assets reflects management’s view of long-term investment returns and the effect of a 1% variation in such rate of return would result in a change to the net periodic benefit cost of approximately $85 million. Management’s assumption of the expected long-term rate of return is subject to risks and uncertain- ties that could cause the actual rate of return to differ materially from management’s assumption. There can be no assurance that the plan assets will be able to earn the expected long-term rate of Pension Plan at December 31, 2012 was above the market-related return on plan assets. value of assets by $698 million, the Company’s expected return on plan assets for 2013 would increase by approximately $50 million. Net periodic benefit cost for pensions for 2013 The assets of the Company’s various plans are held in separate trust funds which are diversified by asset type, country and invest- ment strategies. Each year, the CN Board of Directors reviews and confirms or amends the Statement of Investment Policies and Procedures (SIPP) which includes the plans’ long-term asset mix and related benchmark indices (Policy). This Policy is based on a In 2013, the Company expects a net periodic benefit cost in the range of $100 million to $115 million for all its defined benefit pension plans. The unfavorable variance compared to 2012 is mainly the result of an increase in the amortization of actuarial losses due to a decrease in the discount rate used from 4.84% to 4.15% as well as a decrease in the expected rate of return from long-term forward-looking view of the world economy, the 7.25% to 7.00%, partly offset by lower interest costs. dynamics of the plans’ benefit liabilities, the market return expec- tations of each asset class and the current state of financial markets. The target long-term asset mix in 2012 was: 2% cash and short-term investments, 38% bonds, 47% equities, 4% real estate, 5% oil and gas and 4% infrastructure assets. 38 2012 Annual Report U.S. GAAP Canadian National Railway Company Management’s Discussion and Analysis Plan asset allocation Funding of pension plans Based on the fair value of the assets held as at December  31, For accounting purposes, the funded status is calculated under 2012, excluding the economic exposure of derivatives, the assets generally accepted accounting principles for all pension plans. For of the Company’s various plans are comprised of 4% in cash and funding purposes, the funded status is also calculated under short-term investments, 27% in bonds, 1% in mortgages, 41% in going-concern and solvency scenarios as prescribed under pension equities, 2% in real estate assets, 8% in oil and gas, 4% in infra- legislation and subject to guidance issued by the Canadian structure, 9% in absolute return investments, and 4% in risk- Institute of Actuaries (CIA) for all of the Canadian defined benefit based allocation investments. See Note 11 – Pensions and other pension plans. The Company’s funding requirements are deter- postretirement benefits to the Company’s 2012 Annual mined upon completion of actuarial valuations. Actuarial valua- Consolidated Financial Statements for information on the fair tions are required on an annual basis for all Canadian plans, or value measurements of such assets. when deemed appropriate by the OSFI. A significant portion of the plans’ assets are invested in pub- The latest actuarial valuation of the CN Pension Plan for fund- licly traded equity securities whose return is primarily driven by ing purposes was conducted as at December 31, 2011 and indi- stock market performance. Debt securities also account for a sig- cated a funding excess on a going-concern basis of approximately nificant portion of the plans’ investments and provide a partial $1.1 billion and a funding deficit on a solvency basis of approxi- offset to the variation in the pension benefit obligation that is mately $1.3  billion. The Company’s next actuarial valuation driven by changes in the discount rate. The funded status of the required as at December 31, 2012 will be performed in 2013. This plan fluctuates with market conditions and impacts funding actuarial valuation is expected to identify a going-concern surplus requirements. The Company will continue to make contributions of approximately $1.4 billion, while on a solvency basis a funding to the pension plans that as a minimum meet pension legislative deficit of approximately $2.0 billion is expected due to the level of requirements. interest rates applicable during that measurement period. The federal pension legislation requires funding deficits, as calculated Rate of compensation increase and health care cost trend rate under current pension regulations, to be paid over a number of The rate of compensation increase is determined by the Company years. Actuarial valuations are also required annually for the based upon its long-term plans for such increases. For 2012, a rate Company’s U.S. pension plans. of compensation increase of 3.00% and 3.25% was used to In 2012, in anticipation of its future funding requirements, the determine the projected benefit obligation and the net periodic Company made voluntary contributions of $700 million in excess benefit cost, respectively. of the required contributions mainly to strengthen the financial For postretirement benefits other than pensions, the Company position of its main pension plan, the CN Pension Plan. These reviews external data and its own historical trends for health care contributions can be treated as a prepayment against its required costs to determine the health care cost trend rates. For measure- special solvency payments. As at December  31, 2012, the ment purposes, the projected health care cost trend rate for pre- Company had $785 million of accumulated prepayments which scription drugs was assumed to be 8% in 2012, and it is assumed remain available to offset future required solvency deficit pay- that the rate will decrease gradually to 4.5% in 2028 and remain ments. The Company expects to use approximately $415 million at that level thereafter. of these prepayments to satisfy its 2013 required solvency deficit For the year ended December  31, 2012, a one-percent- payment. As a result, the Company’s cash contributions for 2013 age-point change in either the rate of compensation increase or are expected to be in the range of $135 million to $335 million, the health care cost trend rate would not cause a material change including a potential voluntary contribution of up to $200 million, to the Company’s net periodic benefit cost for both pensions and for all the Company’s pension plans. The Company expects cash other postretirement benefits. from operations and its other sources of financing to be sufficient to meet its 2013 funding obligations. Adverse changes to the assumptions used to calculate the Company’s funding status, particularly the discount rate, as well as changes to existing federal pension legislation could signifi- cantly impact the Company’s future contributions. Canadian National Railway Company U.S. GAAP 2012 Annual Report 39 Management’s Discussion and Analysis Information disclosed by major pension plan The following table provides the Company’s plan assets by category, projected benefit obligation at end of year, as well as Company and employee contributions by major defined benefit pension plan: In millions Plan assets by category Cash and short-term investments Bonds Mortgages Equities Real estate Oil and gas Infrastructure Absolute return Risk-based allocation Other (1) Total plan assets Projected benefit obligation at end of year Company contributions in 2012 Employee contributions in 2012 December 31, 2012 CN Pension Plan BC Rail Ltd Pension Plan U.S. and other plans $ 582 4,017 129 6,129 268 1,289 654 1,430 566 (22) $ 15,042 $ 15,247 $ $ 784 55 $ $ $ $ $ 22 174 4 195 10 45 23 46 18 13 550 548 16 - $ $ $ $ $ 11 84 - 99 1 5 2 5 2 10 219 540 33 - Total $ 615 4,275 133 6,423 279 1,339 679 1,481 586 1 $ 15,811 $ 16,335 $ $ 833 55 (1) Other consists of net operating assets required to administer the trust funds’ investment assets and the plans’ benefit and funding activities. Additional disclosures are provided in Note 11 – Pensions and other postretirement benefits to the Company’s 2012 Annual Consolidated Financial Statements. Income taxes approximately $1.2 billion and, based upon the level of historical The Company follows the asset and liability method of accounting taxable income and projections of future taxable income over the for income taxes. Under the asset and liability method, the change periods in which the deferred income tax assets are deductible, in the net deferred income tax asset or liability is included in the management believes it is more likely than not that the Company computation of Net income or Other comprehensive income will realize the benefits of these deductible differences. (loss). Deferred income tax assets and liabilities are measured Management has assessed the impacts of the current economic using enacted income tax rates expected to apply to taxable environment and concluded there are no significant impacts to its income in the years in which temporary differences are expected assertions for the realization of deferred income tax assets. to be recovered or settled. As a result, a projection of taxable In addition, Canadian or domestic tax rules and regulations, as income is required for those years, as well as an assumption of the well as those relating to foreign jurisdictions, are subject to inter- ultimate recovery/settlement period for temporary differences. pretation and require judgment by the Company that may be The projection of future taxable income is based on manage- challenged by the taxation authorities upon audit of the filed ment’s best estimate and may vary from actual taxable income. On income tax returns. Tax benefits are recognized if it is more likely an annual basis, the Company assesses the need to establish a than not that the tax position will be sustained on examination by valuation allowance for its deferred income tax assets, and if it is the taxation authorities. As at December  31, 2012, the total deemed more likely than not that its deferred income tax assets amount of gross unrecognized tax benefits was $36 million before will not be realized, a valuation allowance is recorded. The ulti- considering tax treaties and other arrangements between taxation mate realization of deferred income tax assets is dependent upon authorities. The amount of net unrecognized tax benefits as at the generation of future taxable income during the periods in December 31, 2012 was $30 million. If recognized, all of the net which those temporary differences become deductible. unrecognized tax benefits as at December 31, 2012 would affect Management considers the scheduled reversals of deferred the effective tax rate. The Company believes that it is reasonably income tax liabilities including the available carryback and carry- possible that approximately $16 million of the net unrecognized forward periods, projected future taxable income, and tax plan- tax benefits as at December 31, 2012 related to various federal, ning strategies in making this assessment. As at December  31, state, and provincial income tax matters, each of which are indi- 2012, in order to fully realize all of the deferred income tax assets, vidually insignificant, may be recognized over the next twelve the Company will need to generate future taxable income of months as a result of settlements and a lapse of the applicable 40 2012 Annual Report U.S. GAAP Canadian National Railway Company Management’s Discussion and Analysis statute of limitations. In Canada, the Company’s federal and pro- corporate income tax rate changes and other legislated state tax vincial income tax returns filed for the years 2007 to 2011 remain revisions that was partly offset by an income tax recovery of subject to examination by the taxation authorities. An examina- $11 million relating to certain fuel costs attributed to various tion of the Company’s federal income tax returns for 2008 is wholly-owned subsidiaries’ fuel consumption in prior periods. For currently in progress and is expected to be completed during the year ended December 31, 2010, the Company recorded total 2013. Examinations on specific tax positions taken for federal and income tax expense of $772 million, of which $418 million of the provincial income tax returns for the 2007 year are currently in reported income tax expense was for deferred income taxes. The progress and are also expected to be completed during 2013. In Company’s net deferred income tax liability at December 31, 2012 the U.S., the federal income tax returns filed for the years 2007 as was $5,512 million ($5,287 million at December  31, 2011). well as 2009 to 2011 remain subject to examination by the taxa- Additional disclosures are provided in Note 13 – Income taxes to tion authorities, and the state income tax returns filed for the the Company’s 2012 Annual Consolidated Financial Statements. years 2008 to 2011 remain subject to examination by the taxation authorities. Examinations of various state income tax returns by Business risks the state taxation authorities are currently in progress, including In the normal course of business, the Company is exposed to two additional state examinations commenced in 2012. The various business risks and uncertainties that can have an effect on Company does not anticipate any significant impacts to its results the Company’s results of operations, financial position, or liquidity. of operations or financial position as a result of the final resolu- While some exposures may be reduced by the Company’s risk tions of such matters. management strategies, many risks are driven by external factors The Company’s deferred income tax assets are mainly composed beyond the Company’s control or are of a nature which cannot be of temporary differences related to the pension liability, accruals for eliminated. The following is a discussion of key areas of business personal injury claims and other reserves, other postretirement risks and uncertainties. benefits liability, and net operating losses and tax credit carryfor- wards. The majority of these accruals will be paid out over the next Competition five years. The Company’s deferred income tax liabilities are mainly The Company faces significant competition, including from rail composed of temporary differences related to properties. The rever- carriers and other modes of transportation, and is also affected by sal of temporary differences is expected at future-enacted income its customers’ flexibility to select among various origins and desti- tax rates which could change due to fiscal budget changes and/or nations, including ports, in getting their products to market. changes in income tax laws. As a result, a change in the timing and/ Specifically, the Company faces competition from Canadian Pacific or the income tax rate at which the components will reverse, could Railway Company (CP), which operates the other major rail system materially affect deferred income tax expense as recorded in the in Canada and services most of the same industrial areas, com- Company’s results of operations. A one-percentage-point change in modity resources and population centers as the Company; major the Company’s reported effective income tax rate would have the U.S. railroads and other Canadian and U.S. railroads; long-distance effect of changing the income tax expense by $37 million in 2012. trucking companies, transportation via the St. Lawrence-Great From time to time, the federal, provincial, and state govern- Lakes Seaway and the Mississippi River and transportation via pipe- ments enact new corporate income tax rates resulting in either lines. In addition, while railroads must build or acquire and main- lower or higher tax liabilities. Such enactments occurred in each of tain their rail systems, motor carriers and barges are able to use 2012 and 2011 and resulted in an income tax expense of $35 mil- public rights-of-way that are built and maintained by public entities lion and a net income tax expense of $40 million, respectively, without paying fees covering the entire costs of their usage. with corresponding adjustments to the Company’s net deferred Competition is generally based on the quality and the reliability income tax liability. of the service provided, access to markets, as well as price. Factors For the year ended December  31, 2012, the Company affecting the competitive position of customers, including exchange recorded total income tax expense of $978 million, of which rates and energy cost, could materially adversely affect the demand $451 million was a deferred income tax expense and included a for goods supplied by the sources served by the Company and, net income tax expense of $28 million, which consisted of a therefore, the Company’s volumes, revenues and profit margins. $35 million income tax expense resulting from the enactment of Factors affecting the general market conditions for our customers higher provincial corporate income tax rates that was partly offset can result in an imbalance of transportation capacity relative to by a $7 million income tax recovery resulting from the recapital- demand. An extended period of supply/demand imbalance could ization of a foreign investment. For the year ended December 31, negatively impact market rate levels for all transportation services, 2011, the Company recorded total income tax expense of and more specifically the Company’s ability to maintain or increase $899 million, of which $531 million of the reported income tax rates. This, in turn, could materially and adversely affect the expense was for deferred income taxes, and included a $40 mil- Company’s business, results of operations or financial position. lion net income tax expense resulting from the enactment of state Canadian National Railway Company U.S. GAAP 2012 Annual Report 41 Management’s Discussion and Analysis The level of consolidation of rail systems in the U.S. has payment of environmental penalties and remediation obligations, resulted in larger rail systems that are able to offer seamless ser- and damages relating to harm to individuals or property. vices in larger market areas and, accordingly, compete effectively The environmental liability for any given contaminated site with the Company in numerous markets. This requires the varies depending on the nature and extent of the contamination; Company to consider arrangements or other initiatives that would the available clean-up techniques; evolving regulatory standards similarly enhance its own service. governing environmental liability; and the number of potentially There can be no assurance that the Company will be able to responsible parties and their financial viability. As such, the ulti- compete effectively against current and future competitors in the mate cost of addressing known contaminated sites cannot be transportation industry, and that further consolidation within the definitively established. Also, additional contaminated sites yet transportation industry and legislation allowing for more leniency unknown may be discovered or future operations may result in in size and weight for motor carriers will not adversely affect the accidental releases. Company’s competitive position. No assurance can be given that While some exposures may be reduced by the Company’s risk competitive pressures will not lead to reduced revenues, profit mitigation strategies (including periodic audits, employee training margins or both. Environmental matters programs and emergency plans and procedures), many environ- mental risks are driven by external factors beyond the Company’s control or are of a nature which cannot be completely eliminated. The Company’s operations are subject to numerous federal, pro- Therefore, there can be no assurance, notwithstanding the vincial, state, municipal and local environmental laws and regula- Company’s mitigation strategies, that liabilities or costs related to tions in Canada and the U.S. concerning, among other things, environmental matters will not be incurred in the future or that emissions into the air; discharges into waters; the generation, environmental matters will not have a material adverse effect on handling, storage, transportation, treatment and disposal of the Company’s results of operations, financial position or liquidity, waste, hazardous substances and other materials; decommission- and reputation in a particular quarter or fiscal year. ing of underground and aboveground storage tanks; and soil and groundwater contamination. A risk of environmental liability is Personal injury and other claims inherent in railroad and related transportation operations; real In the normal course of business, the Company becomes involved estate ownership, operation or control; and other commercial in various legal actions seeking compensatory and occasionally activities of the Company with respect to both current and past punitive damages, including actions brought on behalf of various operations. As a result, the Company incurs significant operating purported classes of claimants and claims relating to employee and and capital costs, on an ongoing basis, associated with environ- third-party personal injuries, occupational disease, and property mental regulatory compliance and clean-up requirements in its damage, arising out of harm to individuals or property allegedly railroad operations and relating to its past and present ownership, caused by, but not limited to, derailments or other accidents. The operation or control of real property. Company maintains provisions for such items, which it considers to While the Company believes that it has identified the costs be adequate for all of its outstanding or pending claims and ben- likely to be incurred for environmental matters in the next several efits from insurance coverage for occurrences in excess of certain years based on known information, the discovery of new facts, amounts. The final outcome with respect to actions outstanding or future changes in laws, the possibility of releases of hazardous pending at December 31, 2012, or with respect to future claims, materials into the environment and the Company’s ongoing cannot be predicted with certainty, and therefore there can be no efforts to identify potential environmental liabilities that may be assurance that their resolution will not have a material adverse associated with its properties may result in the identification of effect on the Company’s results of operations, financial position or additional environmental liabilities and related costs. liquidity, in a particular quarter or fiscal year. In railroad and related transportation operations, it is possible that derailments or other accidents, including spills and releases of Labor negotiations hazardous materials, may occur that could cause harm to human Canadian workforce health or to the environment. In addition, the Company is also As at December 31, 2012, CN employed a total of 16,092 employ- exposed to potential catastrophic liability risk, faced by the rail- ees in Canada, of which 11,948 were unionized employees. From road industry generally, in connection with the transportation of time to time, the Company negotiates to renew collective agree- toxic inhalation hazard materials such as chlorine and anhydrous ments with various unionized groups of employees. In such cases, ammonia, commodities that the Company may be required to the collective agreements remain in effect until the bargaining transport to the extent of its common carrier obligations. As a process has been exhausted as per the Canada Labour Code. result, the Company may incur costs in the future, which may be On January  27, 2012, the tentative agreement reached on material, to address any such harm, compliance with laws or other December  12, 2011 between CN and Teamsters Canada Rail risks, including costs relating to the performance of clean-ups, Conference (TCRC) covering approximately 1,500 locomotive 42 2012 Annual Report U.S. GAAP Canadian National Railway Company Management’s Discussion and Analysis engineers was ratified. The new collective agreement will expire the EJ&E and WC merger on January  1, 2013, train and engine on December 31, 2014. service employees of the former EJ&E are now governed by the On February 8, 2012, the tentative agreement reached on terms of the WC collective agreements and the former EJ&E col- December  15, 2011 between CN and the United Steelworkers lective agreements cease to exist. (USW) covering approximately 2,900 track maintenance employ- The WC rail traffic controllers (RTCs) ratified their first collec- ees was ratified. The new collective agreement will expire on tive agreement on February 29, 2012, which led to an Implementing December 31, 2014. Agreement that combined the WC, ICRR and GTW RTC’s under On May 28, 2012, the tentative agreement reached on one collective agreement in the centralized Rail Traffic Control April 11, 2012 between CN and the TCRC covering approximately Center in Homewood, Illinois. 200 rail traffic controllers was ratified. The new collective agree- ment will expire on December 31, 2014. The general approach to labor negotiations by U.S. Class I railroads is to bargain on a collective national basis. GTW, ICRR, On January  31, 2013, the tentative agreement reached on WC, BLE, PCD and EJ&E have bargained on a local basis rather December  21, 2012 between CN and the International Brother- than holding national, industry-wide negotiations because they hood of Electrical Workers (IBEW), covering approximately believe it results in agreements that better address both the 700 signal and communications employees was ratified. The new employees’ concerns and preferences, and the railways’ actual collective agreement will expire on December 31, 2016. operating environment. However, local negotiations may not gen- Disputes relating to the renewal of collective agreements could dispute may be localized. The Company believes the potential potentially result in strikes, work stoppages, slowdowns and loss mutual benefits of local bargaining outweigh the risks. of business. Future labor agreements or renegotiated agreements Where negotiations are ongoing, the terms and conditions of could increase labor and fringe benefits expenses. There can be no existing agreements generally continue to apply until new agree- assurance that the Company will be able to renew and have its ments are reached or the processes of the Railway Labor Act have erate federal intervention in a strike or lockout situation, since a collective agreements ratified without any strikes or lockouts or been exhausted. that the resolution of these collective bargaining negotiations will not have a material adverse effect on the Company’s results of There can be no assurance that there will not be any work action operations or financial position. U.S. workforce by any of the bargaining units with which the Company is cur- rently in negotiations or that the resolution of these negotiations will not have a material adverse effect on the Company’s results As at December 31, 2012, CN employed a total of 7,338 employ- of operations or financial position. ees in the U.S., of which 5,752 were unionized employees. As of February 1, 2013, the Company had in place agreements Regulation with bargaining units representing the entire unionized workforce The Company’s rail operations in Canada are subject to (i) eco- at Grand Trunk Western Railroad Company (GTW), companies nomic regulation by the Canadian Transportation Agency under owned by Illinois Central Railroad Company (ICRR), companies the Canada Transportation Act (CTA), and (ii) safety regulation by owned by Wisconsin Central Transportation Corporation (WC), the federal Minister of Transport under the Railway Safety Act and Bessemer & Lake Erie Railroad Company (BLE) and The Pittsburgh certain other statutes. The Company’s U.S. rail operations are and Conneaut Dock Company (PCD). Agreements in place have subject to (i) economic regulation by the STB and (ii) safety regu- various moratorium provisions, ranging from 2010 to 2016, which lation by the Federal Railroad Administration (FRA). preserve the status quo in respect of the given collective agree- ment during the terms of such moratoriums. Some of these agree- Economic regulation – Canada ments are currently under renegotiation. The CTA provides rate and service remedies, including final offer In conjunction with a notice of exemption filed with the STB arbitration (FOA), competitive line rates and compulsory inter- allowing for the intra-corporate merger of Elgin, Joliet and Eastern switching. The CTA also regulates the maximum revenue entitle- Railway Company (EJ&E) and WC, the Company has served notice ment for the movement of grain, charges for railway ancillary to unions representing train and engine service employees on services and noise-related disputes. In addition, various Company those properties to consolidate the collective agreements. As of business transactions must gain prior regulatory approval, with August 30, 2012, CN reached tentative agreements with the attendant risks and uncertainties. United Transportation Union (UTU) and the Brotherhood of On December 11, 2012, the Government introduced Bill C-52 Locomotive Engineers and Trainmen (BLET) to complete the con- which gives shippers a right to an agreement respecting the level of solidation of the collective agreements covering all impacted train service to be provided by a railway company. The Bill also sets out a and engine employees. Ratification of both of these agreements process by which the level of service to be provided by the railway was completed on October 7, 2012. Effective with the closing of company can be established through an arbitration process Canadian National Railway Company U.S. GAAP 2012 Annual Report 43 Management’s Discussion and Analysis in the event that the parties cannot reach agreement through gation and determine that a failure to meet these standards is due their own commercial negotiations. However, the arbitration pro- to the host railroad’s failure to provide preference to Amtrak, the cess will not be available to a shipper in respect of a matter that STB is authorized to assess damages against the host railroad. On is governed by a written agreement between the shipper and the January  19, 2012, Amtrak filed a petition with the STB to com- railway company or in respect of traffic that is subject to a decision mence such an investigation, including a request for damages for issued under the final arbitration process. preference failures, for allegedly sub-standard performance of Amtrak trains on CN’s ICRR and GTW lines. On March 9, 2012, CN No assurance can be given that any current or future legislative responded and on March 27, 2012, Amtrak and CN filed a joint action by the federal government or other future government motion requesting the STB to hold the proceedings in abeyance in initiatives will not materially adversely affect the Company’s results order to enter into a STB-supervised mediation. The STB appointed of operations or financial position. Economic regulation – U.S. a mediator for the matter on April 10, 2012, and ordered the proceedings held in abeyance until October 4, 2012 when the mediation ended and the proceedings resumed. The Company is The STB serves as both an adjudicatory and regulatory body and also participating in a railroad industry challenge to the constitu- has jurisdiction over railroad rate and service issues and rail tionality of the joint FRA/Amtrak performance metrics and stan- restructuring transactions such as mergers, line sales, line con- dards. On May 31, 2012, the U.S. District Court in Washington struction and line abandonments. As such, various Company D.C. upheld PRIIA’s constitutionality over the industry’s challenge. business transactions must gain prior regulatory approval, with The decision was appealed to the U.S. Court of Appeals for the attendant risks and uncertainties. On May 23, 2012, the Company D.C. Circuit. Briefing is complete and the Court will hear oral filed with the STB a notice of exemption for the intra-corporate arguments on February 19, 2013. merger of EJ&E into WC. The notice became effective on June 22, The U.S. Congress has had under consideration for several 2012 and the Company consummated the merger effective years various pieces of legislation that would increase federal January 1, 2013. economic regulation of the railroad industry. Broad legislation to The STB has undertaken proceedings in a number of areas modify economic regulation of the rail industry (S. 158) and legis- recently on rail issues. On February 24, 2011, the STB held a hear- lation to repeal the rail industry’s limited antitrust exemptions (S. ing to review the commodities and forms of service currently 49) were introduced in 2011 in the Senate. S. 49 has also been exempt from STB regulation and is considering the comments on approved by the Senate Judiciary Committee and there is no these matters and may take further action. On May 7, 2012, the assurance that this or similar legislation will not progress through STB proposed new regulations concerning the liability of third the legislative process in 2013 or in future years. parties for rail car demurrage providing that any person receiving The acquisition of the EJ&E in 2009 followed an extensive reg- rail cars from a carrier for loading or unloading who detains the ulatory approval process by the STB, which included an cars beyond a specified period of time may be held liable for Environmental Impact Statement (EIS) that resulted in conditions demurrage if that person has actual notice of the carrier’s demur- imposed to mitigate municipalities’ concerns regarding increased rage tariff providing for such liability prior to the carrier’s placement rail activity expected along the EJ&E line (see Contractual obliga- of the cars. On July 25, 2012, following hearings in June 2011 on tions section of this MD&A). The Company accepted the STB- the state of competition in the railroad industry, the STB com- imposed conditions with one exception. The Company filed an menced a proceeding to evaluate a proposal made by the National appeal at the U.S. Court of Appeals for the District of Columbia Industrial Transportation League for competitive switching. In a Circuit challenging the STB’s condition requiring the installation of first phase, the STB has asked parties to submit a wide variety of grade separations at two locations along the EJ&E line at Company data to assess the scope and potential impact of the proposal. Also funding levels significantly beyond prior STB practice. Appeals were on July 25, 2012, the STB issued a notice of proposed rulemaking also filed by certain communities challenging the sufficiency of the to raise relief caps and remove certain other limitations for rate EIS. On March 15, 2011, the Court denied the CN and community complaints brought under its simplified rate guidelines. appeals. As such, the Company estimates its total remaining com- As part of the Passenger Rail Investment and Improvement Act mitment related to the acquisition to be approximately $100 mil- of 2008 (PRIIA), the U.S. Congress has authorized the STB to lion (US$100 million). The commitment for the grade separation investigate any railroad over whose track Amtrak operates that projects is based on estimated costs provided by the STB at the fails to meet an 80 percent on-time performance standard for time of acquisition and could be subject to adjustment. Amtrak operations extending over two calendar quarters and to The STB also imposed a five-year monitoring and oversight determine the cause of such failures. Compliance with this man- condition, subsequently extended to six years, during which the date began with the third quarter of 2010 and is governed by Company is required to file with the STB monthly operational performance metrics and standards jointly issued by the FRA and reports as well as quarterly reports on the implementation status Amtrak on May 12, 2010. Should the STB commence an investi- of the STB-imposed mitigation conditions. This permits the STB to 44 2012 Annual Report U.S. GAAP Canadian National Railway Company Management’s Discussion and Analysis take further action if there is a material change in the facts and U.S. destinations and that amendment of the current HMT struc- circumstances upon which it relied in imposing the specific mitiga- ture should be considered so as to assist U.S. seaports. tion conditions. On November 8, 2012, the STB denied the request of the Village of Barrington, IL, that the STB impose addi- No assurance can be given that these or any future regulatory tional mitigation that would require CN to fund the full cost of a initiatives by the U.S. federal government will not materially grade separation at a location along the EJ&E line in Barrington. adversely affect the Company’s results of operations, or its com- On December 26, 2012, the Village appealed the STB’s decision to petitive and financial position. the U.S. Court of Appeals for the D.C. Circuit. A first oversight audit of the Company’s EJ&E’s operational and environmental Safety regulation – Canada reporting was completed in April 2010, and after public comment Rail safety regulation in Canada is the responsibility of Transport was finalized by the STB in December 2010. In December 2011, Canada, which administers the Canadian Railway Safety Act, as the STB directed a second oversight audit that commenced on well as the rail portions of other safety-related statutes. On February 17, 2012, that audit was completed on April 30, 2012, June 4, 2010, the Minister of Transport tabled Bill C-33 proposing and released publicly by the STB on June 18, 2012. a number of amendments to the Railway Safety Act. The Standing The resolution of matters that could arise during the STB’s Committee on Transport and Infrastructure completed its study of remaining oversight of the transaction cannot be predicted with Bill C-33, but the Bill died on the Order Paper when Parliament certainty, and therefore, there can be no assurance that their res- was dissolved in March 2011. On October 6, 2011, the Government olution will not have a material adverse effect on the Company’s tabled Bill S-4 which included essentially the same provisions as financial position or results of operations. those that were in Bill C-33. Bill S-4 received Royal Assent on The Company’s ownership of the former Great Lakes May 17, 2012 and will come into force on May 1, 2013. Transportation vessels is subject to regulation by the U.S. Coast Guard (USCG) and the Department of Transportation, Maritime Safety regulation – U.S. Administration, which regulate the ownership and operation of Rail safety regulation in the U.S. is the responsibility of the FRA, vessels operating on the Great Lakes and in U.S. coastal waters. In which administers the Federal Railroad Safety Act, as well as the addition, the Environmental Protection Agency (EPA) has authority rail portions of other safety statutes. In 2008, the U.S. federal to regulate air emissions from these vessels. On August 28, 2009, government enacted legislation reauthorizing the Federal Railroad the EPA issued a proposed rule to extend an ongoing rulemaking to Safety Act. This legislation covers a broad range of safety issues, limit sulfur emissions for ocean-going vessels to operations in the including fatigue management, positive train control (PTC), grade Great Lakes. The EPA’s proposed rule would have had an adverse impact on the Company’s Great Lakes Fleet operations. The Company’s U.S.-flag vessel operator filed comments on September crossings, bridge safety, and other matters. The legislation requires all Class I railroads and intercity passenger and commuter railroads to implement a PTC system by December  31, 2015 on mainline 28, 2009 in the proceeding. On December 22, 2009, the EPA issued track where intercity passenger railroads and commuter railroads its final emissions regulations, which addressed many of Great operate and where toxic inhalation hazard materials are trans- Lakes Fleet’s concerns. In addition, the USCG on August 28, 2009 ported. PTC is a collision avoidance technology intended to over- proposed to amend its regulations on ballast water management; ride locomotive controls and stop a train before an accident. The the Company’s U.S.-flag vessel operator participated in this Company is taking steps to ensure implementation of PTC in rulemaking proceeding. The USCG published its final rule in this proceeding on March 23, 2012. At present, vessels operating on the Great Lakes are not covered by the final rule, but expansion of accordance with the new law, including working with other Class  I railroads to satisfy the requirements for U.S. network interoperability. The Company’s PTC Implementation Plan, submit- the new requirements at some time in the future is possible. ted in April 2010, has been approved by the FRA. Total implemen- On November 8, 2011, the Federal Maritime Commission tation costs associated with PTC are estimated to be (FMC), which has authority over oceanborne transport of cargo US$220 million. The legislation also caps the number of on-duty into and out of the U.S., initiated a Notice of Inquiry to examine and limbo time hours for certain rail employees on a monthly whether the U.S. Harbor Maintenance Tax (HMT) and other fac- basis. The Company is taking appropriate steps and is working tors may be contributing to the diversion of U.S.-bound cargo to with the FRA to ensure that its operations conform to the law’s Canadian and Mexican seaports, which could affect CN rail oper- requirements. ations. The Company filed comments in this proceeding on January  9, 2012. In July 2012, the FMC issued its study, which No assurance can be given that these or any future regulatory found that carriers shipping cargo through Canadian or Mexican initiatives by the Canadian and U.S. federal governments will not ports violate no U.S. law, treaty, agreement, or FMC regulation. materially adversely affect the Company’s results of operations, or The report stated, however, that the HMT is one of many factors its competitive and financial position. affecting the increased use of foreign ports for cargo bound for Canadian National Railway Company U.S. GAAP 2012 Annual Report 45 Management’s Discussion and Analysis Security transfer of all such cars to and from shippers, receivers and The Company is subject to statutory and regulatory directives in other carriers that will move from, to, or through designated the U.S. addressing homeland security concerns. In the U.S., high-threat urban areas. safety matters related to security are overseen by the Transportation (iii) The PHMSA has issued regulations to enhance the crashwor- Security Administration (TSA), which is part of the U.S. Department thiness protection of tank cars used to transport toxic inhala- of Homeland Security (DHS) and the Pipeline and Hazardous tion hazard materials and to limit the operating conditions of Materials Safety Administration (PHMSA), which, like the FRA, is such cars. part of the U.S. Department of Transportation. Border security falls (iv) In Canada, the Transportation of Dangerous Goods Act estab- under the jurisdiction of U.S. Customs and Border protection lishes the safety requirements for the transportation of goods (CBP), which is part of the DHS. In Canada, the Company is sub- classified as dangerous and enables the establishment of regu- ject to regulation by the Canada Border Services Agency (CBSA). lations for security training and screening of personnel working More specifically, the Company is subject to: with dangerous goods, as well as the development of a program (i) Border security arrangements, pursuant to an agreement the to require a transportation security clearance for dangerous Company and CP entered into with the CBP and the CBSA. goods and that dangerous goods be tracked during transport. (ii) The CBP’s Customs-Trade Partnership Against Terrorism (C-TPAT) program and designation as a low-risk carrier under While the Company will continue to work closely with the CBSA, CBSA’s Customs Self-Assessment (CSA) program. CBP, and other Canadian and U.S. agencies, as described above, (iii) Regulations imposed by the CBP requiring advance notification no assurance can be given that these and future decisions by the by all modes of transportation for all shipments into the U.S. U.S., Canadian, provincial, state, or local governments on home- The CBSA is also working on similar requirements for Canada- land security matters, legislation on security matters enacted by bound traffic. the U.S. Congress or Parliament, or joint decisions by the industry (iv) Inspection for imported fruits and vegetables grown in Canada in response to threats to the North American rail network, will not and the agricultural quarantine and inspection (AQI) user fee materially adversely affect the Company’s results of operations, or for all traffic entering the U.S. from Canada. its competitive and financial position. The Company has worked with the Association of American Radio communications Railroads to develop and put in place an extensive industry-wide The Company uses radios for a variety of operational purposes. security plan to address terrorism and security-driven efforts by Licenses for these activities, as well as the transfer or assignment state and local governments seeking to restrict the routings of of these licenses, require authorization of the Federal certain hazardous materials. If such state and local routing restric- Communications Commission (FCC). The Company uncovered a tions were to go into force, they would be likely to add to security number of instances where such authorization was not obtained concerns by foreclosing the Company’s most optimal and secure and disclosed those instances to the FCC on a voluntary basis. The transportation routes, leading to increased yard handling, longer Company is undertaking a number of corrective actions with the hauls, and the transfer of traffic to lines less suitable for moving FCC to address the situation, the whole without prejudice to a hazardous materials, while also infringing upon the exclusive and future FCC enforcement action and the imposition of fines. uniform federal oversight over railroad security matters. Transportation of hazardous materials Other risks Economic conditions The Company may be required to transport toxic inhalation haz- The Company, like other railroads, is susceptible to changes in the ard materials to the extent of its common carrier obligations and, economic conditions of the industries and geographic areas that as such, is exposed to additional regulatory oversight. produce and consume the freight it transports or the supplies it (i) The PHMSA requires carriers operating in the U.S. to report requires to operate. In addition, many of the goods and commodi- annually the volume and route-specific data for cars containing ties carried by the Company experience cyclicality in demand. Many these commodities; conduct a safety and security risk analysis of the bulk commodities the Company transports move offshore and for each used route; identify a commercially practicable alter- are affected more by global rather than North American economic native route for each used route; and select for use the practi- conditions. Adverse North American and global economic condi- cal route posing the least safety and security risk. tions, or economic or industrial restructuring, that affect the produc- (ii) The TSA requires rail carriers to provide upon request, within ers and consumers of the commodities carried by the Company, five minutes for a single car and 30 minutes for multiple cars, including customer insolvency, may have a material adverse effect on location and shipping information on cars on their networks the volume of rail shipments and/or revenues from commodities containing toxic inhalation hazard materials and certain radio- carried by the Company, and thus materially and negatively affect its active or explosive materials; and ensure the secure, attended results of operations, financial position, or liquidity. 46 2012 Annual Report U.S. GAAP Canadian National Railway Company Management’s Discussion and Analysis Pensions markets. Government response to such events could adversely affect Overall returns in the capital markets and the level of interest rates the Company’s operations. Insurance premiums could also increase affect the funded status of the Company’s defined benefit pen- significantly or coverage could become unavailable. sion plans. For accounting purposes, the funded status of all pension Customer credit risk plans is calculated at the measurement date, which for the In the normal course of business, the Company monitors the Company is December  31, using generally accepted accounting financial condition and credit limits of its customers and reviews principles. Adverse changes with respect to pension plan returns the credit history of each new customer. Although the Company and the level of interest rates from the last measurement date may believes there are no significant concentrations of credit risk, eco- have a material adverse effect on the funded status and signifi- nomic conditions can affect the Company’s customers and can cantly impact future pension expense. result in an increase to the Company’s credit risk and exposure to For funding purposes, the funded status of the Canadian pen- the business failures of its customers. To manage its credit risk on sion plans is calculated to determine the required level of contri- an ongoing basis, the Company’s focus is on keeping the average butions using going-concern and solvency scenarios as prescribed daily sales outstanding within an acceptable range and working under pension legislation and subject to guidance issued by the with customers to ensure timely payments, and in certain cases, Canadian Institute of Actuaries. Adverse changes with respect to requiring financial security, including letters of credit. A wide- pension plan returns and the level of interest rates from the date spread deterioration of customer credit and business failures of of the last actuarial valuations as well as changes to existing fed- customers could have a material adverse effect on the Company’s eral pension legislation may significantly impact future pension results of operations, financial position or liquidity. contributions and have a material adverse effect on the funded status of the plans and the Company’s results of operations. The Liquidity Company’s funding requirements are determined upon comple- Disruptions in the financial markets or deterioration of the tion of actuarial valuations which are required on an annual basis Company’s credit ratings could hinder the Company’s access to for all Canadian plans, or when deemed appropriate by the OSFI. external sources of funding to meet its liquidity needs. There can The federal pension legislation allows funding deficits to be paid be no assurance that changes in the financial markets will not over a number of years. Actuarial valuations are also required have a negative effect on the Company’s liquidity and its access to annually for the Company’s U.S. pension plans. capital at acceptable rates. In 2012, in anticipation of its future funding requirements, the Company made voluntary contributions of $700 million ($350 mil- Supplier risk lion in 2011) in excess of the required contributions mainly to The Company operates in a capital-intensive industry where the strengthen the financial position of its main pension plan, the CN complexity of rail equipment limits the number of suppliers avail- Pension Plan. The Company can treat these contributions as a able. The supply market could be disrupted if changes in the prepayment against future pension deficit funding requirements. economy caused any of the Company’s suppliers to cease produc- As a result, the Company’s cash contributions for 2013 are tion or to experience capacity or supply shortages. This could also expected to be in the range of $135 million to $335 million, result in cost increases to the Company and difficulty in obtaining including a potential voluntary contribution of up to $200 million, and maintaining the Company’s rail equipment and materials. for all the Company’s pension plans. Since the Company also has foreign suppliers, international rela- The Company expects cash from operations and its other tions, trade restrictions and global economic and other conditions sources of financing to be sufficient to meet its funding obligation. may potentially interfere with the Company’s ability to procure Trade restrictions necessary equipment. To manage its supplier risk, it is the Company’s long-standing practice to ensure that more than one Global as well as North American trade conditions, including trade source of supply for a key product or service, where feasible, is barriers on certain commodities, may interfere with the free circu- available. Widespread business failures of, or restrictions on sup- lation of goods across Canada and the U.S. pliers, could have a material adverse effect on the Company’s results of operations or financial position. Terrorism and international conflicts Potential terrorist actions can have a direct or indirect impact on the Availability of qualified personnel transportation infrastructure, including railway infrastructure in The Company, like other companies in North America, may expe- North America, and can interfere with the free flow of goods. Rail rience demographic challenges in the employment levels of its lines, facilities and equipment could be directly targeted or become workforce. Changes in employee demographics, training require- indirect casualties, which could interfere with the free flow of goods. ments and the availability of qualified personnel, particularly International conflicts can also have an impact on the Company’s locomotive engineers and trainmen, could negatively impact the Canadian National Railway Company U.S. GAAP 2012 Annual Report 47 Management’s Discussion and Analysis Company’s ability to meet demand for rail service. The Company Transportation network disruptions expects that approximately 40% of its workforce will be eligible to Due to the integrated nature of the North American freight trans- retire or leave through normal attrition (death, termination, resig- portation infrastructure, the Company’s operations may be nega- nation) within the next five-year period. The Company monitors tively affected by service disruptions of other transportation links employment levels to ensure that there is an adequate supply of such as ports and other railroads which interchange with the personnel to meet rail service requirements. However, the Company. A significant prolonged service disruption of one or Company’s efforts to attract and retain qualified personnel may be more of these entities could have an adverse effect on the hindered by specific conditions in the job market. No assurance Company’s results of operations, financial position or liquidity. can be given that demographic or other challenges will not mate- Furthermore, deterioration in the cooperative relationships with rially adversely affect the Company’s results of operations or its the Company’s connecting carriers could directly affect the financial position. Fuel costs Company’s operations. Weather and climate change The Company, like other railroads, is susceptible to the volatility of The Company’s success is dependent on its ability to operate its fuel prices due to changes in the economy or supply disruptions. railroad efficiently. Severe weather and natural disasters, such as Fuel shortages can occur due to refinery disruptions, production extreme cold or heat, flooding, drought, hurricanes and earth- quota restrictions, climate, and labor and political instability. Rising quakes, can disrupt operations and service for the railroad, affect fuel prices could materially adversely affect the Company’s the performance of locomotives and rolling stock, as well as dis- expenses. As such, CN has implemented a fuel surcharge program rupt operations for both the Company and its customers. Climate with a view of offsetting the impact of rising fuel prices. The sur- change, including the impact of global warming, has the potential charge applied to customers is determined in the second calendar physical risk of increasing the frequency of adverse weather month prior to the month in which it is applied, and is calculated events, which can disrupt the Company’s operations, damage its using the average monthly price of West-Texas Intermediate crude infrastructure or properties, or otherwise have a material adverse oil (WTI) for revenue-based tariffs and On-Highway Diesel (OHD) effect on the Company’s results of operations, financial position or for mileage-based tariffs. Increases in fuel prices or supply disrup- liquidity. In addition, although the Company believes that the tions may materially adversely affect the Company’s results of growing support for climate change legislation is likely to result in operations, financial position or liquidity. changes to the regulatory framework in Canada and the U.S., it is Foreign currency too early to predict the manner or degree of such impact on the Company at this time. Restrictions, caps, taxes, or other controls The Company conducts its business in both Canada and the U.S. on emissions of greenhouse gasses, including diesel exhaust, and as a result, is affected by currency fluctuations. The estimated could significantly increase the Company’s capital and operating annual impact on net income of a year-over-year one-cent change costs or affect the markets for, or the volume of, the goods the in the Canadian dollar relative to the US dollar is in the range of Company carries thereby resulting in a material adverse effect on $5 million to $15 million. Changes in the exchange rate between operations, financial position, results of operations or liquidity. the Canadian dollar and other currencies (including the US dollar) More specifically, climate change legislation and regulation could make the goods transported by the Company more or less com- (a) affect CN’s utility coal customers due to coal capacity being petitive in the world marketplace and thereby may adversely affect replaced with natural gas generation and renewable energy; (b) the Company’s revenues and expenses. Reliance on technology make it difficult for CN’s customers to produce products in a cost-competitive manner due to increased energy costs; and (c) increase legal costs related to defending and resolving legal claims The Company relies on information technology in all aspects of its and other litigation related to climate change. business. While the Company has business continuity and disaster recovery plans in place, a significant disruption or failure of its information technology systems could result in service interrup- tions, safety failures, security violations, regulatory compliance failures or other operational difficulties and compromise corporate information and assets against intruders and, as such, could adversely affect the Company’s results of operations, financial position or liquidity. If the Company is unable to acquire or imple- ment new technology, it may suffer a competitive disadvantage, which could also have an adverse effect on the Company’s results of operations, financial position or liquidity. 48 2012 Annual Report U.S. GAAP Canadian National Railway Company Management’s Discussion and Analysis Controls and procedures The Company’s Chief Executive Officer and its Chief Financial Officer, after evaluating the effectiveness of the Company’s “dis- closure controls and procedures” (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) as of December  31, 2012, have concluded that the Company’s disclosure controls and procedures were effective. During the fourth quarter ended December 31, 2012, there was no change in the Company’s internal control over financial report- ing that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting. As of December  31, 2012, management has assessed the effectiveness of the Company’s internal control over financial reporting using the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control – Integrated Framework. Based on this assess- ment, management has determined that the Company’s internal control over financial reporting was effective as of December 31, 2012, and issued Management’s Report on Internal Control over Financial Reporting dated February 1, 2013 to that effect. The Company’s 2012 Annual Information Form (AIF) and Form 40-F, may be found on SEDAR at www.sedar.com and on EDGAR at www.sec.gov, respectively. Copies of such documents, as well as the Company’s Notice of Intention to Make a Normal Course Issuer Bid, may be obtained by contacting the Corporate Secretary’s office. Montreal, Canada February 1, 2013 Canadian National Railway Company U.S. GAAP 2012 Annual Report 49 Management’s Report on Internal Control Report of Independent Registered Public Accounting Firm over Financial Reporting Management is responsible for establishing and maintaining ade- To the Shareholders and Board of Directors of the Canadian quate internal control over financial reporting. Internal control National Railway Company over financial reporting is a process designed to provide reason- able assurance regarding the reliability of financial reporting and We have audited the accompanying consolidated balance sheets the preparation of financial statements for external purposes in of the Canadian National Railway Company (the “Company”) as accordance with generally accepted accounting principles. of December  31, 2012 and 2011, and the related consolidated Because of its inherent limitations, internal control over financial statements of income, comprehensive income, changes in share- reporting may not prevent or detect misstatements. holders’ equity and cash flows for each of the years in the three- Management has assessed the effectiveness of the Company’s year period ended December  31, 2012. These consolidated internal control over financial reporting as of December 31, 2012 financial statements are the responsibility of the Company’s man- using the criteria set forth by the Committee of Sponsoring agement. Our responsibility is to express an opinion on these Organizations of the Treadway Commission (COSO) in Internal consolidated financial statements based on our audits. Control – Integrated Framework. Based on this assessment, man- We conducted our audits in accordance with Canadian gener- agement has determined that the Company’s internal control over ally accepted auditing standards and the standards of the Public financial reporting was effective as of December 31, 2012. Company Accounting Oversight Board (United States). Those stan- KPMG LLP, an independent registered public accounting firm, dards require that we plan and perform the audit to obtain reason- has issued an unqualified audit report on the effectiveness of the able assurance about whether the financial statements are free of Company’s internal control over financial reporting as of material misstatement. An audit includes examining, on a test basis, December 31, 2012 and has also expressed an unqualified audit evidence supporting the amounts and disclosures in the financial opinion on the Company’s 2012 consolidated financial statements statements. An audit also includes assessing the accounting princi- as stated in their Reports of Independent Registered Public ples used and significant estimates made by management, as well Accounting Firm dated February 1, 2013. as evaluating the overall financial statement presentation. We Claude Mongeau President and Chief Executive Officer February 1, 2013 Luc Jobin Executive Vice-President and Chief Financial Officer February 1, 2013 believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of the Company as of December 31, 2012 and 2011, and its consolidated results of operations and its consoli- dated cash flows for each of the years in the three-year period ended December  31, 2012, in conformity with United States generally accepted accounting principles. We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the Company’s internal control over financial reporting as of December  31, 2012, based on criteria established in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”), and our report dated February 1, 2013 expressed an unqualified opinion on the effectiveness of the Company’s internal control over financial reporting. KPMG LLP* Montreal, Canada February 1, 2013 * FCPA auditor, FCA, public accountancy permit No. A106087 KPMG LLP is a Canadian limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. KPMG Canada provides services to KPMG LLP. 50 2012 Annual Report U.S. GAAP Canadian National Railway Company Report of Independent Registered Public Accounting Firm To the Shareholders and Board of Directors of the Canadian financial reporting includes those policies and procedures that National Railway Company (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the We have audited the Canadian National Railway Company’s (the assets of the company; (2) provide reasonable assurance that trans- “Company”) internal control over financial reporting as of actions are recorded as necessary to permit preparation of financial December  31, 2012, based on criteria established in Internal statements in accordance with generally accepted accounting Control – Integrated Framework issued by the Committee of principles, and that receipts and expenditures of the company are Sponsoring Organizations of the Treadway Commission (“COSO”). being made only in accordance with authorizations of manage- The Company’s management is responsible for maintaining effec- ment and directors of the company; and (3) provide reasonable tive internal control over financial reporting, and for its assessment assurance regarding prevention or timely detection of unautho- of the effectiveness of internal control over financial reporting rized acquisition, use, or disposition of the company’s assets that included in the accompanying Management’s Report on Internal could have a material effect on the financial statements. Control over Financial Reporting. Our responsibility is to express Because of its inherent limitations, internal control over finan- an opinion on the Company’s internal control over financial cial reporting may not prevent or detect misstatements. Also, reporting based on our audit. projections of any evaluation of effectiveness to future periods are We conducted our audit in accordance with the standards of subject to the risk that controls may become inadequate because the Public Company Accounting Oversight Board (United States). of changes in conditions, or that the degree of compliance with Those standards require that we plan and perform the audit to the policies or procedures may deteriorate. obtain reasonable assurance about whether effective internal In our opinion, the Company maintained, in all material control over financial reporting was maintained in all material respects, effective internal control over financial reporting as of respects. Our audit included obtaining an understanding of inter- December  31, 2012, based on criteria established in Internal nal control over financial reporting, assessing the risk that a mate- Control – Integrated Framework issued by the COSO. rial weakness exists, and testing and evaluating the design and We also have audited, in accordance with Canadian generally operating effectiveness of internal control based on the assessed accepted auditing standards and the standards of the Public risk. Our audit also included performing such other procedures as Company Accounting Oversight Board (United States), the con- we considered necessary in the circumstances. We believe that our solidated balance sheets of the Company as of December  31, audit provides a reasonable basis for our opinion. 2012 and 2011, and the related consolidated statements of A company’s internal control over financial reporting is a pro- income, comprehensive income, changes in shareholders’ equity cess designed to provide reasonable assurance regarding the reli- and cash flows for each of the years in the three-year period ability of financial reporting and the preparation of financial ended December  31, 2012, and our report dated February  1, statements for external purposes in accordance with generally 2013 expressed an unqualified opinion on those consolidated accepted accounting principles. A company’s internal control over financial statements. KPMG LLP* Montreal, Canada February 1, 2013 * FCPA auditor, FCA, public accountancy permit No. A106087 KPMG LLP is a Canadian limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. KPMG Canada provides services to KPMG LLP. Canadian National Railway Company U.S. GAAP 2012 Annual Report 51 Consolidated Statement of Income In millions, except per share data Year ended December 31, 2012 2011 2010 Revenues Operating expenses Labor and fringe benefits Purchased services and material Fuel Depreciation and amortization Equipment rents Casualty and other Total operating expenses Operating income Interest expense Other income (Note 12) Income before income taxes Income tax expense (Note 13) Net income Earnings per share (Note 15) Basic Diluted Weighted-average number of shares Basic Diluted $ 9,920 $ 9,028 $ 8,297 1,952 1,812 1,744 1,248 1,120 1,036 1,524 1,412 1,048 924 249 338 884 228 276 834 243 368 6,235 5,732 5,273 3,685 3,296 3,024 (342) 315 (341) 401 (360) 212 3,658 3,356 2,876 (978) (899) (772) $ 2,680 $ 2,457 $ 2,104 $ 6.15 $ 5.45 $ 4.51 $ 6.12 $ 5.41 $ 4.48 435.6 451.1 466.3 437.7 454.4 470.1 See accompanying notes to consolidated financial statements. 52 2012 Annual Report U.S. GAAP Canadian National Railway Company Consolidated Statement of Comprehensive Income In millions Net income Other comprehensive income (loss) (Note 18) Foreign exchange gain (loss) on: Year ended December 31, 2012 2011 2010 $ 2,680 $ 2,457 $ 2,104 Translation of the net investment in foreign operations (128) 130 (330) Translation of US dollar-denominated long-term debt designated as a hedge of the net investment in U.S. subsidiaries 123 (122) 315 Pension and other postretirement benefit plans (Note 11): Net actuarial loss arising during the year Prior service cost arising during the year Amortization of net actuarial loss included in net periodic benefit cost (income) Amortization of prior service cost included in net periodic benefit cost (income) Derivative instruments (Note 17) Other comprehensive loss before income taxes Income tax recovery Other comprehensive loss Comprehensive income (660) (1,541) (931) (6) 119 7 - (28) 8 4 (2) (545) (1,551) 127 421 (418) (1,130) (5) 1 2 (1) (949) 188 (761) $ 2,262 $ 1,327 $ 1,343 See accompanying notes to consolidated financial statements. Canadian National Railway Company U.S. GAAP 2012 Annual Report 53 Consolidated Balance Sheet In millions Assets Current assets Cash and cash equivalents Restricted cash and cash equivalents (Note 8) Accounts receivable (Note 3) Material and supplies Deferred and receivable income taxes (Note 13) Other Total current assets Properties (Note 4) Intangible and other assets (Note 5) Total assets Liabilities and shareholders’ equity Current liabilities Accounts payable and other (Note 6) Current portion of long-term debt (Note 8) Total current liabilities Deferred income taxes (Note 13) Pension and other postretirement benefits, net of current portion (Note 11) Other liabilities and deferred credits (Note 7) Long-term debt (Note 8) Shareholders’ equity Common shares (Note 9) Accumulated other comprehensive loss (Note 18) Retained earnings Total shareholders’ equity Total liabilities and shareholders’ equity On behalf of the Board: David G. A. McLean Director Claude Mongeau Director December 31, 2012 2011 $ 155 521 831 230 43 89 $ 101 499 820 201 122 105 1,869 1,848 24,541 23,917 249 261 $ 26,659 $ 26,026 $ 1,626 $ 1,580 577 2,203 5,555 784 776 6,323 135 1,715 5,333 1,095 762 6,441 4,108 4,141 (3,257) (2,839) 10,167 9,378 11,018 10,680 $ 26,659 $ 26,026 See accompanying notes to consolidated financial statements. 54 2012 Annual Report U.S. GAAP Canadian National Railway Company Consolidated Statement of Changes in Shareholders’ Equity In millions Issued and outstanding common shares Accumulated other Common comprehensive loss shares Total Retained shareholders’ equity earnings Balances at December 31, 2009 471.0 $ 4,266 $ (948) $ 7,915 $ 11,233 Net income Stock options exercised and other (Notes 9, 10) Share repurchase program (Note 9) Other comprehensive loss (Note 18) Dividends ($1.08 per share) Balances at December 31, 2010 Net income Stock options exercised and other (Notes 9, 10) Share repurchase programs (Note 9) Other comprehensive loss (Note 18) Dividends ($1.30 per share) Balances at December 31, 2011 Net income Stock options exercised and other (Notes 9, 10) Share repurchase programs (Note 9) Other comprehensive loss (Note 18) Dividends ($1.50 per share) Balances at December 31, 2012 124 (913) (761) (503) 74 (1,420) (1,130) (585) 2,104 2,104 - 3.4 (15.0) - - - 124 (138) - - - - - (761) - (775) - - (503) 459.4 4,252 (1,709) 8,741 11,284 - 2.6 (19.9) - - - 74 (185) - - 2,457 2,457 - - - - (1,235) (1,130) - - (585) 442.1 4,141 (2,839) 9,378 10,680 - 3.2 (16.9) - - - 128 (161) - - - - - 2,680 2,680 - 128 (1,239) (1,400) (418) - - (652) (418) (652) 428.4 $ 4,108 $ (3,257) $ 10,167 $ 11,018 See accompanying notes to consolidated financial statements. Canadian National Railway Company U.S. GAAP 2012 Annual Report 55 Consolidated Statement of Cash Flows In millions Operating activities Net income Year ended December 31, 2012 2011 2010 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization Deferred income taxes (Note 13) Gain on disposal of property (Notes 4, 12) Changes in operating assets and liabilities: Accounts receivable Material and supplies Accounts payable and other Other current assets Pensions and other, net Net cash provided by operating activities Investing activities Property additions Disposal of property (Note 4) Change in restricted cash and cash equivalents Other, net Net cash used in investing activities Financing activities Issuance of debt Repayment of debt Issuance of common shares due to exercise of stock options and related excess tax benefits realized (Note 10) Repurchase of common shares (Note 9) Dividends paid Net cash used in financing activities Effect of foreign exchange fluctuations on US dollar-denominated cash and cash equivalents 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: $ 2,680 $ 2,457 $ 2,104 924 451 884 531 (281) (348) (20) (30) 129 (13) (51) 11 34 (2) 834 418 (152) (3) (43) 285 13 (780) (540) (457) 3,060 2,976 2,999 (1,731) (1,625) (1,586) 311 (22) 21 369 (499) 26 168 - 35 (1,421) (1,729) (1,383) 2,354 1,361 - (2,001) (1,083) (184) 117 77 (1,400) (1,420) (652) (585) 115 (913) (503) (1,582) (1,650) (1,485) (3) 54 101 14 (389) 490 7 138 352 $ 155 $ 101 $ 490 $ 9,877 $ 8,995 $ 8,404 Employee services, suppliers and other expenses (5,241) (4,643) (4,334) Interest Personal injury and other claims (Note 16) Pensions (Note 11) Income taxes (Note 13) (364) (79) (844) (289) (329) (97) (468) (482) (366) (64) (427) (214) Net cash provided by operating activities $ 3,060 $ 2,976 $ 2,999 See accompanying notes to consolidated financial statements. 56 2012 Annual Report U.S. GAAP Canadian National Railway Company Notes to Consolidated Financial Statements Canadian National Railway Company, together with its wholly-owned subsidiaries, collectively “CN” or “the Company,” 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 freight 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, inter- modal and automotive. 1 Summary of significant accounting policies comprehensive income (loss) (see Note 18 – Accumulated other comprehensive loss). These consolidated financial statements are expressed in Canadian The Company designates the US dollar-denominated long- dollars, except where otherwise indicated, and have been pre- term debt of the parent company as a foreign currency hedge pared in accordance with United States generally accepted of its net investment in U.S. subsidiaries. Accordingly, foreign accounting principles (U.S. GAAP). The preparation of financial ex change gains and losses, from the dates of designation, on the statements in conformity with generally accepted accounting translation of the US dollar-denominated long-term debt are also principles requires management to make estimates and assump- included in Other comprehensive income (loss). tions that affect the reported amounts of revenues and expenses during the period, the reported amounts of assets and liabilities, D. Cash and cash equivalents and the disclosure of contingent assets and liabilities at the date Cash and cash equivalents include highly liquid investments pur- of the financial statements. On an ongoing basis, management chased three months or less from maturity and are stated at cost, reviews its estimates, including those related to personal injury which approximates market value. and other claims, environmental matters, depreciation, pensions and other postretirement benefits, and income taxes, based upon E. Restricted cash and cash equivalents currently available information. Actual results could differ from The Company has the option, under its bilateral letter of credit these estimates. A. Principles of consolidation facility agreements with various banks, to pledge collateral in the form of cash and cash equivalents for a minimum term of one month, equal to at least the face value of the letters of credit These consolidated financial statements include the accounts of issued. Restricted cash and cash equivalents are shown separately all subsidiaries. The Company’s investments in which it has signif- on the balance sheet and include highly liquid investments pur- icant influence are accounted for using the equity method and all chased three months or less from maturity and are stated at cost, other investments are accounted for using the cost method. which approximates market value. B. Revenues F. Accounts receivable Freight revenues are recognized using the percentage of com- Accounts receivable are recorded at cost net of billing adjustments pleted service method based on the transit time of freight as it and an allowance for doubtful accounts. The allowance for doubt- moves from origin to destination. The allocation of revenues ful accounts is based on expected collectability and considers his- between reporting periods is based on the relative transit time in torical experience as well as known trends or uncertainties related each period with expenses being recorded as incurred. Revenues to account collectability. When a receivable is deemed uncollect- related to non-rail transportation services are recognized as service ible, it is written off against the allowance for doubtful accounts. is performed or as contractual obligations are met. Revenues are Subsequent recoveries of amounts previously written off are cred- presented net of taxes collected from customers and remitted to ited to the bad debt expense in Casualty and other in the governmental authorities. C. Foreign currency Consolidated Statement of Income. G. Material and supplies All of the Company’s United States (U.S.) operations are self- Material and supplies, which consist mainly of rail, ties, and other contained foreign entities with the US dollar as their functional items for construction and maintenance of property and equip- currency. Accordingly, the U.S. operations’ assets and liabilities are ment, as well as diesel fuel, are valued at weighted-average cost. translated into Canadian dollars at the rate in effect at the balance sheet date and the revenues and expenses are translated at aver- age exchange rates during the year. All adjustments resulting from the translation of the foreign operations are recorded in Other Canadian National Railway Company U.S. GAAP 2012 Annual Report 57 Notes to Consolidated Financial Statements 1 Summary of significant accounting policies continued H. Properties The Company reviews the carrying amounts of intangible assets held and used whenever events or changes in circum- stances indicate that such carrying amounts may not be recover- able based on future undiscounted cash flows. Assets that are Railroad properties are carried at cost less accumulated deprecia- deemed impaired as a result of such review are recorded at the tion including asset impairment write-downs. Labor, materials and lower of carrying amount or fair value. other costs associated with the installation of rail, ties, ballast and other structures are capitalized to the extent they meet the J. Pensions Company’s capitalization criteria. Major overhauls and large refur- Pension costs are determined using actuarial methods. Net bishments of equipment are also capitalized when they result in periodic benefit cost is charged to income and includes: an extension to the service life or increase the functionality of the (i) the cost of pension benefits provided in exchange for employ- asset. Repair and maintenance costs are expensed as incurred. ees’ services rendered during the year; The cost of properties, including those under capital leases, net (ii) the interest cost of pension obligations; of asset impairment write-downs, is depreciated on a straight-line (iii) the expected long-term return on pension fund assets; basis over their estimated service lives, measured in years, except (iv) the amortization of prior service costs and amendments over for rail which is measured in millions of gross tons per mile. The the expected average remaining service life of the employee Company follows the group method of depreciation whereby a group covered by the plans; and single composite depreciation rate is applied to the gross invest- (v) the amortization of cumulative net actuarial gains and losses ment in a class of similar assets, despite small differences in the in excess of 10% of the greater of the beginning of year service life or salvage value of individual property units within the balances of the projected benefit obligation or market-related same asset class. value of plan assets, over the expected average remaining In accordance with the group method of depreciation, upon service life of the employee group covered by the plans. sale or retirement of properties in the normal course of business, cost less net salvage value is charged to accumulated depreciation. The pension plans are funded through contributions determined As a result, no gain or loss is recognized in income under the in accordance with the projected unit credit actuarial cost method. group method as it is assumed that the assets within the group on average have the same life and characteristics and therefore that K. Postretirement benefits other than pensions gains or losses offset over time. For retirements of depreciable The Company accrues the cost of postretirement benefits other properties that do not occur in the normal course of business, a than pensions using actuarial methods. These benefits, which are gain or loss may be recognized if the retirement varies significantly funded as they become due, include life insurance programs, from the retirement pattern identified through depreciation stud- medical benefits and, for a closed group of employees, free rail ies. A gain or loss is recognized in Other income for the sale of travel benefits. land or disposal of assets that are not part of railroad operations. The Company amortizes the cumulative net actuarial gains and Assets held for sale are measured at the lower of their carrying losses in excess of 10% of the projected benefit obligation at the amount or fair value, less cost to sell. Losses resulting from signif- beginning of the year, over the expected average remaining ser- icant rail line sales are recognized in income when the asset meets vice life of the employee group covered by the plan. the criteria for classification as held for sale, whereas losses result- ing from significant rail line abandonments are recognized in the L. Personal injury and other claims Consolidated Statement of Income when the asset ceases to be In Canada, the Company accounts for costs related to employee used. Gains are recognized in income when they are realized. work-related injuries based on actuarially developed estimates of The Company reviews the carrying amounts of properties held the ultimate cost associated with such injuries, including compen- and used whenever events or changes in circumstances indicate sation, health care and third-party administration costs. that such carrying amounts may not be recoverable based on In the U.S., the Company accrues the expected cost for per- future undiscounted cash flows. Assets that are deemed impaired sonal injury, property damage and occupational disease claims, as a result of such review are recorded at the lower of carrying based on actuarial estimates of their ultimate cost. amount or fair value. I. Intangible assets For all other legal actions in Canada and the U.S., the Company maintains, and regularly updates on a case-by-case basis, provisions Intangible assets consist mainly of customer contracts and rela- for such items when the expected loss is both probable and can be tionships assumed through past acquisitions and are being amor- reasonably estimated based on currently available information. tized on a straight-line basis over 40 to 50 years. 58 2012 Annual Report U.S. GAAP Canadian National Railway Company Notes to Consolidated Financial Statements M. Environmental expenditures for the assumptions used to determine fair value and for other Environmental expenditures that relate to current operations, or to required disclosures. an existing condition caused by past operations, are expensed unless they can contribute to current or future operations. Environmental liabilities are recorded when environmental assess- 2 Accounting changes ments occur, remedial efforts are probable, and when the costs, based on a specific plan of action in terms of the technology to be The Company adopts accounting standards that are issued by used and the extent of the corrective action required, can be rea- the Financial Accounting Standards Board (FASB), if applicable. sonably estimated. The Company accrues its allocable share of For the years 2012, 2011 and 2010, there were no accounting liability taking into account the Company’s alleged responsibility, standard updates issued by FASB that had a significant impact on the number of potentially responsible parties and their ability to the Company’s consolidated financial statements, except as pay their respective shares of the liability. Recoveries of environ- noted below. mental remediation costs from other parties are recorded as assets when their receipt is deemed probable and collectability is reason- In June 2011, the FASB issued Accounting Standards Update ably assured. N. Income taxes (ASU) 2011-05, Presentation of Comprehensive Income, giving companies the option to present the components of net income and comprehensive income in either one or two consecutive The Company follows the asset and liability method of accounting financial statements. ASU 2011-05 eliminates the option to pres- for income taxes. Under the asset and liability method, the change ent the components of other comprehensive income in the state- in the net deferred income tax asset or liability is included in the ment of changes in shareholders’ equity. ASU 2011-05 also computation of Net income or Other comprehensive income requires reclassification adjustments for each component of accu- (loss). Deferred income tax assets and liabilities are measured mulated other comprehensive income (AOCI) in both net income using enacted tax rates expected to apply to taxable income in the and other comprehensive income (OCI) to be separately disclosed years in which temporary differences are expected to be recovered on the face of the financial statements. In December  2011, the or settled. O. Derivative financial instruments FASB issued ASU 2011-12, Deferral of the Effective Date for Amendments to the Presentation of Reclassifications of Items Out of Accumulated Other Comprehensive Income, which deferred The Company uses derivative financial instruments from time to the effective date to present reclassification adjustments in net time in the management of its interest rate and foreign currency income. The effective date of the deferral is consistent with the exposures. Derivative instruments are recorded on the balance effective date of ASU 2011-05 which is effective for fiscal years sheet at fair value and the changes in fair value are recorded in beginning on or after December 15, 2011. The FASB is re-evaluat- Net income or Other comprehensive income (loss) depending on ing the requirements, with a final decision expected in the first the nature and effectiveness of the hedge transaction. Income and quarter of 2013. The Company has adopted the currently effective expense related to hedged derivative financial instruments are requirements of these ASUs. 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 based on the grant-date fair value using the Black- Scholes option-pricing model. The Company expenses the fair value of its stock option awards on a straight-line basis, over the period during which an employee is required to provide service (requisite service period) or until retirement eligibility is attained, whichever is shorter. The Company also follows the fair value based approach for cash settled awards using a lattice-based valuation model. Compensation cost for cash settled awards is based on the fair value of the awards at period-end and is recog- nized over the period during which an employee is required to provide service (requisite service period) or until retirement eligi- bility is attained, whichever is shorter. See Note 10 – Stock plans, 3 Accounts receivable In millions Freight Non-freight Gross accounts receivable Allowance for doubtful accounts Net accounts receivable December 31, 2012 2011 $ 674 167 841 $ 630 206 836 (10) (16) $ 831 $ 820 Canadian National Railway Company U.S. GAAP 2012 Annual Report 59 Notes to Consolidated Financial Statements 4 Properties In millions December 31, 2012 Depreciation rate Accumulated Cost depreciation Net December 31, 2011 Accumulated depreciation Cost Net Track and roadway (1) Rolling stock Buildings Information technology (2) Other 2% 4% 2% 12% 6% $ 26,209 $ 6,948 $ 19,261 $ 25,534 $ 6,903 $ 18,631 4,989 1,275 976 1,273 1,785 3,204 492 427 529 783 549 744 4,923 1,220 931 1,213 1,668 3,255 473 383 477 747 548 736 Total properties including capital leases $ 34,722 $ 10,181 $ 24,541 $ 33,821 $ 9,904 $ 23,917 Capital leases included in properties Track and roadway (3) $ 417 $ Rolling stock Buildings Other 1,222 109 91 53 353 18 17 $ 364 869 91 74 $ 417 $ 48 $ 1,144 109 102 317 16 15 369 827 93 87 Total capital leases included in properties $ 1,839 $ 441 $ 1,398 $ 1,772 $ 396 $ 1,376 (1) Includes the cost of land of $1,766 million and $1,798 million as at December 31, 2012 and December 31, 2011, respectively. (2) The Company capitalized $93 million in 2012 and $94 million in 2011 of internally developed software costs pursuant to FASB Accounting Standards Codification 350-40, “Intangibles – Goodwill and Other, Internal – Use Software.” (3) Includes $108 million of right-of-way access in both years. Accounting policy for capitalization of costs • Ties: installation of 5 or more ties per 39 feet; The Company’s railroad operations are highly capital intensive. • Ballast: installation of 171 cubic yards of ballast per mile. The Company’s properties consist mainly of a large base of homo- geneous or network-type assets such as rail, ties, ballast and other Expenditures relating to the Company’s properties that do not structures, which form the Company’s Track and roadway proper- meet the Company’s capitalization criteria are considered normal ties, and Rolling stock. The Company’s capital expenditures are for repairs and maintenance and are expensed. For Track and road- the replacement of assets and for the purchase or construction of way properties, such expenditures include but are not limited to assets to enhance operations or provide new service offerings to spot tie replacement, spot or broken rail replacement, physical customers. A large portion of the Company’s capital expenditures track inspection for detection of rail defects and minor track cor- are for self-constructed properties including the replacement of rections, and other general maintenance of track infrastructure. existing track and roadway assets and track line expansion, as well For the ballast asset, the Company also engages in “shoulder as major overhauls and large refurbishments of rolling stock. ballast undercutting” that consists of removing some or all of the Expenditures are generally capitalized if they extend the life of ballast, which has deteriorated over its service life, and replacing the asset or provide future benefits such as increased reve- it with new ballast. When ballast is installed as part of a shoulder nue-generating capacity, functionality, or physical or service ballast undercutting project, it represents the addition of a new capacity. The Company has a process in place to determine asset and not the repair or maintenance of an existing asset. As whether its capital programs qualify for capitalization. For Track such, the Company capitalizes expenditures related to shoulder and roadway properties, the Company establishes basic capital ballast undercutting given that an existing asset is retired and programs to replace or upgrade the track infrastructure assets replaced with a new asset. Under the group method of account- which are capitalized if they meet the capitalization criteria. These ing for properties, the deteriorated ballast is retired at its average basic capital programs are planned in advance and carried out by cost measured using the quantities of new ballast added. the Company’s engineering workforce. For purchased assets, the Company capitalizes all costs neces- In addition, for Track and roadway properties, expenditures sary to make the asset ready for its intended use. Expenditures that meet the minimum level of activity as defined by the that are capitalized as part of self-constructed properties include Company are also capitalized as detailed below: direct material, labor, and contracted services, as well as other • Land: all purchases of land; allocated costs which are not charged directly to capital projects. • Grading: installation of road bed, retaining walls, drainage These allocated costs include, but are not limited to, fringe bene- structures; fits, small tools and supplies, machinery used on projects and • Rail and related track material: installation of 39 or more con- project supervision. The Company reviews and adjusts its alloca- tinuous feet of rail; tions, as required, to reflect the actual costs incurred each year. 60 2012 Annual Report U.S. GAAP Canadian National Railway Company Notes to Consolidated Financial Statements Costs of deconstruction and removal of replaced assets, as additional gross tons can be carried over the rail for its remain- referred to herein as dismantling costs, are distinguished from ing service life. The Company amortizes the cost of rail grinding installation costs for self-constructed properties based on the over the remaining life of the rail asset, which includes the incre- nature of the related activity. For Track and roadway properties, mental life extension generated by the rail grinding. employees concurrently perform dismantling and installation of new track and roadway assets and, as such, the Company esti- Disposal of property mates the amount of labor and other costs that are related to 2012 dismantling. The Company determines dismantling costs based on Bala-Oakville an analysis of the track and roadway installation process. On March 23, 2012, the Company entered into an agreement Accounting policy for depreciation with Metrolinx to sell a segment of the Bala and a segment of the Oakville subdivisions in Toronto, Ontario, together with the rail Properties are carried at cost less accumulated depreciation includ- fixtures and certain passenger agreements (collectively the “Bala- ing asset impairment write-downs. The cost of properties, includ- Oakville”), for cash proceeds of $311 million before transaction ing those under capital leases, net of asset impairment costs. Under the agreement, the Company obtained the perpetual write-downs, is depreciated on a straight-line basis over their right to operate freight trains over the Bala-Oakville at its then estimated service lives, measured in years, except for rail which is current level of operating activity, with the possibility of increasing measured in millions of gross tons per mile. The Company follows its operating activity for additional consideration. The transaction the group method of depreciation whereby a single composite resulted in a gain on disposal of $281 million ($252 million after- depreciation rate is applied to the gross investment in a class of tax) that was recorded in Other income under the full accrual similar assets, despite small differences in the service life or salvage method of accounting for real estate transactions. value of individual property units within the same asset class. The Company uses approximately 40 different depreciable asset 2011 classes. IC RailMarine For all depreciable assets, the depreciation rate is based on the On August 1, 2011, the Company sold substantially all of the assets estimated service lives of the assets. Assessing the reasonableness of IC RailMarine Terminal Company (“IC RailMarine”), an indirect of the estimated service lives of properties requires judgment and subsidiary of the Company, to Raven Energy, LLC, an affiliate of is based on currently available information, including periodic Foresight Energy, LLC (“Foresight”) and the Cline Group (“Cline”), for depreciation studies conducted by the Company. The Company’s cash proceeds of $70 million (US$73 million) before transaction U.S. properties are subject to comprehensive depreciation studies costs. IC RailMarine is located on the east bank of the Mississippi as required by the Surface Transportation Board (STB) and are River and stores and transfers bulk commodities and liquids between conducted by external experts. Depreciation studies for Canadian rail, ship and barge, serving customers in North American and global properties are not required by regulation and are therefore con- markets. Under the sale agreement, the Company will benefit from ducted internally. Studies are performed on specific asset groups a 10-year rail transportation agreement with Savatran LLC, an affiliate on a periodic basis. Changes in the estimated service lives of the of Foresight and Cline, to haul a minimum annual volume of coal assets and their related composite depreciation rates are imple- from four Illinois mines to the IC RailMarine transfer facility. The mented prospectively. transaction resulted in a gain on disposal of $60 million ($38 million For the rail asset, the estimated service life is measured in mil- after-tax) that was recorded in Other income. lions of gross tons per mile and varies based on rail characteristics such as weight, curvature and metallurgy. The annual composite Lakeshore East depreciation rate for rail assets is determined by dividing the esti- On March 24, 2011, the Company entered into an agreement mated annual number of gross tons carried over the rail by the with Metrolinx to sell a segment of the Kingston subdivision estimated service life of the rail measured in millions of gross tons known as the Lakeshore East in Pickering and Toronto, Ontario, per mile. For the rail asset, the Company capitalizes the costs of together with the rail fixtures and certain passenger agreements rail grinding which consists of restoring and improving the rail (collectively the “Lakeshore East”), for cash proceeds of $299 mil- profile and removing irregularities from worn rail to extend the lion before transaction costs. Under the agreement, the Company service life. The service life of the rail asset is based on expected obtained the perpetual right to operate freight trains over the future usage of the rail in its existing condition, determined using Lakeshore East at its then current level of operating activity, with railroad industry research and testing, less the rail asset’s usage to the possibility of increasing its operating activity for additional date. The service life of the rail asset is increased incrementally as consideration. The transaction resulted in a gain on disposal of rail grinding is performed thereon. As such, the costs incurred for $288 million ($254 million after-tax) that was recorded in Other rail grinding are capitalized given that the activity extends the income under the full accrual method of accounting for real service life of the rail asset beyond its original or current condition estate transactions. Canadian National Railway Company U.S. GAAP 2012 Annual Report 61 Notes to Consolidated Financial Statements 4 Properties continued 6 Accounts payable and other 2010 Oakville subdivision On March 29, 2010, the Company entered into an agreement with Metrolinx to sell a portion of the property known as the Oakville subdivision in Toronto, Ontario, together with the rail fixtures and certain passenger agreements (collectively the “Oakville subdivision”), for proceeds of $168 million before trans- action costs, of which $24 million was placed in escrow at the time of disposal and was entirely released by December 31, 2010 in accordance with the terms of the agreement. Under the agree- ment, the Company obtained the perpetual right to operate freight trains over the Oakville subdivision at its then current level of operating activity, with the possibility of increasing its operating activity for additional consideration. The transaction resulted in a gain on disposal of $152 million ($131 million after-tax) that was In millions Trade payables Payroll-related accruals Income and other taxes Accrued charges Accrued interest December 31, 2012 2011 $ 386 $ 445 340 294 135 105 88 82 31 17 343 130 121 123 84 84 63 18 Stock-based incentives liability (Note 10) Personal injury and other claims provisions (Note 16) Environmental provisions (Note 16) Other postretirement benefits liability (Note 11) Other Total accounts payable and other 148 169 $ 1,626 $ 1,580 recorded in Other income under the full accrual method of 7 Other liabilities and deferred credits accounting for real estate transactions. In millions December 31, 2012 2011 Personal injury and other claims provisions, net of current portion (Note 16) $ 232 $ 226 Stock-based incentives liability, net of current portion (Note 10) Environmental provisions, net of current portion (Note 16) Deferred credits and other 203 180 92 249 89 267 Total other liabilities and deferred credits $ 776 $ 762 5 Intangible and other assets In millions December 31, 2012 2011 Deferred and long-term receivables $ Intangible assets (A) Investments (B) Other $ 87 57 30 75 98 54 31 78 Total intangible and other assets $ 249 $ 261 A. Intangible assets Intangible assets consist mainly of customer contracts and rela- tionships assumed through past acquisitions. B. Investments As at December 31, 2012, the Company had $20 million ($21 mil- lion as at December 31, 2011) of investments accounted for under the equity method and $10 million ($10 million as at December 31, 2011) of investments accounted for under the cost method. 62 2012 Annual Report U.S. GAAP Canadian National Railway Company Notes to Consolidated Financial Statements 8 Long-term debt In millions Debentures and notes: (A) Canadian National series: 4.40% 10-year notes (B) 4.95% 6-year notes (B) 5.80% 10-year notes (B) 1.45% 5-year notes (B) 5.85% 10-year notes (B) 5.55% 10-year notes (B) 6.80% 20-year notes (B) 5.55% 10-year notes (B) 2.85% 10-year notes (B) 2.25% 10-year notes (B) 7.63% 30-year debentures 6.90% 30-year notes (B) 7.38% 30-year debentures (B) 6.25% 30-year notes (B) 6.20% 30-year notes (B) 6.71% Puttable Reset Securities PURSSM (B) 6.38% 30-year debentures (B) 3.50% 30-year notes (B) Illinois Central series: 5.00% 99-year income debentures 7.70% 100-year debentures Outstanding US dollar- denominated amount Maturity December 31, 2012 2011 Mar. 15, 2013 $ 400 $ 398 $ 407 Jan. 15, 2014 June 1, 2016 Dec. 15, 2016 Nov. 15, 2017 May 15, 2018 July 15, 2018 Mar. 1, 2019 Dec. 15, 2021 Nov. 15, 2022 May 15, 2023 July 15, 2028 Oct. 15, 2031 Aug. 1, 2034 June 1, 2036 July 15, 2036 Nov. 15, 2037 Nov. 15, 2042 Dec. 1, 2056 Sep. 15, 2096 325 250 300 250 325 200 550 400 250 150 475 200 500 450 250 300 250 7 125 323 249 298 249 323 199 547 398 249 149 473 199 498 448 249 298 249 7 124 331 254 305 254 331 203 559 407 - 153 483 203 509 458 254 305 - 7 127 Total US dollar-denominated debentures and notes $ 5,957 5,927 5,550 BC Rail series: Non-interest bearing 90-year subordinated notes (C) July 14, 2094 Total debentures and notes Other: Commercial paper (F) (G) Capital lease obligations and other (D) Total debt, gross Less: Net unamortized discount Total debt (E) (1) Less: Current portion of long-term debt (E) Total long-term debt (1) See Note 17 – Financial instruments, for the fair value of debt.. 842 842 6,769 6,392 - 985 82 957 7,754 7,431 854 855 6,900 6,576 577 135 $ 6,323 $ 6,441 Footnotes to the table follow on the next page. Canadian National Railway Company U.S. GAAP 2012 Annual Report 63 Notes to Consolidated Financial Statements 8 Long-term debt continued Canadian prime rate, bankers’ acceptance rates, the U.S. federal funds effective rate and the London Interbank Offer Rate, plus A. The Company’s debentures, notes and revolving credit facility applicable margins. The credit facility agreement has one financial are unsecured. covenant, which limits debt as a percentage of total capitalization, and with which the Company is in compliance. As at December 31, B. These debt securities are redeemable, in whole or in part, at the 2012 and December 31, 2011, the Company had no outstanding option of the Company, at any time, at the greater of par and a borrowings under its revolving credit facility. formula price based on interest rates prevailing at the time of redemption. G. The Company has a commercial paper program, which is backed by its revolving credit facility, enabling it to issue commer- C. The Company records these notes as a discounted debt of cial paper up to a maximum aggregate principal amount of $8 million, using an imputed interest rate of 5.75%. The discount $800 million, or the US dollar equivalent. As at December  31, of $834 million is included in the net unamortized discount. 2012, the Company had no borrowings of commercial paper ($82 million (US$81 million) at a weighted-average interest rate of D. During 2012, the Company recorded $94 million in assets it 0.20% as at December 31, 2011) presented in Current portion of acquired through equipment leases ($87 million in 2011), for long-term debt on the Consolidated Balance Sheet. which an equivalent amount was recorded in debt. Interest rates for capital lease obligations range from approxi- H. The aggregate amount of debt payable in US currency as at mately 0.7% to 8.5% with maturity dates in the years 2013 December  31, 2012 was US$6,690 million (C$6,656 million), through 2037. The imputed interest on these leases amounted to including US$733 million relating to capital leases and other, and $249 million as at December  31, 2012 and $299 million as at US$6,295 million (C$6,402 million), including US$757 million December 31, 2011. relating to capital leases and other, as at December 31, 2011. The capital lease obligations are secured by properties with a net carrying amount of $1,021 million as at December 31, 2012 I. On April 29, 2011, the Company entered into a series of three- and $993 million as at December 31, 2011. year bilateral letter of credit facility agreements with various banks to support its requirements to post letters of credit in the ordinary E. Long-term debt maturities, including repurchase arrangements course of business. On March 23, 2012, the agreements were and capital lease repayments on debt outstanding as at December 31, amended to extend the maturity by one year to April 28, 2015 2012, for the next five years and thereafter, are as follows: and an additional letter of credit agreement was signed with an additional bank. Under these agreements as amended, the Company has the option from time to time to pledge collateral in the form of cash or cash equivalents, for a minimum term of one month, equal to at least the face value of the letters of credit issued. As at December  31, 2012, the Company had letters of credit drawn of $551 million ($499 million as at December  31, 2011) from a total committed amount of $562 million ($520 mil- lion as at December  31, 2011) with the various banks. As at December  31, 2012, cash and cash equivalents of $521 million ($499 million as at December 31, 2011) were pledged as collateral and recorded as Restricted cash and cash equivalents on the Consolidated Balance Sheet. In millions 2013 (1) 2014 2015 2016 2017 2018 and thereafter (1) Current portion of long-term debt. Capital leases Debt Total $ 179 $ 398 $ 577 208 81 268 133 114 320 - 545 246 528 81 813 379 4,408 4,522 $ 983 $ 5,917 $ 6,900 F.  On May 6, 2011, the Company entered into a $800 million four-year revolving credit facility agreement with a consortium of lenders. On March 23, 2012, the agreement was amended to extend the term to May 5, 2017. The agreement allows for an increase in the facility amount, up to a maximum of $1,300 mil- lion, as well as the option to extend the term by an additional year at each anniversary date, subject to the consent of individual lenders. The credit facility, containing customary terms and condi- tions, is available for general corporate purposes, including back-stopping the Company’s commercial paper program, and provides for borrowings at various interest rates, including the 64 2012 Annual Report U.S. GAAP Canadian National Railway Company Notes to Consolidated Financial Statements 9 Capital stock 10 Stock plans A. Authorized capital stock The Company has various stock-based incentive plans for eligi- The authorized capital stock of the Company is as follows: ble employees. A description of the Company’s major plans is • Unlimited number of Common Shares, without par value provided below: • Unlimited number of Class A Preferred Shares, without par value, issuable in series A. Employee Share Investment Plan • Unlimited number of Class B Preferred Shares, without par The Company has an Employee Share Investment Plan (ESIP) giv- value, issuable in series ing eligible employees the opportunity to subscribe for up to 10% of their gross salaries to purchase shares of the Company’s com- B. Issued and outstanding common shares mon stock on the open market and to have the Company invest, The following table provides the activity of the issued and out- on the employees’ behalf, a further 35% of the amount invested standing common shares of the Company for the years ended by the employees, up to 6% of their gross salaries. December 31, 2012, 2011 and 2010: In millions Year ended December 31, 2012 2011 2010 Issued and outstanding common shares at beginning of year 442.1 459.4 471.0 Number of shares repurchased through buyback programs Stock options exercised Issued and outstanding common shares (16.9) (19.9) 3.2 2.6 (15.0) 3.4 at end of year 428.4 442.1 459.4 Share repurchase programs On October 24, 2011, the Board of Directors of the Company approved a share repurchase program which allowed for the repurchase of up to 17.0 million common shares between October 28, 2011 and October 27, 2012 pursuant to a normal course issuer bid at prevailing market prices plus brokerage fees, or such other prices as may be permitted by the Toronto Stock The following table provides the number of participants hold- ing shares, the total number of ESIP shares purchased on behalf of employees, including the Company’s contributions, as well as the resulting expense recorded for the years ended December  31, 2012, 2011 and 2010: Year ended December 31, 2012 2011 2010 Number of participants holding shares 17,423 16,218 14,997 Total number of ESIP shares purchased on behalf of employees (millions) 1.3 1.3 Expense for Company contribution (millions) $ 24 $ 21 $ 1.3 19 B. Stock-based compensation plans The following table provides the total stock-based compensation expense for awards under all plans, as well as the related tax ben- efit recognized in income, for the years ended December  31, Exchange. The Company repurchased a total of 16.7 million com- 2012, 2011 and 2010: mon shares under this share repurchase program. On October 22, 2012, the Board of Directors of the Company In millions Year ended December 31, 2012 2011 2010 approved a new share repurchase program which allows for the repurchase of up to $1.4 billion in common shares, not to exceed 18.0 million common shares, between October 29, 2012 and October 28, 2013 pursuant to a normal course issuer bid at pre- vailing market prices plus brokerage fees, or such other prices as may be permitted by the Toronto Stock Exchange. The following table provides the activities under such share repurchase programs, as well as the share repurchase programs of the prior years: In millions, except per share data Year ended December 31, 2012 2011 2010 Number of common shares (1) 16.9 19.9 15.0 Weighted-average price per share (2) $ 82.73 $ 71.33 $ 60.86 Amount of repurchase $ 1,400 $ 1,420 $ 913 (1) Includes common shares purchased in the first and fourth quarters of 2012 and 2011 and in the second and third quarters of 2010 pursuant to private agreements between the Company and arm’s-length third-party sellers. (2) Includes brokerage fees. Cash settled awards Restricted share unit plan $ Voluntary Incentive Deferral Plan Stock option awards $ 76 19 95 10 $ 81 21 102 10 77 18 95 9 Total stock-based compensation expense $ 105 $ 112 $ 104 Tax benefit recognized in income $ 25 $ 24 $ 27 (i) Cash settled awards Restricted share units In 2012, 2011 and 2010, the Company granted 0.5 million restricted share units (RSUs), respectively, to designated manage- ment employees entitling them to receive payout in cash based on the Company’s share price. The RSUs granted are generally sched- uled for payout after three years (“plan period”) and vest condi- tionally upon the attainment of a target relating to return on invested capital (ROIC) over the plan period. Such performance Canadian National Railway Company U.S. GAAP 2012 Annual Report 65 Notes to Consolidated Financial Statements 10 Stock plans continued In February 2012, the Company’s Board of Directors unani- mously voted to forfeit and cancel the RSU payout of approxi- vesting criteria results in a performance vesting factor that ranges mately $18 million otherwise due in February 2012 to its former from 0% to 150% depending on the level of ROIC attained. Chief Executive Officer (CEO) after determining that the former Payout is conditional upon the attainment of a minimum share CEO was likely in breach of his non-compete and non-disclosure price, calculated using the average of the last three months of the of confidential information conditions contained in the former plan period. In addition, commencing at various dates, for senior CEO’s employment agreement. Pending a final resolution of the and executive management employees (“executive employees”), legal proceedings, the Company, without prejudice, has not payout for RSUs is also conditional on compliance with the condi- recorded a gain from the cancellation of the RSU payout. See tions of their benefit plans, award or employment agreements, Note 16 – Major commitments and contingencies. including but not limited to non-compete, non-solicitation and As at December 31, 2012, 0.1 million RSUs remained autho- non-disclosure of confidential information conditions. Current or rized for future issuance under this plan. former executive employees who breach such conditions of their benefit plans, award or employment agreements will forfeit the RSU Voluntary Incentive Deferral Plan payout. Should the Company reasonably determine that a current The Company has a Voluntary Incentive Deferral Plan (VIDP), pro- or former executive employee may have violated the conditions of viding eligible senior management employees the opportunity to their benefit plans, award or employment agreement, the Company elect to receive their annual incentive bonus payment and other may at its discretion change the manner of vesting of the RSUs to eligible incentive payments in deferred share units (DSUs). A DSU suspend payout on any RSUs pending resolution of such matter. is equivalent to a common share of the Company and also earns The value of the payout is equal to the number of RSUs dividends when normal cash dividends are paid on common awarded multiplied by the performance vesting factor and by the shares. The number of DSUs received by each participant is estab- 20-day average closing share price ending on January  31 of the lished using the average closing price for the 20 trading days prior following year. On December 31, 2012, for the 2010 grant, the to and including the date of the incentive payment. For each level of ROIC attained resulted in a performance vesting factor of participant, the Company will grant a further 25% of the amount 150%. As the minimum share price condition was met, payout elected in DSUs, which will vest over a period of four years. The under the plan of approximately $70 million, calculated using the election to receive eligible incentive payments in DSUs is no longer Company’s average share price during the 20-day period ending available to a participant when the value of the participant’s on January 31, 2013, will be paid to employees meeting the con- vested DSUs is sufficient to meet the Company’s stock ownership ditions of their benefit plans, award or employment agreements guidelines. The value of each participant’s DSUs is payable in cash in the first quarter of 2013. at the time of cessation of employment. The Company’s liability for DSUs is marked-to-market at each period-end based on the Company’s closing stock price. The following table provides the 2012 activity for all cash settled awards: In millions Outstanding at December 31, 2011 Granted (Payout) Vested during year Outstanding at December 31, 2012 RSUs VIDP Nonvested Vested Nonvested Vested 0.9 0.5 0.9 (0.7) (0.5) 0.5 0.9 0.7 (1) - - - - 1.4 - - 1.4 (1) Includes the units of the RSU payout currently in dispute. See Note 16 – Major commitments and contingencies. 66 2012 Annual Report U.S. GAAP Canadian National Railway Company Notes to Consolidated Financial Statements The following table provides valuation and expense information for all cash settled awards: In millions, unless otherwise indicated RSUs (1) VIDP (2) Total Year of grant 2012 2011 2010 2009 2008 Stock-based compensation expense recognized over requisite service period Year ended December 31, 2012 Year ended December 31, 2011 Year ended December 31, 2010 Liability outstanding December 31, 2012 December 31, 2011 Fair value per unit December 31, 2012 ($) $ 24 N/A N/A $ $ 26 19 N/A $ 24 N/A $ $ 45 19 $ $ $ $ $ 26 27 17 70 44 $ $ $ $ $ - 35 34 N/A - 26 $ $ $ $ $ 19 21 18 $ 95 $ 102 $ 95 18 (3) 82 N/A N/A $ 134 $ 119 $ 291 $ 264 $ 67.90 $ 88.05 $ 90.33 N/A N/A $ 90.33 N/A Fair value of awards vested during the year Year ended December 31, 2012 Year ended December 31, 2011 Year ended December 31, 2010 Nonvested awards at December 31, 2012 $ - N/A N/A $ $ - - N/A $ $ $ Unrecognized compensation cost $ 21 $ 14 $ 70 - - - Remaining recognition period (years) 2.0 1.0 N/A Assumptions (5) Stock price ($) Expected stock price volatility (6) Expected term (years) (7) Risk-free interest rate (8) Dividend rate ($) (9) $ 90.33 16% 2.0 1.13% $ 1.50 $ 90.33 13% 1.0 1.09% $ 1.50 $ 90.33 N/A N/A N/A N/A N/A 82 - $ $ N/A N/A $ 37 $ $ $ 1 1 1 $ $ $ 71 83 38 N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A $ 1 $ 36 N/A (4) N/A $ 90.33 N/A N/A N/A N/A N/A N/A N/A N/A N/A (1) Compensation cost is based on the fair value of the awards at period-end using the lattice-based valuation model that uses the assumptions as presented herein. (2) Compensation cost is based on intrinsic value. (3) Consists of the carrying value of the RSU payout currently in dispute. See Note 16 – Major commitments and contingencies. (4) The remaining recognition period has not been quantified as it relates solely to the 25% Company grant and the dividends earned thereon, representing a minimal number of units. (5) Assumptions used to determine fair value are at December 31, 2012. (6) Based on the historical volatility of the Company’s stock over a period commensurate with the expected term of the award. (7) Represents the remaining period of time that awards are expected to be outstanding. (8) Based on the implied yield available on zero-coupon government issues with an equivalent term commensurate with the expected term of the awards. (9) Based on the annualized dividend rate. Canadian National Railway Company U.S. GAAP 2012 Annual Report 67 Notes to Consolidated Financial Statements 10 Stock plans continued (ii) Stock option awards Options issued by the Company include conventional options, which vest over a period of time; and performance-accelerated stock options. As at December  31, 2012, the performance- The Company has stock option plans for eligible employees to accelerated stock options were fully vested. acquire common shares of the Company upon vesting at a price For 2012, 2011 and 2010, the Company granted 0.6 million, equal to the market value of the common shares at the date of 0.6 million and 0.7 million, respectively, of conventional stock granting. The options are exercisable during a period not exceed- options to designated senior management employees that vest ing 10 years. The right to exercise options generally accrues over over a period of four years of continuous employment. a period of four years of continuous employment. Options are not The total number of options outstanding at December  31, generally exercisable during the first 12 months after the date of 2012, for conventional and performance-accelerated options was grant. At December  31, 2012, 10.4 million common shares 4.1 million and 0.2 million, respectively. remained authorized for future issuances under these plans. The following table provides the activity of stock option awards during 2012, and for options outstanding and exercisable at December 31, 2012, the weighted-average exercise price: Outstanding at December 31, 2011 (1) Granted Exercised Vested Outstanding at December 31, 2012 (1) Exercisable at December 31, 2012 (1) Options outstanding Weighted- average of options exercise price Number In millions 6.9 0.6 (3.2) N/A 4.3 2.5 $ 40.80 $ 76.70 $ 31.38 N/A $ 52.09 $ 44.82 Nonvested options Weighted- Number average grant of options date fair value In millions 2.0 0.6 N/A (0.8) 1.8 $ 13.71 $ 15.49 N/A $ 13.24 $ 14.56 N/A N/A (1) Stock options with a US dollar exercise price have been translated to Canadian dollars using the foreign exchange rate in effect at the balance sheet date. The following table provides the number of stock options outstanding and exercisable as at December 31, 2012 by range of exercise price and their related intrinsic value, and for options outstanding, the weighted-average years to expiration. The table also provides the aggregate intrinsic value for in-the-money stock options, which represents the value that would have been received by option holders had they exercised their options on December 31, 2012 at the Company’s closing stock price of $90.33. Range of exercise prices $20.42 - $34.00 $34.01 - $44.05 $44.06 - $51.85 $51.86 - $68.95 $68.96 - $88.75 Balance at December 31, 2012 (1) Options outstanding Weighted- Number average years to expiration of options Weighted- average exercise price In millions Aggregate intrinsic value In millions Options exercisable Number of options In millions Weighted- average exercise price Aggregate intrinsic value In millions 0.7 0.6 1.3 0.7 1.0 4.3 3.6 4.5 5.2 6.4 8.7 5.9 $ 29.21 $ 39.74 $ 48.93 $ 58.58 $ 73.35 $ 40 28 55 22 17 $ 52.09 $ 162 0.5 0.4 1.1 0.4 0.1 2.5 $ 27.54 $ 39.28 $ 48.53 $ 55.46 $ 69.12 $ 31 23 45 14 2 $ 44.82 $ 115 (1) Stock options with a US dollar exercise price have been translated to Canadian dollars using the foreign exchange rate in effect at the balance sheet date. As at December 31, 2012, all stock options outstanding were in-the-money. The weighted-average years to expiration of exercisable stock options was 4.5 years. 68 2012 Annual Report U.S. GAAP Canadian National Railway Company Notes to Consolidated Financial Statements The following table provides valuation and expense information for all stock option awards: In millions, unless otherwise indicated Year of grant 2012 2011 2010 2009 2008 2007 2006 Total Stock-based compensation expense recognized over requisite service period (1) Year ended December 31, 2012 $ 4 Year ended December 31, 2011 Year ended December 31, 2010 N/A N/A $ $ 2 5 N/A $ $ $ 2 2 4 $ $ $ 2 2 2 $ $ $ - 1 2 N/A - 1 $ $ N/A N/A $ - $ $ $ 10 10 9 Fair value per unit At grant date ($) $ 15.49 $ 15.66 $ 13.09 $ 12.60 $ 12.44 $ 13.37 $ 13.80 N/A Fair value of awards vested during the year Year ended December 31, 2012 $ - Year ended December 31, 2011 Year ended December 31, 2010 N/A N/A $ $ 2 - N/A $ $ $ 2 2 - $ $ $ Nonvested awards at December 31, 2012 Unrecognized compensation cost $ 4 $ 3 $ 1 $ Remaining recognition period (years) 3.0 2.0 1.0 4 4 4 - - $ $ $ $ 3 3 3 - - N/A 3 3 $ $ N/A N/A $ 3 $ $ $ 11 12 13 N/A N/A N/A N/A $ 8 N/A Assumptions Grant price ($) $ 76.70 $ 68.94 $ 54.76 $ 42.14 $ 48.51 $ 52.79 $ 51.51 Expected stock price volatility (2) 26% 26% 28% 39% 27% 24% 25% Expected term (years) (3) Risk-free interest rate (4) Dividend rate ($) (5) 5.4 1.33% $ 1.50 5.3 2.53% $ 1.30 5.4 2.44% $ 1.08 5.3 1.97% $ 1.01 5.3 3.58% $ 0.92 5.2 4.12% $ 0.84 5.2 4.04% $ 0.65 N/A N/A N/A N/A N/A (1) Compensation cost is based on the grant date fair value using the Black-Scholes option-pricing model that uses the assumptions at the grant date. (2) Based on the average of the historical volatility of the Company’s stock over a period commensurate with the expected term of the award and the implied volatility from traded options on the Company’s stock. (3) Represents the period of time that awards are expected to be outstanding. The Company uses historical data to estimate option exercise and employee termination, and groups of employ- ees that have similar historical exercise behavior are considered separately. (4) Based on the implied yield available on zero-coupon government issues with an equivalent term commensurate with the expected term of the awards. (5) Based on the annualized dividend rate. The following table provides information related to stock (iii) Stock price volatility options exercised during the years ended December  31, 2012, Compensation cost for the Company’s RSU plans is based on the 2011 and 2010: In millions Year ended December 31, 2012 2011 2010 Total intrinsic value Cash received upon exercise of options Related excess tax benefit realized $ 167 $ 101 $ 16 $ 122 $ 68 $ 9 $ 125 $ 87 $ 28 fair value of the awards at period end using the lattice-based valuation model for which a primary assumption is the Company’s share price. In addition, the Company’s liability for the VIDP is marked-to-market at period-end and, as such, is also reliant on the Company’s share price. Fluctuations in the Company’s share price cause volatility to stock-based compensation expense as recorded in net income. The Company does not currently hold any derivative financial instruments to manage this exposure. A $1 increase in the Company’s share price at December 31, 2012 would have increased stock-based compensation expense by $4 million, whereas a $1 decrease in the price would have reduced it by $3 million. Canadian National Railway Company U.S. GAAP 2012 Annual Report 69 Notes to Consolidated Financial Statements 11 Pensions and other postretirement benefits A. Description of the CN Pension Plan The CN Pension Plan is a contributory defined benefit pension plan The Company has various retirement benefit plans under which that covers the majority of CN employees. It provides for pensions substantially all of its employees are entitled to benefits at retire- based mainly on years of service and final average pensionable earn- ment age, generally based on compensation and length of service ings and is generally applicable from the first day of employment. and/or contributions. Senior and executive management employ- Indexation of pensions is provided after retirement through a gain/ ees (“executive employees”) subject to certain minimum service loss sharing mechanism, subject to guaranteed minimum increases. and age requirements, are also eligible for an additional retire- An independent trust company is the Trustee of the Company’s pen- ment benefit under their Special Retirement Stipend Agreements sion trust funds (including the CN Pension Trust Fund). As Trustee, the (SRS), the Supplemental Executive Retirement Plan (SERP) or the trust company performs certain duties, which include holding legal Defined Contribution Supplemental Executive Retirement Plan title to the assets of the CN Pension Trust Fund and ensuring that the (DC SERP). Executive employees who breach the non-compete, Company, as Administrator, complies with the provisions of the CN non-solicitation and non-disclosure of confidential information Pension Plan and the related legislation. The Company utilizes a mea- conditions of the SRS, SERP or DC SERP plans or other employ- surement date of December 31 for the CN Pension Plan. ment agreement will forfeit the retirement benefit under these plans. Should the Company reasonably determine that a current B. Funding policy or former executive employee may have violated the conditions of Employee contributions to the CN Pension Plan are determined by their SRS, SERP, or DC SERP plan or other employment agreement, the plan rules. Company contributions are in accordance with the the Company may at its discretion withhold or suspend payout of requirements of the Government of Canada legislation, The Pension the retirement benefit pending resolution of such matter. In Benefits Standards Act, 1985, including amendments thereto, and February 2012, the Company’s Board of Directors unanimously are determined by actuarial valuations. Actuarial valuations are voted to forfeit and cancel the $1.5 million annual retirement required on an annual basis for all Canadian plans, or when deemed benefit otherwise due to its former CEO after determining that appropriate by the Office of the Superintendent of Financial the former CEO was likely in breach of the non-compete, non-so- Institutions (OSFI). These actuarial valuations are prepared in accor- licitation and non-disclosure of confidential information condi- dance with legislative requirements and with the recommendations tions contained in the former CEO’s employment agreement. On of the Canadian Institute of Actuaries for the valuation of pension December 21, 2012, the former CEO filed amended counterclaims plans. The most recently filed actuarial valuation of the CN Pension and affirmative defenses in the United States District Court for the Plan was conducted as at December 31, 2011 and indicated a fund- Northern District of Illinois to CN’s amended claims in which the ing excess on a going-concern basis of approximately $1.1 billion and former CEO claims that CN failed to pay monthly retirement ben- a funding deficit on a solvency basis of approximately $1.3  billion. efit installments due through June 28, 2012, the date on which The Company’s next actuarial valuation required as at December 31, the former CEO entered into an executive employment agreement 2012 will be performed in 2013. This actuarial valuation is expected with the Company’s major competitor in Canada. In addition, the to identify a going-concern surplus of approximately $1.4  billion, former CEO made binding judicial admissions in these court doc- while on a solvency basis a funding deficit of approximately $2.0 bil- uments that he was not entitled to retirement benefits beyond lion is expected due to the level of interest rates as at the measure- June 28, 2012. As such, the Company, without prejudice, has ment date, December  31, 2012. The federal pension legislation recorded a settlement gain of $20 million from the termination of requires funding deficits, as calculated under current pension regula- the former CEO’s retirement benefit plan for the period beyond tions, to be paid over a number of years. Actuarial valuations are also June 28, 2012 which is partially offset by the recognition of past required annually for the Company’s U.S. pension plans. accumulated actuarial losses of approximately $4 million. See In 2012, in anticipation of its future funding requirements, the Note 16 – Major commitments and contingencies. Company made voluntary contributions of $700 million in excess The Company also offers postretirement benefits to certain of the required contributions mainly to strengthen the financial employees providing life insurance, medical benefits and, for a position of its main pension plan, the CN Pension Plan. These closed group of employees, free rail travel benefits during retire- voluntary contributions can be treated as a prepayment against its ment. These postretirement benefits are funded as they become required special solvency payments. As at December 31, 2012, the due. The information in the tables that follow pertains to all of the Company had $785 million of accumulated prepayments which Company’s defined benefit plans. However, the following descrip- remain available to offset future required solvency deficit pay- tions relate solely to the Company’s main pension plan, the CN ments. The Company expects to use approximately $415 million Pension Plan, unless otherwise specified. of these prepayments to satisfy its 2013 required solvency deficit payment. As a result, the Company’s cash contributions for 2013 are expected to be in the range of $135 million to $335 million, including a potential voluntary contribution of up to $200 million, 70 2012 Annual Report U.S. GAAP Canadian National Railway Company Notes to Consolidated Financial Statements for all the Company’s pension plans. As at February 1, 2013, the (ii) Mortgages consist of mortgage products which are primarily Company contributed $94 million to its defined benefit pension conventional or participating loans secured by commercial plans for 2013. C. Plan assets properties. (iii) Equity investments are diversified by country, issuer and industry sector. The most significant allocation either to an The assets of the Company’s various plans are held in separate individual issuer or industry sector was approximately 4% trust funds which are diversified by asset type, country and and 24%, respectively, in 2012. investment strategies. Each year, the CN Board of Directors (iv) Real estate is a diversified portfolio of Canadian land and reviews and confirms or amends the Statement of Investment commercial properties held by the trusts’ wholly-owned sub- Policies and Procedures (SIPP) which includes the plans’ long-term sidiaries. asset mix and related benchmark indices (“Policy”). This Policy is (v) Oil and gas investments include petroleum and natural gas based on a long-term forward-looking view of the world econ- properties operated by the trusts’ wholly-owned subsidiaries omy, the dynamics of the plans’ benefit liabilities, the market and Canadian marketable securities. return expectations of each asset class and the current state of (vi) Infrastructure investments are publicly traded trust units, partic- financial markets. ipations in private infrastructure funds and public debt and Annually, the CN Investment Division, a division of the equity securities of infrastructure and utility companies. Some Company created to invest and administer the assets of the plans, of these investments are held by the trusts’ wholly-owned proposes a short-term asset mix target (“Strategy”) for the com- subsidiaries. ing year, which is expected to differ from the Policy, because of (vii) Absolute return investments are a portfolio of units of exter- current economic and market conditions and expectations. The nally managed hedge funds. Investment Committee of the Board (“Committee”) regularly (viii) Risk-based allocation is a portfolio of externally managed compares the actual asset mix to the Policy and Strategy asset funds where each asset class contributes equally to the over- mixes and evaluates the actual performance of the trust funds in all risk of the portfolio. Some of these investments are held relation to the performance of the Policy, calculated using Policy by the trusts’ wholly-owned subsidiaries. asset mix and the performance of the benchmark indices. The Company’s 2012 target long-term asset mix and actual The plans’ investment manager monitors market events and asset allocation for the Company’s pension plans are as follows: exposures to markets, currencies and interest rates daily. When Asset allocation Target long-term asset mix Percentage of plan assets 2012 2011 Cash and short-term investments Bonds and mortgages Equities Real estate Oil and gas Infrastructure Absolute return Risk-based allocation Total 2% 38% 47% 4% 5% 4% - - 4% 28% 41% 2% 8% 4% 9% 4% 7% 28% 42% 2% 8% 5% 8% - investing in foreign securities, the plans are exposed to foreign currency risk that may be adjusted or hedged; the effect of which is included in the valuation of the foreign securities. Net of the effects mentioned above, the plans were 68% exposed to the Canadian dollar, 8% to European currencies, 12% to the US dollar and 12% to various other currencies as at December  31, 2012. Interest rate risk represents the risk that the fair value of the investments will fluctuate due to changes in market interest rates. Sensitivity to interest rates is a function of the timing and amount of cash flows of the assets and liabilities of the plans. To manage credit risk, established policies require dealing with counterparties 100% 100% 100% considered to be of high credit quality. Derivatives are used from The Committee’s approval is required for all major investments in illiquid securities. The SIPP allows for the use of derivative finan- cial instruments to implement strategies or to hedge or adjust existing or anticipated exposures. The SIPP prohibits investments in securities of the Company or its subsidiaries. Investments held in the trust funds consist mainly of the following: (i) Cash, short-term investments and bonds consist primarily of highly liquid securities which ensure adequate cash flows are available to cover near-term benefit payments. Short-term secu- rities are almost exclusively obligations issued by Canadian char- tered banks. As at December  31, 2012, 91% of bonds were issued or guaranteed by Canadian, U.S. or other governments. time to time to adjust asset mix or exposures to foreign currencies, interest rate or market risks of the portfolio or anticipated trans- actions. Derivatives are contractual agreements whose value is derived from interest rates, foreign exchange rates, and equity or commodity prices. When derivatives are used for hedging pur- poses, the gains or losses on the derivatives are offset by a corre- sponding change in the value of the hedged assets. Derivatives may include forwards, futures, swaps and options. The tables on the following page present the fair value of plan assets excluding the economic exposure of derivatives as at December 31, 2012 and 2011 by asset class, their level within the fair value hierarchy and the valuation techniques and inputs used to measure such fair value. Canadian National Railway Company U.S. GAAP 2012 Annual Report 71 Notes to Consolidated Financial Statements 11 Pensions and other postretirement benefits continued In millions Asset class Cash and short-term investments (1) Bonds (2) Canada and supranational Provinces of Canada Corporate Emerging market debt Mortgages (3) Equities (4) Canadian U.S. International Real estate (5) Oil and gas (6) Infrastructure (7) Absolute return (8) Multi-strategy funds Fixed income funds Commodity funds Equity funds Global macro funds Risk-based allocation (9) Other (10) Total plan assets In millions Asset class Cash and short-term investments (1) Bonds (2) Canada and supranational Provinces of Canada Emerging market debt Mortgages (3) Equities (4) Canadian U.S. International Real estate (5) Oil and gas (6) Infrastructure (7) Absolute return (8) Multi-strategy funds Fixed income funds Equity funds Global macro funds Other (10) Total plan assets Fair value measurements at December 31, 2012 Total Level 1 Level 2 Level 3 $ 615 $ 13 $ 602 $ 1,735 2,152 35 353 133 2,220 1,121 3,082 279 1,339 679 410 425 91 259 296 586 - - - - - 2,198 1,121 3,082 - 370 8 - - - - - - 1,735 2,152 35 353 133 - - - - 29 94 410 415 91 259 296 586 - - - - - - 22 - - 279 940 577 - 10 - - - - $ 15,810 $ 6,792 $ 7,190 $ 1,828 1 $ 15,811 Fair value measurements at December 31, 2011 Total Level 1 Level 2 Level 3 $ 1,026 $ 21 $ 1,005 $ 1,650 1,937 288 178 2,395 1,125 2,712 214 1,232 707 358 214 260 368 - - - 8 2,373 1,125 2,712 - 343 9 - - - - 1,650 1,937 288 170 - - - - - 79 358 214 260 368 - - - - - 22 - - 214 889 619 - - - - $ 14,664 $ 6,591 $ 6,329 $ 1,744 55 $ 14,719 Level 1: Fair value based on quoted prices in active markets for identical assets. Level 2: Fair value based on significant observable inputs. Level 3: Fair value based on significant unobservable inputs. 72 2012 Annual Report U.S. GAAP Canadian National Railway Company Notes to Consolidated Financial Statements The following table reconciles the beginning and ending balances of the fair value of investments classified as Level 3: In millions Equities (4) Real estate (5) Oil and gas (6) Infra- structure (7) Absolute return (8) Total Fair value measurements based on significant unobservable inputs (Level 3) Additional information (11) Infra- structure hedged Absolute return hedged Beginning balance at December 31, 2010 $ 24 $ 318 $ 852 $ 493 $ 206 $ 1,893 $ 496 $ 207 Actual return relating to assets still held at the reporting date Purchases, sales and settlements Transfers in and/or out of Level 3 2 (4) - 58 (162) - 90 (53) - 74 52 - Balance at December 31, 2011 $ 22 $ 214 $ 889 $ 619 $ Actual return relating to assets still held at the reporting date Purchases, sales and settlements Transfers in and/or out of Level 3 2 (2) - 68 (3) - 90 (39) - (13) (29) - (7) (1) (198) - - 10 - 217 (168) (198) 63 62 - $ 1,744 $ 621 $ 147 (63) - 5 (50) - (8) (1) (198) - - 10 - Ending balance at December 31, 2012 $ 22 $ 279 $ 940 $ 577 $ 10 $ 1,828 $ 576 $ 10 (1) Short-term investments consist primarily of securities issued by Canadian chartered banks. Such investments are valued at cost, which approximates fair value. (2) Bonds are valued using prices obtained from independent pricing data suppliers, predominantly TSX Inc. When prices are not available from independent sources, the bond is valued by comparison to prices obtained for a bond of similar interest rate, maturity and risk. (3) Mortgages are secured by real estate. The fair value measurement of $133 million ($170 million in 2011) of mortgages categorized as Level 2 is based on current market yields of financial instruments of similar maturity, coupon and risk factors. Mortgages denominated in foreign currencies are fully hedged back to the Canadian dollar, the effects of which are reflected in the values presented in the tables above. (4) The fair value of equity investments of $22 million ($22 million in 2011) categorized as Level 3 represent units in private equity funds which are valued by their administrators. (5) The fair value of real estate investments of $279 million ($214 million in 2011) includes land and buildings classified as Level 3. Land is valued based on the fair value of comparable assets, and buildings are valued based on the present value of estimated future net cash flows or the fair value of comparable assets. Independent valuations of land and buildings are performed triennially. (6) The fair value of oil and gas investments of $940 million ($889 million in 2011) classified as Level 3 is valued based on estimated future net cash flows that are discounted using prevailing market rates for transactions in similar assets. The future net cash flows are based on forecasted oil and gas prices and projected future annual production and costs. (7) Infrastructure funds consist of $8 million ($9 million in 2011) of trust units that are publicly traded and classified as Level 1, $94 million ($79 million in 2011) of bank loans and bonds issued by infrastructure companies classified as Level 2 and $577 million ($619 million in 2011) of infrastructure funds that are classified as Level 3 and are valued based on discounted cash flows or earnings multiples. Infrastructure funds cannot be redeemed; distributions will be received from the funds as the underlying investments are liquidated. Infrastructure funds denominated in foreign currencies are fully hedged back to the Canadian dollar, the effects of which are reflected in the values presented in the additional information table presented above. (8) Absolute return investments are valued using the net asset value as reported by the fund administrators. All hedge fund investments have contractual redemption frequencies, ranging from monthly to annually, and redemption notice periods varying from 5 to 90 days. Hedge fund investments that have redemption dates less frequent than every four months or that have restrictions on contractual redemption features at the reporting date are classified as Level 3. (9) Risk-based allocation investments are valued using the net asset value as reported by the fund administrators. All funds have contractual redemption frequencies ranging from daily to annually, and redemption notice periods varying from 5 to 60 days. (10) Other consists of net operating assets required to administer the trust funds’ investment assets and the plans’ benefit and funding activities. Such assets are valued at cost and have not been assigned to a fair value category. (11) This additional information demonstrates the fair value of the infrastructure funds and absolute return investments after considering the effects of foreign currency hedges. Canadian National Railway Company U.S. GAAP 2012 Annual Report 73 Notes to Consolidated Financial Statements 11 Pensions and other postretirement benefits continued D. Additional disclosures (i) Obligations and funded status In millions Year ended December 31, 2012 2011 2012 2011 Pensions Other postretirement benefits Change in benefit obligation Projected benefit obligation at beginning of year $ 15,548 $ 14,895 $ 284 $ 283 Amendments Interest cost Actuarial loss (gain) Service cost Curtailment gain Plan participants’ contributions Foreign currency changes - 740 812 134 - 55 (5) 27 788 577 124 - 54 5 Benefit payments, settlements and transfers (1) (949) (922) 6 13 (3) 4 (6) - (3) (18) 1 14 (2) 4 (1) - 3 (18) Projected benefit obligation at end of year $ 16,335 $ 15,548 $ 277 $ 284 Component representing future salary increases (443) (437) - - Accumulated benefit obligation at end of year $ 15,892 $ 15,111 $ 277 $ 284 Change in plan assets Fair value of plan assets at beginning of year $ 14,719 $ 15,092 $ Employer contributions Plan participants’ contributions Foreign currency changes Actual return on plan assets Benefit payments, settlements and transfers Fair value of plan assets at end of year Funded status (Deficiency of fair value of plan assets over projected benefit obligation at end of year) (1) Includes the settlement gain related to the termination of the former CEO’s retirement benefit plan. Measurement date for all plans is December 31. 833 55 (2) 1,135 (929) 458 54 1 36 (922) $ 15,811 $ 14,719 $ - - - - - - - $ $ - - - - - - - $ (524) $ (829) $ (277) $ (284) The projected benefit obligation and fair value of plan assets for the CN Pension Plan at December 31, 2012 were $15,247 million and $15,042 million, respectively ($14,514 million and $13,992 million, respectively, at December 31, 2011). (ii) Amounts recognized in the Consolidated Balance Sheet In millions Current liabilities (Note 6) Noncurrent liabilities Total amount recognized December 31, 2012 2011 2012 2011 Pensions Other postretirement benefits $ - $ - $ (17) $ (18) (524) (829) (260) (266) $ (524) $ (829) $ (277) $ (284) (iii) Amounts recognized in Accumulated other comprehensive loss (Note 18) In millions Net actuarial gain (loss) Prior service cost December 31, 2012 2011 2012 2011 Pensions Other postretirement benefits $ (3,264) $ (2,720) $ (26) $ (30) $ $ 6 (6) $ $ 3 (3) 74 2012 Annual Report U.S. GAAP Canadian National Railway Company Notes to Consolidated Financial Statements (iv) Information for the pension plans with an accumulated benefit obligation in excess of plan assets In millions December 31, 2012 2011 Projected benefit obligation Accumulated benefit obligation Fair value of plan assets $ $ $ 526 461 201 $ 15,015 $ 14,606 $ 14,191 2012 N/A N/A N/A 2011 N/A N/A N/A Pensions Other postretirement benefits At December 31, 2012, the fair value of the plan assets exceeded the accumulated benefit obligation for the CN Pension Plan. (v) Components of net periodic benefit cost (income) In millions Service cost Interest cost Curtailment gain Settlement loss (gain) (1) Expected return on plan assets Amortization of prior service cost Amortization of net actuarial loss (gain) Year ended December 31, 2012 Pensions 2011 $ 124 788 - 3 $ 2010 99 837 - - (1,005) (1,009) 2 8 - 3 $ Other postretirement benefits 2012 2011 2010 4 13 (6) - - 3 - $ 4 14 (1) - - 2 - $ 3 16 (1) - - 2 (2) $ 134 740 - (12) (994) 4 119 Net periodic benefit cost (income) $ (9) $ (80) $ (70) $ 14 $ 19 $ 18 (1) Includes the settlement gain related to the termination of the former CEO’s retirement benefit plan. The estimated prior service cost and net actuarial loss for defined benefit pension plans that will be amortized from Accumulated other comprehensive loss into net periodic benefit cost (income) over the next fiscal year are $4 million and $236 million, respectively. The estimated prior service cost and net actuarial gain for other postretirement benefits that will be amortized from Accumulated other comprehensive loss into net periodic benefit cost (income) over the next fiscal year are $1 million and $1 million, respectively. (vi) Weighted-average assumptions used in accounting for pensions and other postretirement benefits December 31, 2012 Pensions 2011 2010 2012 2011 2010 Other postretirement benefits To determine projected benefit obligation Discount rate (1) Rate of compensation increase (2) To determine net periodic benefit cost Discount rate (1) Rate of compensation increase (2) Expected return on plan assets (3) 4.15% 3.00% 4.84% 3.25% 5.32% 3.50% 4.01% 3.00% 4.70% 3.25% 4.84% 3.25% 7.25% 5.32% 3.50% 7.50% 6.19% 3.50% 7.75% 4.70% 3.25% N/A 5.29% 3.50% N/A 5.29% 3.50% 6.01% 3.50% N/A (1) The Company’s discount rate assumption, which is set annually at the end of each year, is used to determine the projected benefit obligation at the end of the year and the net periodic benefit cost for the following year. The discount rate is used to measure the single amount that, if invested at the measurement date in a portfolio of high-quality debt instruments with a rating of AA or better, would provide the necessary cash flows to pay for pension benefits as they become due. The discount rate is determined by management with the aid of third- party actuaries. For the Canadian pension and other postretirement benefit plans, future expected benefit payments at each measurement date are discounted using spot rates from a derived AA corporate bond yield curve. The derived curve is based on observed rates for AA corporate bonds with short-term maturities and a projected AA corporate curve for longer term maturities based on spreads between observed AA corporate bonds and AA provincial bonds. The derived curve is expected to generate cash flows that match the estimated future benefit payments of the plans as the bond rate for each maturity year is applied to the plans’ corresponding expected benefit payments of that year. (2) The rate of compensation increase is determined by the Company based upon its long-term plans for such increases. (3) 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 multiple factors. The expected long-term rate of return is determined based on expected future performance for each asset class and is weighted based on the current asset portfolio mix. Consideration is taken of the historical performance, the premium return generated from an actively managed portfolio, as well as current and future anticipated asset allocations, economic developments, inflation rates and administrative expenses. Based on these factors, the rate is determined by the Company. For 2012, the Company used a long-term rate of return assump- tion of 7.25% on the market-related value of plan assets to compute net periodic benefit cost. 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. Effective January 1, 2013, the Company will reduce the expected long-term rate of return on plan assets from 7.25% to 7.00% to reflect management’s current view of long-term investment returns. The effect of this change in management’s assumption will be to increase net periodic benefit cost by approximately $20 million. Canadian National Railway Company U.S. GAAP 2012 Annual Report 75 Notes to Consolidated Financial Statements 11 Pensions and other postretirement benefits continued (vii) Health care cost trend rate for other postretirement benefits For measurement purposes, increases in the per capita cost of covered health care benefits were assumed to be 8% for 2012 and 2013. It is assumed that the rate will decrease gradually to 4.5% in 2028 and remain at that level thereafter. Assumed health care costs have a significant effect on the amounts reported for the health care plan. A one-percentage-point change in the assumed health care cost trend rate would have the following effect: In millions One-percentage-point Effect on total service and interest costs Effect on benefit obligation (viii) Estimated future benefit payments In millions 2013 2014 2015 2016 2017 Years 2018 to 2022 E. Defined contribution and other plans 12 Other income Increase $ $ 1 12 Pensions $ 983 $ 1,007 $ 1,029 $ 1,052 $ 1,067 $ 5,449 Decrease $ $ (1) (10) Other postretirement benefits $ $ $ $ $ $ 17 18 18 19 19 95 In millions Year ended December 31, 2012 2011 2010 Gain on disposals of properties (1) $ 295 $ 348 $ 157 Gain on disposal of land Investment income and other 20 - 30 23 20 35 Total other income $ 315 $ 401 $ 212 (1) 2012 includes $281 million for the disposal of the Bala-Oakville, 2011 includes $60 mil- lion and $288 million for the disposal of substantially all of the assets of IC RailMarine and the Lakeshore East, respectively, and 2010 includes $152 million for the sale of a portion of the property known as the Oakville subdivision. See Note 4 – Properties. The Company maintains defined contribution pension plans for certain salaried employees as well as certain employees covered by collective bargaining agreements. The Company also maintains other plans including Section 401(k) savings plans for certain U.S. based employees. The Company’s contributions under these plans are expensed as incurred and amounted to $11 million, $10 mil- lion and $16 million for 2012, 2011 and 2010, respectively. F. Contributions to multi-employer plan Under collective bargaining agreements, the Company partici- pates in a multi-employer benefit plan named the Railroad Employees National Early Retirement Major Medical Benefit Plan which is administered by the National Carriers’ Conference Committee (NCCC), and provides certain postretirement health care benefits to certain retirees. The Company’s contributions under this plan are expensed as incurred and amounted to $11 million, $11 million and $10 million in 2012, 2011 and 2010, respectively. The annual contribution rate for the plan is deter- mined by the NCCC and for 2012 was $154.49 per month per active employee ($164.41 in 2011). The plan covered 874 retirees in 2012 (846 in 2011). 76 2012 Annual Report U.S. GAAP Canadian National Railway Company Notes to Consolidated Financial Statements 13 Income taxes As at December 31, 2012, Deferred and receivable income taxes include a net deferred income tax asset of $43 million. As at December  31, 2011, Deferred and receivable income taxes included a net deferred income tax asset of $46 million and an income tax receivable of $76 million. The Company’s consolidated effective income tax rate differs from the Canadian, or domestic, statutory Federal tax rate. The effective tax rate is affected by recurring items such as tax rates in provincial, U.S. federal, state and other foreign jurisdictions and the proportion of income earned in those jurisdictions. The effec- tive tax rate is also affected by discrete items such as income tax rate enactments and lower tax rates on capital dispositions that Significant components of deferred income tax assets and liabilities are as follows: In millions December 31, 2012 2011 Deferred income tax assets Pension liability Personal injury claims and other reserves Other postretirement benefits liability Net operating losses and tax credit carryforwards (1) Total deferred income tax assets Deferred income tax liabilities Properties and other Total deferred income tax liabilities Total net deferred income tax liability $ 148 $ 226 123 82 7 360 134 85 5 450 5,872 5,737 5,872 5,737 $ 5,512 $ 5,287 $ 2,267 $ 2,046 3,245 3,241 $ 5,512 $ 5,287 may occur in any given year. The reconciliation of income tax Total net deferred income tax liability expense is as follows: In millions Year ended December 31, 2012 2011 2010 Federal tax rate 15.0% 16.5% 18.0% Income tax expense at the statutory Federal tax rate $ (549) $ (554) $ (518) Income tax (expense) recovery resulting from: Domestic Foreign Total net deferred income tax liability $ 5,512 $ 5,287 Net current deferred income tax asset 43 46 Net noncurrent deferred income tax liability $ 5,555 $ 5,333 Provincial and foreign taxes (425) (360) (308) (1) Net operating losses and tax credit carryforwards will expire between the years 2014 Deferred income tax adjustments due to rate enactments Gain on disposals Other (1) Income tax expense (35) 44 (13) (40) 62 (7) - 32 22 $ (978) $ (899) $ (772) Cash payments for income taxes $ 289 $ 482 $ 214 (1) Comprises adjustments relating to the resolution of matters pertaining to prior years’ income taxes, including net recognized tax benefits, and other items. The following table provides tax information on a domestic and foreign basis: and 2032. On an annual basis, the Company assesses the need to estab- lish 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, a valuation allowance is recorded. The ultimate realization of deferred income tax assets is dependant upon the generation of future taxable income during the periods in which those temporary differences become deductible. Management considers the scheduled reversals of deferred income tax liabilities including the available carryback and carry- forward periods, projected future taxable income, and tax plan- In millions Year ended December 31, 2012 2011 2010 ning strategies in making this assessment. As at December  31, Income before income taxes Domestic Foreign Current income tax expense Domestic Foreign Deferred income tax expense Domestic Foreign $ 2,656 $ 2,464 $ 2,052 1,002 892 824 2012, in order to fully realize all of the deferred income tax assets, the Company will need to generate future taxable income of approximately $1.2 billion and, based upon the level of historical $ 3,658 $ 3,356 $ 2,876 taxable income and projections of future taxable income over the $ (314) $ (340) $ (306) (213) (28) (48) $ (527) $ (368) $ (354) $ (370) $ (288) $ (248) (81) (243) (170) $ (451) $ (531) $ (418) periods in which the deferred income tax assets are deductible, management believes it is more likely than not that the Company will realize the benefits of these deductible differences. Management has assessed the impacts of the current economic environment and concluded there are no significant impacts to its assertions for the realization of deferred income tax assets. The Company has not recognized a deferred income tax asset ($297 million as at December 31, 2012) on the unrealized foreign exchange loss recorded in Accumulated other comprehensive loss relating to its net investment in foreign subsidiaries, as the Company does not expect this temporary difference to reverse in the foreseeable future. Canadian National Railway Company U.S. GAAP 2012 Annual Report 77 Notes to Consolidated Financial Statements 13 Income taxes continued authorities. Examinations of various state income tax returns by the state taxation authorities are currently in progress, including The Company recognized tax credits of $1 million in each of two additional state examinations commenced in 2012. The 2012, 2011, and 2010 for eligible research and development Company does not anticipate any significant impacts to its results expenditures, which reduced the cost of properties. of operations or financial position as a result of the final resolu- The following table provides a reconciliation of unrecognized tions of such matters. tax benefits on the Company’s domestic and foreign tax positions: $ 36 $ 46 $ 57 The Company’s strategic initiatives, which drive its operational In millions Year ended December 31, 2012 2011 2010 Gross unrecognized tax benefits at beginning of year $ 46 $ 57 $ 83 Increases for: Tax positions related to the current year Tax positions related to prior years Decreases for: Tax positions related to prior years Settlements 1 3 - (13) Lapse of the applicable statute of limitations (1) 1 11 - (21) (2) 4 5 (31) - (4) Gross unrecognized tax benefits at end of year Adjustments to reflect tax treaties and other arrangements (6) (11) (27) Net unrecognized tax benefits at end of year $ 30 $ 35 $ 30 As at December 31, 2012, the total amount of gross unrecognized tax benefits was $36 million, before considering tax treaties and other arrangements between taxation authorities. If recognized, all of the net unrecognized tax benefits as at December 31, 2012 would affect the effective tax rate. The Company believes that it is reasonably pos- sible that approximately $16 million of the net unrecognized tax benefits as at December 31, 2012 related to various federal, state, and provincial income tax matters, each of which are individually insignifi- cant, may be recognized over the next twelve months as a result of settlements and a lapse of the applicable statute of limitations. The Company recognizes accrued interest and penalties related to gross unrecognized tax benefits in Income tax expense in the Company’s Consolidated Statement of Income. The Company recognized approximately $3 million, $4 million and $5 million in accrued interest and penalties during the years ended December 31, 2012, 2011 and 2010, respectively. The Company had approxi- mately $9 million and $13 million of accrued interest and penalties as at December 31, 2012 and 2011, respectively. In Canada, the Company’s federal and provincial income tax 14 Segmented information The Company manages its operations as one business segment over a single network that spans vast geographic distances and territories, with operations in Canada and the United States. Financial information reported at this level, such as revenues, operating income, and cash flow from operations, is used by cor- porate management, including the Company’s chief operating decision-maker, in evaluating financial and operational perfor- mance and allocating resources across CN’s network. direction, are developed and managed centrally by corporate management and are communicated to its regional activity cen- ters (the Western Region, Eastern Region and Southern Region). Corporate management is responsible for, among others, CN’s marketing strategy, the management of large customer accounts, overall planning and control of infrastructure and rolling stock, the allocation of resources, and other functions such as financial plan- ning, accounting and treasury. The role of each region is to manage the day-to-day service requirements within their respective territories and control direct costs incurred locally. Such cost control is required to ensure that pre-estab- lished efficiency standards set at the corporate level are met. The regions execute the overall corporate strategy and operating plan established by corporate management, as their management of throughput and control of direct costs does not serve as the platform for the Company’s decision-making process. Approximately 95% of the Company’s freight revenues are from national accounts for which freight traffic spans North America and touches various commodity groups. As a result, the Company does not manage revenues on a regional basis since a large number of the movements originate in one region and pass through and/or terminate in another region. The regions also demonstrate common characteristics in each returns filed for the years 2007 to 2011 remain subject to exam- of the following areas: ination by the taxation authorities. An examination of the Company’s federal income tax returns for 2008 is currently in progress and is expected to be completed during 2013. Examinations on specific tax positions taken for federal and pro- vincial income tax returns for the 2007 year are currently in prog- ress and are also expected to be completed during 2013. In the U.S., the federal income tax returns filed for the years 2007 as well as 2009 to 2011 remain subject to examination by the taxa- tion authorities, and the state income tax returns filed for the years 2008 to 2011 remain subject to examination by the taxation (i) each region’s sole business activity is the transportation of freight over the Company’s extensive rail network; (ii) the regions service national accounts that extend over the Company’s various commodity groups and across its rail net- work; (iii) the services offered by the Company stem predominantly from the transportation of freight by rail with the goal of optimizing the rail network as a whole; (iv) the Company and its subsidiaries, not its regions, are subject to single regulatory regimes in both Canada and the U.S. 78 2012 Annual Report U.S. GAAP Canadian National Railway Company Notes to Consolidated Financial Statements For the reasons mentioned herein, the Company reports as 16 Major commitments and contingencies one operating segment. The following tables provide information by geographic area: A. Leases In millions Year ended December 31, 2012 2011 2010 Revenues (1) Canada U.S. $ 6,770 $ 6,169 $ 5,630 3,150 2,859 2,667 $ 9,920 $ 9,028 $ 8,297 (1) For the years ended December 31, 2012, 2011 and 2010, the largest customer repre- sented approximately 2%, 3% and 3%, respectively, of total revenues. The Company has operating and capital leases, mainly for loco- motives, freight cars and intermodal equipment. Of the capital leases, many provide the option to purchase the leased items at fixed values during or at the end of the lease term. As at December  31, 2012, the Company’s commitments under these operating and capital leases were $676 million and $1,232 mil- lion, respectively. Minimum rental payments for operating leases having initial non-cancelable lease terms of more than one year In millions Year ended December 31, 2012 2011 2010 and minimum lease payments for capital leases in each of the next Net income Canada U.S. In millions Properties Canada U.S. $ 1,972 $ 1,836 $ 1,498 708 621 606 $ 2,680 $ 2,457 $ 2,104 December 31, 2012 2011 $ 14,406 $ 13,824 10,135 10,093 $ 24,541 $ 23,917 five years and thereafter are as follows: In millions Operating Capital 2013 2014 2015 2016 2017 2018 and thereafter Less: imputed interest on capital leases at rates ranging from approximately 0.7% to 8.5% Present value of minimum lease payments included in debt $ 134 $ 103 83 61 49 246 676 $ 219 268 109 296 144 196 1,232 249 $ 983 15 Earnings per share Year ended December 31, 2012 2011 2010 Basic earnings per share Diluted earnings per share $ $ 6.15 $ 5.45 $ 4.51 6.12 $ 5.41 $ 4.48 The following table provides a reconciliation between basic and diluted earnings per share: The Company also has operating lease agreements for its automotive fleet with one-year non-cancelable terms for which its practice is to renew monthly thereafter. The estimated annual rental payments for such leases are approximately $30 million and generally extend over five years. Rent expense for all operating leases was $162 million, $143 million and $176 million for the years ended December 31, 2012, 2011 and 2010, respectively. Contingent rentals and sub- In millions Year ended December 31, 2012 2011 2010 lease rentals were not significant. Net income $ 2,680 $ 2,457 $ 2,104 Weighted-average shares outstanding 435.6 451.1 466.3 Effect of stock options 2.1 3.3 3.8 Weighted-average diluted shares outstanding B. Commitments As at December  31, 2012, the Company had commitments to acquire railroad ties, rail, freight cars, locomotives, and other 437.7 454.4 470.1 equipment and services, as well as outstanding information tech- Basic earnings per share are calculated based on the weighted- average number of common shares outstanding over each period. Diluted earnings per share are calculated based on the weighted-av- erage diluted shares outstanding using the treasury stock method, which assumes that any proceeds received from the exercise of in-the-money stock options would be used to purchase common shares at the average market price for the period. For the years ended December 31, 2012, 2011 and 2010, 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, were nil, 0.1 million and nil, respectively. nology service contracts and licenses, at an aggregate cost of $735 million ($727 million as at December  31, 2011). The Company also has remaining estimated commitments in relation to the acquisition of the principal lines of the former Elgin, Joliet and Eastern Railway Company of approximately $100 million (US$100 million) to be spent over the next few years for railroad infrastructure improvements, grade separation projects, as well as commitments under a series of agreements with individual com- munities and a comprehensive voluntary mitigation program established to address surrounding municipalities’ concerns. The commitment for the grade separation projects is based on esti- mated costs provided by the STB at the time of acquisition and Canadian National Railway Company U.S. GAAP 2012 Annual Report 79 Notes to Consolidated Financial Statements 16 Major commitments and contingencies continued former CEO entered into an executive employment agreement with the Company’s major competitor in Canada. The counterclaims seek affirmative damages from the Company. The Company believes it could be subject to adjustment. In addition, remaining implemen- has strong defenses and is vigorously defending those claims, but in tation costs associated with the U.S. federal government legisla- any event, the Company believes the potential liability on the claims tive requirement to implement positive train control (PTC) by 2015 is not material. In addition, the former CEO made binding judicial are estimated to be approximately $180 million (US$180 million). admissions in these court documents that he was not entitled to The Company also has agreements with fuel suppliers to purchase retirement benefits beyond June 28, 2012. As such, the Company, approximately 84% of its estimated 2013 volume and 30% of its without prejudice, has recorded a settlement gain of $20 million anticipated 2014 volume at market prices prevailing on the date from the termination of the former CEO’s retirement benefit plan for of the purchase. C. Contingencies the period beyond June 28, 2012 which is partially offset by the recognition of past accumulated actuarial losses of $4 million. The Company, without prejudice, has not recorded a gain of In the normal course of business, the Company becomes involved approximately $18 million from the cancellation of the former in various legal actions seeking compensatory and occasionally CEO’s RSU payout and a settlement gain of $0.7 million associated punitive damages, including actions brought on behalf of various with the former CEO’s 2012 retirement benefit liability through purported classes of claimants and claims relating to employee and June 28, 2012 pending a final resolution of the legal proceedings. third-party personal injuries, occupational disease and property The Company is also seeking to recover $3 million of retirement damage, arising out of harm to individuals or property allegedly benefits paid to the former CEO as the Company believes that the caused by, but not limited to, derailments or other accidents. former CEO has failed to fulfill the terms of his employment agree- Proceedings against former CEO ment as well as reasonable legal fees and other costs. The Company has not recognized the recovery of these amounts. In February 2012, the Company’s Board of Directors unanimously voted to forfeit and cancel the RSU payout of approximately $18 mil- Canada lion, the $1.5 million annual retirement benefit, and other benefits Employee injuries are governed by the workers’ compensation (collectively the “Benefits”) otherwise due to its former CEO, after legislation in each province whereby employees may be awarded determining that the former CEO was likely in breach of his either a lump sum or a future stream of payments depending on non-compete and non-disclosure of confidential information condi- the nature and severity of the injury. As such, the provision for tions contained in the former CEO’s employment agreement. The employee injury claims is discounted. In the provinces where the Company‘s determination was based on certain facts, including the Company is self-insured, costs related to employee work-related former CEO’s active participation in concert with the largest share- injuries are accounted for based on actuarially developed esti- holder of the Company’s major competitor in Canada for the express mates of the ultimate cost associated with such injuries, including purpose of installing the former CEO as Chief Executive Officer of the compensation, health care and third-party administration costs. A competitor; the former CEO’s admission that he has taken a personal comprehensive actuarial study is generally performed at least on a $5 million stock position in the competitor; and statements by the triennial basis. For all other legal actions, the Company maintains, former CEO and the largest shareholder to the effect that the former and regularly updates on a case-by-case basis, provisions for such CEO has developed a strategic plan for the operation of the items when the expected loss is both probable and can be reason- Company’s competitor to make it a stronger competitor to the ably estimated based on currently available information. Company; the Company reasonably believes that any such strategic In 2012, the Company recorded an $18 million increase to its plan would necessarily draw upon the Company’s confidential infor- provision for personal injuries and other claims as a result of a mation, which would constitute a clear and material breach of the comprehensive actuarial study for employee injury claims as well former CEO’s employment agreement. The Company has filed legal as various other legal claims. proceedings in the United States District Court for the Northern As at December 31, 2012, 2011 and 2010, the Company’s pro- District of Illinois seeking, among other things, a declaration that the vision for personal injury and other claims in Canada was as follows: Company’s termination of the Benefits is valid. On June 28, 2012, the former CEO was named President and CEO and a member of the Board of Directors of the Company’s major competitor in Canada. On December 21, 2012, the former CEO filed amended counter- claims and affirmative defenses in the United States District Court for the Northern District of Illinois to CN’s amended claims in which the former CEO claims that CN failed to pay monthly retirement benefit installments due through June 28, 2012, the date on which the In millions 2012 2011 2010 Balance January 1 Accruals and other Payments $ 199 $ 200 $ 178 55 (45) 31 (32) 59 (37) Balance December 31 $ 209 $ 199 $ 200 Current portion – Balance December 31 $ 39 $ 39 $ 39 80 2012 Annual Report U.S. GAAP Canadian National Railway Company Notes to Consolidated Financial Statements United States As at December  31, 2012, 2011 and 2010, the Company’s Personal injury claims by the Company’s employees, including provision for personal injury and other claims in the U.S. was as claims alleging occupational disease and work-related injuries, are follows: subject to the provisions of the Federal Employers’ Liability Act (FELA). Employees are compensated under FELA for damages assessed based on a finding of fault through the U.S. jury system or through individual settlements. As such, the provision is undis- counted. With limited exceptions where claims are evaluated on a case-by-case basis, the Company follows an actuarial-based approach and accrues the expected cost for personal injury, includ- ing asserted and unasserted occupational disease claims, and prop- erty damage claims, based on actuarial estimates of their ultimate cost. A comprehensive actuarial study is performed annually. For employee work-related injuries, including asserted occupa- tional disease claims, and third-party claims, including grade crossing, trespasser and property damage claims, the actuarial valuation considers, among other factors, the Company’s histori- cal patterns of claims filings and payments. For unasserted occu- pational disease claims, the actuarial study includes the projection of the Company’s experience into the future considering the potentially exposed population. The Company adjusts its liability based upon management’s assessment and the results of the study. On an ongoing basis, management reviews and compares the assumptions inherent in the latest actuarial study with the current claim experience and, if required, adjustments to the lia- bility are recorded. Due to the inherent uncertainty involved in projecting future events, including events related to occupational diseases, which include but are not limited to, the timing and number of actual claims, the average cost per claim and the legislative and judicial environment, the Company’s future payments may differ from current amounts recorded. In 2012, the Company recorded a $7 million increase to its provision for U.S. personal injury and other claims attributable to non-occupational disease and third-party claims, which was offset by a $6 million net reduction mainly attributable to occupational disease claims pursuant to the 2012 external actuarial studies. In previous years, external actuarial studies reflecting favorable claims development have supported net reductions to the Company’s provision for U.S. personal injury and other claims of $6 million and $19 million in 2011 and 2010, respectively. The previous years’ reductions were mainly attributable to decreases in the Company’s estimates of unasserted claims and costs related to asserted claims as a result of its ongoing risk mitigation strategy focused on reducing the frequency and severity of claims through injury prevention and containment; mitigation of claims; and lower settlements for existing claims. In millions 2012 2011 2010 Balance January 1 Accruals and other Payments $ 111 $ 146 $ 166 28 (34) 30 (65) 7 (27) Balance December 31 $ 105 $ 111 $ 146 Current portion – Balance December 31 $ 43 $ 45 $ 44 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, 2012, or with respect to future claims, cannot be reasonably determined. When establishing provisions for contingent liabilities the Company considers, where a probable loss estimate cannot be made with reasonable certainty, a range of potential probable losses for each such matter, and records the amount it considers the most reasonable estimate within the range. However, when no amount within the range is a better estimate than any other amount, the minimum amount in the range is accrued. For matters where a loss is reasonably possible but not probable, a range of potential losses could not be estimated due to various factors which may include the limited availability of facts, the lack of demand for specific damages and the fact that proceedings were at an early stage. Based on information currently available, the Company believes that the eventual outcome of the actions against the Company will not, individually or in the aggregate, have a material adverse effect on the Company’s consol- idated financial position. However, due to the inherent inability to predict with certainty unforeseeable future developments, there can be no assurance that the ultimate resolution of these actions will not have a material adverse effect on the Company’s results of operations, financial position or liquidity in a particular quarter or fiscal year. D. 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 U.S. concerning, among other things, emissions into the air; discharges into waters; the generation, handling, stor- age, transportation, treatment and disposal of waste, hazardous substances, and other materials; decommissioning of underground and aboveground storage tanks; and soil and groundwater con- tamination. A risk of environmental liability is inherent in railroad and related transportation operations; real estate ownership, oper- ation or control; and other commercial activities of the Company with respect to both current and past operations. Known existing environmental concerns The Company has identified approximately 300 sites at which it is or may be liable for remediation costs, in some cases along with other potentially responsible parties, associated with alleged contamination and is subject to environmental clean-up and Canadian National Railway Company U.S. GAAP 2012 Annual Report 81 Notes to Consolidated Financial Statements 16 Major commitments and contingencies As at December  31, 2012, 2011 and 2010, the Company’s continued provision for specific environmental sites was as follows: enforcement actions, including those imposed by the United States Federal Comprehensive Environmental Response, Compensation and Liability Act of 1980 (CERCLA), also known as the Superfund law, or analogous state laws. CERCLA and similar state laws, in addition to other similar Canadian and U.S. laws, generally impose joint and several liability for clean-up and enforcement costs on current and former owners and operators of a site, as well as those whose waste is disposed of at the 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 10 sites gov- erned by the Superfund law (and analogous state laws) 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 addressing these known contaminated sites cannot be definitely established given that the estimated environmental liability for any given site may vary depending on the nature and extent of the contamination; the nature of antici- pated response actions, taking into account the available clean-up techniques; evolving regulatory standards governing environmen- tal liability; and the number of potentially responsible parties and their financial viability. As a result, liabilities are recorded based on the results of a four-phase assessment conducted on a site-by-site basis. A liability is initially recorded when environmental assess- ments occur, remedial efforts are probable, 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 rea- sonably estimated. The Company estimates the costs related to a particular site using cost scenarios established by external consul- tants based on the extent of contamination and expected costs for remedial efforts. In the case of multiple parties, the Company accrues its allocable share of liability taking into account the Company’s alleged responsibility, the number of potentially responsible parties and their ability to pay their respective share of the liability. Adjustments to initial estimates are recorded as addi- tional information becomes available. The Company’s provision for specific environmental sites is undiscounted and includes costs for remediation and restoration of sites, as well as monitoring costs. Environmental accruals, which are classified as Casualty and other in the Consolidated Statement of Income, include amounts for newly identified sites or contaminants as well as adjustments to initial estimates. Recoveries of environmental remediation costs from other parties are recorded as assets when their receipt is deemed probable. In millions 2012 2011 2010 Balance January 1 Accruals and other Payments $ 152 $ 150 $ 103 (5) (24) 17 (15) 67 (20) Balance December 31 $ 123 $ 152 $ 150 Current portion – Balance December 31 $ 31 $ 63 $ 34 The Company anticipates that the majority of the liability at December  31, 2012 will be paid out over the next five years. However, some costs may be paid out over a longer period. The Company expects to partly recover certain accrued remediation costs associated with alleged contamination and has recorded a receivable in Intangible and other assets for such recoverable amounts. Based on the information currently available, the Company considers its provisions to be adequate. Unknown existing environmental concerns 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 discovery of new facts, future changes in laws, the possibility of releases of hazardous materials into the environment and the Company’s ongoing efforts to iden- tify potential environmental liabilities that may be associated with its properties may result in the identification of additional environ- mental liabilities and related costs. The magnitude of such addi- tional liabilities and the costs of complying with future environmental laws and containing or remediating contamination cannot be reasonably estimated due to many factors, including: (i) the lack of specific technical information available with respect to many sites; (ii) 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 uncer- tainty regarding the timing of the work with respect to partic- ular sites; and (iv) the determination of the Company’s liability in proportion to other potentially responsible parties and the ability to recover costs from any third parties with respect to particular sites. 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 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 liabilities or costs, although management believes, based on current information, that the costs to address environmental matters will not have a material adverse effect on the Company’s financial 82 2012 Annual Report U.S. GAAP Canadian National Railway Company Notes to Consolidated Financial Statements position or liquidity. Costs related to any unknown existing or future value of the assets at the end of their respective lease term is less contamination will be accrued in the period in which they become than the fair value, as estimated at the inception of the lease, then probable and reasonably estimable. Future occurrences the Company must, under certain conditions, compensate the lessor for the shortfall. At December 31, 2012, the maximum expo- sure in respect of these guarantees was $156 million. There are no In railroad and related transportation operations, it is possible that recourse provisions to recover any amounts from third parties. derailments or other accidents, including spills and releases of hazard- ous materials, may occur that could cause harm to human health or (ii) Other guarantees to the environment. As a result, the Company may incur costs in the As at December  31, 2012, the Company, including certain of its future, which may be material, to address any such harm, compliance subsidiaries, has granted $551 million of irrevocable standby letters with laws and other risks, including costs relating to the performance of credit and $11 million of surety and other bonds, issued by highly of clean-ups, payment of environmental penalties and remediation rated financial institutions, to third parties to indemnify them in the obligations, and damages relating to harm to individuals or property. event the Company does not perform its contractual obligations. As Regulatory compliance at December 31, 2012, the maximum potential liability under these guarantee instruments was $562 million, of which $489 million The Company may incur significant capital and operating costs asso- related to workers’ compensation and other employee benefit lia- ciated with environmental regulatory compliance and clean-up bilities and $73 million related to equipment under leases and other requirements, in its railroad operations and relating to its past and liabilities. The letters of credit were drawn on the Company’s bilat- present ownership, operation or control of real property. Operating eral letter of credit facilities. The Company has not recorded a liabil- expenses for environmental matters amounted to $16 million in ity as at December  31, 2012 with respect to these guarantee 2012, $4 million in 2011 and $23 million in 2010. In addition, based instruments as they relate to the Company’s future performance on the results of its operations and maintenance programs, as well and the Company does not expect to make any payments under as ongoing environmental audits and other factors, the Company these guarantee instruments. The majority of the guarantee instru- plans for specific capital improvements on an annual basis. Certain ments mature at various dates between 2013 and 2015. of these improvements help ensure facilities, such as fuelling stations and waste water and storm water treatment systems, comply with (iii) General indemnifications environmental standards and include new construction and the In the normal course of business, the Company has provided updating of existing systems and/or processes. Other capital expen- indemnifications, customary for the type of transaction or for the ditures relate to assessing and remediating certain impaired proper- railway business, in various agreements with third parties, includ- ties. The Company’s environmental capital expenditures amounted ing indemnification provisions where the Company would be to $13 million in 2012, $11 million in 2011 and $14 million in 2010. required to indemnify third parties and others. Indemnifications are found in various types of contracts with third parties which E. Guarantees and indemnifications include, but are not limited to: In the normal course of business, the Company, including certain (a) contracts granting the Company the right to use or enter upon of its subsidiaries, enters into agreements that may involve provid- property owned by third parties such as leases, easements, ing guarantees or indemnifications to third parties and others, trackage rights and sidetrack agreements; which may extend beyond the term of the agreements. These (b) contracts granting rights to others to use the Company’s prop- include, but are not limited to, residual value guarantees on oper- erty, such as leases, licenses and easements; ating leases, standby letters of credit, surety and other bonds, and (c) contracts for the sale of assets; indemnifications that are customary for the type of transaction or (d) contracts for the acquisition of services; for the railway business. (e) financing agreements; The Company is required to recognize a liability for the fair (f) trust indentures, fiscal agency agreements, underwriting value of the obligation undertaken in issuing certain guarantees agreements or similar agreements relating to debt or equity on the date the guarantee is issued or modified. In addition, securities of the Company and engagement agreements with where the Company expects to make a payment in respect of a financial advisors; guarantee, a liability will be recognized to the extent that one has (g) transfer agent and registrar agreements in respect of the not yet been recognized. Company’s securities; (h) trust and other agreements relating to pension plans and other (i) Guarantee of residual values of operating leases plans, including those establishing trust funds to secure pay- The Company has guaranteed a portion of the residual values of ment to certain officers and senior employees of special retire- certain of its assets under operating leases with expiry dates ment compensation arrangements; between 2013 and 2020, for the benefit of the lessor. If the fair (i) pension transfer agreements; Canadian National Railway Company U.S. GAAP 2012 Annual Report 83 Notes to Consolidated Financial Statements 16 Major commitments and contingencies (ii) Fuel continued The Company is exposed to commodity price risk related to pur- chases of fuel and the potential reduction in net income due to (j) master agreements with financial institutions governing deriv- increases in the price of diesel. The impact of variable fuel ative transactions; expense is mitigated substantially through the Company’s fuel (k) settlement agreements with insurance companies or other third surcharge program which apportions incremental changes in fuel parties whereby such insurer or third-party has been indemnified prices to shippers within agreed upon guidelines. While this pro- for any present or future claims relating to insurance policies, gram provides effective coverage, residual exposure remains incidents or events covered by the settlement agreements; and given that fuel price risk cannot be completely mitigated due to (l) acquisition agreements. timing and given the volatility in the market. As such, the Company may enter into derivative instruments to mitigate such To the extent of any actual claims under these agreements, the risk when considered appropriate. Company maintains provisions for such items, which it considers to be adequate. Due to the nature of the indemnification clauses, (iii) Interest rate the maximum exposure for future payments may be material. The Company is exposed to interest rate risk, which is the risk that However, such exposure cannot be reasonably determined. the fair value or future cash flows of a financial instrument will During the year, the Company entered into various indemnifica- vary as a result of changes in market interest rates. tion contracts with third parties for which the maximum exposure Such risk exists in relation to the Company’s pension and post- for future payments cannot be reasonably determined. As a result, retirement plans and to its long-term debt. Overall return in the the Company was unable to determine the fair value of these guar- capital markets and the level of interest rates affect the funded antees and accordingly, no liability was recorded. There are no status of the Company’s pension plans, particularly the Company’s recourse provisions to recover any amounts from third parties. main Canadian pension plan. Adverse changes with respect to 17 Financial instruments A. Risk management pension plan returns and the level of interest rates from the date of the last actuarial valuations may have a material adverse effect on the funded status of the plans and on the Company’s results of operations. The Company mainly issues fixed-rate debt, which exposes the In the normal course of business, the Company is exposed to vari- Company to variability in the fair value of the debt. The Company ous risks such as customer credit risk, commodity price risk, interest also issues debt with variable interest rates through commercial rate risk, foreign currency risk, and liquidity risk. To manage these paper borrowings and capital leases, which exposes the Company risks, the Company follows a financial risk management frame- to variability in interest expense. To manage its interest rate expo- work, which is monitored and approved by the Company’s Finance sure, the Company manages its borrowings in line with liquidity Committee, with a goal of maintaining a strong balance sheet, needs, maturity schedule, and currency and interest rate profile. In optimizing earnings per share and free cash flow, financing its anticipation of future debt issuances, the Company may enter into operations at an optimal cost of capital and preserving its liquidity. forward rate agreements. The Company does not currently hold The Company has limited involvement with derivative financial any significant derivative financial instruments to manage its inter- instruments in the management of its risks and does not use them est rate risk. At December 31, 2012, Accumulated other compre- for trading purposes. At December 31, 2012, the Company did not hensive loss included an unamortized gain of $8 million, $6 million have any significant derivative financial instruments outstanding. after-tax ($8 million, $6 million after-tax at December  31, 2011) (i) Customer credit risk relating to treasury lock transactions settled in a prior year, which are being amortized over the term of the related debt. In the normal course of business, the Company monitors the financial condition and credit limits of its customers and reviews (iv) Foreign currency the credit history of each new customer. Although the Company The Company conducts its business in both Canada and the U.S. believes there are no significant concentrations of credit risk, eco- and as a result, is affected by currency fluctuations. Changes in nomic conditions can affect the Company’s customers and can the exchange rate between the Canadian dollar and other curren- result in an increase to the Company’s credit risk and exposure to cies (including the US dollar) make the goods transported by the business failures of its customers. To manage its credit risk, on an Company more or less competitive in the world marketplace and ongoing basis, the Company’s focus is on keeping the average thereby further affect the Company’s revenues and expenses. daily sales outstanding within an acceptable range and working All of the Company’s U.S. operations are self-contained foreign with customers to ensure timely payments, and in certain cases, entities with the US dollar as their functional currency. Accordingly, requiring financial security, including letters of credit. the U.S. operations’ assets and liabilities are translated into 84 2012 Annual Report U.S. GAAP Canadian National Railway Company Notes to Consolidated Financial Statements Canadian dollars at the rate in effect at the balance sheet date B. Fair value of financial instruments and the revenues and expenses are translated at average For financial assets and liabilities measured at fair value on a recur- exchange rates during the year. All adjustments resulting from the ring basis, fair value is the price the Company would receive to sell translation of the foreign operations are recorded in Other com- an asset or pay to transfer a liability in an orderly transaction with prehensive income (loss). For the purpose of minimizing volatility a market participant at the measurement date. In the absence of of earnings resulting from the conversion of US dollar-denomi- active markets for identical assets or liabilities, such measurements nated long-term debt into the Canadian dollar, the Company involve developing assumptions based on market observable data designates the US dollar-denominated long-term debt of the par- and, in the absence of such data, internal information that is ent company as a foreign currency hedge of its net investment in believed to be consistent with what market participants would use U.S. subsidiaries. As a result, from the dates of designation, for- in a hypothetical transaction that occurs at the measurement date. eign exchange gains and losses on translation of the Company’s Observable inputs reflect market data obtained from independent US dollar-denominated long-term debt are recorded in sources, while unobservable inputs reflect the Company’s market Accumulated other comprehensive loss. assumptions. Preference is given to observable inputs. These two Occasionally, the Company enters into short-term foreign types of inputs create the following fair value hierarchy: exchange contracts as part of its cash management strategy. The Company does not hold or issue derivative financial instruments Level 1: Quoted prices for identical instruments in active markets. for trading or speculative purposes. Changes in the fair value of Level 2: Quoted prices for similar instruments in active markets; forward contracts, resulting from changes in foreign exchange quoted prices for identical or similar instruments in mar- rates, are recognized in the Consolidated Statement of Income as kets that are not active; and model-derived valuations they occur. As at December 31, 2012, a loss of $1 million, before whose inputs are observable or whose significant value tax, related to the fair value of the foreign exchange forward drivers are observable. contracts of US$400 million, was recorded in Other income on the Level 3: Significant inputs to the valuation model are unobservable. Consolidated Statement of Income. (v) Liquidity risk The Company uses the following methods and assumptions to estimate the fair value of each class of financial instruments for The Company monitors and manages its cash requirements to which the carrying amounts are included in the Consolidated ensure sufficient access to funds to meet operational and invest- Balance Sheet under the following captions: ing requirements. The Company pursues a solid financial policy (i) Cash and cash equivalents, Restricted cash and cash equiva- framework with the goal of maintaining a strong balance sheet, lents, Accounts receivable, Other current assets, Accounts by monitoring its adjusted debt-to-total capitalization ratio and its payable and other: adjusted debt-to-adjusted earnings before interest, income taxes, The carrying amounts approximate fair value because of the depreciation and amortization (EBITDA) multiple, and preserving short maturity of these instruments. Cash and cash equivalents an investment grade credit rating to be able to maintain access to and Restricted cash and cash equivalents include highly liquid public financing. investments purchased three months or less from maturity and The Company’s principal source of liquidity is cash generated are classified as Level 1. Accounts receivable, Other current from operations, which is supplemented by its commercial paper assets, and Accounts payable and other are classified as program to meet short-term liquidity needs. If the Company were Level  2 as they may not be priced using quoted prices, but to lose access to the program for an extended period of time, the rather determined from market observable information. Company could rely on its $800 million revolving credit facility. (ii) Intangible and other assets: The Company’s primary uses of funds are for working capital Included in Intangible and other assets are equity investments requirements, including income tax installments as they become for which the carrying value approximates the fair value, with due and pension contributions, contractual obligations, capital the exception of certain cost investments for which the fair expenditures relating to track infrastructure and other, acquisi- value is estimated based on the Company’s proportionate tions, dividend payouts, and the repurchase of shares through a share of the underlying net assets. Intangible and other assets share buyback program, when applicable. The Company sets pri- are classified as Level 3 as their fair value is based on significant orities on its uses of available funds based on short-term opera- unobservable inputs. tional requirements, expenditures to maintain a safe railway and (iii) Debt: strategic initiatives, while also considering its long-term contrac- The fair value of the Company’s debt is estimated based on the tual obligations and returning value to its shareholders. 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 matu- rity. The Company’s debt is classified as Level 2. Canadian National Railway Company U.S. GAAP 2012 Annual Report 85 Notes to Consolidated Financial Statements 17 Financial instruments continued The following table presents the carrying amounts and estimated fair values of the Company’s financial instruments as at December 31, 2012 and December 31, 2011 for which the carrying values on the Consolidated Balance Sheet are different from their fair values: In millions Financial assets Investments (Note 5) Financial liabilities Total debt (Note 8) December 31, 2012 December 31, 2011 Carrying amount Fair value Carrying amount Fair value $ 30 $ 125 $ 31 $ 126 $ 6,900 $ 8,379 $ 6,576 $ 7,978 18 Accumulated other comprehensive loss The components of Accumulated other comprehensive loss are as follows: In millions Foreign exchange loss Pension and other postretirement benefit plans Derivative instruments (Note 17) Accumulated other comprehensive loss December 31, 2012 2011 $ (791) $ (769) (2,472) (2,076) 6 6 $ (3,257) $ (2,839) The components of Other comprehensive loss and the related tax effects are as follows: In millions Year ended December 31, 2012 2011 2010 Accumulated other comprehensive loss – Balance at January 1 $ (2,839) $ (1,709) $ (948) Other comprehensive income (loss): Foreign exchange gain (loss) (net of income tax (expense) recovery of $(17), $19 and $(53), for 2012, 2011 and 2010, respectively) Pension and other postretirement benefit plans (net of income tax recovery of $144, $401 and $241, for 2012, 2011 and 2010, respectively) Derivative instruments (net of income tax recovery of nil, $1 and nil for 2012, 2011 and 2010, respectively) Other comprehensive loss (22) 27 (396) (1,156) - (1) (418) (1,130) (68) (692) (1) (761) Accumulated other comprehensive loss – Balance at December 31 $ (3,257) $ (2,839) $ (1,709) 86 2012 Annual Report U.S. GAAP Canadian National Railway Company Corporate Governance – Delivering Responsibly CN is committed to being a good corporate citizen. At CN, sound We are proud of our corporate governance practices. For more corporate citizenship touches nearly every aspect of what we do, information on these practices, please refer to our website, as well from governance to business ethics, from safety to environmental as to our proxy circular – mailed to our shareholders and also protection. Central to this comprehensive approach is our strong available on our website. CN understands that our long-term belief that good corporate citizenship is simply good business. success is connected to our contribution to a sustainable future. CN has always recognized the importance of good gover- That is why we are committed to the safety of our employees, the nance. As it evolved from a Canadian institution to a North public and the environment; delivering reliable, efficient service so American publicly traded company, CN voluntarily followed cer- our customers succeed in global markets; building stronger com- tain corporate governance requirements that, as a company based munities; and providing a great place to work. Our sustainability in Canada, it was not technically compelled to follow. We con- activities are outlined in our Delivering Responsibly report, which tinue to do so today. Since many of our peers – and shareholders – can be found on our website: www.cn.ca are based in the United States, we want to provide the same For the fourth straight year, CN’s practices have earned it a assurances of sound practices as our U.S. competitors. place on the Dow Jones Sustainability Index (DJSI) North America, Hence, we adopt and adhere to corporate governance prac- which includes an assessment of CN’s governance practices. tices that either meet or exceed applicable Canadian and U.S. CN received the Best Corporate Governance Award from corporate governance standards. As a Canadian reporting IR Magazine in 2009 and 2010, and in 2011 we received the issuer with securities listed on the Toronto Stock Exchange (TSX) Canadian Coalition for Good Governance (CCGG) Award for and the New York Stock Exchange (NYSE), CN complies with Best Disclosure of Board Governance Practices and Director applicable rules adopted by the Canadian Securities Administrators Qualifications; and in 2012 the CCGG Award for Best Disclosure and the rules of the U.S. Securities and Exchange Commission of Approach to Executive Compensation. giving effect to the provisions of the U.S. Sarbanes-Oxley Act of 2002. 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 website (www.cn.ca in the Delivering Responsibly – Governance section), our governance prac tices comply with the NYSE corporate governance rules in all significant respects. Consistent with the belief that ethical conduct goes beyond compliance and resides in a solid governance culture, the Delivering Responsibly – Governance section on the CN website contains CN’s Corporate Governance Manual (including the char- ters 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 wrong- doings 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 website. Canadian National Railway Company 2012 Annual Report 87 Shareholder and Investor Information Annual meeting Shareholder services The annual meeting of shareholders will be held at 9:30 a.m. MDT on April 23, 2013 at: The Fairmont Hotel Macdonald Empire Ballroom 10065 100th Street Edmonton, Alberta, Canada 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 Transfer agent and registrar Computershare Trust Company of Canada Offices in: Montreal, Quebec; Toronto, Ontario; Calgary, Alberta; Vancouver, British Columbia Telephone: 1-800-564-6253 www.investorcentre.com Co-transfer agent and co-registrar Computershare Trust Company N.A. Att: Stock Transfer Department Overnight Mail Delivery: 250 Royall Street, Canton MA 02021 Regular Mail Delivery: P.O. Box 43070, Providence, RI 02940-3070 Telephone: 303-262-0600 or 1-800-962-4284 Shareholders having inquiries concerning their shares, wishing to obtain information about CN, or to receive dividends by direct deposit or in U.S. dollars may obtain detailed information by communicating with: Computershare Trust Company of Canada Shareholder Services 100 University Avenue, 9th Floor Toronto, Ontario M5J 2Y1 Telephone: 1-800-564-6253 www.investorcentre.com 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 Janet Drysdale Vice-President, Investor Relations Telephone: 514-399-0052 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: La version française du présent rapport est disponible à l’adresse suivante : CN Public Affairs Affaires publiques du CN 935 de La Gauchetière Street West Montreal, Quebec H3B 2M9 Telephone: 1-888-888-5909 Email: contact@cn.ca 935, rue de La Gauchetière Ouest Montréal (Québec) H3B 2M9 Téléphone : 1-888-888-5909 Courriel : contact@cn.ca 88 2012 Annual Report Canadian National Railway Company A TRUE BACKBONE OF THE ECONOMY 2 0 1 2 a n n u a l r e p o r t 935 de La Gauchetière Street West Montreal, Quebec H3B 2M9 www.cn.ca 2 0 1 2 a n n u a l r e p o r t 

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