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IlI. Financial Condition 39

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Report of the Auditing Committee of the National Academy of Sciences Dr. Bruce Alberts, President National Academy of Sciences Dear Dr. Alberts: In accordance with Bylaw V-6 of the National Academy of Sciences, the firm of KPMG, LLP was retained to conduct an audit of the accounts of the Treasurer for the year ended December 3l, 2001, and to report to the Auditing Committee. The independent accountants have completed their audit of the financial statements and have submitted their report, a copy of which is attached, concerning financial statements to which they refer. The Auditing Committee has reviewed the report and recommends its acceptance in compliance with the governing bylaw and that the opinion of the independent accountants be published with the report of the Treasurer. Respectfully submitted, JACK HALPERN, Chair PURNELL CHOPPIN M. GORDON WOLMAN National Academy of Sciences 40

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Independent Auditors' Report The Auditing Committee National Academy of Sciences: We have audited the accompanying statements of financial position of the National Academy of Sciences (NAS) as of December 31, 2001 and 2000, and the related statements of activities and cash flows for the years then ended. These financial statements are the responsibility of the NAS's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audit in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of the NAS as of December 31, 2001 and 2000, and its changes in net assets and its cash flows for the years then ended in conformity with accounting principles generally accepted in the United States of America. As discussed in note 3 to the financial statements, the net assets as of January 1, 2000 have been restated. As discussed in note 12 to the financial statements, the NAS adopted the provisions of Statement of Financial Accounting Standard No. 133, Accounting for Derivative Instruments and Hedging Activities, in 2001. April 19, 2002 KPMG, LLP 41

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NATIONAL ACADEMY OF SCIENCES Statements of Financial Position December 31, 2001 and 2000 ($ in thousands) Assets Current assets: 2001 2000 Cash and cash equivalents Short-term investments (note 4) Contracts receivable - U.S. government (note 11) Contributions and other receivables (note 6) Publications and supplies inventories Bond proceeds held with trustee (note 12) Prepaid expenses and other Total current assets Einstein Memorial Property and equipment (note 5) Other assets (note 14) Long-term investments (note 4) Contributions receivable (note 6) Liabilities and Net Assets Current liabilities: $ 13,664 52,025 38,015 11,473 2,151 37,952 2,771 59 49,481 35,298 13,444 2,378 78,332 2,567 158,051 181,559 1.723 109,571 6,808 274,797 24,895 1,723 68,560 5,972 300,709 23,527 $575,845 582,050 Accounts payable and accrued expenses (note 11) Deferred revenue (note 7) Other liabilities (note 12) Total current liabilities Bonds payable (note 12) Funds held on behalf of others (note 4) Note payable (note 13) Accrued lease liability (note 12) Accrued employee benefits (note 14) Deferred gain (note 12) Other liabilities Total liabilities Net assets: Unrestricted (note 3) Temporarily restricted (note 9) Permanently restricted (note 9) Total net assets Commitments and contingencies (notes 8, 11, 12, 14 and 15) Total liabilities and net assets See accompanying notes to financial statements. 42 $ 33,105 31,927 7,810 27,410 29,017 7,733 72,842 64,160 129,987 19,652 10,000 20,308 7,760 3,198 2,196 129,992 20,950 24,045 7,486 4,650 2,323 265,943 253,606 99,506 127,518 82,878 114,818 133,894 79,732 309,902 328,444 $575,845 582,050

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NATIONAL ACADEMY OF SCIENCES Statements of Activities Years ended December 31, 2001 and 2000 ($ in thousands) 2001 2000 Temporarily Permanently Temporarily Permanently Unrestricted Restricted Restricted Totals Unrestricted Restricted Restricted Totals Revenues, gains, and other support: Government contracts and grants $163,856 163,856 165,729 165,729 Private contracts and grants 21,147 11,888 33,035 20,524 11,429 31,953 Other contributions 3,977 1,033 3,146 8,156 5,568 22,939 5,805 34,312 Fees and publications 14,405 14,405 14,911 14,911 Investment income (note 4) (2,838) (7,040) (9,878) 6,141 (393) 5,748 Otherincome(notel2) 4,731 4,731 5,511 5,511 Net assets released from restriction (note 9) 12,257 (12,257) 12,315 (1235) Total revenues, gains, and other support $217,535 (6,376) 3,146 214,305 230,699 21,660 5,805 258,164 Expenses: Change in net assets, before Programs (note 10) $175,698 175,698 179,488 179,488 Management and general 57,225 57,225 54,446 54,446 Fundraising 2,712 2,712 3,433 3,433 Total expenses 235,635 235,635 237,367 237,367 cumulative effect of change in accounting principle (18,100) (6,376) 3,146 (21,330) (6,668) 21,660 5,805 20,797 Cumulative effect of a change in accounting principle (note 12) 2,788 2,788 Change in net assets (note 3) (15,312) (6,376) 3,146 (18,542) (6,668) 21,660 5,805 20,797 Net assets at beginning of the year, as restated (note 3) 114,818 133,894 79,732 328,444 121,486 112,234 73,927 307,647 Net assets at end of the year $ 99,506 127,518 82,878 309,902 114,818 133,894 79,732 328,444 See accompanying notes to financial statements. 43

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NATIONAL ACADEMY OF SCIENCES Statements of Cash Flows Years ended December 31, 2001 and 2000 ($ in thousands) Cash flows from operating activities: 2001 2000 Change in net assets $~18,542) 20,797 Adjustments to reconcile change in net assets to net cash flow used for operating activities: Depreciation and amortization 2,654 3,406 Loss (gain) on disposal of property and equipment 733 (548) Bad debt expense 656 37 Net loss on investments 23,376 20,128 Amortization of deferred gain on building sale (1,452) Decrease in funds held on behalf of others 1,298 760 Contributions restricted for construction and permanent endowment (8,780) (1,535) Increase in other receivables (53) (28,530) Increase in contracts receivable - U.S. government (2,717) (3,848) Decrease (increase) in publications and supplies inventories 227 (156) Decrease in bond proceeds held with trustee 40,380 14,300 Increase in prepaid expenses and other current assets (204) (180) Increase in other assets (836) (34) Increase in accounts payable and accrued expenses 5,720 4,339 (Decrease) increase in other current liabilities (131) 232 Increase in deferred revenue 2,910 10,423 (Decrease) increase in other liabilities (1,047) 971 Net cash provided by operations 44,192 40,562 Cash flows from investing activities: Purchase of property and equipment (44,403) (17,956) Sale or maturity of investments 237,340 35,276 Purchase of investments (238,646) (90,913) Net cash used for investing activities (45,709) (73,593) Cash flows from financing activities: Contributions restricted for construction and permanent endowment 8,780 1,535 Proceeds from bank note 10,000 Proceeds from line of credit 38,700 55,646 Payments on line of credit (38,700) (58,596) Proceeds from Green/Harris sale-leaseback 36,210 Payments on lease liability (3,658) (1,802) Net cash provided by financing activities 15,122 32,993 Net increase (decrease) in cash and cash equivalents 13,605 (38) Cash and cash equivalents, beginning of year 59 97 Cash and cash equivalents, end of year 13,664 59 Supplemental disclosure of cash flow information: Interest paid $ 6,985 6,733 See accompanying notes to financial statements. 44

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NATIONAL ACADEMY OF SCIENCES Notes to Financial Statements December 31, 2001 and 2000 (1) ORGANIZATION AND RELATED ENTITIES (a) National Academy of Sciences The National Academy of Sciences (NAS) was formed under a charter that was passed as an Act of Incorporation by the United States Congress and signed into law on March 3, 1863. The NAS operates as a private cooperative society of distinguished scholars engaged in scientific or engineering research, dedicated to the furtherance of sci- ence and its use for the general welfare. The NAS is exempt from federal income taxes under Section 501(c)~3) of the Internal Revenue Code, except for unrelated busi- ness income. (b) National Research Council Most of the activities undertaken by the NAS are carried out through the divisions, offices, and boards of the National Research Council (NRC), which draw on a wide cross section of the nation's leading scientists and engi- neers for advisory services to government agencies and the Congress. To respond effectively to both the disciplinary concerns of the research community and the complex interdisciplinary problems facing American society, the NRC is organized into 5 major units responsible for most study activities: Division of Behavioral and Social Sciences and Education; Division on Earth and Life Studies; Division on Engineering and Physical Sciences; Policy and Global Affairs Division; and Transportation Research Board. NRC activities are under the control of the NAS gover- nance structure, and therefore are included in the NAS's financial statements. (c) Institute of Medicine The Institute of Medicine (IOM), established in 1970, conducts studies of policy issues related to health and medicine. The IOM issues position statements on these policies, cooperates with the major scientific and profes- sional societies in the field, identifies qualified individuals to serve on study groups in other organization units, and disseminates information to the public and the relevant professions. The IOM was established as a separate mem- bership organization within the NAS. The financial activ- ity and results of the IOM are included in the NAS financial statements. (d) National Academy of Engineering The National Academy of Engineering (NAE) was estab- lished in December 1964 under the charter of the National Academy of Sciences as a related parallel organization, autonomous in its governance, administration, and in the selection of its members. The NAE shares with the NAS the responsibility for advising the federal government on scientific issues. The financial activity and results of the NAE are not included in the NAS financial statements, except to the extent those activities are conducted through the NRC. (e) National Academy of Engineering Fund The National Academy of Engineering Fund (NAEF) is a separately incorporated not-for-profit organization estab- lished and controlled by the NAE to raise funds to support its goals. The financial activity and results of the NAEF are not included in the NAS financial statements. ~ The National Academies' Corporation The National Academies' Corporation (TNAC) was sepa- rately incorporated in 1986 as a not-for-profit corporation for the purpose of constructing and maintaining a study and conference facility. This facility, the Arnold and Mabel Beckman Center, located in Irvine, California, operates to expand and support the general activities of the NAS, NRC, IOM, and NAE. The NAS and the NAEF are 50/50 joint investors of TNAC, and therefore share control. The financial position and results of TNAC are not consoli- dated in the NAS's financial statements. (2) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (a) Basis of Accounting Net assets and revenues, expenses, gains, and losses are classified based on the existence or absence of donor- imposed restrictions. Accordingly, net assets of the NAS are classified and reported as follows: 45

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Permanently restricted: Net assets subject to donor-im- posed stipulations that they be maintained in perpetuity by the NAS. Generally, the donors of these assets permit the NAS to use all or part of the income earned on related investments for general or specific purposes. Temporarily restricted: Net assets subject to donor-im- posed stipulations that may or will be met either by actions of the NAS and/or the passage of time. When a donor restriction expires, temporarily restricted net assets are reclassified as unrestricted net assets. Unrestricted: Net assets arising from exchange transac- tions and unexpended contributions that are not subject to donor-imposed stipulations. (bJ Cash Equivalents The NAS reports as cash equivalents excess cash invested in overnight government-backed repurchase agreements. Cash equivalents also include money market funds in short-term investment accounts. (c) Investments Equity and debt securities are reported at fair value, based on quoted market prices. Investments in real estate mort- gages are recorded at cost and consist of mortgages on the principal administrative facilities that the NAS currently occupies. Changes in the fair value of investments are reported within investment income in the statement of activities. The NAS holds certain short-term investments for pro- gram and operational liquidity requirements. Certain investments are pooled for long-term investment purposes. Investments in the pool are administered as an open-end investment trust, with shares of the pool funds expressed in terms of participating capital units (PCU). PCU values are used to determine equity among funds in the pool whenever additional funds are contributed or withdrawn. (d) Contributions revenue. The net asset restrictions are released through reclassification when the funds are used for the donor-specified purpose. Gifts of land, buildings, and equipment are reported as unrestricted net assets unless explicit donor stipulations specify how the donated assets must be used. Temporary restrictions on gifts to acquire long-lived assets are consid- ered met in the period in which the assets are acquired or placed in service. (e) Contracts and Grants Major NAS activities are performed under cost-reimburs- able contracts with the U.S. government. Federal sponsors who individually accounted for more than 10% of NAS revenues are summarized below: Years ended December 31, Federal Agency Transportation NASA DHHS Energy 2001 2000 25% 2% 11% 25% 11% 11% 11% It is the policy of the NAS to record federal contracts as exchange transactions, recognizing revenue as recoverable - costs are incurred. Revenues from non-federal grants qualifying as contribu- tions are recorded when the NAS is notified of the grant award. Such grants are classified as temporarily restricted if use of the grant funds is limited to specific areas of study, or to be used in future periods. ~ Deferred Revenue For both federal and non-federal grants and contracts that are determined to be exchange transactions, revenue is recog- nized as the related costs are incurred. Funds received in advance of being earned for these grants are recorded as deferred revenue on the statement of financial position. (gJ Fair Value of Financial Instruments The carrying value of bonds payable in the financial statements was less than their fair value by approximately $137,000 on December 31, 2001 and exceeded their fair .. . . value by approximately $28 000 on December 31 2000. Contnbut~ons, Including unconditional promises to give, ' ' are recognized as revenues in the period received. Condi- NAS makes limited use of derivative financial instruments tional promises to give are not recognized until the condi- for the purpose of managing interest rate risks. Current lions on which they depend are substantially met. Contri- market pricing models are used to estimate fair values of buttons subject to donor-imposed stipulations that are met interest rate swap agreements. The fair market value of all in the same year as received are reported as unrestricted other financial instruments in the financial statements approximates reported carrying value. 46

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(h) Inventories Inventories are stated at the lower of cost or net realizable value and include supplies, and both work-in-process and finished goods related to the publication activities of the NAS. The majority of the NAS's inventories of publica- tions and supplies reside with the National Academy Press (NAP). NAP uses the full absorption costing methodology in pricing finished products. This methodology includes direct printing and related indirect costs. (i) Property and Equipment Depreciation of NAS buildings and equipment is com- puted on a straight-line basis using the following lives: Buildings - 40 to 50 years Building and leasehold improvements - lesser of the remaining life of the building or estimated useful life of improvement Furniture and equipment - 4 to 10 years The Einstein Memorial sculpture is not depreciated. Con- struction-in-progress is not depreciated until the related assets are placed in service. a' Use of Estimates The preparation of these financial statements in confor- mity with accounting principles generally accepted in the United States of America requires management to make certain estimates and assumptions. These estimates and assumptions may affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities as of the date of the financial statements. Actual results could differ from those estimates. (k) Reclassircahons Certain amounts from the prior year have been reclassified to conform to the current year presentation. (3) RESTATEMENT OF FINANCIAL STATEMENTS During 2001, NAS determined that receivables related to the cumulative indirect cost under-recovery for one operat- ing unit had been incorrectly recorded, and were required to be written off. This adjustment has been recorded by restatement of the net assets of the NAS as of January 1, 2000. The total write-off amounted to approximately $3.1 million, of which $265,000 related to the year ended December 31, 2000 and the remainder of $2.8 million related to years prior to 2000. A summary of the effects of the restatement is as follows ($ in thousands): January 1 unrestricted net assets, as previously reported $115,083 124,349 Write-off of unbilled indirect cost under-recovery (265) (2,863) January 1 unrestricted net assets, as restated $114,818 121,486 2001 2000 The effects on change in unrestricted net assets for the year ended December 31, 2000 is as follows ($ in thousands): Change in unrestricted net assets, as previously reported: $(6,403) Recognition of 2000 write-off of receivables (265) Change in unrestricted net assets for the year ended December 31, 2000, as restated $(6,668) (4) INVESTMENTS Investments, reported at fair value (except as noted) con- sisted of the following as of December 31, 2001 and 2000 ($ in thousands): Short-term investments: Cash equivalents Bonds and notes Treasury securities Equity securities Escrow Endowment and trust investments: Cash equivalents Bonds and notes Equity securities Other long-term investments: Escrow: Cash equivalents Bonds and notes Equity securities Total long-term investments 2001 2000 113 108 40,686 16,860 11,226 27,812 4,701 52,025 49,481 2,702 1,791 46,739 73,235 190,115 188,764 239,556 263,790 8,663 9,711 248,219 273,501 246 1,358 7,004 9,124 19,328 16,726 26,578 27,208 $274,797 300,709 The NAS received proceeds from the sale and leaseback of the Green/Harris facility of approximately $36 million in 2000 (see note 12~. These proceeds were placed in an 47

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escrow account held to cover payments under the lease (5) PROPERTY AND EQUIPMENT obligation to the former landlord. In 2000, the amount required to fund the lease payments for 2001 has been included in the short-term investment balance above, with the remaining balance classified as other long-term invest- ments. During 2001, payments of $3.5 million were made from the escrow account and payments of $1.6 million were made from operating cash. Vanguard equity funds comprised approximately $107 million and $123 million of the total equity securities funds at December 31, 2001 and 2000, respectively. Private equity investments, represented by limited partner- ship interests comprised approximately $6.5 million and $8.0 million of the total investments on December 31, 2001 and 2000, respectively. NAS had a remaining commitment on December 31, 2001 and 2000, to provide approximately $11.1 million and $12.5 million to these partnerships. During 2001, the NAS invested in hedge funds which totaled approximately $22 million at December 31, 2001, and are included in endowment and trust equity securities above. The unrealized gain on these funds, which is included as a component of investment income in the accompanying statement of activities, was approximately $74,000 for the year ended December 31, 2001. Fair value of the buildings relating to the real estate mortgage investments approximated $36 million on De- cember 31, 2001 and 2000. The NAS pledged its invest- ment in the real estate mortgages as collateral on its commitment under the operating lease for the Green/ Harris facility during 2000 (see note 15~. TNAC, a related entity, invests certain of its assets in the NAS endowment and trust investment pool. TNAC invest- ments participate in the investment pool experience equally with all other funds in this pool. The NAS's obligation to TNAC for these funds held in trust, which totaled $19.7 million and $21.0 million as of December 31, 2001 and 2000, respectively, is reported as funds held on behalf of others within the statements of financial position. Investment income (loss) is reported net of investment expenses of approximately $401,000 and $91,000 for the years ended December 31, 2001 and 2000, respectively, and is comprised of the following ($ in thousands): 200~ 2000 Interest and dividends income Net gain (loss) on investments 48 $ 13,498 25,876 (23,376) (20,128) $ (9,878) 5,748 Property and equipment as of December 31, 2001 and 2000, were as follows ($ in thousands): 2001 $ 29,723 27,055 13,311 70,283 6,949 147,321 2000 Land Furniture and equipment Buildings and improvements Construction in progress (note 12) Leasehold improvements Less - accumulated depreciation and amortization (6) CONTRIBUTIONS RECEIVABLE 29,723 26,623 13,004 27,732 6,949 104,031 (37,750) (35,471) $109,571 68,560 Contributions not yet collected are reported as other receivables (current and long-term) in the statements of financial position, and mature as follows ($ in thousands): Years ending December 31 2002 2003 2004 2005 2006 Thereafter Less - discount to estimated net present value Less - allowance for uncollectible pledges Less - current portion $ 6,497 2,832 1,571 1,111 700 25,699 38,410 (7,018) (12) 31,380 (6,485) $24,895 Contributions pledged during 2001 have been discounted at 4%. Contributions pledged prior to 2001 have been discounted at 5%. During 2000, the NAS was named the beneficiary of a $25 million charitable remainder trust for the purpose of establishing a science museum at its new headquarters facility (see note 12~. This contribution was discounted to its present value using a rate of 5%, and is reported as a long-term contributions receivable. (7) DEFERRED REVENUE Deferred revenue consisted of the following as of Decem- ber 31, 2001 and 2000 ($ in thousands):

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Advances from private grants arid contract sponsors Advances from U.S. government sponsors Publication subscriptions and other (8) [INK OF CREDIT $22,856 6,028 3,043 $31,927 29,017 19,826 6,549 2,642 The NAS has an $11.0 million unsecured line of credit from Bank of America with an interest rate of LIB OR plus 0.40%. There were no outstanding balances on the line on December 31, 2001 and December 31, 2000. Interest expense for the years ended December 31, 2001 and 2000, was approximately $33,000 and $143,000, respectively. (9) RESTRICTED NETASSETS Temporarily restricted net assets were available for the following purposes as of December 31, 2001 and 2000 ($ in thousands): 2001 $102,876 22,081 2,561 $127,518 133,894 2000 Sponsored research and advisory programs Prizes arid awards Woods Hole facility 106,119 24,530 3,245 Temporarily restricted net assets were released from re- striction for the following purposes during the years ended December 31, 2001 and 2000 ($ in thousands): 2001 2000 Sponsored research and advisory programs Prizes arid awards Woods Hole facility $11,151 787 319 $12,257 12,315 11,237 779 299 The income generated by permanently restricted net assets is to be used to support donor-specified programs or general activities of the NAS. As of December 31, 2001 and 2000, the NAS held the following permanently re- stricted net assets, classified by the purpose for which the income is to be used ($ in thousands): 2001 2000 Sponsored research and advisory programs Prizes arid awards $79,559 3,319 $82,878 79,732 76,415 3,317 2001 2000 (10) PROGRAM EXPENSES Program expenses for the years ended December 31, 2001 and 2000, are summarized as follows ($ in thousands): 2001 2000 Policy arid Global Affairs Transportation Research Board Earth arid Life Sciences Institute of Medicine Engineenng arid Physical Sciences Behavioral and Social Sciences arid Education National Sciences Resource Center National Academy of Engineenng Prizes, awards, and other $ 49,186 48,251 42,573 43,938 22,014 26,674 21,520 20,607 20,036 19,798 15,685 15,089 552 564 3,822 2,996 310 1,571 $175,698 179,488 (11) RECOVERY OF INDIRECT COSTS The NAS receives indirect cost recovery on its federal contracts and grants. The negotiated overhead rates were 62.00% and 59.60%, and the general and administrative (G&A) rates were 16.81% and 20.38%, respectively, for the years ended December 31, 2001 and 2000. Overhead is applied to direct salaries, accrued leave, fringe benefits, and services provided by outside contractors (e.g., temporary personnel agencies, consultants) on NAS property. G&A is applied to direct costs and overhead less subcontract costs and stipends. Therefore, both the over- head and G&A rates are applied to projects incurring direct salaries and other direct costs such as travel. If a program does not require direct salaries, such as a travel grant program, a subcontract/flow-through administration rate of 3.07% and 2.80% was applied for the years ended December 31, 2001 and 2000, respectively. Certain off-site work (not performed on NAS property), was assessed reduced overhead rates of 36.92% and 43.64% for the years ended December 31, 2001 and 2000, respectively. NAS bills for indirect cost recovery throughout the year based on pre-negotiated rates, as noted above. At the end of each year, NAS compares actual expenses incurred in each of its cost pools to the amounts recovered based on its billing rates. The difference is recorded as its indirect cost carryforward. If NAS overrecovers on its indirect costs during the year, a liability is recorded. If NAS underrecovers, a receivable balance is recorded. The NAS recognized a cumulative net underrecovery of $2.9 million as of December 31,2001, which is included in the contracts receivable balance in the statements of finan- cial position. The NAS recognized a net overrecovery of 49

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$1.1 million as of December 31, 2000, included in the accounts payable balance in the statements of financial . . position. (12) BUl[DINGPROJECTAND FINANCING (a) Revenue Bonds In January 1999, the District of Columbia issued $130,960,000 of tax-exempt revenue bonds on behalf of the NAS. The NAS is obligated under these bonds as follows ($ in thousands): Senes 1999A revenue bonds, senal, with interest rates ranging from 3.9% to 5%, maturing at venous dates from January 1, 2003 through 2012. Senes 1999A revenue bonds, term Interest rate 5%, due January 1, 2019. Interest rate 5%, due January 1, 2028. Senes l999B revenue bonds at a flexible rate due January 1, 2039. Senes l999C revenue bonds, variable rate due January 1, 2039. Total bonds, at face value Less - net unamortized discount Total bonds payable 2001 2000 $ 16,330 16,330 17,085 17,085 32,545 32,545 32,500 32,500 32,500 32,500 130,960 130,960 (973) (968) $129,987 129,992 The serial and term bonds represent unsecured general obligations of the NAS. Interest on the Series 1999A revenue bond is payable semiannually every January 1 and July 1, commencing on July 1, 1999. Interest on the l999B and l999C bonds is payable monthly. The term bonds maturing on January 1, 2019 and January 1, 2028 are subject to mandatory redemption by operation of sinking fund installments. The installment payments for the term bonds maturing January 1,2019, begin on January 1, 2013 and range from $2.1 to $2.8 million per year through the maturity date. Installment payments for the term bond maturing January 1, 2028, begin on January 1, 2020, and range from $2.9 to $4.3 million per year through the maturity date. Interest expense on the bonds payable for 2001 and 2000 totaled $5.3 million and $6.0 million, respectively. NAS, in 2001 and 2000, capitalized interest of approximately $2,247,000 and $1,498,000, respectively. The bond proceeds are held by a Trustee and invested in a guaranteed investment contract. The Trustee reimburses the NAS for expenditures related to the building project. 50 (b) Building Project Proceeds from the sale of the revenue bonds described above will finance the cost of the acquisition of 44,250 square feet of land and related construction of an office building, as well as pay certain costs of issuing the bonds. This building will consolidate NAS's program activities into one location. Construction began in the summer of 1999 and has an anticipated completion date of summer 2002. (c) Interest Rate Swaps In October 1999, the NAS entered into a swap agreement, with an effective date of February 1, 2000. This swap agreement related to the $66 million face amount of its Series 1999A revenue bonds. The agreement provides for the NAS to receive 4.97% in interest on a notional amount of $65 million and to pay interest at a floating rate option based on the weekly interest rate resets of tax-exempt variable-rate issues per the BMA Municipal Swap Index. The NAS entered into this swap agreement to manage its exposure to interest rate changes. The fixed-rate debt obligations expose the NAS to variability in the cost recovery stream due to changes in interest rates. The NAS recovers the costs of borrowing through a capital invest- ment incentive rate that is set by the U.S. government and is tied to a variable index. If interest rates increase, the capital investment incentive recovery increases. Conversely, if interest rates decrease, the capital invest- ment incentive recovery decreases. Therefore, the NAS entered into a derivative instrument that ties the fixed-rate debt to a variable index to manage fluctuations in cash flows resulting from interest rate risk. By using derivative financial instruments to hedge exposures to changes in interest rates, the NAS exposes itself to credit risk and market risk. Credit risk is the failure of the counterparty to perform under the terms of the derivative contract. When the fair value of a derivative contract is positive, the counterparty owes the NAS, which creates credit risk for the NAS. When the fair value of a derivative contract is negative, the NAS owes the counterparty, and therefore, it does not possess credit risk. The NAS minimizes the credit risk in derivative instruments by entering into transactions with high-quality counterparties. During 2000, the NAS received payments of $2,971,000 from Bank of America based on the 5.17% fixed rate, and paid $2,126,000 based on an average variable rate of 3.88% resulting in $845,000 gain which is reflected as

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other income in the statement of activities for the year ended December 31, 2000. In January 2001, the NAS amended the October 1999 agreement by assuming responsibility for the fixed rate payments for the period 2001-2003 in exchange for an immediate cash payment of $2,435,000. Based on 1999 results, the NAS would have received payments during this period having a net present value (using a 10% discount rate) of $1,952,000. Consequently, the NAS received its three year projected return immediately, plus a $483,000 market premium. Beginning January 1, 2004, the variable rate swap transac- tion becomes effective again with 16 years remaining under the agreement. In October 2001, the NAS further amended the agreement for the 2004-2020 period by agreeing to give up the benefit of any 30-day period during which the BMA index falls below 2.25% and stays there for the entire 30 days. Each time this occurs, the rate on the swap portfolio reverts to the fixed rate of 5.1 % for that month only. In exchange for the opportunity to benefit from interest rates below the 2.25% floor, the NAS received a cash payment of $1,527,000. The NAS recognized the cash payments of $2,435,000 and $1,527,000 as other income in the accom- panying statement of activities for the year ended Decem- ber 31, 2001. On January 1, 2001, NAS adopted Statement of Financial Accounting Standards No. 133 (SFAS 133), "Accounting for Derivative Instruments and Hedging Activities." SEAS 133 requires all derivatives to be recorded at fair value. Adoption of this standard resulted in recording a cumula- tive effect of a change in accounting principle gain as of January 1, 2001 of approximately $2.8 million and a corresponding derivative asset. For the year ended Decem- ber 31, 2001, the NAS recorded a loss on the change in the fair value of its derivative instruments in the amount of approximately $4.9 million which is included as a reduc- tion of other income in the accompanying statement of activities. Prior to the adoption of SEAS 133, the differen- tial to be paid or received for interest rate swaps was accrued and recognized in other income. (d) Sale-leaseback of Green/Harris Facility In 1999, under a separate trust agreement, the Trustee, an unrelated third party, held record legal title to the Green/ Harris facility that was under lease by the NAS for a portion of its operations. This trust agreement would have conveyed title to the NAS in 2007, if NAS accepted title. In 2000, the NAS entered into a contract with a third party to sell its future interest in the property for approximately $36 million. The NAS also entered into another contract in 2000 to lease back the entire facility until 2002 (at a monthly rate of $400,000) and a portion of the facility from 2003 to 2007 (at a monthly rate of $200,000~. These amounts are included in future minimum rental payments summarized in note 15. The sale-leaseback transaction resulted in a gain of $6.8 million, of which $4.7 million and $6.1 million was deferred at December 31, 2001 and 2000, respectively. The deferred gain will be fully recognized by 2007. The NAS remains obligated through 2007 for remaining lease payments, with a present value of approximately $24 million and $28 million as of December 31, 2001 and 2000, respectively, under the original lease agreement with the Trustee. The current and long-term portions of this obligation are reflected as other current liabilities and accrued lease liability, respectively, within the statements of financial position as of December 31, 2001 and 2000. (13) NOTE PAYABLE During 2001, the NAS entered into a loan agreement of $10 million with Bank of America. The note bears interest at 30 day LIB OR plus 50 basis points and is payable monthly. The note matures on December 31, 2004. (/4) EMPLOYEE BENEFITS (a) Pension Plans The NAS has an insured, noncontributory, defined contri- bution pension plan covering substantially all of its em- ployees. The plan is intended to qualify under Section 401(a) of the Internal Revenue Code and uses Teachers Insurance and Annuity Association/College Retirement Equities Fund (TIAA/CREF) group retirement annuity contracts as the investing vehicle. Participants in this plan vest immediately. The NAS has received a favorable determination letter from the IRS on the qualification of this plan under Section 401(a) of the Internal Revenue Code. In addition, the NAS has a voluntary employee contribu- tion retirement plan that is funded solely by employee contributions made on a pretax salary-reduction basis 51

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under Section 403(b) of the Internal Revenue Code. The investing vehicles under this voluntary plan are retirement annuity contracts issued by TIAA/CREF and mutual funds offered by the Vanguard Group, Inc. Pension expense for the years ended December 31, 2001 and 2000, amounted to $7.0 million and $6.4 million, respectively. NAS policy is to fund pension benefits as they are earned. NAS normal retirement age is 65, but there is no mandatory age for retirement. (by Deferred Compensation The NAS holds long-term investments as part of a deferred compensation arrangement for certain employees. The fair value of these investments were approximately $5.5 m~l- lion and $6.0 million as of December 31, 2001 and 2000, which are reported in other assets. The related obligation is included in accrued employee benefits on the statements of financial position. 2001 (c) Postretirement Benefits The NAS provides certain health care and life insurance benefits for retired employees. All employees may become eligible for these benefits if they reach normal retirement age while working for the NAS and meet certain service requirements. An insurance company whose premiums are determined on an expenence-rated basis provides these benefits for retirees. The plan is contributory for employ- ees who retire after January 1,1990. Employees contribute 25% of the monthly premium. The NAS has elected to recognize the initial postretirement benefit obligation over a period of 20 years. The accrued postretirement benefit obligation is reported in accrued employee benefits on the statements of financial position. The postretirement benefit cost for the years ended December 31, 2001 and 2000, includes the following components ($ in thousands): 2000 Life Life insurance Health insurance Health benefits benefits Total benefits benefits Total Change in benefits obligations Benefit obligation, January 1 $ 603 10,067 10,670 590 9,443 10,033 Service cost 8 409 417 7 306 313 Interest cost 50 744 794 42 685 727 Actuarial (gain) loss 174 2,507 2,681 20 270 290 Benefits paid (70) (599) (669) (56) (637) (693) Benefits obligation, December 31 Change in plan assets Fair value of plan assets, January 1 Actual return on plan assets Employer contributions Benefits paid Fair value of plan assets, December 31 Funded Status Benefit obligation Unrecognized translation obligation Unrecognized prior service cost Unrecognized net actuarial (gain) loss Prepaid (accrued) benefit cost Components of net periodic benefit cost Service cost Interest cost Expected return on plan assets Amortization of transition obligation Amortization of unrecognized (gains) losses Net periodic cost 52 765 13,128 13,893 603 10,067 10,670 70 (70) 4,859 4,859 5,133 5,133 5,133 (274) 599 (599) 5,133 (274) 669 (669) 56 (56) 4,675 458 637 (637) 4,675 458 693 (693) (765) 321 284 (159) (1,273) (1,432) (126) (725) (851) (8,269) 5,069 64 1,863 (9,034) 5,390 65 2,147 (603) 347 130 (4,934) 5,474 (1,265) (5,537) 5,821 (1,135) 8 50 26 19 409 744 (411) 405 417 7 306 794 42 685 (411) (374) 431 26 405 19 7 (63) 26 313 727 (374) 431 (56) $ 103 1,147 1,250 82 959 1,041

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AS OF JANUARY 1, 2002 OFFICERS Bruce Alberts, NAS President James S. Langer, NAS Vice-President R. Stephen Berry, NAS Home Secretary F. Sherwood Rowland, NAS Foreign Secretary Ronald L. Graham, NAS Treasurer FINANCE COMMITTEE Ronald Graham, Chair Bruce Alberts Elwyn R. Berlekamp Elkan R. Blout David M. Kipnis Lawrence R. Klein William Rutter Paul A. Samuelson Joseph B. Martin, M.D.: TOM Representative BUD GET AND INTERNAL AFFAIRS COMMITTEE Ronald Graham, Chair John Brauman Purnell Choppin Robert C. Dynes James Langer Jane Lubchenco AUDITING COMMITTEE Jack Halpern, Chair Purnell Choppin M. Gordon Wolman FINANCIAL MANAGEMENT STAFF Archie L. Turner, Chief Financial Officer Linda White, Director of Finance Mun Lim, Controller 54