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 June 2007 Dr. Ralph Cicerone, President National Academy of Sciences Dear Dr. Cicerone: 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, 2006, 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 M. GORDON WOLMAN PURNELL W. CHOPPIN National Academy of Sciences THE NATIONAL ACADEMIES Advisers to the Nation on Science, Engineering, and Medicine 2101 Constitution Avenue, NW Washington, DC 20418

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Report of the Treasurer to the Council of the National Academy of Sciences 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, 2006 and 2005, 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, 2006 and 2005, and its changes in net assets and its cash flows for the years then ended in conformity with U.S. generally accepted accounting principles. June 4, 2007 KPMG LLP. KPMG LLP, a U.S. limited liability partnership, is a member of KPMG International, a Swiss cooperative.

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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, 2006 and 2005 (Dollars in thousands) Assets 2006 2005 Current assets: Cash and cash equivalents $ 3,782 $ 3,640 Short-term investments (note 3)   45,785   48,609 Contracts receivable – U.S. government (note 11)   41,304   45,474 Contributions and other receivables (note 5)   16,175   11,188 Publications and supplies inventories   1,387   1,683 Prepaid expenses and other current assets   3,092   3,364 Total current assets   111,525   113,958 Other assets (notes 12, 14, and 15)   11,883   10,499 Long-term investments (note 3)   429,321   373,827 Contributions receivable, net (note 5)   38,017   38,219 Property and equipment, net (note 4)   135,415   132,623 Einstein Memorial   1,723   1,723   $ 727,884 $ 670,849 Liabilities and Net Assets Liabilities: Current liabilities:   Accounts payable and accrued expenses $ 32,262 $ 28,397 Deferred revenue (note 6)   27,646   19,995 Line of credit (note 7)   3,765   17,528 Other current liabilities (note 12)   9,985   11,014 Total current liabilities   73,658   76,934 Bonds payable (note 12)   122,709   124,282 Funds held on behalf of others (note 3)   23,014   22,584 Note payable (note 13)   3,027   10,000 Accrued employee benefits (note 14)   7,321   7,613 Other long-term liabilities (note 12)   1,858   3,257 Total liabilities   231,587   244,670 Net assets: Unrestricted   180,569   129,498 Temporarily restricted (note 8)   206,438   190,844 Permanently restricted (note 9)   109,290   105,837 Total net assets   496,297   426,179 Commitments and contingencies (notes 3, 11, 12, 14, 16, and 17)   Total liabilities and net assets $ 727,884 $ 670,849 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 Statements of Activities Years ended December 31, 2006 and 2005 (Dollars in thousands)   2006 2005 Unrestricted Temporarily restricted Permanently restricted Totals Unrestricted Temporarily restricted Permanently restricted Totals Revenues, gains, and other support: Government contracts and grants (note 11) $ 178,926 - - 178,926 $ 179,871 - - 179,871 Private contracts and grants   20,987 30,544 - 51,531   20,421 24,175 - 44,596 Other contributions   3,898 122 3,453 7,473   3,315 419 8,210 11,944 Fees and publications   19,832 - - 19,832   18,975 - - 18,975 Investment income, net (note 3)   34,795 33,619 - 68,414   18,066 17,441 - 35,507 Other income (note 12)   9,311 - - 9,311   11,959 - - 11,959 Net assets released from restriction (note 8)   48,691 (48,691) - -   22,465 (22,465) - - Total revenues, gains, and other support   316,440 15,594 3,453 335,487   275,072 19,570 8,210 302,852 Expenses (notes 12,14, and 15): Programs (note 10)   221,656 - - 221,656   223,531 - - 223,531 Management and general   41,154 - - 41,154   40,211 - - 40,211 Fundraising   2,559 - - 2,559   2,329 - - 2,329 Total expenses   265,369 - - 265,369   266,071 - - 266,071 Change in net assets   51,071 15,594 3,453 70,118   9,001 19,570 8,210 36,781 Net assets at beginning of the year   129,498 190,844 105,837 426,179   120,497 171,274 97,627 389,398 Net assets at end of the year $ 180,569 206,438 109,290 496,297 $ 129,498 190,844 105,837 426,179 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 Statements of Cash Flows Years ended December 31, 2006 and 2005 (Dollars in thousands)   2006 2005 Cash flows from operating activities: Change in net assets $ 70,118 $ 36,781 Adjustments to reconcile change in net assets to net cash provided by operating activities: Depreciation and amortization   6,660   6,719 Loss on disposal of property and equipment   123   21 Gain on sale of property and equipment   -   (1,911) Bad debt expense   161   66 Net gain on investments   (48,925)   (20,844) Net gain on investments held on behalf of others   (430)   (791) Amortization of deferred gain   (738)   (746) Gain on interest rate swap   (708)   (650) Contributions restricted for construction or endowment   (3,635)   (3,922) (Increase) decrease in assets: Other receivables   (4,947)   (2,601) Contracts receivable — U.S. government   4,169   1,225 Publications and supplies inventories   296   4 Prepaid expenses and other current assets   272   (78) Other assets   (675)   (2,207) Increase (decrease) in liabilities: Accounts payable and accrued expenses   3,865   (1,145) Deferred revenue   7,651   (1,303) Other current liabilities   739   17 Funds held on behalf of others   430   791 Accrued lease liability and deferred gain   (661)   (9) Accrued employee benefits   (292)   (3,489) Net cash provided by operating activities   33,473   5,928 Cash flows from investing activities: Additions to property and equipment   (9,582)   (1,410) Proceeds from sale of property and equipment   -   2,000 Sales or maturities of investments   255,416   185,701 Purchases of investments   (258,730)   (192,792) Net cash used in investing activities   (12,896)   (6,501) Cash flows from financing activities: Contributions restricted for construction or endowment   3,635   3,922 Proceeds from line of credit   109,793   128,399 Payments on line of credit   (123,556)   (125,662) Proceeds from bank note   3,027   - Payments on bank note   (10,000)   - Payments on bond principal   (1,505)   (1,445) Payments on capital lease liability   (1,829)   (4,436) Net cash provided by financing activities   (20,435)   778 Net increase (decrease) in cash and cash equivalents   142   205 Cash and cash equivalents, beginning of year   3,640   3,435 Cash and cash equivalents, end of year $ 3,782 $ 3,640 Supplemental disclosure of cash flow information: Interest paid $ 6,019 $ 5,772 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, 2006 and 2005 (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 the NAS governance structure, and therefore are included in the NAS financial statements. (c) Institute of Medicine The Institute of Medicine (IOM), established in 1970, conducts studies of policy issues related to health and medicine. 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 activities 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 NAE conducts both independent program activities and activities through the NRC. The results of these activities are included in the NAS financial statements. (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 activities 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 2006 and 2005, for which NAS paid $286,000 and $275,000, 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 Investments are stated at fair value. The fair value of all debt and equity securities with a readily determinable fair value are based on quotations obtained from national security exchanges. Alternative investments, consisting of hedge funds and private placement equities, which are not readily marketable, are carried at estimated fair values as provided by the investment managers. Management reviews and evaluates the values provided by the investment managers and agrees with the valuation methods and assumptions used in determining the fair value of the alternative investments. Investments in real estate mortgages are recorded at cost, which approximates fair value, and consist of mortgages on certain administrative facilities that NAS occupies. 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. Allowances are recorded for estimated uncollectible contributions based upon management’s judgment and analysis of the credit worthiness of the donor, past collection experience, and other relevant factors. Contributions to be received after one year are discounted at an appropriate rate commensurate with risks involved. Amortization of the discount is recorded as additional revenue and is used in accordance with donor imposed restrictions, if any, on the contributions. NAS performs certain fundraising activities on behalf of NAEF. NAS collected a total of $4.0 million and $3.7 million in 2006 and 2005, respectively, on behalf of NAEF. NAS disbursed $3.9 million and $3.4 million to NAEF from these collected amounts in 2006 and 2005, respectively. Amounts collected but not yet remitted to NAEF are reported as assets and liabilities in the 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 2006 2005 Department of Transportation 31% 26% Department of Health and Human Services 11% 13% National Aeronautics and Space Administration 5% 11% 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.

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Report of the Treasurer to the Council of the National Academy of Sciences (g) Fair Value of Financial Instruments The carrying value of bonds payable in the financial statements was less than their fair value by approximately $3.2 million and $3.4 million on December 31, 2006 and 2005, 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 both work-in-process and finished goods related to publication activities. The majority of NAS publication inventories and supplies reside with an NAS unit, the National Academy Press (NAP). NAP uses the full absorption costing methodology in pricing finished products. This methodology includes direct printing and related indirect costs. (i) Property and Equipment Depreciation of NAS buildings and equipment is computed on a straight-line basis using the following lives: Buildings – 40 to 50 years Building and leasehold improvements – lesser of the remaining life of the building or improvement Furniture and equipment – 4 to 10 years The Einstein Memorial sculpture is valued at cost and 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 U.S. generally accepted accounting principles 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, 2006 and 2005 (dollars in thousands):   2006 2005 Short-term investments: Cash equivalents $ 7,640 $ 8,972 Bonds and notes   23,540   21,715 Equity securities   14,605   17,922 Total short-term investments $ 45,785 $ 48,609 Long-term investments: Pooled endowment and trust investments: Cash equivalents $ 19,519 $ 20,841 Bonds and notes   32,772   32,902 Equity securities   252,744   227,898 Real estate   17,726   16,308 Hedge funds   69,197   42,066 Private placements   13,598   11,546     405,556   351,561 Other long-term investments: Cash equivalents   819   2,717 Bonds and notes   8,369   10,100 Equity securities   14,577   9,449     23,765   22,266 Total long-term investments $ 429,321 $ 373,827 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 2006 and 2005, NAS made lease payments of approximately $2.4 million and $2.3 million, respectively. Vanguard equity funds comprised approximately $142 million and $125 million of the total equity securities funds at December 31, 2006 and 2005, respectively. At December 31, 2006 and 2005, real estate investments include real estate mortgages at cost and shares of real estate investment trusts at fair value. 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 $5.5 million and $4.6 million for the years ended December 31, 2006 and 2005, respectively.

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Report of the Treasurer to the Council of the National Academy of Sciences Private equity investments are comprised of limited partnership interests. NAS had remaining commitments at December 31, 2006 and 2005 to provide approximately $4.1 million and $5.7 million, respectively, to these partnerships. As of December 31, 2006 and 2005, respectively, NAS held alternative investments with fair values of approximately $82.8 million and $53.6 million. These fair values were estimated by the general partners of these investment funds in the absence of readily ascertainable values at those dates. TNAC, a related entity, invests certain of its assets in the NAS long-term investment pool. TNAC investments participate in the investment pool experience proportionally with all other funds in this pool. The NAS obligation to TNAC for these funds held in trust, which totaled approximately $23 million as of both December 31, 2006 and 2005, 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 $472,000 and $569,000 for the years ended December 31, 2006 and 2005, respectively, and is comprised of the following (dollars in thousands):   2006 2005 Interest and dividends income $ 19,489 $ 14,663 Net gain on investments 48,925 20,844 Total investment income, net $ 68,414 $ 35,507 (4) PROPERTY AND EQUIPMENT Property and equipment as of December 31, 2006 and 2005, were as follows (dollars in thousands):   2006 2005 Land $ 29,689 $ 29,689 Furniture and equipment   31,040   30,285 Buildings and improvements   108,608   108,285 Construction in progress   776   170 Leasehold improvements   6,960   6,894     177,073   175,323 Less accumulated depreciation and amortization   (41,658)   (42,700) Total property and equipment, net $ 135,415 $ 132,623 (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 2007 $ 11,119 2008   4,500 2009   3,355 2010   3,271 2011   11,628 Thereafter   22,045     55,918 Less discount at rates from 3% to 5% to estimate net present value   (6,782) Less allowance for uncollectible contributions   (108)     49,028 Less current portion   (11,011) Total contributions receivable, long-term $ 38,017 At December 31, 2005, the discount on contributions receivable was $7.7 million at rates ranging from 3% to 5%. The allowance for uncollectible contributions was $47,000 at December 31, 2005. (6) DEFERRED REVENUE Deferred revenue consisted of the following as of December 31, 2006 and 2005 (dollars in thousands):   2006 2005 Advances from private grants and contract sponsors $21,383 $13,844 Advances from U.S. government sponsors 2,604 3,207 Publication subscriptions and other 3,659 2,944 Total deferred revenue $27,646 $19,995 (7) LINE OF CREDIT NAS is party to a $22 million unsecured line of credit from Bank of America which bears interest at LIBOR plus 0.40% and expires on July 31, 2007. Interest expense related to the line of credit for the years ended December 31, 2006 and 2005, was approximately $445,000 and $343,000, respectively.

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Report of the Treasurer to the Council of the National Academy of Sciences (8) TEMPORARILY RESTRICTED NET ASSETS Temporarily restricted net assets were available for the following purposes as of December 31, 2006 and 2005 (dollars in thousands):   2006 2005 Sponsored research and advisory programs $174,650 $164,170 Prizes and awards 27,243 22,838 Woods Hole facility 4,545 3,836 Total temporarily restricted net assets $206,438 $190,844 Temporarily restricted net assets were released from restriction for the following purposes during the years ended December 31, 2006 and 2005 (dollars in thousands):   2006 2005 Sponsored research and advisory programs $47,352 $21,031 Prizes and awards 759 1,169 Woods Hole facility 580 265 Total temporarily restricted net assets released from restriction $48,691 $22,465 (9) PERMANENTLY RESTRICTED NET ASSETS The income generated by permanently restricted net assets is available to support donor-specified programs. As of December 31, 2006 and 2005, NAS held the following permanently restricted net assets, classified by the purpose for which the income is to be used (dollars in thousands):   2006 2005 Sponsored research and advisory programs $104,177 $100,725 Prizes and awards 5,113 5,112 Total permanently restricted net assets $109,290 $105,837 (10) PROGRAM EXPENSES Program expenses for the years ended December 31, 2006 and 2005 are summarized as follows (dollars in thousands):   2006 2005 Transportation Research Board $ 59,045 $ 54,873 Policy and Global Affairs   53,625   64,784 Institute of Medicine   23,626   23,640 Earth and Life Sciences   20,247   19,588 Engineering and Physical Sciences   17,318   18,048 Behavioral and Social Sciences and Education   15,876   11,119 Proceedings of the National Academy of Sciences   11,627   11,117 National Academy Press   6,533   6,817 National Academy of Engineering   6,240   6,240 Koshland Science Museum   1,614   1,579 NAS and National Sciences Resource Center   5,905   5,726 Total program expenses   $221,656   $223,531 (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 is recorded. NAS has a cumulative net underrecovery of approximately $2.4 million and $4.3 million as of December 31, 2006 and 2005, 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

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Report of the Treasurer to the Council of the National Academy of Sciences 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):   2006 2005 Series 1999A revenue bonds, serial, with interest rates ranging from 4.1% to 5% maturing at various dates from January 1, 2007 through 2012 $ 10,650 $ 12,155 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 (3.37% in 2006 and 2.59% in 2005) due January 1, 2039   32,500   32,500 Series 1999C revenue bonds, term, at variable rates (3.52% in 2006 and 2.21% in 2005) due January 1, 2039   32,500   32,500 Total bonds, at face value   125,280   126,785 Less unamortized discount and premium   (1,006)   (998) Total bonds payable   124,274   125,787 Less current portion (included in other current liabilities)   (1,565)   (1,505) Bonds payable, long-term $ 122,709 $ 124,282 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. 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: 2007 $ 1,565 2008   1,645 2009   1,725 2010   1,810 2011   1,905 Thereafter   116,630   $ 125,280 Interest expense on the bonds payable for 2006 and 2005 totaled $5.2 million and $4.6 million, respectively. (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.

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Report of the Treasurer to the Council of the National Academy of Sciences 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, 2006 and 2005, NAS recorded a gain on the change in the fair value of its derivative instruments in the amount of approximately $708,000 and $650,000 respectively, which is included in other income in the accompanying statements of activities. The fair value of the interest rate swap was $1.9 million and $1.1 million as of December 31, 2006 and 2005, respectively, and is included in 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 are included in future minimum rental payments summarized in note 16. The sale-leaseback transaction resulted in a gain of $6.8 million, of which $430,000 and $1.2 million were deferred at December 31, 2006 and 2005, respectively. The deferred gain will be fully recognized by 2007. The deferred gain is reported within other current liabilities 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 $2.8 million and $7.5 million as of December 31, 2006 and 2005, respectively. This obligation is included within other current liabilities in the statements of financial position. (13) NOTE PAYABLE At December 31, 2005, NAS had a loan agreement of $10 million with Bank of America, with a maturity date of July 31, 2010. Interest on the note was calculated at 30-day LIBOR plus 50 basis points and was payable monthly. The interest rate at December 31, 2005 was 4.84%. In July 2006, NAS chose to repay this loan in full. During 2006, NAS entered into a loan agreement with Bank of America for an amount up to $5 million. The principal balance of this note on December 31, 2006 is payable in equal monthly installments until January 1, 2012. On December 31, 2006, the principal balance was approximately $3.8 million. The note bears interest at 30-day LIBOR plus 40 basis points. The interest rate at December 31, 2006 was 5.75%. (14) EMPLOYEE BENEFITS (a) Retirement Plans NAS has a noncontributory defined contribution retirement plan covering substantially all of its employees (based on certain benefit eligibility requirements). 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, 2006 and 2005, amounted to approximately $9.4 and $9.1 million, respectively. The NAS policy is to fund pension benefits as they are earned. The NAS normal retirement age is 60, 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 $4.6 million as of both December 31, 2006 and 2005, 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 health and life insurance benefits for employees retired due to length of service. All benefit-eligible employees may become eligible for service retiree benefits if they reach age 60 while working for NAS and complete 5 years of service in a benefit-eligible status for medical and life benefits. In addition, certain health and life insurance benefits are provided for employees retired due to disability. A benefit-eligible employee may become eligible for disabled retiree benefits if deemed totally disabled under NAS’ disability

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Report of the Treasurer to the Council of the National Academy of Sciences insurance or if they are eligible for disability benefits from the Social Security Administration. Life insurance benefits are provided based on coverage at date of disability and health insurance may be continued if the disabled retiree had participated in an NAS health insurance plan for 5 years at the date of disability. Insurance companies whose premiums are determined on an experience-rated basis provide life and health insurance benefits for retirees. Medicare supplement insurance is not experience rated. The retiree welfare plan is contributory for health insurance purposes for employees who retire after January 1, 1990. Participant contributions for health insurance are based on a percentage of the monthly premium paid by NAS (from 25% to 100%). The participant contribution is also based on their date of retirement, length of service and choice of health insurance carrier. 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. Effective January 1, 2007, NAS increased the life insurance benefit from $3,000 to $10,000. This change is shown as a plan amendment in the change in benefit obligation. In 2006, the Financial Accounting Standards Board issued SFAS No. 158, Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans, which is effective for NAS for the year ended December 31, 2007. This statement requires that an employer recognize the funded status of its benefit plans in its statement of financial position and report the corresponding gains and losses in its statement of activities. 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, 2006 and 2005 (dollars in thousands):   2006 2005 Life insurance benefits Health benefits Total Life insurance benefits Health benefits Total Change in benefits obligations: Benefit obligation, January 1 $ 811 $ 13,719 $ 14,530 $ 814 $ 15,379 $ 16,193 Service cost   14   664   678   13   671   684 Interest cost   45   772   817   45   864   909 Plan participant contributions   -   (104)   (104)   -   (130)   (130) Plan amendments   1,781   -   1,781   -   -   - Actuarial gain   (79)   (524)   (603)   (56)   (2,368)   (2,424) Benefits paid   (6)   (568)   (574)   (5)   (697)   (702) Benefits obligation, December 31 $ 2,566 $ 13,959 $ 16,525 $ 811 $ 13,719 $ 14,530 Change in plan assets, combined: Fair value of plan assets, January 1 $ - $ 9,695 $ 9,695 $ - $ 5,430 $ 5,430 Actual return on plan assets   -   1,542   1,542   -   314   314 Employer contributions   -   1,153   1,153   5   4,523   4,528 Plan participants contributions   -   104   104   -   125   125 Benefits paid   -   (574)   (574)   (5)   (697)   (702) Fair value of plan assets, December 31 $ - $ 11,920 $ 11,920 $ - $ 9,695 $ 9,695 Funded status: Unfunded benefit obligation $ (2,566) $ (2,039) $ (4,605) $ (811) $ (4,024) $ (4,835) Unrecognized transition obligation   193   -   193   218   -   218 Unrecognized prior service cost   1,903   (131)   1,772   140   (150)   (10) Unrecognized net actuarial (gain) loss   (275)   198   (77)   (203)   1,782   1,579 Accrued benefit cost $ (745) $ (1,972) $ (2,717) $ (656) $ (2,392) $ (3,048)

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Report of the Treasurer to the Council of the National Academy of Sciences   2006 2005 Life insurance benefits Health benefits Total Life insurance benefits Health benefits Total Components of net periodic benefit cost: Service cost $ 14 $ 664 $ 678 $ 13 $ 671 $ 684 Interest cost   45   772   817   45   864   909 Expected return on plan assets   -   (728)   (728)   -   (435)   (435) Amortization of transition obligation   25   -   25   26   -   26 Amortization of prior service cost   18   (19)   (1)   18   (19)   (1) Amortization of unrecognized (gains) losses   (13)   44   31   (7)   312   305 Net periodic cost $ 89 $ 733 $ 822 $ 95 $ 1,393 $ 1,488 The assumptions used to determine net periodic benefit cost for years ended December 31, 2006 and 2005 are as follows:   2006 2005 Discount rate 5.75% 5.75% Expected long-term return on plan assets 7.5% 8.0% The assumptions used to calculate the accumulated postretirement benefit obligation for the years ended December 31, 2006 and 2005 are as follows:   2006 2005 Discount rate 5.75% 5.75% NAS postretirement benefit plan asset allocations at December 31, 2006 and 2005, by asset category are as follows:   2006 2005 Cash 5% 31% Bonds and notes 25% 15% Equity securities 70% 54%   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 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%. A large cash transfer was made at the end of 2005 that was not invested as of December 31, 2005. 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 actuarially determined net periodic cost for 2007, which is $923,000. The following benefit payments, which reflect future services, are expected to be paid, as of December 31, 2006 (dollars in thousands): Years ending December 31: 2007 $ 787 2008   889 2009   1,000 2010   1,052 2011   1,128 2012-2016   6,401   $ 11,257 The measurement date of the plan assets and benefit obligations for 2006 and 2005 is December 31, 2006 and 2005, respectively. The trend rate for growth in healthcare costs used in calculating the accumulated postretirement benefit obligation was 9.5% and 9.6% during the years ended December 31, 2006 and 2005, respectively, declining gradually to 5% in the year 2018. 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, 2006, would have resulted in an estimated $1.6 million increase or $1.4 million decrease in the postretirement benefit obligation and an estimated

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Report of the Treasurer to the Council of the National Academy of Sciences $211,000 increase or $174,000 decrease in the 2006 benefit expense. The effect of a 1% change in the assumed healthcare cost trend rate at December 31, 2005, would have resulted in an estimated $1.6 million increase or $1.4 million decrease in the postretirement benefit obligation and an estimated $223,000 increase or $184,000 decrease in the 2005 benefit expense. (15) RELATED PARTY TRANSACTIONS The NAS Council authorized a non-interest bearing, collateralized advance to an employee in connection with the purchase of the employee’s residence. In May 2005, the agreement between the parties was executed. It provides that the repayment obligation will be adjusted to allocate to each party its proportional share of the appreciation or depreciation in the value of the residence, which is based on the relative financing percentage provided by each party. The agreement will terminate upon pay-back of the advance, sale of the property, or the end of the individual’s employment with NAS, which will not exceed 12 years. The estimated present value of the receivable at December 31, 2006 and 2005, is $2.5 million and $2.25 million, respectively, and is included in other assets on the statement of financial position. (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 2007 $ 3,146 2008   1,910 2009   1,948 2010   1,831 2011   1,643 Thereafter   8,535   $ 19,013 The total of minimum rental payments to be received in 2007 under noncancelable subleases as of December 31, 2006 is approximately $1.6 million. Rental expense amounted to approximately $3.7 million and $3.0 million for the years ended December 31, 2006 and 2005, respectively. (b) Contingencies NAS receives a portion of its revenues directly or indirectly from federal government grants and contracts, all of which are subject to audit by the Defense Contract Audit Agency, which has completed its examinations through December 31, 2004. 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. (17) RISKS AND UNCERTAINTIES NAS invests in various investment securities. Investment securities are exposed to various risks such as interest rate, market and credit risks. Due to the level of risk associated with investment securities, it is at least reasonably possible that changes in the values of investment securities will occur in the near term and that such changes could materially affect the amounts reported.

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Report of the Treasurer to the Council of the National Academy of Sciences 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 Ralph J. Cicerone David M. Kipnis Lawrence R. Klein William J. Rutter Paul A. Samuelson IOM Representative: John D. Stobo BUDGET AND INTERNAL AFFAIRS COMMITTEE Ronald L. Graham, Chair Claude R. Canizares Barbara A. Schaal Susan R. Wessler Y.W. Kan AUDITING COMMITTEE Jack Halpern, Chair Jerry P. Gollub Gerald M. Rubin M. Gordon Wolman Purnell W. Choppin FINANCIAL MANAGEMENT STAFF Archie L. Turner, Chief Financial Officer Didi Salmon, Controller

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