Report of the Treasurer to the Council for the Year Ended December 31, 2003 (2004)

NATIONAL ACADEMY OF SCIENCES

December 31, 2003 and 2002

(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. NAS operates as a private cooperative society of distinguished scholars engaged in scientific or engineering research, dedicated to the furtherance of science and its use for the general welfare. NAS is exempt from federal income taxes under Section 501(c)(3) of the Internal Revenue Code, except for unrelated business income.

(b) National Research Council

Most of the activities undertaken by NAS are carried out through the divisions and boards of the National Research Council (NRC), 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, NRC is organized into five 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

• Transportation Research Board

NRC activities are under the control of NAS’s governance structure, and therefore are included in 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. IOM issues position statements on these policies, cooperates with the major scientific and professional 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 membership organization within NAS. The financial activity and results of IOM are included in NAS’ financial statements.

(d) National Academy of Engineering

The National Academy of Engineering (NAE) was established in December 1964 under the charter of NAS as a related parallel organization, autonomous in its governance, administration, and 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.

(e) National Academy of Engineering Fund

The National Academy of Engineering Fund (NAEF) is a separately incorporated not-for-profit organization established and controlled by NAE to raise funds to support its goals. The financial activity and results of NAEF are not included in NAS’s financial statements.

(f) The National Academies’ Corporation

The National Academies’ Corporation (TNAC) was separately 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 position and results of TNAC are not consolidated in NAS’ financial statements. NAS utilized the Beckman Center for meetings in 2003 and 2002, for which TNAC was paid $261,000 and $256,000, respectively.

(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-imposed stipulations that they 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-imposed stipulations that may or will be met either by actions of NAS and/or the passage of time. When a donor restriction expires, temporarily restricted net assets are reclassified to unrestricted net assets.

Unrestricted – Net assets arising from exchange transactions and contributions not subject to donor-imposed stipulations.

(b) Cash Equivalents

NAS reports liquid, temporary investments purchased with original maturities of three months or less as cash equivalents.

(c) Investments

Equity and debt securities are reported at fair value, based on quoted market prices. Investments in real estate mortgages are recorded at cost and consist of mortgages on certain administrative facilities that NAS occupies.

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 (PCUs). PCU values are used to determine equity in the allocation of investment income among funds in the pool whenever additional funds are contributed or withdrawn.

(d) Contributions

Contributions, including unconditional promises to give, are recognized as revenues in the period received. Conditional promises to give are not recognized until any conditions on which receipt depends are substantially met.

Gifts of land, buildings, or equipment are reported as unrestricted net assets unless explicit donor stipulations specify how the donated assets must be used. Temporary restrictions on gifts that must be used to acquire long-lived assets are released in the period in which the assets are acquired or placed in service.

NAS performs certain fundraising activities on behalf of NAEF. A total of approximately $2,924,000 and $4,002,000 in 2003 and 2002, respectively, was collected by NAS on behalf of NAEF. NAS disbursed approximately $2,810,000 and $3,479,000 to NAEF from these collected amounts in 2003 and 2002, respectively. Amounts collected but not yet remitted to NAEF are reported as assets and liabilities on NAS financial statements.

(e) Contracts and Grants

The majority of NAS activities are performed under cost-reimbursable contracts with the U.S. government. Federal sponsors individually accounting for more than 10% of NAS revenues are summarized below:

NAS records federal contracts as exchange transactions, recognizing revenue as recoverable costs are incurred.

Revenues from nonfederal grants qualifying as contributions are recorded by NAS upon notification by NAS of the grant award. Such grants are classified as temporarily restricted when use of the grant funds are limited to specific areas of study or to be used in future periods.

(f) 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 received in advance of being earned for these grants are recorded as deferred revenue in the statements of financial position.

(g) Fair Value of Financial Instruments

The carrying value of bonds payable in the financial statements was less than their fair value by approximately $3,303,000 and $3,059,000 on December 31, 2003 and 2002, 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 their reported carrying values.

(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 an NAS unit, 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 computed 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. Construction-in-progress is not depreciated until the related assets are placed in service.

(j) Use of Estimates

The preparation of these financial statements in conformity 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) Reclassifications

Certain amounts from the prior year have been reclassified to conform to the current year presentation.

Investments, which are reported at fair value (except as noted), consisted of the following as of December 31, 2003 and 2002 ($ in thousands):

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 available for future payments toward related obligations to the former landlord. In 2003 and 2002, NAS made lease payments of approximately $2.3 million and $2.7 million, respectively. Portions of the 2002 payments were made from operating cash.

Vanguard equity funds comprised approximately $109 million and $76 million of the total equity securities funds at December 31, 2003 and 2002, respectively.

Private equity investments, represented by limited partnership interests, comprised approximately $7.5 million and $6.7 million of the endowment and trust equity securities on December 31, 2003 and 2002, respectively. NAS had remaining commitments at December 31, 2003 and 2002 to provide approximately $7.2 million and $9.1 million, respectively, to these partnerships.

NAS invests a portion of its endowment in hedge funds, which totaled approximately $29 million and $26 million at December 31, 2003, and 2002, 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 statements of activities, was approximately $1,600,000 and $193,000 for the years ended December 31, 2003, and 2002, respectively.

Fair value of the buildings relating to the real estate mortgage investments approximated $36 million on December 31, 2003 and 2002. NAS pledged its investment in the real estate mortgages as collateral on its commitment under the operating lease for the Green/Harris facility during 2000 (see notes 12 and 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 approximately $20 million and $17 million as of December 31, 2003 and 2002, respectively, is reported as funds held on behalf of others in the statements of financial position.

Investment income (loss) is reported net of investment expenses of approximately $494,000 and $534,000 for the years ended December 31, 2003 and 2002, respectively, and is comprised of the following ($ in thousands):

Property and equipment as of December 31, 2003 and 2002, were as follows ($ in thousands):

Construction in progress primarily relates to the Marian Koshland Science Museum, which opened in April 2004.

Contributions not yet collected are included in contributions and other receivables (current) and contributions receivable (long-term) in the statements of financial position, and mature as follows ($ in thousands):

Deferred revenue consisted of the following as of December 31, 2003 and 2002 ($ in thousands):

NAS is party to an $18 million unsecured line of credit from Bank of America bearing interest at LIBOR plus 0.40%. Outstanding balances on the line on December 31, 2003 and 2002 were approximately $7.5 million and $13.7 million, respectively, and are included in line of credit and other liabilities in the statements of financial position.

Interest expense related to the line for the years ended December 31, 2003 and 2002, was approximately $185,000 and $111,000, respectively.

Temporarily restricted net assets were available for the following purposes as of December 31, 2003 and 2002 ($ in thousands):

Temporarily restricted net assets were released from restriction for the following purposes during the years ended December 31, 2003 and 2002 ($ in thousands):

The income generated by permanently restricted net assets is available to support donor-specified programs. As of December 31, 2003 and 2002, NAS held the following permanently restricted net assets, classified by the purpose for which the income is to be used ($ in thousands):

Program expenses for the years ended December 31, 2003 and 2002 are summarized as follows ($ in thousands):

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, consultants) 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 administration rate is applied. Certain off-site work (not performed on NAS property) is assessed reduced overhead rates.

NAS bills for indirect cost recovery throughout the year based on prenegotiated rates. 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 $12.5 million and $4.0 million as of December 31, 2003 and 2002, respectively, which is included in the contracts receivable balance in the statements of financial position.

(a) Building Project Revenue Bonds

In January 1999, the District of Columbia issued $130,960,000 of tax-exempt revenue bonds on behalf of 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 consolidates most of NAS’ program activities into one location. The facility was occupied in July 2002.

NAS is obligated under the revenue bonds as follows ($ in thousands):

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 1999C 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 2003 and 2002 totaled $ 3.9 million and $4.2 million, respectively. NAS, in 2003 and 2002, capitalized net interest of approximately $0 and $292,000, respectively.

The unexpended bond proceeds are held by a Trustee and invested in a guaranteed investment contract. The Trustee reimburses NAS for expenditures related to the building project.

(b) Interest Rate Swaps

In October 1999, 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 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 investment incentive recovery increases.

Conversely, if interest rates decrease, the capital investment incentive recovery decreases. Therefore, 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, 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. Beginning January 1, 2004, the variable rate swap transaction becomes effective again with 16 years remaining under the agreement.

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 remains below 2.25% 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 accordance with Statement of Financial Accounting Standards No. 133 (SFAS 133), Accounting for Derivative Instruments and Hedging Activities, for the year ended December 31, 2003 and 2002, NAS recorded a gain on the change in the fair value of its derivative instruments in the amount of approximately $187,000 and $2,500,000, respectively, which is included as an increase in other income in the accompanying statements of activities.

(c) 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. In 2000, NAS entered into a contract with a third party to sell its future interest in the property for approximately $36 million. NAS simultaneously agreed to lease back the entire facility until 2002 (at a monthly rate of $400,000) and a portion of the facility until 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 $2.6 million and $3.3 million was deferred at December 31, 2003 and 2002, respectively. The deferred gain will be fully recognized by 2007. The current and long-term portions of the deferred gain are reflected as line of credit and other current liabilities and deferred gain and other liabilities, respectively, in the statements of financial position.

NAS remains obligated through 2007 for remaining lease payments, with a present value of approximately $16.2 million and $20 million as of December 31, 2003 and 2002, respectively, under the original lease agreement with the Trustee. The current and long-term portions of this obligation are reflected as line of credit and other current liabilities and accrued lease liability, respectively, in the statements of financial position.

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.

(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 immediately. 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 contributions made on a pretax salary-reduction basis under Section 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, 2003 and 2002, amounted to approximately $8.8 million and $8.7 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.

(b) Deferred Compensation

NAS holds long-term investments as part of a deferred compensation arrangement for certain employees. The fair value of these investments was approximately $4.9 million and $4.4 million as of December 31, 2003 and 2002, which are reported within other assets in the statements of financial position. The related obligation is included in accrued employee benefits on the statements of financial position.

(c) Postretirement Benefits

NAS provides certain healthcare and life insurance benefits 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 determined on an experience-rated basis provides these benefits for retirees. The plan is contributory for employees 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 financial position.

The following table presents the changes in benefit obligations, changes in plan assets, funded status, and the components of net periodic benefit cost for the years ended December 31, 2003 and 2002 ($ in thousands):

The assumptions used to determine net periodic benefit cost for years ended December 31, 2003 and 2002 are as follows:

The assumptions used to calculate the accumulated postretirement benefit obligation for the years ended December 31, 2003 and 2002 are as follows:

NAS’ postretirement benefit plan asset allocations at December 31, 2003 and 2002, by asset category are as follows:

The investment objective of the Plan is to produce a rate of return over the long-term that will provide for some fund growth, curb against the effect of inflation, and provide for some stability in different market environments. The fund is diversified between fixed income and equity investments. With this diversification and investment in broader

market funds, there is reasonable assurance that no single security or class of securities will have a disproportionate impact on the Plan assets. Equity securities are targeted at 60% and bonds and notes at 40%.

The overall long-term rate of return was developed by estimating the long-term real rate of return for the Plan’s asset mix, while taking into account the effects of inflation. This estimate was developed by evaluating the history and similar asset allocation of the NAS Endowment.

NAS expects to contribute to the Plan the amount of benefit payments for 2004. Based on the actuarial assumptions, the projected net benefit payments for 2004 are $859,000.

The measurement date of the plan assets and benefit obligations for 2003 and 2002 is January 1, 2004 and 2003, respectively.

The trend rates for growth in healthcare costs used in calculating the accumulated postretirement benefit obligation were 10.5% during the years ended December 31, 2003 and 2002, declining gradually to 5.0%. The healthcare cost trend rate assumption has a significant impact on the postretirement benefit costs and obligations. The effect of a 1% change in the assumed healthcare cost trend rate at December 31, 2003, would have resulted in an approximate $2,259,000 increase or $1,879,000 decrease in the postretirement benefit obligation and an approximate $286,000 increase or $233,000 decrease in the 2003 benefit expense.

The effect of a 1% change in the assumed healthcare 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 approximate $223,000 increase or $183,000 decrease in the 2002 benefit expense.

On December 8, 2003, the President signed into law the Medicare Prescription Drug Improvement and Modernization Act of 2003 (the Act). The Act introduces prescription drug benefits under Medicare (Medicare Part D) as well as a federal subsidy to sponsors of retiree health care benefit plans that provide a benefit that is at least actuarially equivalent to Medicare Part D. FASB Statement 106, Employers’ Accounting for Postretirement Benefits Other Than Pensions (FAS 106), requires presently enacted changes in relevant laws to be considered in current period measurements of postretirement costs and the accumulated postretirement benefit obligation. However, certain accounting issues raised by the Act are not specifically addressed by Statement of Financial Accounting Standard No. 106 (SFAS No. 106), and significant uncertainties exist as to the direct and indirect effects of the Act.

In January 2004, the Financial Accounting Standards Board issued SFAS No. 106-1, Accounting and Disclosure Requirements Related to the Medicare Prescription Drug, Improvement and Modernization Act of 2003. SFAS No. 106-1, which became effective for fiscal years ending after December 7, 2003, allows for a deferral in recognizing the effects of the Act until authoritative guidance on the accounting for the federal subsidy is issued or other events occur. For the year ended December 31, 2003, NAS has elected deferral, as management and its advisors do not have sufficient information available on which to measure the effects of the Act on NAS’ postretirement benefit costs and obligation.

(d) Postemployment 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 $987,000 and $976,000 on December 31, 2003 and 2002, respectively. These estimated liabilities are calculated on an actuarially determined basis and reported as accrued employee benefits in the statements of financial position. The total postemployment benefit expense for the years ended December 31, 2003 and 2002 was approximately $220,000 and $205,000, respectively.

(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):

Rental expense amounted to $2.9 million and $6.2 million for the years ended December 31, 2003 and 2002, respectively.

(b) Contingencies

NAS receives a portion of its revenues directly or indirectly 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, 2000. 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. While the ultimate outcome 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.

Bruce Alberts, NAS President

James S. Langer, NAS Vice -President

John Brauman, NAS Home Secretary

Michael T. Clegg, NAS Foreign Secretary

Ronald L. Graham, NAS Treasurer

Ronald Graham, Chair

Elwyn R. Berlekamp

Elkan R. Blout

David M. Kipnis

Lawrence R. Klein

William Rutter

Paul A. Samuelson

Ronald Graham, Chair

Roger Beachy

Robert C. Dynes

James S. Langer

Cherry A. Murray

Gerald M. Rubin

Jack Halpern, Chair

Purnell W. Choppin

M. Gordon Wolman

Elaine Fuchs

Herbert Tabor

Archie L. Turner, Chief Financial Officer

Didi Salmon, Controller

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