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IlI. Financial Condition 41

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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. Alherts: in accordance with Bylaw V-6 of the National Academy of Sciences, the firm of KPMG, LLP was retained to conduct an auclit of the accounts of the Treasurer for the year enclect December 3 I, 2002, anti to report to the Auditing Committee. The independent accountants have completest 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 ant! recommencts its acceptance in compliance with the governing bylaw ant! that the opinion of the in~iepenclent accountants be published with the report of the Treasurer. Respectfully submitted, JACK HALPERN, Chair PURNELL CHOPPER M. GORDON WOLMAN National Academy of Sciences 42

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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, 2002 ant] 2001, ant! the related statements of activities ant! cash flows for the years then ended. These financial statements are the responsibility of NAS' 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 stanclards 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 clisclosures in the financial statements. An audit also includes assessing the accounting principles user! and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our auclits 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 NAS as of December 3 l, 2002 and 2001, and its changes in net assets ant! its cash flows for the years then encled in conformity with accounting principles generally accepted in the United States of America. As cliscussecl in note 9 to the financial statements, NAS changed its accounting policy related to temporarily restricted contributions whose restrictions are met in the same year as received. April 15, 2003 KPMG, LLP 43

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NATIONAL ACADEMY OF SCIENCES Statements of Financial Position December 3l, 2002 and 2001 ($ in thousa,2(lsJ Assets 2002 2001 Current assets: Cash and cash equivalents $ 793 337 Short-term investments (note 3) 62,762 68,656 Contracts receivable - U.S. government (note 1 1) 42,461 35,153 Contributions and other receivables (notes 5 and 16) 16,442 20,261 Publications and supplies inventories 2,231 2,151 Bond proceeds held with trustee (note 12) 3,372 37,952 Prepaid expenses and other 2,685 2,771 Total current assets 130,746 167,281 Other assets (note 14) 6,681 6,702 Long-term investments (note 3) 238,587 271,493 Contributions receivable (note 5 and 16) 30,030 19,076 Property and equipment (note 4) 140,971 109,571 Einstein Memorial 1,723 1,723 $548,738 575,846 Liabilities anti Net Assets Current liabilities: Accounts payable and accrued expenses Deferred revenue (note 6) Other liabilities (note 7 and 12) Total current liabilities Bonds payable (note 12) Funds held on behalf of others (note 3) Note payable (note 13) Accrued lease liability (note 12) Accrued employee benefits (note 14) Deferred gain (note 12) Other liabilities $ 33,025 33,105 28,432 31,927 23,885 7,811 85,342 72,843 128,641 16,975 10,000 16,220 7,744 2,590 70 129,987 19,652 10,000 20,308 7,760 3,198 2,196 Total liabilities 267,582 265,944 Net assets: Unrestricted Temporarily restricted (note 8) Permanently restricted (note 8) Total net assets Commitments and contingencies (notes 3, 1 1, 12, 14, and 15) Total I Abilities and net assets See accompanying notes to financial statements. 44 74,536 113,420 93,200 99,506 127,518 82,878 281,156 309 902 $548 738 575 846 , ,

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NATIONAL ACADEMY OF SCIENCES Statements of Activities Years ended December 3l, 2002 and 2001 ($ in thousf''~rls) 2002 2001 Temporarily Permanently Temporarily Permanently Unrestricted Restricted Restricted Totals Unrestricted Restricted Restricted Totals Revenues, Gaines, al other support: Government c~t~acts and grants $187,315 — 187,315 $163,856 — 163,856 Private co'~t~.~cts arid grants (note 9) 25,677 15,059 — 40,736 19,007 14,028 33,035 Other co~trib~tio~s 3,236 268 10,322 13,826 3,977 1,033 3,146 8,156 Fees arid p~blic.~tio~s 16,384 — 16,384 14,405 — 14,405 Investment loss (Foote 3) (11,405) (10,045) — (21,450) (2,838) (7,040) (9,878) Other inch (Foote 12) 9,355 — — 9,355 4,731 4,731 Net assets released from restrictions (quotes 8 and 9) 19,380 (19,380) _ _ 14,397 (14,397) Total reve~es, gains, arid othc~ support $249,942 (14,098) 10,322 246,166 217,535 (6,376) 3,146 214,305 Expenses: Programs (ate l0) Management arid general Fundraisii~g Total exposes Change in net assets, before $212,032 59,737 3,143 212,032 59,737 3,143 274,9 12 274,912 175,698 57,225 2,712 175,698 57,225 2,712 235,635 235,635 cumulative effect of change in accounting principle (24,970) (14,098) 10,322 (28,746) (18,100) (6,376) 3,146 (21,330) Cumulative effect ot ~ change in accounting principle (note 12) — — — — 2,788 2,788 Change in net assets (24,970) (14,098) 10,322 (28,746) (15,312) (6,376) 3,146 (18,542) Net assets at begi~i'~g of the year 99,506 127,518 82,878 309,902 114,818 Net assets ate'~clof the year $ 74,536 113,420 93,200 281,156 $ 99,506 See accompanying Ties to financial statements. 133,894 79,732 328,444 127,518 82,878 309,902 45

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NATIONAL ACADEMY OF SCIENCES Statements of Cash Flows Years ended December 31, 2002 and 2001 ($ in thous~c'~ds) 2002 2001 Cash flows from operating activities: Change in net assets Adjustments to reconcile change in net assets to net cash flow (used for) provided by operating activities: Net depreciation and amortization Loss fin disposal of property and equipment Bad debt expense Net loss on investments Decrease in investments held for others Amos tization of deferred gain on building sale Cants ibutions restricted for construction or endowment Increase in other receivables (Increase) decrease in contracts receivable - U.S. government (Incrc~se) decrease in publications and supplies inventories Decrease (increase) in prepaid expenses and other current assets Decrease (increase) in other assets (Decrease) increase in accounts payable and accrued expenses (Decrease) increase in deferred revenue Increase in other current liabilities Decrease in funds held on behalf of others (Decrease) increase in accrued employee benefits Decrease in deferred gain Dense in other liabilities Nct cash (used for) provided by operations Cash flows fit om investing activities: Additions to property and equipment Withdr`~tl of bond proceeds held with trustee Sale or n~tturity of investments Purchase of investments Nct cash provided by (used for) investing activities Cash flows lrom financing activities: Contributions restricted for construction or endowment Proceeds from bank note Proceeds from line of credit Payments on line of credit Payment. on capital lease liability Net cash provided by financing activities Net increase in cash and cash equivalents Cash and clash equivalents, beginning of year Cash and c.~;h equivalents, end of year Supplemental disclosure of cash flow information: Interest liquid See accomp.~ying notes to financial statements. 46 $(28,746) (18,542) 3,186 144 82 28,677 2,677 (1,391) (3,288) (7,217) (7,308) (80) 227 86 (204) 21 (730) (44) 5,720 (3,495) 2,910 3,457 1,321 (2,677) (1,298) (16) 274 (608) (1,452) (2,068) (23) (18,608) 3,812 2,654 733 656 23,376 1,298 (1,452) (8,780) (3,022) 146 (36,076) 34,580 192,259 (184,813) 5,950 (44,403) 40,380 237,340 (251,973 (18,656) 3,288 127,282 (113,553) (3,903) 13,114 15,122 8,780 10,000 38,700 (38,700) (3,658) 456 337 278 59 793 337 $ 5,762 6,985

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NATIONA L ACADEMY OF SCIENCES Notes to Financial Statements Decembe' 3], 2002 and 2001 ~ ~ ORGANIZATION AND RENTED ENTITIES (a) Natzo''n I' Academy of Sciences The Natio~.~l Academy of Sciences (NAS) was formed under a chart ter that was passed as an Act of Incorporation by the United States Congress and signed into law on March 3, 1863. 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. NAS is exempt from federal income taxes under Section 50lfc)~3) of the Internal Revenue Code, except for unrelated business income. (b) Natzo'`al Research Council Most of the activities undertaken by NAS are carried out through the divisions and boards of the National Research Council (NIECE, which draw on a wide cross section of the nation's leading scientists and engineers for advisory services to government agencies and 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 five major units responsible for most study activities: . . l~ivi.sion 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' 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. IOM was established as a separate member- ship organization within NAS. The financial activity and results of IOM are included in the NAS' financial state- ments. (d) National Academy of Engirzeerir~g The National Academy of Engineering (NAE) was estab- lished in December 1964 under the charter of NAS as a related parallel organization, autonomous in its gover- nance, administration, and in the selection of its members. NAE shares with NAS the responsibility for advising the federal government on scientific issues. The financial activity and results of NAE are not included in NAS' financial statements, except to the extent those activities are conducted through NRC. (be) 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 NAE to raise funds to support its goals. The financial activity and results of NAEF are not included in NAS' financial statements. NAS performed certain fundraising activities on behalf of NAEF. A total of $4,002,000 and $3,717,000 in 2002 and 2001, respectively, was collected by NAS on behalf of NAEF. NAS disbursed $3,479,000 and $3,937,000 to NAEF from these collected amounts in 2002 and 2001, respectively. (f) 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 NAS, NRC, IOM, and NAE. NAS and NAEF are 50/50 joint investors of TNAC, and therefore share control. The financial posi- tion and results of TNAC are not consolidated in NAS' financial statements. NAS utilized the Beckman Center for meetings in 2002 and 2001 for which TNAC was paid $256,000 and $312,000, respectively. 47

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(2) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (a) Basis of Accounting Net assets, revenues, expenses, gains, and losses are classified based on the existence or absence of donor- imposed restrictions. Accordingly, net assets of NAS are classified and reported as follows: Permanently restricted: Net assets subject to donor-im- posed stipulations that t hey be maintained in perpetuity by NAS. Generally, the donors of these assets permit 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 NAS and/or the passage of time. When a donor restric- tion expires, temporarily restricted net assets are reclassi- fied as unrestricted net assets. Unrestricted: Net assets arising from exchange transac- tions and unexpended contributions that are not subject to donor-imposed stipulations. id) Contributions Contributions, including unconditional promises to give, are recognized as revenues in the period received. Condi- tional promises to give are not recognized until the condi- tions on which they depend are substantially met. The net asset restrictions are released through reclassifica- tion when the funds are used for the donor-specified purpose (see note 91. 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: (b) Cash Equivalents Percentage of NAS revenues NAS reports as cash equivalents excess cash invested in FederalAgency 2002 2001 Department of Transportation 25% 25% overnight gox~ernment-backed repurchase agreements. National Aeronautics and Space Administration 11% 12% Department of Health and Human Services 13% 11% Ēc) 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 NAS currently occu- pies. NAS holds certain short-term investments for program and operational liquidity requirements. Changes in the fair value of investments are reported within investment income in the statements of activities. 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. 48 It is the policy of 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 NAS is notified of the grant award. Such grants are classified as temporarily restricted if use of the grant funds are limited to specific areas of study, or to be used in future periods (see note 91. ~ Deferred Revenue For both federal and nonfederal grants and contracts that are determined to be exchange transactions, revenue is recognized as the related costs are incurred. Funds re- ceived in advance of being earned for these grants are recorded as deferred revenue on the statements of financial position.

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(g) Fair Value of Financial Instruments The carrying value of bonds payable in the financial statements was less than their fair value by approximately $3,059,000 and $137,000 on December 31, 2002 and 2001, respectively. NAS makes limited use of derivative financial instruments for the purpose of managing interest rate risks. Current market pricing models are used to estimate fair values of interest rate swap agreements. The fair market value of all other financial instruments in the financial statements approximates reported carrying value. (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 NAS. The majority of NAS' publication inventories 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 st~-aight-line basis using the following lives: Asset Class Buildings Building and leasehold improvements Furniture and equipment Depreciable Lives 40 to 50 years Lesser of the remaining life of the building or estimated useful life of improvement 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. ~i) 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 disclosures in the financial statements. Actual results could differ from those estimates. (k) Reclassif cations Certain amounts from the prior year have been reclassified to conform to the current year presentation (see note 9~. (3) INVESTMENTS Investments, which are reported at fair value (except as noted), consisted of the following as of December 31, 2002 and 2001 ($ in thousands): Short-term investments: Cash equivalents Bonds and notes Equity securities Total short-term investments Endowment and trust investments: Cash equivalents Bonds and notes Equity securities Real estate mortgages - at cost Other long-term investments: Cash equivalents Bonds and notes Equity securities 2002 2001 $ 9,795 $ 13,498 39,750 41,889 13,217 13,269 62,762 68,656 $1,696 $2,702 42,355 46,739 167,909 190,115 21 1,960 239,556 7,416 8,663 219,376 248,219 1,588 188 17,623 5,801 — 17,285 19,21 1 23,274 $238,587 $271,493 NAS received proceeds from the sale and leaseback of the Green/Harris facility of approximately $36 million in 2000 (see note 12). Remaining proceeds are held within other long-term investments, and are used for payments under the related obligation to the former landlord. However, in 2002 and 2001, lease payments of approximately $2.7 million and $1.6 million, respectively, were paid from operating cash. Vanguard equity funds comprised approximately $76 mil- lion and $107 million of the total equity securities funds at December 31, 2002 and 2001, respectively. Private equity investments, represented by limited partner- ship interests, comprised approximately $6.7 million and $6.5 million of the total investments on December 31, 2002 and 2001, respectively. NAS had a remaining com- mitment at December 31, 2002 and 2001, to provide approximately $9.1 million and $11.1 million to these partnerships. 49

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NAS invests a portion of its endowment in hedge funds, which totaled approximately $26 million and $22 million at December 31, 2002, and 2001, respectively, 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 $193,000 and $74,000, for the years ended December 31, 2002 and 2001, respectively. Fair value of the buildings relating to the real estate mortgage investments approximated $36 million on De- eember 3 1, 2002 and 2001. NAS pledged its investment i n 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 NAS' endowment and trust investment pool. TNAC investments participate in the investment pool experience equally with all other funds in this pool. NAS' obligation to TNAC for these funds held in trust, which totaled $17.0 million and $19.7 million as of December 31, 2002 and 2001, respee- tively, 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 $534,000 and $401,000 for the years ended December 31, 2002 and 2001, respectively, and is comprised of the following ($ in thousands): (5) CONTRIBUTIONS RECEIVABLE Contributions not yet collected are reported as eontribu- tions and other receivables (current) and contributions receivable (long-term) in the statements of finaceial posi- tion, and mature as follows ($ in thousands): Year ending December 31 2003 2004 2005 2006 2007 Thereafter Less discount to estimated net present value Less allowance for uncollectible pledges Less current portion Total long-tenn contributions receivable $ 8,646 4,574 3,173 2,761 700 25,000 44,854 (6,179) (12) 38,663 (8,633) $30,030 Contributions pledged during 2002 and 2001 have been discounted at 3% and 4%, respectively. Contributions pledged prior to 2001 have been discounted at 5%. During 2000, 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 121. This contribution was discounted to its present value using a rate of 5%, and is reported as a long-term contributions receivable. 2002 2001 Interest and dividends income $ 7,227 $ 13,498 (6) DEFERRED REVENUE Net (loss) on investments Total investment loss (28,677) (23,376) $(21,450) $ (9,878) Deferred revenue consisted of the following as of Deeem- ber 31, 2002 and 2001 ($ in thousands): 2002 2001 (4) PROPERTYAND EQU PMENT Advances from private grants and contract sponsors $18,738 $22,856 Property and equipment as of December 31, 2002 and Advances from U.S.goven~ment sponsors 5,748 6,028 2001, were as follows ($ in thousands): Publication subscriptions and other 3,946 3,043 Total deferred revenue $28,432 $31,927 2002 2001 Land Furniture and equipment Buildings and improvements Construction in progress (note 12) Leasehold improvements Less - accumulated depreciation and amortization Total property and equipment, net 50 $ 29,689 $ 29,723 24,484 27,055 106,001 13,31 1 787 70,283 6,840 6,949 167,801 147,321 (26,830) (37,750) $140,971 $109,571 (7) LINE OF CREDIT NAS has a $16 million unsecured line of credit from Bank of America with an interest rate of LIBOR plus 0.40%. The outstanding balance on the line on Deeember 31, 2002, and 2001 was approximately $13.7 million and $0, respee- tively, and is included in other liabilities (current) in the statements of financial position.

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Interest expense related to the line for the years ended December 3 1, 2002 and 2001, was approximately $1 1 1,000 and $33,000, respectively. (8) RESTRICTED NETASSETS Temporarily restricted net assets were available for the following purposes as of December 31, 2002 and 2001 ($ in thousands): 2002 2001 $ 92,688 $102,876 1 8,979 22,08 1 1,753 2,561 $1 13 420 $127 518 , , Sponsored research and advisory programs Prices and awards Woods Hole facility Total temporarily restricted net assets Temporarily restricted net assets were released from re- striction for the following purposes during the years ended December 31, 2002 and 2001 ($ in thousands): 2002 2001 $18,326 $13,291 745 787 309 319 Sponsored research and advisory programs Prizes and awards Woods Hole facility Total temporarily restricted net assets released from restriction $19,380 $14,397 The income generated by permanently restricted net assets is to be used to support donor-specified programs or general activities of NAS. As of December 31, 2002 and 2001, NAS held the following permanently restricted net assets, classified by the purpose for which the income is to be used ($ in thousands): 2002 2001 $89,873 $79,559 3,327 3,319 $93,200 $82,878 Sponsored research and advisory programs Prizes and awards Total permanently restricted net assets (9) CHANGE IN ACCOUNTING FOR CONTRIBUTIONS In 2002, NAS adopted a policy to report all contributions subject to donor-imposed stipulations as temporarily re- stricted revenue in the year received. Previously, these contributions were reported as unrestricted revenue if the restrictions were met in the same year. NAS determined this change provided a more useful presentation of the complete population of temporarily restricted contribu- tions. NAS reclassified approximately $2.1 million on the 2001 statement of activities from unrestricted private con- tracts and grants revenue to temporarily restricted revenue and increased the net assets released from restriction by the same amount to conform to the current year policy. (10) PROGRAM EXPENSES Program expenses for the years ended December 31, 2002 and 2001 are summarized as follows ($ in thousands): 2002 200 Policy and Global Affairs Transportation Research Board Earth and Life Sciences Institute of Medicine Engineenng and Physical Sciences Behavioral and Social Sciences and Education National Sciences Resource Center National Academy of Engineering NAS and National Academy Press Total program expenses $ 59,229 $ 49,186 5 1,736 42,573 26,169 22,014 26,796 21,520 21,314 20,036 18,198 15,685 1,782 552 5,315 3,822 1,493 310 $212 032 $175 698 , , (11) RECOVERY OF INDIRECT COSTS NAS receives indirect cost recovery on its federal contracts and grants. Overhead is applied to direct salaries, accrued leave, fringe benefits, and services provided by outside contractors (e.g., temporary personnel agencies, consult- ants) on NAS property. G&A is applied to direct costs and overhead less subcontract costs and stipends. Therefore, both the overhead 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 admin- istration rate is applied. Certain off-site work (not Der- ~ . ~ ~ . _ ~ — ~ formed on NAN property), Is assessed reduced overhead rates. 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. NAS has a cumulative net underrecovery of $4.0 million and $2.9 million as of December 31, 2002 and 2001, respectively, which is included in the contracts receivable balance in the statements of financial position. (~2) BUILDING PROJECT AND F NANC NG (a) Building Project Revenue Bonds In January 1999, the District of Columbia issued $130,960,000 of tax-exempt revenue bonds on behalf of 51

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NAS. Proceeds from the sale of the revenue bonds financed the cost of the acquisition of 44,250 square feet of land and related construction of an office building, as well as paid certain costs of issuing the bonds. This building will consolidate NAS' program activities into one location. Construction began in the summer of 1999, was completed In October 1999, NAS entered into a swap agreement, with in the summer of 2002 and the facility was occupied in an effective date of February 1, 2000. This swap agreement July 2002. related to the $66 million face amount of its Series 1999A revenue bonds. The agreement provides for 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. NAS entered into this swap agreement to manage its exposure to interest rate changes. The fixed-rate debt obligations expose NAS to variability in the cost recovery stream due to changes in interest rates. NAS recovers the costs of borrowing through a capital investment incentive rate that is set by the U.S. government and is tied to a variable index. If interest rates increase, the capital invest- ment incentive recovery increases. Conversely, if interest rates decrease, the capital invest- ment incentive recovery decreases. Therefore, NAS en- tered 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, 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 NAS, which creates credit risk for NAS. When the fair value of a derivative contract is negative, NAS owes the counterparty, and therefore, it does not possess credit risk. NAS minimizes the credit risk in derivative instruments by entering into transactions with high-quality counterparties. In January 2001, 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, NAS would have received payments during this period having a net present value (using a 10% discount rate) of $1,952,000. Consequently, NAS received its three year projected return immediately, plus a $483,000 market premium. Beginning January 1, 2004, the variable rate swap transac- tion becomes effective again with 16 years remaining under the agreement. NAS is obligated under these bonds as follows ($ in thousands): guaranteed investment contract. The Trustee reimburses NAS for expenditures related to the building project. 2002 2001 Series 1999A revenue bonds, serial, with interest rates ranging from 3.9% to 5% maturing at various dates from January 1, 2003 through 2012. Series 1999A revenue bonds, term Interest rate 5%, due January 1, 2019. Interest rate 5%, due January 1, 2028. Series l999B revenue bonds, term, at flexible rates due January 1, 2039. Series l999C revenue bonds, term, at variable rates due January 1, 2039. Total bonds, at face value Less net unamortized discount Total bonds payable Less current portion Noncurrent bonds payable $ 16,330 $ 16,330 17,085 17,085 32,545 32,545 32,500 32,500 32.500 32,500 130,960 130,960 (979) (973) 129,981 129,987 (1,340) — $128,641 $129,987 The serial and term bonds represent unsecured general obligations of NAS. Interest on all Series 1999A revenue bonds is payable semiannually every January 1 and July 1, commencing on July 1, 1999. Interest on the 1999B 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 Janu- ary 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 2002 and 2001 totaled $4.2 million and $5.3 million, respectively. NAS, in 2002 and 2001, capitalized net interest of approximately $292,000 and $2,247,000, respectively. The bond proceeds are held by a Trustee and invested in a 52 (b) Interest Rate Swaps

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In October 2001, 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, NAS received a cash payment of $1,527,000. NAS recognized the cash payments of $2,435,000 and $1,527,000 as other income in the accompanying state- ment of activities for the year ended December 31, 2001. On January 1, 2001, NAS adopted Statement of Financial Accounting Standards No. 133 (SEAS 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 vear enabled Decem- 1 ~ ~ ~ A A ~ ~ ~ ~ ner As, chug, CAN recorded a gain on the change in the fair value of its derivative instruments in the amount of approximately $2.5 million which is included as an in- crease in other income in the accompanying statement of activities. Likewise, for the year ended December 31, 2001, NAS recorded a loss on the change in fair value of its derivative instruments in the amount of approximately $4.9 million which is included as a reduction of other Income. (cJ 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 NAS for a portion of its operations. This trust agreement would have conveyed title to NAS in 2007. if NAS accepted title. In 2000, NAS entered into a contract with a third party to sell its future interest in the property for approximately $36 million. 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 $3.3 million and $4.7 million was deferred at December 3 1, 2002 and 2001, respectively. The deferred gain will be fully recognized by 2007. The current and long-term portions of the deferred gain are reflected as other current liabilities and deferred gain, respectively, within the statements of financial position as of Decem- ber 31, 2002 and 2001. NAS remains obligated through 2007 for remaining lease payments, with a present value of approximately $20 million and $24 million as of December 31, 2002 and 2001, 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, 2002 and 2001. (13) NOTE PAYABLE During 2001, NAS entered into a loan agreement of $10 million with Bank of America. The note bears interest at 30 day LIBOR plus 50 basis points and is payable monthly. The note matures on December 31, 2004. (14) EMPLOYEE BENEP TS (a) Pension Plans NAS has an insured, noncontributory, defined contribution pension plan covering substantially all of its employees. 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 investment vehicle. Participants in this plan vest immedi- ately. 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, NAS has a voluntary employee contribution retirement plan that is funded solely by employee contribu- tions made on a pretax salary-reduction basis under Sec- tion 403(b) of the Internal Revenue Code. The investment 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, 2002 and 2001, amounted to $8.7 million and $7.0 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. (~) Deferred Compensation NAS holds long-term investments as part of a deferred SJ

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compensation arrangement for certain employees. The fair value of these investments was approximately $4.4 million and $5.5 million as of December 31, 2002 and 2001, which are reported within other assets on the statements of financial position. The related obligation is included in accrued em- ployee benefits on the statements of financial position. (c) Postret~rement Benefits NAS provides certain health care and life insurance ben- efits for retired employees. All employees may become eligible for these benefits if they reach normal retirement age while working for NAS and meet certain service requirements. An insurance company whose premiums are 2002 determined on an experience-rated basis provides these benefits for retirees. The plan is contributory for employ- ees who retire after January 1, 1990. Employees contribute 25% of the monthly premium. NAS has elected to recognize the initial postretirement benefit obligation over a period of 20 years. The accrued postretirement benefit obligation is reported in accrued employee benefits on the statements of finan- cial position. The postret~rement benefit cost for the years ended De- cember 31, 2002 and 2001 includes the following compo- nents ($ in thousands): 200 Life Life insurance Health insurance Health benefits benefits Total benefits benefits Total Change in benefits obligations Benefit obligation, January 1 $ 765 13,128 13,893 $ 603 10,067 10,670 Service cost 9 561 570 8 409 417 Interest cost 51 895 946 50 744 794 Actuarial loss 17 1,225 1,242 174 2,507 2,681 Benefits paid (75) (700) (775) (70) (599) (669) 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 $ 767 15,109 15,876 $ 765 13,128 13,893 75 (75) 4,859 (568) 700 (700) 4,859 (568) 775 (775) $ 70 (70) 5,133 (274) 599 (599) 5,133 (274) 669 (669) $ 4 291 4 291 $ 4 859 4 859 , . . . Funded Status Benefit obligation $ (767) (10,818) (11,585) $ (765) (8,269) (9,034) Unrecognized translation obligation 296 4,663 4,959 321 5,069 5,390 Unrecognized prior service cost 1 57 58 1 64 65 Unrecognized net actuarial (gain) loss 279 3,986 4,265 284 1,863 2,147 Accrued benefit cost $ (191) (2,112) (2,303) $ (159) (1,273) (1,432) Components of net periodic benefit cost Service cost Interest cost Expected return on plan assets Amortization of transition obligation Amortization of prior service cost Amortization of unrecognized losses Net periodic cost 54 9 51 26 22 561 895 (389) 405 7 59 570 946 (389) 431 7 $ 8 409 50 744 (41 1) 405 26 417 794 (41 1) 431 81 19 19 $ 108 1538 1646 $ 103 1 147 1250 , . . .

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The discount rates used to calculate the accumulated postretirement benefit obligation for the years ended De- cember 31, 2002 and 2001 were 6.5% and 7.0%, respec- tively. The trend rates for growth in health care costs used in calculating the accumulated pos "retirement benefit obli- gation were 10.5% and 10.1% for retirees under age 65 and 10.1% for retirees age 65 and older during the years ended December 31, 2002 and 2001, declining gradually to 5.0%. The health care cost trend rate assumption has a significant impact on the postretirement benefit costs and obligations. The effect of a 1% change in the assumed health care cost trend rate at December 31, 2002, would have resulted in an approximate $1,777,000 increase or $1,490,000 decrease in the postretirement benefit obligation and an approxi- mate $223,000 increase or $183,000 decrease in the 2002 benefit expense. The effect of a 1% change in the assumed health care cost trend rate at December 31, 2001, would have resulted in an approximate $1,554,000 increase or $1,307,000 decrease in the postretirement benefit obligation and an approxi- mate $173,000 increase or $147,000 decrease in the 2001 benefit expense. (d) Poste~nployment Benefits NAS also provides certain postemployment benefits to former or inactive employees prior to their eligibility for retirement benefits. The liability for these benefits was $976,000 and $610,000 on December 31, 2002 and 2001, respectively. It is calculated on an actuarially determined basis and is recorded in accrued employee benefits on the statements of financial position. The total postemployment benefit expense for the years ended December 31, 2002 and 2001 was approximately $205,000 and $122,000, respectively. (15) COMM TMENTS AND CONTINGENCIES (a) Leases NAS is committed to several noncancelable operating leases for office space and equipment. Future minimum rental payments due under noncancelable operating leases are as follows ($ in thousands): Years Ending December 31: 2003 2004 2005 2006 2007 Thereafter Minimum rentals $ 2,966 2,810 2,783 2,744 1,984 1,058 $14 345 Rental expense amounted to $6.2 million and 7.6 million for the years ended December 31, 2002 and 2001, respec- tively. (b) Contingencies NAS receives a portion of its revenues directly or indi- rectly from federal government grants and contracts, all of which are subject to audit by the Defense Contract Audit Agency, which has completed its examinations through December 31, 1999. A contingency exists relating to unexamined periods to refund any amounts received in excess of allowable costs. Management is of the opinion that no material liability will result from future audits. (c) Litigation NAS is a defendant in several lawsuits. The extent of possible liability that may result from these lawsuits cannot be reasonably estimated. While the ultimate out- come of the litigation is uncertain, NAS' management believes that it has strong legal positions, intends to vigorously defend its actions, and has concluded that the probable outcomes will not have a materially adverse impact on the organization. (76) SUBSEQUENT EVENT In February 2003, NAS signed a grant agreement to receive approximately $40 million over 15 years from a private grantor. The funds will be restricted for use in the Future Initiatives program. The Future Initiatives program is a national effort to catalyze a broad-based increase of interdisciplinary inquiry, focusing on opportunities at the interface of science, engineering, and health research. 55

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OFFICERS Bruce Alberts, NAS President James S. Langer, NAS Vice -President R. Stephen Berry, NAS Home Secretary Michael T. Clegg, 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 Edward Shortliffe: IOM Representative BUDGETAND INTERNAL AFFAIRS COMMITTEE Ronald Graham, Chai Joel E. Cohen Robert C. Dynes James S. Langer Cherry A. Murray Gerald M. Rubin AUDITING COMMITTEE Jack Halpern, Chair Purnell W. Choppin M. Gordon Wolman FINANCIAL MANAGEMENT STAFF Archie L. Turner, Chief Financial Officer Linda White, Director of Finance Mun Lim, Controller (January-October 2002) Didi Salmon, Controller (November-December 2002) 56