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III. Financial Condition 39

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Report of the Auditing Committee of the National Academy of Sciences June 2006 Dr. Ralph Cicerone, President National Academy of Sciences Dear Dr. Cicerone: In accordance with Bylaw V6 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, 2005, 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 JERRY P. GOLLUB GERALD M. RUBIN HERBERT TABOR M. GORDON WOLMAN National Academy of Sciences 2101 Constitution Avenue, NW Washington, DC 20418 40

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KPMG LLP 2001 M Street, NW Washington, DC 20036 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, 2005 and 2004, 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 as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of NAS' 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, 2005 and 2004, and its changes in net assets and its cash flows for the years then ended in conformity with U.S. generally accepted accounting principles. April 24, 2006 KPMG LLP. KPMG LLP, a U.S. limited liability partnership, is a member of KPMG International, a Swiss association.

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NATIONAL ACADEMY OF SCIENCES Statements of Financial Position December 31, 2005 and 2004 (Dollars in thousands) Assets 2005 2004 Current assets: Cash and cash equivalents $ 3,640 $ 3,435 Short-term investments (note 3) 48,609 53,304 Contracts receivable U.S. government (note 11) 45,474 46,699 Contributions and other receivables (note 5) 11,188 14,598 Publications and supplies inventories 1,683 1,687 Prepaid expenses and other 3,364 3,286 Total current assets 113,958 123,009 Other assets (notes 12, 14, and 15) 10,499 7,642 Long-term investments (note 3) 373,827 340,406 Contributions receivable (note 5) 38,219 32,274 Property and equipment, net (note 4) 132,623 138,110 Einstein Memorial 1,723 1,723 $ 670,849 $ 643,164 Liabilities and Net Assets Liabilities: Current liabilities: Accounts payable and accrued expenses $ 28,397 $ 29,542 Deferred revenue (note 6) 19,995 21,298 Line of credit (note 7) 17,528 14,791 Other current liabilities (note 12) 11,014 10,778 Total current liabilities 76,934 76,409 Bonds payable (note 12) 124,282 125,795 Funds held on behalf of others (note 3) 22,584 21,793 Note payable (note 13) 10,000 10,000 Accrued lease liability and deferred gain (note 12) 3,257 8,667 Accrued employee benefits (note 14) 7,613 11,102 Total liabilities 244,670 253,766 Net assets: Unrestricted 129,498 120,497 Temporarily restricted (note 8) 190,844 171,274 Permanently restricted (note 9) 105,837 97,627 Total net assets 426,179 389,398 Commitments and contingencies (notes 3, 11, 12, 14, 16, and 17) Total liabilities and net assets $ 670,849 $ 643,164 See accompanying notes to financials statements. 42

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NATIONAL ACADEMY OF SCIENCES Statements of Activities Years ended December 31, 2005 and 2004 (Dollars in thousands) 2005 2004 Temporarily Permanently Temporarily Permanently Unrestricted restricted restricted Totals Unrestricted restricted restricted Totals Revenues, gains, and other support: Government contracts and grants (note 11) $ 179,871 - - 179,871 $ 176,376 - - 176,376 Private contracts and grants 20,421 24,175 - 44,596 21,504 13,265 - 34,769 Other contributions 3,315 419 8,210 11,944 5,361 309 1,534 7,204 Fees and publications 18,975 - - 18,975 20,073 - - 20,073 Investment income, net (note 3) 18,066 17,441 - 35,507 20,825 17,987 - 38,812 Other income (note 12) 11,959 - - 11,959 8,565 - - 8,565 Net assets released from restriction (note 8) 22,465 (22,465) - - 21,040 (21,040) - - Total revenues, gains, and other support 275,072 19,570 8,210 302,852 273,744 10,521 1,534 285,799 Expenses (notes 12,14, and 15): Programs (note 10) 223,531 - - 223,531 214,165 - - 214,165 Management and general 40,211 - - 40,211 37,543 - - 37,543 Fundraising 2,329 - - 2,329 2,669 - - 2,699 Total expenses 266,071 - - 266,071 254,377 - - 254,377 Change in net assets 9,001 19,570 8,210 36,781 19,367 10,521 1,534 31,422 Net assets at beginning of the year 120,497 171,274 97,627 389,398 101,130 160,753 96,093 357,976 Net assets at end of the year $ 129,498 190,844 105,837 426,179 $ 120,497 171,274 97,627 389,398 See accompanying notes to financial statements. 43

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NATIONAL ACADEMY OF SCIENCES Statements of Cash Flows Years ended December 31, 2005 and 2004 (Dollars in thousands) 2005 2004 Cash flows from operating activities: Change in net assets $ 36,781 $ 31,422 Adjustments to reconcile change in net assets to net cash provided by operating activities: Depreciation and amortization 5,274 5,095 Loss on disposal of property and equipment 21 155 Gain on sale of property and equipment (1,911) - Bad debt expense 66 246 Net gain on investments (20,844) (31,269) Net gain on investments held on behalf of others (791) (1,826) Amortization of deferred gain (746) (738) (Gain) loss on interest rate swap (650) 164 Contributions restricted for construction or endowment (3,922) (3,777) (Increase) decrease in assets: Other receivables (2,601) 16,492 Contracts receivable U.S. government 1,225 2,200 Publications and supplies inventories 4 (62) Prepaid expenses and other current assets (78) (937) Other assets (2,207) (69) Increase (decrease) in liabilities: Accounts payable and accrued expenses (1,145) (6,053) Deferred revenue (1,303) 880 Other current liabilities 17 435 Funds held on behalf of others 791 1,826 Accrued lease liability and deferred gain (9) (18) Accrued employee benefits (3,489) 1,404 Net cash provided by operating activities 4,483 15,570 Cash flows from investing activities: Additions to property and equipment (1,410) (3,494) Proceeds from sale of property and equipment 2,000 - Sales or maturities of investments 185,701 194,434 Purchases of investments (192,792) (213,896) Net cash used in investing activities (6,501) (22,956) Cash flows from financing activities: Contributions restricted for construction or endowment 3,922 3,777 Proceeds from line of credit 128,399 131,036 Payments on line of credit (125,662) (123,800) Payments on capital lease liability (4,436) (4,290) Net cash provided by financing activities 2,223 6,723 Net increase (decrease) in cash and cash equivalents 205 (663) Cash and cash equivalents, beginning of year 3,435 4,098 Cash and cash equivalents, end of year $ 3,640 $ 3,435 Supplemental disclosure of cash flow information: Interest paid $ 5,772 $ 4,987 See accompanying notes to financial statements. 44

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NATIONAL ACADEMY OF SCIENCES tional units, and disseminates information to the public and the relevant professions. IOM was established as a Notes to separate membership organization within NAS. The financial activity and results of IOM are included in the Financial Statements NAS financial statements. December 31, 2005 and 2004 (d) National Academy of Engineering The National Academy of Engineering (NAE) was (1) ORGANIZATION AND RELATED established in 1964 under the charter of NAS as a related parallel organization, autonomous in its governance, ENTITIES administration, and the selection of its members. NAE (a) National Academy of Sciences shares with NAS the responsibility for advising the federal government on scientific issues. The NAE The National Academy of Sciences (NAS) was formed conducts both independent program activities and under a charter that was passed as an Act of Incorporation activities through the NRC. The results of these activities by the United States Congress and signed into law on are included in the NAS financial statements. March 3, 1863. NAS operates as a private cooperative society of distinguished scholars engaged in scientific or (e) National Academy of Engineering Fund engineering research, dedicated to the furtherance of science and its use for the general welfare. NAS is exempt The National Academy of Engineering Fund (NAEF) is a from federal income taxes under Section 501(c)(3) of the separately incorporated not-for-profit organization Internal Revenue Code, except for unrelated business established and controlled by NAE to raise funds to income. support its goals. The financial activity and results of NAEF are not included in the NAS financial statements. (b) National Research Council (f) The National Academies' Corporation Most of the activities undertaken by NAS are carried out through the divisions and boards of the National Research The National Academies' Corporation (TNAC) was Council (NRC), which draw on a wide cross section of separately incorporated in 1986 as a not-for-profit the nation's leading scientists and engineers for advisory corporation for the purpose of constructing and maintain- services to government agencies and Congress. To ing a study and conference facility. This facility, the respond effectively to both the disciplinary concerns of Arnold and Mabel Beckman Center, located in Irvine, the research community and the complex interdisciplinary California, operates to expand and support the general problems facing American society, NRC is organized into activities of NAS, NRC, IOM, and NAE. NAS and NAEF the following five major units responsible for most study are 50 50 joint venturers of TNAC, and therefore share activities: control. The financial position and results of TNAC are not consolidated in the NAS financial statements. NAS Division of Behavioral and Social Sciences and utilized the Beckman Center for meetings in 2005 and Education 2004, for which NAS paid $275,000 and $233,000, Division on Earth and Life Studies respectively. Division on Engineering and Physical Sciences Policy and Global Affairs Division (2) SUMMARY OF SIGNIFICANT Transportation Research Board ACCOUNTING POLICIES NRC activities are under the control of the NAS govern- (a) Basis of Accounting ance structure, and therefore are included in the NAS financial statements. Net assets, revenues, gains, and losses are classified based on the existence or absence of donor-imposed restrictions. (c) Institute of Medicine Accordingly, net assets of NAS are classified and reported as follows: The Institute of Medicine (IOM), established in 1970, conducts studies of policy issues related to health and Permanently restricted Net assets subject to donor- medicine. IOM issues position statements on these imposed stipulations that they be maintained in perpetuity policies, cooperates with the major scientific and by NAS. Generally, the donors of these assets permit professional societies in the field, identifies qualified NAS to use all or part of the income earned on related individuals to serve on study groups in other organiza- investments for general or specific purposes. 45

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Temporarily restricted Net assets subject to donor- lived assets are released in the period in which the assets imposed stipulations that may or will be met either by are acquired or placed in service. actions of NAS and/or the passage of time. When a donor restriction expires, temporarily restricted net assets are NAS performs certain fundraising activities on behalf of reclassified to unrestricted net assets. NAEF. NAS collected a total of $3.7 million and $2.3 million in 2005 and 2004, respectively, on behalf of Unrestricted Net assets arising from exchange transac- NAEF. NAS disbursed $3.4 million and $2.0 million to tions and contributions not subject to donor imposed NAEF from these collected amounts in 2005 and 2004, stipulations. respectively. Amounts collected but not yet remitted to NAEF are reported as assets and liabilities in the NAS (b) Cash Equivalents financial statements. NAS reports liquid, temporary investments purchased (e) Contracts and Grants with original maturities of three months or less as cash equivalents. The majority of NAS activities are performed under cost- reimbursable contracts with the U.S. government. Federal (c) Investments sponsors individually providing more than 10% of NAS revenues are summarized below: Investments are stated at fair value. The fair value of all debt and equity securities with a readily determinable fair Percentage of value are based on quotations obtained from national NAS revenues security exchanges. Alternative investments, consisting Federal agency sponsor 2005 2004 of hedge funds and private placement equities, which are Department of Transportation 26% 27% not readily marketable, are carried at estimated fair values National Aeronautics and Space Administra- as provided by the investment managers. Management tion 11% 12% Department of Health and Human Services 13% 12% reviews and evaluates the values provided by the investment managers and agrees with the valuation NAS records federal contracts as exchange transactions, methods and assumptions used in determining the fair recognizing revenue as recoverable costs are incurred. value of the alternative investments. Revenues from nonfederal grants qualifying as contribu- Investments in real estate mortgages are recorded at cost, tions are recorded by NAS upon notification of the grant which approximates fair value, and consist of mortgages award. Such grants are classified as temporarily restricted on certain administrative facilities that NAS occupies. net assets when use of the grant funds are limited to specific areas of study or to be used in future periods. Changes in the fair value of investments are reported within investment income in the statements of activities. (f) Deferred Revenue Certain investments are pooled for long-term investment For both federal and nonfederal grants and contracts that purposes. Investments in the pool are administered as an are determined to be exchange transactions, revenue is open-end investment trust, with shares of the pool funds recognized as the related costs are incurred. Funds expressed in terms of participating capital units (PCUs). received in advance of being earned for these grants are PCU values are used to determine equity in the allocation recorded as deferred revenue in the statements of financial of investment income among funds in the pool whenever position. additional funds are contributed or withdrawn. (g) Fair Value of Financial Instruments (d) Contributions The carrying value of bonds payable in the financial Contributions, including unconditional promises to give, statements was less than their fair value by approximately are recognized as revenues in the period received. $3.4 million and $3.7 million on December 31, 2005 and Conditional promises to give are not recognized until all 2004, respectively. conditions on which receipt depends are substantially met. NAS makes limited use of derivative financial instru- Gifts of land, buildings, or equipment are reported as ments for the purpose of managing interest rate risks. unrestricted net assets unless explicit donor stipulations Current market pricing models are used to estimate fair specify how the donated assets must be used. Temporary values of interest rate swap agreements. The fair market restrictions on gifts that must be used to acquire long- value of all other financial instruments in the financial statements approximates their reported carrying values. 46

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(continued) 2005 2004 (h) Inventories Pooled endowment and trust investments: Inventories are stated at the lower of cost or net realizable Cash equivalents $ 20,841 $ 2,253 value and include both work-in-process and finished Bonds and notes 32,902 34,096 goods related to publication activities. The majority of Equity securities 227,898 235,782 Real estate 16,308 14,621 NAS publication inventories and supplies reside with an Hedge funds 42,066 25,704 NAS unit, the National Academy Press (NAP). NAP uses Private placements 11,546 9,412 the full absorption costing methodology in pricing 351,561 321,868 finished products. This methodology includes direct printing and related indirect costs. Other long-term investments: Cash equivalents $ 2,717 $ 2,503 (i) Property and Equipment Bonds and notes 10,100 7,595 Depreciation of NAS buildings and equipment is Equity securities 9,449 8,440 computed on a straight-line basis using the following 22,266 18,538 lives: Total long-term investments $ 373,827 $ 340,406 Buildings 40 to 50 years Building and leasehold improvements lesser of the NAS received proceeds from the sale and leaseback of the Green/Harris facility of approximately $36 million in remaining life of the building or improvement 2000 (see note 12). Remaining proceeds were invested Furniture and equipment 4 to 10 years within other long-term investments, and are available for future payments toward related obligations to the former The Einstein Memorial sculpture is valued at cost and is landlord. In both 2005 and 2004, NAS made lease not depreciated. Construction-in-progress is not depreci- payments of approximately $2.3 million. ated until the related assets are placed in service. Vanguard equity funds comprised approximately $125 (j) Use of Estimates million and $127 million of the total equity securities The preparation of these financial statements in confor- funds at December 31, 2005 and 2004, respectively. mity with U.S. generally accepted accounting principles requires management to make certain estimates and At December 31, 2005, real estate investments include assumptions. These estimates and assumptions may affect real estate mortgages at cost and shares of real estate the reported amounts of assets and liabilities and disclo- investment trusts. At December 31, 2004, these invest- sures in the financial statements. Actual results could ments also include ownership of a residential property differ from those estimates. located in Washington D.C., recorded at fair value. (k) Reclassifications NAS invests a portion of its endowment in hedge funds. The unrealized gain on these funds, which is included as a Certain amounts from the prior year have been reclassi- component of investment income in the accompanying fied to conform to the current year presentation. statements of activities, was approximately $4.6 million and $1.7 million for the years ended December 31, 2005 and 2004, respectively. (3) INVESTMENTS Private equity investments are comprised of limited Investments, which are reported at fair value (except as partnership interests. NAS had remaining commitments at noted), consisted of the following as of December 31, December 31, 2005 and 2004 to provide approximately 2005 and 2004 (dollars in thousands): $5.7 million and $5.4 million, respectively, to these 2005 2004 partnerships. Short-term investments: Cash equivalents $ 8,972 $ 6,689 As of December 31, 2005 and 2004, respectively, NAS Bonds and notes 21,715 32,429 held alternative investments with fair values of approxi- Equity securities 17,922 14,186 mately $53.6 million and $35.1 million. These fair values Total short-term investments 48,609 53,304 were estimated by the general partners of these invest- ment funds in the absence of readily ascertainable values at those dates. 47

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TNAC, a related entity, invests certain of its assets in the (continued) NAS long-term investment pool. TNAC investments Less discount at rates from 3% to 5% to estimate participate in the investment pool experience proportion- net present value (7,672) ally with all other funds in this pool. The NAS obligation Less allowance for uncollectible contributions (47) to TNAC for these funds held in trust, which totaled 46,505 approximately $23 million and $22 million as of Decem- ber 31, 2005 and 2004, respectively, is reported as funds Less current portion (8,286) held on behalf of others in the statements of financial Total contributions receivable, long-term $ 38,219 position. Investment income is reported net of investment expenses At December 31, 2004, the discount on contributions of approximately $569,000 and $694,000 for the years receivable was $6.2 million at rates ranging from 3% to ended December 31, 2005 and 2004, respectively, and is 5%. The allowance for uncollectible contributions was comprised of the following (dollars in thousands): $42,000 at December 31, 2004. 2005 2004 (6) DEFERRED REVENUE Interest and dividends income $ 14,663 $ 7,543 Net gain on investments 20,844 31,269 Deferred revenue consisted of the following as of December 31, 2005 and 2004 (dollars in thousands): Total investment income, net $ 35,507 $ 38,812 2005 2004 Advances from private grants and contract (4) PROPERTY AND EQUIPMENT sponsors $13,844 $13,903 Advances from U.S. government sponsors 2,944 3,904 Property and equipment as of December 31, 2005 and Publication subscriptions and other 3,207 3,491 2004, were as follows (dollars in thousands): Total deferred revenue $19,995 $21,298 2004 2003 Land $ 29,689 $ 29,689 (7) LINE OF CREDIT Furniture and equipment 30,285 29,421 Buildings and improvements 108,285 108,533 NAS is party to a $22 million unsecured line of credit Construction in progress 170 919 from Bank of America which bears interest at LIBOR Leasehold improvements 6,894 6,894 plus 0.40% and expires on July 31, 2006. Interest expense related to the line of credit for the years ended December 175,323 175,456 Less accumulated depreciation and 31, 2005 and 2004, was approximately $343,000 and amortization (42,700) (37,346) $302,000, respectively. Total property and equipment, net $132,623 $ 138,110 (8) TEMPORARILY RESTRICTED NET (5) CONTRIBUTIONS RECEIVABLE ASSETS Contributions not yet collected are included in contribu- Temporarily restricted net assets were available for the tions and other receivables (current) and contributions following purposes as of December 31, 2005 and 2004 receivable (long term) in the statements of financial (dollars in thousands): position, and mature as follows (dollars in thousands): 2005 2004 Years ending December 31 Sponsored research and advisory programs $155,908 $139,865 2006 $ 8,333 Prizes and awards 31,410 28,275 2007 4,154 2008 3,261 Woods Hole facility 3,526 3,134 2009 3,294 Total temporarily restricted net assets $190,844 $171,274 2010 3,269 Thereafter 31,913 54,224 48

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Temporarily restricted net assets were released from (11) RECOVERY OF INDIRECT COSTS restriction for the following purposes during the years ended December 31, 2005 and 2004 (dollars in thou- NAS receives indirect cost recovery on its federal sands): contracts and grants. An overhead assessment is applied to direct salaries, accrued leave, fringe benefits, and services provided by outside contractors (e.g., temporary 2005 2004 personnel agencies, consultants) on NAS property. A Sponsored research and advisory programs $18,332 $19,921 general and administrative assessment (G&A) is applied Prizes and awards 3,868 850 to direct costs and overhead less subcontract costs and stipends. Therefore, both the overhead and G&A rates are Woods Hole facility 265 269 applied to projects incurring direct salaries and other Total temporarily restricted net assets released direct costs such as travel. If a program does not require from restriction $22,465 $21,040 direct salaries, such as a travel grant program, a subcon- tract/flow-through administration rate is applied. Certain off-site work (not performed on NAS property) is (9) PERMANENTLY RESTRICTED NET assessed reduced overhead rates. ASSETS NAS bills for indirect cost recovery throughout the year The income generated by permanently restricted net based on negotiated rates. At the end of each year, NAS assets is available to support donor-specified programs. compares actual expenses incurred in each of its cost As of December 31, 2005 and 2004, NAS held the pools to the amounts recovered based on its billing rates. following permanently restricted net assets, classified by The difference is recorded as its indirect cost carryfor- the purpose for which the income is to be used (dollars in ward. If NAS overrecovers on its indirect costs during the thousands): year, a liability is recorded. If NAS underrecovers, a receivable is recorded. 2005 2004 NAS has a cumulative net underrecovery of approxi- Sponsored research and advisory programs $102,447 $ 94,237 mately $4.3 million and $10.6 million as of December 31, Prizes and awards 3,390 3,390 2005 and 2004, respectively, which is included in the contracts receivable balance in the statements of financial Total permanently restricted net assets $105,837 $ 97,627 position. (10) PROGRAM EXPENSES (12) BUILDING PROJECT AND FINANCING Program expenses for the years ended December 31, 2005 and 2004 are summarized as follows (dollars in thou- (a) Building Project Revenue Bonds sands): In January 1999, the District of Columbia issued $130,960,000 of tax-exempt revenue bonds on behalf of 2005 2004 NAS. Proceeds from the sale of the revenue bonds Policy and Global Affairs $ 64,784 $ 65,522 financed the cost of the acquisition of 44,250 square feet Transportation Research Board 54,873 49,349 of land and related construction of an office building, as well as paid certain costs of issuing the bonds. This Earth and Life Sciences 23,640 20,235 building consolidates most of NAS' program activities Institute of Medicine 19,588 18,582 into one location. The facility was occupied in July 2002. Engineering and Physical Sciences 18,048 17,682 Behavioral and Social Sciences and NAS is obligated under the revenue bonds as follows Education 11,119 12,191 Proceedings of the National Academy of (dollars in thousands): Sciences 11,117 11,249 National Academy Press 6,817 6,752 2005 2004 Series 1999A revenue bonds, serial, with National Academy of Engineering 6,240 5,437 interest rates ranging from 4.1% to Koshland Science Museum 1,579 2,042 5% maturing at various dates from NAS and National Sciences Resource January 1, 2006 through 2012 $ 12,155 $ 13,600 Center 5,726 5,124 Series 1999A revenue bonds, term Interest rate 5%, due January 1, 2019 17,085 17,085 Total program expenses $223,531 $214,165 Interest rate 5%, due January 1, 2028 32,545 32,545 49

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(continued) 2005 2004 based on the weekly interest rate resets of tax exempt Series 1999B revenue bonds, term, at variable-rate issues per the BMA Municipal Swap Index. flexible rates (2.59% in 2005 and 1.18% in 2004) due January 1, 2039 32,500 32,500 NAS entered into this swap agreement to manage its Series 1999C revenue bonds, term, at exposure to interest rate changes. The fixed-rate debt variable rates (2.21% in 2005 and obligations expose NAS to variability in the cost recovery 1.23% in 2004) due January 1, 2039 32,500 32,500 Total bonds, at face value 126,785 128,230 stream due to changes in interest rates. NAS recovers the costs of borrowing through a capital investment incentive Less unamortized discount and premium (998) (990) rate that is set by the U.S. government and is tied to a Total bonds payable 125,787 127,240 variable index. If interest rates increase, the capital investment incentive recovery increases. Less current portion (1,505) (1,445) Bonds payable, long-term $ 124,282 $ 125,795 Conversely, if interest rates decrease, the capital invest- ment incentive recovery decreases. Therefore, NAS The serial and term bonds represent unsecured general entered into a derivative instrument that ties the fixed-rate obligations of NAS. debt to a variable index to manage fluctuations in cash flows resulting from interest rate risk. By using derivative Interest on all Series 1999A revenue bonds is payable financial instruments to hedge exposures to changes in semiannually every January 1 and July 1. Interest on the interest rates, NAS exposes itself to credit risk and market 1999B and 1999C bonds is payable monthly. risk. Credit risk is the failure of the counterparty to perform under the terms of the derivative contract. When The term bonds maturing on January 1, 2019, and January the fair value of a derivative contract is positive, the 1, 2028, are subject to mandatory redemption by opera- counterparty owes NAS, which creates credit risk for tion of sinking fund installments. The installment NAS. When the fair value of a derivative contract is payments for the term bonds maturing January 1, 2019, negative, NAS owes the counterparty, and therefore, it begin on January 1, 2013, and range from $2.1 to $2.8 does not possess credit risk. NAS minimizes the credit million per year through the maturity date. Installment risk in derivative instruments by entering into transactions payments for the term bond maturing January 1, 2028, with high-quality counterparties. begin on January 1, 2020, and range from $2.9 to $4.3 million per year through the maturity date. In January 2001, NAS amended the October 1999 agreement by assuming responsibility for the fixed rate Scheduled maturities and sinking fund requirements are payments for the period 2001-2003 in exchange for an as follows (dollars in thousands): immediate cash payment of $2,435,000. Beginning January 1, 2004, the variable rate swap transaction Years ending December 31: becomes effective again with 16 years remaining under 2006 $ 1,505 the agreement. 2007 1,565 In October 2001, NAS further amended the agreement for 2008 1,645 the 2004-2020 period by agreeing to give up the benefit of 2009 1,725 any 30-day period during which the BMA index remains 2010 1,810 below 2.25% for the entire 30 days. Each time this occurs, Thereafter 118,535 the rate on the swap portfolio reverts to the fixed rate $ 126,785 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 Interest expense on the bonds payable for 2005 and 2004 February 2005. totaled $4.6 million and $3.9 million, respectively. In accordance with Statement of Financial Accounting (b) Interest Rate Swaps Standards No. 133 (SFAS 133), Accounting for Deriva- tive Instruments and Hedging Activities, for the year In October 1999, NAS entered into a swap agreement, ended December 31, 2005 and 2004, NAS recorded a gain with an effective date of February 1, 2000. This swap (loss) on the change in the fair value of its derivative agreement related to the $66 million face amount of its instruments in the amount of approximately $650,000 and Series 1999A revenue bonds. The agreement provides for ($164,000), respectively, which is included in other NAS to receive 4.97% in interest on a notional amount of income in the accompanying statements of activities. The $65 million and to pay interest at a floating rate option fair value of the interest rate swap was $1.1 million and 50

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$498,000 in 2005 and 2004, respectively, and is included determination letter from the IRS on the qualification of in other assets on the statements of financial position. this plan under Section 401(a) of the Internal Revenue Code. (c) Sale-Leaseback of Green/Harris Facility In addition, NAS has a voluntary employee contribution In 1999, under a separate trust agreement, the Trustee, an retirement plan that is funded solely by employee unrelated third party, held record legal title to the contributions made on a pretax salary-reduction basis Green/Harris facility that was under lease by NAS for a under Section 403(b) of the Internal Revenue Code. The portion of its operations. This trust agreement would have investment vehicles under this voluntary plan are conveyed title to NAS in 2007. In 2000, NAS entered into retirement annuity contracts issued by TIAA/CREF and a contract with a third party to sell its future interest in the mutual funds offered by the Vanguard Group, Inc. property for approximately $36 million. NAS simultane- ously agreed to lease back the entire facility until 2002 (at Pension expense for the years ended December 31, 2005 a monthly rate of $400,000) and a portion of the facility and 2004, amounted to approximately $9.1 million each until 2007 (at a monthly rate of $200,000). These amounts year. The NAS policy is to fund pension benefits as they are included in future minimum rental payments summa- are earned. The NAS normal retirement age is 65, but rized in note 15. there is no mandatory age for retirement. The sale-leaseback transaction resulted in a gain of $6.8 (b) Deferred Compensation million, of which $1.2 million and $1.9 million were deferred at December 31, 2005 and 2004, respectively. NAS holds long-term investments as part of a deferred The deferred gain will be fully recognized by 2007. The compensation arrangement for certain employees. The current portion of the deferred gain is reported within fair value of these investments was approximately $4.6 other current liabilities and the long-term portion is million and $4.9 million as of December 31, 2005 and reported within accrued lease liability and deferred gain in 2004, which is reported within other assets in the the statements of financial position. statements of financial position. The related obligation is included in accrued employee benefits in the statements Under the original lease agreement with the Trustee, NAS of financial position. remains obligated through 2007 for remaining lease payments, which have a present value of approximately (c) Postretirement and Postemployment Benefits $7.5 million and $11.9 million as of December 31, 2005 and 2004, respectively. The current portion of this NAS provides certain health and life insurance benefits obligation is included within other current liabilities and for employees retired due to length of service. All the long-term portion is included within accrued lease benefit-eligible employees may become eligible for liability and deferred gain, respectively, in the statements service retiree benefits if they reach age 60 while working of financial position. for NAS and complete 5 years of service in a benefit- eligible status for medical benefits and 10 years of service for life insurance benefits. In addition, certain health and (13) NOTE PAYABLE life insurance benefits are provided for employees retired due to disability. A benefit-eligible employee may NAS has a loan agreement of $10 million with Bank of become eligible for disabled retiree benefits if deemed America which matures on July 31, 2010. The note bears interest at 30-day LIBOR plus 50 basis points and is totally disabled under NAS' disability insurance. Life insurance benefits are provided based on coverage at date payable monthly. The interest rate at December 31, 2005 of disability and health insurance may be continued if the and 2004, respectively was 4.84% and 2.85%. disabled retiree had participated in an NAS health insurance plan for 5 years at the date of disability. (14) EMPLOYEE BENEFITS Insurance companies whose premiums are determined on an experience-rated basis provide life and health insur- (a) Retirement Plans ance benefits for retirees. Medicare supplement insur- NAS has an insured, noncontributory, defined contribu- ance is not experience rated. The plan is contributory for tion pension plan covering substantially all of its employ- health insurance purposes for employees who retire after ees. The plan is intended to qualify under Section 401(a) January 1, 1990. Participants contribute 25% to 100% of of the Internal Revenue Code and uses Teachers Insur- the monthly premium based on their choice of health ance and Annuity Association/College Retirement insurance carrier and length of service. Equities Fund (TIAA/CREF) group retirement annuity contracts as the investment vehicle. Participants in this NAS has elected to recognize the initial postretirement plan vest immediately. NAS has received a favorable benefit obligation over a period of 20 years. The accrued 51

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postretirement benefit obligation is reported in accrued expense disclosures. The following disclosures reflect the employee benefits on the statements of financial position. activity of the combined postretirement and postemploy- ment plan. Prior to January 1, 2005, NAS offered certain postem- ployment benefits to former or inactive employees, prior The following table presents the changes in benefit to their eligibility for retirement benefits, through a obligations, changes in plan assets, funded status, and the separate postemployment benefit plan. Effective January components of net periodic benefit cost for the years 1, 2005, this plan was merged with the NAS postretire- ended December 31, 2005 and 2004 (dollars in thou- ment benefit plan and the effects of this merger and plan sands): changes are reported in the 2005 and 2004 liability and 2005 2004 Life Life insurance Health insurance Health benefits benefits Total benefits benefits Total Change in benefits obligations: Benefit obligation, January 1 $ 814 $ 15,379 $ 16,193 $ 1,022 $ 18,411 $ 19,433 Service cost 13 671 684 68 972 1,040 Interest cost 45 864 909 58 1,079 1,137 Plan participants contributions - (130) (130) 157 (4,065) (3,908) Actuarial gain (56) (2,368) (2,424) (370) (145) (515) Benefits paid (5) (697) (702) (121) (873) (994) Benefits obligation, December 31 $ 811 $ 13,719 $ 14,530 $ 814 $ 15,379 $ 16,193 Change in plan assets, combined: Fair value of plan assets, January 1 $ - $ 5,430 $ 5,430 $ - $ 5,118 $ 5,118 Actual return on plan assets - 314 314 - 312 312 Employer contributions 5 4,523 4,528 121 873 994 Plan participants contributions - 125 125 - - - Benefits paid (5) (697) (702) (121) (873) (994) Fair value of plan assets, December 31 $ - $ 9,695 $ 9,695 $ - $ 5,430 $ 5,430 Funded status: Unfunded benefit obligation $ (811) $ (4,024) $ (4,835) $ (814) $ (9,949) $ (10,763) Unrecognized translation obligation 218 - 218 244 - 244 Unrecognized prior service cost 140 (150) (10) 158 (169) (11) Unrecognized net actuarial (gain) loss (203) 1,782 1,579 (149) 4,466 4,317 Accrued benefit cost $ (656) $ (2,392) $ (3,048) $ (561) $ (5,652) $ (6,213) Components of net periodic benefit cost: Service cost $ 13 $ 671 $ 684 $ 68 $ 972 $ 1,040 Interest cost 45 864 909 58 1,078 1,136 Expected return on plan assets - (435) (435) - (409) (409) Amortization of transition obligation 26 - 26 26 405 431 Amortization of prior service cost 18 (19) (1) - 7 7 Amortization of unrecognized (gains) losses (7) 312 305 (48) 293 245 Net periodic cost $ 95 $ 1,393 $ 1,488 $ 104 $ 2,346 $ 2,450 52

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The assumptions used to determine net periodic benefit The following benefit payments, which reflect future cost for years ended December 31, 2005 and 2004 are as services, are expected to be paid, as of December 31, follows: 2005 (dollars in thousands): 2005 2004 Years ending December 31: Discount rate 5.75% 6.0% 2006 $ 667 Expected long-term return on plan assets 8.0% 8.0% 2007 782 2008 860 The assumptions used to calculate the accumulated 2009 943 postretirement benefit obligation for the years ended 2010 1,010 December 31, 2005 and 2004 are as follows: 2011-2015 5,764 2005 2004 $ 10,026 Discount rate 5.75% 5.75% The measurement date of the plan assets and benefit obligations for 2005 and 2004 is January 1, 2006 and NAS postretirement benefit plan asset allocations at 2005, respectively. December 31, 2005 and 2004, by asset category are as follows: The trend rate for growth in healthcare costs used in calculating the accumulated postretirement benefit 2005 2004 obligation was 9.6% during the years ended December 31, Cash 31% 0% 2005 and 2004, declining gradually to 5% in the year Bonds and notes 15% 39% 2018. The healthcare cost trend rate assumption has a significant impact on the postretirement benefit costs and Equity securities 54% 61% obligations. The effect of a 1% change in the assumed 100% 100% healthcare cost trend rate at December 31, 2005, would have resulted in an estimated $1.6 million increase or $1.4 The investment objective of the Plan is to produce a rate million decrease in the postretirement benefit obligation of return over the long term that will provide for some and an estimated $223,000 increase or $184,000 decrease fund growth, curb against the effect of inflation, and in the 2005 benefit expense. provide for some stability in different market environ- ments. The fund is diversified between fixed income and The effect of a 1% change in the assumed healthcare cost equity investments. With this diversification and invest- trend rate at December 31, 2004, would have resulted in ment in broader market funds, there is reasonable an estimated $1.9 million increase or $1.6 million assurance that no single security or class of securities will decrease in the postretirement benefit obligation and an have a disproportionate impact on the Plan assets. Equity estimated $355,000 increase or $288,000 decrease in the securities are targeted at 60% and bonds and notes at 2004 benefit expense. 40%. A large cash transfer was made at the end of 2005 that was not invested as of December 31, 2005. On December 8, 2003, the President signed into law the Medicare Prescription Drug Improvement and Moderni- The overall long-term rate of return was developed by zation Act of 2003 (the Act). Under the Medicare estimating the long-term real rate of return for the Plan's Prescription Drug Program, as proposed under the Act, asset mix, while taking into account the effects of groups who offer retiree prescription coverage at least inflation. This estimate was developed by evaluating the actuarially equivalent to Medicare Plan D are eligible for history and similar asset allocation of the NAS Endow- a subsidy. In 2004, the Financial Accounting Standards ment. Board issued SFAS No. 106-2, Accounting and Disclo- sure Requirements Related to the Medicare Prescription NAS expects to contribute to the Plan the actuarially Drug, Improvement and Modernization Act of 2003, determined net periodic cost for 2006, which is $822,000. which is effective for fiscal years beginning after June 15, 2004, with early adoption encouraged. 53

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NAS adopted this standard in 2004. Based on the NAS (b) Contingencies Plan amendments effective January 1, 2005, the prescrip- tion drug benefits offered by the NAS coverage were NAS receives a portion of its revenues directly or determined to not be actuarially equivalent to Medicare indirectly from federal government grants and contracts, Plan D, and the effects of the Act, excluding the subsidy, all of which are subject to audit by the Defense Contract do not have a significant impact on the per capita claims Audit Agency, which has completed its examinations cost. It is anticipated that the prescription drug component through December 31, 2003. A contingency exists of the program offered by NAS to Medicare eligible relating to unexamined periods to refund any amounts retirees will be modified in future years, but at this time, received in excess of allowable costs. Management is of the design and impact of these changes are not determin- the opinion that no material liability will result from able. future audits. (c) Litigation (15) RELATED PARTY TRANSACTION NAS is a defendant in several lawsuits. While the ultimate The NAS Council authorized a non-interest bearing, outcome of the litigation is uncertain, NAS management collateralized advance to an employee in connection with believes that it has strong legal positions, intends to the purchase of the employee's residence. In May 2005, vigorously defend its actions, and has concluded that the the agreement between the parties was executed and probable outcomes will not have a materially adverse provides for repayment of the funds, which will be impact on NAS. adjusted to allocate each party's proportional share of the appreciation or depreciation in the value of the residence, (17) RISKS AND UNCERTAINTIES which is based on the relative financing percentage provided by each party. The agreement will terminate NAS invests in various investment securities. Investment upon pay-back of the advance, sale of the property, or the securities are exposed to various risks such as interest end of the individual's employment with NAS, which will rate, market and credit risks. Due to the level of risk not exceed 12 years. The estimated present value of the associated with investment securities, it is at least receivable at December 31, 2005 is $2.25 million and is reasonably possible that changes in the values of invest- included in other assets on the statement of financial ment securities will occur in the near term and that such position. changes could materially affect the amounts reported. (16) 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 2006 $ 2,817 2007 2,059 2008 390 2009 388 2010 230 $ 5,884 Rental expense amounted to approximately $3.0 million and $3.1 million for the years ended December 31, 2005 and 2004, respectively. 54

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OFFICERS Ralph J. Cicerone, President Barbara A. Schaal, Vice President John I. Brauman, Home Secretary Michael T. Clegg, Foreign Secretary Ronald L. Graham, Treasurer FINANCE COMMITTEE Ronald L. Graham, Chair Elwyn R. Berlekamp Elkan R. Blout Ralph J. Cicerone David M. Kipnis Lawrence R. Klein William J. Rutter Paul A. Samuelson IOM Representative: James Gavin, III BUDGET AND INTERNAL AFFAIRS COMMITTEE Ronald L. Graham, Chair Roger N. Beachy Claude R. Canizares Ralph J. Cicerone Gerald D. Fischbach Barbara A. Schaal Susan R. Wessler AUDITING COMMITTEE Jack Halpern, Chair Jerry P. Gollub Gerald M. Rubin Herbert Tabor M. Gordon Wolman FINANCIAL MANAGEMENT STAFF Archie L. Turner, Chief Financial Officer Didi Salmon, Controller 55

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