III.
Financial Condition



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Report of the Treasurer to the Council of the National Academy of Sciences III. Financial Condition

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Report of the Treasurer to the Council of the National Academy of Sciences 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 31, 2004, 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 ELAINE FUCHS HERBERT TABOR National Academy of Sciences

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Report of the Treasurer to the Council of the National Academy of Sciences 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, 2004 and 2003, and the related statements of activities and 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 audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes consideration of internal control over financial reporting. Accordingly, we express no such opinion. 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 NAS as of December 31, 2004 and 2003, 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. April 15, 2005

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Report of the Treasurer to the Council of the National Academy of Sciences NATIONAL ACADEMY OF SCIENCES Statements of Financial Position December 31, 2004 and 2003 (Dollars in thousands) Assets 2004 2003 Current assets: Cash and cash equivalents $ 3,435 $ 4,098 Short-term investments (note 3) 53,304 54,486 Contracts receivable – U.S. government (note 11) 46,699 48,899 Contributions and other receivables (note 5) 14,996 27,454 Publications and supplies inventories 1,687 1,625 Prepaid expenses and other 2,888 2,348 Total current assets 123,009 138,910 Other assets (note 14) 7,642 7,737 Long-term investments (note 3) 340,406 286,668 Contributions receivable (note 5) 32,274 36,157 Property and equipment net (note 4) 138,110 141,316 Einstein Memorial 1,723 1,723   $ 643,164 $ 612,511 Liabilities and Net Assets Current liabilities: Accounts payable and accrued expenses $ 29,542 $ 35,665 Deferred revenue (note 6) 21,298 20,419 Note payable (note 13)   10,000 Line of credit and other current liabilities (notes 7 and 12) 25,569 17,679 Total current liabilities 76,409 83,763 Bonds payable (note 12) 125,795 127,245 Funds held on behalf of others (note 3) 21,793 19,967 Note payable (note 13) 10,000 - Accrued lease liability (note 12) 7,499 11,941 Accrued employee benefits (note 14) 11,102 9,698 Deferred gain and other liabilities (note 12) 1,168 1,921 Total liabilities 253,766 254,535 Net assets: Unrestricted 120,497 101,130 Temporarily restricted (note 8) 171,274 160,753 Permanently restricted (note 9) 97,627 96,093 Total net assets 389,398 357,976 Commitments and contingencies (notes 3, 11, 12, 14, and 15)     Total liabilities and net assets $ 643,164 $ 612,511 See accompanying notes to financials statements.

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Report of the Treasurer to the Council of the National Academy of Sciences NATIONAL ACADEMY OF SCIENCES Statements of Activities December 31, 2004 and 2003 (Dollars in thousands)   2004 2003 Unrestricted Temporarily restricted Permanently restricted Totals Unrestricted Temporarily restricted Permanently restricted Totals Revenues, gains, and other support:   Government contracts and grants (note 11) $ 176,376 - - 176,376 $ 184,503 - - 184,503 Private contracts and grants 21,504 13,265 - 34,769 19,959 48,140 - 68,099 Other contributions 5,361 309 1,534 7,204 2,951 257 2,893 6,101 Fees and publications 20,073 - - 20,073 18,192 - - 18,192 Investment income (note 3) 20,825 17,987 - 38,812 30,833 25,287 - 56,120 Other income (note 12) 8,565 - - 8,565 5,996 - - 5,996 Net assets released from restriction (note 8) 21,040 (21,040) - - 26,351 (26,351) - - Total revenues, gains, and other support 273,744 10,521 1,534 285,799 288,785 47,333 2,893 339,011 Expenses:   Programs (note 10) 214,165 - - 214,165 216,094 - - 216,094 Management and general 37,543 - - 37,543 43,023 - - 43,023 Fundraising 2,669 - - 2,669 3,074 - - 3,074 Total expenses 254,377 - - 254,377 262,191 - - 262,191 Change in net assets 19,367 10,521 1,534 31,422 26,594 47,333 2,893 76,820 Net assets at beginning of the year 101,130 160,753 96,093 357,976 74,536 113,420 93,200 281,156 Net assets at end of the year $ 120,497 171,274 97,627 389,398 $ 101,130 160,753 96,093 357,976 See accompanying notes to the financial statements.

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Report of the Treasurer to the Council of the National Academy of Sciences NATIONAL ACADEMY OF SCIENCES Statements of Cash Flows December 31, 2004 and 2003 (Dollars in thousands)   2004 2003 Cash flows from operating activities: Change in net assets $ 31,422 $ 76,820 Adjustments to reconcile change in net assets to net cash provided by (used in) operating activities:     Depreciation and amortization 5,095 4,670 Loss on disposal of property and equipment 155 352 Bad debt expense 246 200 Net gain on investments (31,269) (49,022) Net gain on investments held on behalf of others (1,826) (2,992) Amortization of deferred gain (738) (721) (Gain) loss on interest rate swap 164 (187) Contributions restricted for construction or endowment (3,777) (5,960) Decrease (increase) in other receivables 16,094 (21,294) Decrease (increase) in contracts receivable – U.S. government 2,200 (2,483) (Increase) decrease in publications and supplies inventories (62) 606 (Increase) decrease in prepaid expenses and other current assets (539) 337 Decrease (increase) in other assets (69) (869) (Decrease) increase in accounts payable and accrued expenses (6,053) 2,637 Increase (decrease) in deferred revenue 880 (8,013) Increase (decrease) in line of credit and other current liabilities 435 (209) Increase in funds held on behalf of others 1,826 2,992 Decrease in accrued lease liability (3) (66) Increase in accrued employee benefits 1,404 1,954 Decrease in deferred gain and other liabilities (15) (18) Net cash provided by (used in) operating activities 15,570 (1,266) Cash flows from investing activities:     Additions to property and equipment (3,494) (6,763) Sale or maturity of investments 194,434 231,457 Purchase of investments (213,896) (219,248) Net cash (used in) provided by investing activities (22,956) 5,446 Cash flows from financing activities:     Contributions restricted for construction or endowment 3,777 5,960 Proceeds from line of credit 131,036 132,294 Payments on line of credit (123,800) (138,488) Payments on capital lease liability (4,290) (4,013) Net cash provided by (used in) financing activities 6,723 (4,247) Net decrease in cash and cash equivalents (663) (67) Cash and cash equivalents, beginning of year 4,098 4,165 Cash and cash equivalents, end of year $ 3,435 $ 4,098 Supplemental disclosure of cash flow information:     Interest paid $ 4,987 $ 5,115 See accompanying notes to financial statements.

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Report of the Treasurer to the Council of the National Academy of Sciences NATIONAL ACADEMY OF SCIENCES Notes to Financial Statements December 31, 2004 and 2003 (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. 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 the following 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 organizational 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 the NAS financial statements. (d) National Academy of Engineering The National Academy of Engineering (NAE) was established in 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 the 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 the NAS 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 venturers of TNAC, and therefore share control. The financial position and results of TNAC are not consolidated in the NAS financial statements. NAS utilized the Beckman Center for meetings in 2004 and 2003, for which TNAC was paid $233,000 and $261,000, respectively. (2) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (a) Basis of Accounting Net assets, revenues, 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.

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Report of the Treasurer to the Council of the National Academy of Sciences 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 (including hedge funds and private equity investments) are reported at fair value when quoted market prices are available, or estimated fair value based on amounts reported by fund managers for nonmarketable investments. Investments in real estate mortgages are recorded at cost and consist of mortgages on certain administrative facilities that NAS occupies. Investments in residential property are valued at fair value based on market prices. 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 all 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 $2,282,000 and $2,924,000 in 2004 and 2003, respectively, was collected by NAS on behalf of NAEF. NAS disbursed approximately $2,025,000 and $2,810,000 to NAEF from these collected amounts in 2004 and 2003, 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 providing more than 10% of NAS revenues are summarized below: Federal agency sponsor Percentage of NAS revenues 2004 2003 Department of Transportation 27% 25% National Aeronautics and Space Administration 12% 11% Department of Health and Human Services 12% 12% 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 of the grant award. Such grants are classified as temporarily restricted net assets 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 $3,722,000 and $3,303,000 on December 31, 2004 and 2003, 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 publication activities. The

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Report of the Treasurer to the Council of the National Academy of Sciences 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 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. (3) INVESTMENTS Investments, which are reported at fair value (except as noted), consisted of the following as of December 31, 2004 and 2003 (dollars in thousands):   2004 2003 Short-term investments: Cash equivalents $ 6,689 $ 1,558 Bonds and notes 32,429 41,620 Equity securities 14,186 11,308 Total short-term investments $ 53,304 $ 54,486 Endowment and trust investments: Cash equivalents $ 2,253 $ 1,418 Bonds and notes 34,096 29,158 Equity securities 235,782 194,760 Real estate 14,621 6,051 Hedge funds 25,704 28,915 Private placements 9,412 7,535   321,868 267,837   2004 2003 Other long-term investments: Cash equivalents $ 2,503 $ 2,600 Bonds and notes 7,595 16,231 Equity securities 8,440 -   18,538 18,831 Total long-term investments $ 286,668 $ 340,406 NAS received proceeds from the sale and leaseback of the Green/Harris facility of approximately $36 million in 2000 (see note 12). Remaining proceeds were invested within other long-term investments, and are available for future payments toward related obligations to the former landlord. In both 2004 and 2003, NAS made lease payments of approximately $2.3 million. Vanguard equity funds comprised approximately $127 million and $109 million of the total equity securities funds at December 31, 2004 and 2003, respectively. Real estate investments include real estate mortgages at cost, shares of real estate investment trusts, and ownership of a residential property located in Washington, D.C. NAS invests a portion of its endowment in hedge funds. The unrealized gain on these funds, which is included as a component of investment income in the accompanying statements of activities, was approximately $1.7 million and $1.6 million for the years ended December 31, 2004 and 2003, respectively. Private equity investments are comprised of limited partnership interests. NAS had remaining commitments at December 31, 2004 and 2003 to provide approximately $5.4 million and $7.2 million, respectively, to these partnerships. TNAC, a related entity, invests certain of its assets in the NAS long-term investment pool. TNAC investments participate in the investment pool experience equally with all other funds in this pool. The NAS obligation to TNAC for these funds held in trust, which totaled approximately $22 million and $20 million as of December 31, 2004 and 2003, respectively, is reported as funds held on behalf of others in the statements of financial position. Investment income is reported net of investment expenses of approximately $694,000 and $494,000 for the years ended December 31, 2004 and 2003, respectively, and is comprised of the following (dollars in thousands):   2004 2003 Interest and dividends income $ 7,543 $ 7,098 Net gain on investments 31,269 49,022 Total investment income $ 38,812 $ 56,120

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Report of the Treasurer to the Council of the National Academy of Sciences (4) PROPERTY AND EQUIPMENT Property and equipment as of December 31, 2004 and 2003, were as follows (dollars in thousands):   2004 2003 Land $ 29,689 $ 29,689 Furniture and equipment 29,421 25,750 Buildings and improvements 108,533 106,325 Construction in progress 919 4,213 Leasehold improvements 6,894 6,882   175,456 172,859 Less accumulated depreciation and amortization (37,346) (31,543) Total property and equipment, net $ 138,110 $ 141,316 (5) CONTRIBUTIONS RECEIVABLE 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 (dollars in thousands): Years ending December 31 2005 $ 8,867 2006 5,908 2007 3,351 2008 2,719 2009 2,766 Thereafter 23,940   47,551 Less discount at rates from 3% to 5% to estimate net present value (6,201) Less allowance for uncollectible pledges (42)   41,308 Less current portion (9,034) Total long-term contributions receivable $ 32,274 At December 31, 2003, the discount on pledges receivable was $7,277,000 at rates ranging from 3% to 5%. The allowance for uncollectible pledges was $29,000 at December 31, 2003. (6) DEFERRED REVENUE Deferred revenue consisted of the following as of December 31, 2004 and 2003 (dollars in thousands):   2004 2003 Advances from private grants and contract sponsors $13,903 $12,290 Advances from U.S. government sponsors 3,904 5,149 Publication subscriptions and other 3,491 2,980 Total deferred revenue $21,298 $20,419 (7) LINE OF CREDIT NAS is party to a $24 million unsecured line of credit from Bank of America bearing interest at LIBOR plus 0.40%. Outstanding balances on the line at December 31, 2004 and 2003 were approximately $14.8 million and $7.5 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, 2004 and 2003, was approximately $302,000 and $185,000, respectively. (8) TEMPORARILY RESTRICTED NET ASSETS Temporarily restricted net assets were available for the following purposes as of December 31, 2004 and 2003 (dollars in thousands).   2004 2003 Sponsored research and advisory programs $139,865 $133,301 Prizes and awards 28,275 24,786 Woods Hole facility 3,134 2,666 Total temporarily restricted net assets $171,274 $160,753 Temporarily restricted net assets were released from restriction for the following purposes during the years ended December 31, 2004 and 2003 (dollars in thousands):   2004 2003 Sponsored research and advisory programs $19,921 $25,511 Prizes and awards 850 552 Woods Hole facility 269 288 Total temporarily restricted net assets released from restriction $21,040 $26,351

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Report of the Treasurer to the Council of the National Academy of Sciences (9) PERMANENTLY RESTRICTED NET ASSETS The income generated by permanently restricted net assets is available to support donor specified programs. As of December 31, 2004 and 2003, NAS held the following permanently restricted net assets, classified by the purpose for which the income is to be used (dollars in thousands):   2004 2003 Sponsored research and advisory programs $94,237 $92,764 Prizes and awards 3,390 3,329 Total permanently restricted net assets $97,627 $96,093 (10) PROGRAM EXPENSES Program expenses for the years ended December 31, 2004 and 2003 are summarized as follows (dollars in thousands):   2004 2003 Policy and Global Affairs $ 65,522 $ 63,993 Transportation Research Board 49,349 51,179 Earth and Life Sciences 20,235 2,152 Institute of Medicine 18,582 20,535 Engineering and Physical Sciences 17,682 17,534 Behavioral and Social Sciences and Education 12,191 13,130 Proceedings of the National Academy of Sciences 11,249 9,687 National Academy Press 6,752 7,032 National Academy of Engineering 5,437 5,508 Koshland Science Museum 2,042 924 NAS and National Sciences Resource Center 5,124 4,420 Total program expenses $214,165 $216,094 (11) RECOVERY OF INDIRECT COSTS NAS receives indirect cost recovery on its federal contracts and grants. An overhead assessment is applied to direct salaries, accrued leave, fringe benefits, and services provided by outside contractors (e.g., temporary personnel agencies, consultants) on NAS property. A general and administrative assessment (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 negotiated 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 approximately $10.6 million and $12.5 million as of December 31, 2004 and 2003, respectively, which is included in the contracts receivable balance in the statements of financial position. (12) BUILDING PROJECT AND FINANCING (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 (dollars in thousands):   2004 2003 Series 1999A revenue bonds, serial, with interest rates ranging from 3.9% to 5% maturing at various dates from January 1, 2005 through 2012 $ 13,600 $ 14,990 Series 1999A revenue bonds, term Interest rate 5%, due January 1, 2019 17,085 17,085 Interest rate 5%, due January 1, 2028 32,545 32,545 Series 1999B revenue bonds, term, at flexible rates (1.18% in 2004 and 1.05% in 2003) due January 1, 2039 32,500 32,500 Series 1999C revenue bonds, term, at variable rates (1.23% in 2004 and 1.06% in 2003) due January 1, 2039 32,500 32,500 Total bonds, at face value 128,230 129,620 Less unamortized discount and premium (990) (985) Total bonds payable 127,240 128,635 Less current portion (1,445) (1,390) Noncurrent bonds payable $ 125,795 $ 127,245

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Report of the Treasurer to the Council of the National Academy of Sciences 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. Scheduled maturities and sinking fund requirements are as follows (dollars in thousands): Years ending December 31: 2005 $ 1,445 2006 1,505 2007 1,565 2008 1,645 2009 1,725 Thereafter 120,345   $ 128,230 Interest expense on the bonds payable for both 2004 and 2003 totaled $3.9 million. (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 noted above for that month only. In January 2004, NAS further amended the swap agreement to delay the implementation of the 2.25% floor agreement until February 2005. 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, 2004 and 2003, NAS recorded a (loss) gain on the change in the fair value of its derivative instruments in the amount of approximately ($164,000) and $187,000, respectively, which is reported as other income in the accompanying statements of activities. The fair value of the interest rate swap was $498,000 and $662,000 in 2004 and 2003, respectively, and is reported as other assets on the statements of financial position. (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

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Report of the Treasurer to the Council of the National Academy of Sciences 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 $1.9 million and $2.6 million were deferred at December 31, 2004 and 2003, 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. Under the original lease agreement with the Trustee, NAS remains obligated through 2007 for remaining lease payments, which have a present value of approximately $11.9 million and $16.2 million as of December 31, 2004 and 2003, respectively. 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. (13) NOTE PAYABLE During 2001, NAS entered into a three-year 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. During 2004, NAS extended the term of this note with Bank of America. The note matures on July 31, 2010. (14) EMPLOYEE BENEFITS (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, 2004 and 2003, amounted to approximately $9.1 million and $8.8 million, respectively. The NAS policy is to fund pension benefits as they are earned. The 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 as of December 31, 2004 and 2003, which is reported within other assets in the statements of financial position. The related obligation is included in accrued employee benefits in the statements of financial position. (c) Postretirement and Postemployment 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. Prior to January 1, 2005, NAS offered certain postemployment benefits to former or inactive employees, prior to their eligibility for retirement benefits, through a separate postemployment benefit plan. Effective January 1, 2005, this plan was merged with the NAS postretirement benefit plan and the effects of this merger and plan changes are reported in the 2004 liability and expense disclosures. The postemployment and postretirement liabilities and expenses for 2003 have been also been combined so that the disclosure for 2003 are comparable to 2004. The following disclosures reflect the activity of the combined postretirement and postemployment plan. 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, 2004 and 2003 (dollars in thousands):

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Report of the Treasurer to the Council of the National Academy of Sciences   2004 2003 Life insurance benefits Health benefits Total Life insurance benefits Health benefits Total Change in benefits obligations:   Benefit obligation, January 1 $ 1,022 18,411 19,433 $ 1,102 15,707 16,809 Service cost 68 972 1,040 74 907 981 Interest cost 58 1,079 1,137 67 995 1,062 Plan Amendments 157 (4,065) (3,908) - - - Actuarial (gain)/loss (370) (145) (515) (84) 1,612 1,528 Benefits paid (121) (873) (994) (137) (810) (947) Benefits obligation, December 31 $ 814 15,379 16,193 $ 1,022 18,411 19,433 Change in plan assets:   Fair value of plan assets, January 1 $ - 5,118 5,118 $ - 4,291 4,291 Actual return on plan assets   312 312 - 827 827 Employer contributions 121 873 994 73 654 727 Benefits paid (121) (873) (994) (73) (654) (727) Fair value of plan assets, December 31 $ - 5,430 5,430 $ - 5,118 5,118 Funded status:   Unfunded benefit obligation $ (814) (9,949) (10,763) $ (1,022) (13,293) (14,315) Unrecognized translation obligation 244 - 244 270 4,258 4,528 Unrecognized prior service cost 158 (169) (11) 1 50 51 Unrecognized net actuarial (gain)/loss (149) 4,466 4,317 173 4,806 4,979 Accrued benefit cost $ (561) (5,652) (6,213) $ (578) (4,179) (4,757) Components of net periodic benefit cost:   Service cost $ 68 972 1,040 $ 74 907 981 Interest cost 58 1,078 1,136 67 995 1,062 Expected return on plan assets - (409) (409) - (300) (300) Amortization of transition obligation 26 405 431 26 405 431 Amortization of prior service cost   7 7   7 7 Amortization of unrecognized losses (48) 293 245 51 193 244 Net periodic cost $ 104 2,346 2,450 $ 218 2,207 2,425 The assumptions used to determine net periodic benefit cost for years ended December 31, 2004 and 2003 are as follows:   2004 2003 Discount rate 6.0% 6.5% Expected long-term return on plan assets 8.0% 7.0% The assumptions used to calculate the accumulated postretirement benefit obligation for the years ended December 31, 2004 and 2003 are as follows:   2004 2003 Discount rate 5.75% 6.00% NAS postretirement benefit plan asset allocations at December 31, 2004 and 2003, by asset category are as follows:   2004 2003 Bonds and notes 39% 40% Equity securities 61% 60%   100% 100% 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

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Report of the Treasurer to the Council of the National Academy of Sciences 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 2005. Based on the actuarial assumptions, the projected net benefit payments for 2005 are $781,000. The following benefit payments, which reflect future services, are expected to be paid, as of December 31, 2004 (dollars in thousands): Years ending December 31: 2005 $ 781 2006 859 2007 920 2008 967 2009 1,044 2010-2014 6,148   $ 10,719 The measurement date of the plan assets and benefit obligations for 2004 and 2003 is January 1, 2005 and 2004, respectively. The trend rates for growth in healthcare costs used in calculating the accumulated postretirement benefit obligation were 9.6% and 10.5%, respectively, during the years ended December 31, 2004 and 2003, declining gradually to 5% in the year 2017. 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, 2004, would have resulted in an estimated $1,866,000 increase or $1,561,000 decrease in the postretirement benefit obligation and an estimated $355,000 increase or $288,000 decrease in the 2004 benefit expense. The effect of a 1% change in the assumed healthcare cost trend rate at December 31, 2003, would have resulted in an estimated $2,505,000 increase or $2,081,000 decrease in the postretirement benefit obligation and an estimated $323,000 increase or $274,000 decrease in the 2003 benefit expense. On December 8, 2003, the President signed into law the Medicare Prescription Drug Improvement and Modernization Act of 2003 (the Act). Under the Medicare Prescription Drug Program, as proposed under the Act, groups who offer retiree prescription coverage at least actuarially equivalent to Medicare Plan D are eligible for a subsidy. In 2004, the Financial Accounting Standards Board issued SFAS No. 106-2, Accounting and Disclosure Requirements Related to the Medicare Prescription Drug, Improvement and Modernization Act of 2003, which is effective for fiscal years beginning after June 15, 2004, with early adoption encouraged. NAS has decided to adopt this standard in 2004. Based on the NAS Plan amendments effective January 1, 2005, the prescription drug benefits offered by the NAS coverage were determined to not be actuarially equivalent to Medicare Plan D, and the effects of the Act, excluding the subsidy, do not have a significant impact on the per capita claims cost. It is anticipated that the prescription drug component of the program offered by NAS to Medicare eligible retirees will be modified in future years, but at this time, the design and impact of these changes are not determinable. (15) COMMITMENTS AND CONTINGENCIES (a) Leases NAS is committed to several noncancelable operating leases for office space. Future minimum rental payments due under noncancelable operating leases are as follows (dollars in thousands): Years ending December 31: Minimum rentals 2005 $ 2,752 2006 2,822 2007 2,063 2008 394 2009 392 Thereafter 285   $ 8,708 Rental expense amounted to approximately $3.1 million and $2.9 million for the years ended December 31, 2004 and 2003, respectively.

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Report of the Treasurer to the Council of the National Academy of Sciences (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, 2001. 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 NAS.

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Report of the Treasurer to the Council of the National Academy of Sciences OFFICERS Bruce Alberts, President James S. Langer, Vice President John I. Brauman, Home Secretary Michael T. Clegg, Foreign Secretary Ronald L. Graham, Treasurer FINANCE COMMITTEE Ronald L. Graham, Chair Bruce Alberts Elwyn R. Berlekamp Elkan R. Blout David M. Kipnis Lawrence R. Klein William Rutter Paul A. Samuelson IOM Representative: Steven Schroeder BUDGET AND INTERNAL AFFAIRS COMMITTEE Ronald L. Graham, Chair Roger N. Beachy James S. Langer Cherry A. Murray Phil Needleman Susan R. Wessler AUDITING COMMITTEE Jack Halpern, Chair Purnell W. Choppin M. Gordon Wolman Elaine Fuchs Herbert Tabor FINANCIAL MANAGEMENT STAFF Archie L. Turner, Chief Financial Officer Didi Salmon, Controller

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