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Explanatory Notes to the Financial Statements (Exhibits A, B. and C) June 30, 1996 NOTE 1: ORGANIZATION AND RELATED ENTITIES 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. The NAS operates as a private, coopera- tive society of distinguished scholars in scientific or engi- neering research, dedicated to the furtherance of science and its use for the general welfare. The NAS is exempt from federal income taxes under Section 501(c)~3) of the Internal Revenue Code, except for unrelated business income. National Research Council Most of the activities undertaken by the NAS are carried out through the Commissions, Offices, and Boards of the National Research Council (NRC), which draw upon a wide cross-section of the nation's leading scientists and engineers for advisory services to government agencies and the Con- gress. To enable it to respond effectively to both the disci- plinary concerns of the research community and the com- plex interdisciplinary problems facing American Society, the National Research Council is organized into ten major units, which are responsible for most study activities- Commission on Behavioral and Social Sciences and Edu- cation; Commission on Engineering and Technical Sys- tems; Commission on Geosciences, Environment, and Resources; Commission on Life Sciences; Commission on Physical Sciences, Mathematics and Applications; Office of International Affairs; Office of Scientific and Engineer- ing Personnel; Board on Agriculture; Transportation Research Board; Center for Science, Mathematics, and Engineering Education. The financial activity and results of the National Research Council are included in the NAS's financial statements (see Exhibits A, B. and C). - 36 Institute of Medicine The Institute of Medicine (IOMJ, established in 1970, con- ducts studies of policy issues related to health and medicine; issues position statements on these policies; cooperates with the major scientific and professional societies in the field; identifies qualified individuals to serve on study groups in other organization units; and disseminates information to the public and the relevant professions. The IOM was estab- lished as a separate membership organization within the NAS. The IOM's Policy Division is responsible to the Exec- utive Office of the National Research Council. The financial activity and results of the IOM are included in the NAS's financial statements (see Exhibits A, B. and C). National Academy of Engineering The National Academy of Engineering (NAE) was estab- lished in December 1964, under the charter of the National Academy of Sciences, as a related, parallel organization, autonomous in its administration and in the selection of mem- bers. The NAE shares with the NAS the responsibility for advising the federal government on scientific issues. The NAS is reimbursed by the NAE for indirect costs it incurs on behalf of the NAE. These costs totaled $2.8 million in 1996. The financial activity and results of the NAE are not included in the National Academy of Sciences' financial statements. National Academy of Engineering Fund The National Academy of Engineering Fund (NAEF) is a separately incorporated not-for-profit organization estab- lished by the NAE to raise funds to support the goals of the NAE. The financial activity and results of the NAEF are not included in the NAS's financial statements. The description of a loan between NAEF and the NAS for the acquisition of equipment is disclosed in note 4 to the financial statements. The National Academies' Corporation The National Academies' Corporation (TNAC) was separately incorporated in January 1986 as a not-for-profit corporation for the purpose of constructing and maintaining a study and con- ference facility. This facility, the Arnold and Mabel Beckman Center, is located in Irvine, California, and operates to expand and support the general activities of the NAS, the NRC, the IOM, and the NAE. The NAS and the NAEF are 50/50 joint investors of TNAC. The financial activity and results of TNAC

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are not included in the NAS' financial statements. TNAC uti- lizes the NAS' Endowment and Trust investment pool as a means to invest certain assets. These TNAC investments partic- ipate in the investment pool experience along with all other funds in this pool. Earnings allocated to the TNAC investments are reinvested with the original investments. The NAS's oblig- ation to TNAC for these funds held in trust, which total $10.9 million as of June 30, 1996, is reported as funds held on behalf of others on the statement of financial position. NOTE 2: SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Basis of Accounting In 1996, the NAS adopted the standards for financial reporting set forth in Statement of Financial Accounting Standards (SFAS) No. 117, Financial Statements of Not- for-Profit Organizations and the methods of accounting for contributions set forth in SFAS No. 116, Accounting for Contributions Received and Contributions Made. Adoption of SFAS No. 117 resulted in significant changes in the format and content of the basic financial statements and changes in the classification of certain items. The adop- tion of SFAS No. 116 resulted in changes in the measure- ment and timing of recognition of contributions. The effects of these changes in the recognition of contributions prior to July 1, 1995, are reported as a cumulative effect of change in accounting principle in the 1996 statement of activities. Temporary restrictions are released prospectively upon adoption of SFAS No. 1 16. Under the revised financial reporting standards, net assets and revenues, expenses, gains and losses are classified based on the existence or absence of donor-imposed restrictions. Accordingly, net assets of the NAS are classi- fied and reported as follows: Permanently restricted: Net assets subject to donor- imposed stipulations that they be maintained in perpetuity by the NAS. Generally, the donors of these assets permit the NAS to use all or part of the income earned on related investments for general or specific purposes. Temporarily restricted: Net assets subject to donor- imposed stipulations that may or will be met either by actions of the NAS and/or by 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 transac- tions and unexpended contributions that are not subject to donor-imposed stipulations. The change in classification of the NAS' net assets resulted in the following reclassification of the June 30, 1995, equity (fund balances) as previously reported and the July 1, 1995, equity (net assets' as reported on the 1996 statement of activities. ($ in thousands) Temporarily Permanently Unrestricted Restricted Restricted Totals Fund balances as July 1, 1995 as previously reported: General funds Private programs funds Endowment and trust funds Net assets as of July 1, 1995 as restated Contributions $ 24,341 24,341 11,461 1,969 13,430 36,023 22,475 69,766 128,264 $ 71,825 $24,444 $69,766 $166,035 Contributions' including unconditional promises to give' are recognized as revenues in the period received. Condi- tional promises to give are not recognized until the condi- tions on which they depend are substantially met. Gifts of land, buildings, and equipment are reported as unrestricted net assets unless explicit donor stipulations specify how the donated assets must be used. Temporary restrictions on gifts to acquire long lived assets are consid- ered met in the period in which the assets are acquired or placed in service. Cash and Cash Equivalents The NAS considers excess cash which is invested in overnight, government-backed repurchase agreements and demand deposits to be cash equivalents. Short-Term Investments The NAS holds certain short-term investments for pro- gram and operational liquidity requirements. These investments are carried at cost which approximates fair value. 27

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Endowment and Trust Investments The Endowment and Trust investments are reported at the lower of cost or fair value. Gains or losses arising from the disposition of investments are reported as increases in unrestricted net assets unless otherwise specified by the donor. All Endowment and Trust investments are pooled for investment purposes. Investments in this pool are administered as an open-end investment trust, with shares of the pool funds expressed in terms of participating capital units (PCU). PCU values are used to determine equity among funds in the pool whenev- er new money is contributed or withdrawals are made. Income earned that is not reinvested does not affect the PCU value. Contracts and Grants A major portion of the NAS's activities is performed under cost-reimbursable contracts with the U.S. Government. The largest concentrations within federal contracts are the Department of Transportation (approximately 20~o) and the Department of Defense (approximately 15~o). It is the policy of the NAS to record these contracts as exchange transactions and recognize revenue as costs are incurred. The costs associated with the U.S. Government contracts are subject to audit by the Defense Contract Audit Agency (DCAA), which has completed its examinations through June 30, 1995. Activities supported by individuals or private organizations are generally financed by grants to the NAS. Revenue for grants qualifying as contributions is recorded at the time the NAS is notified of the grant. Such grants are classified as temporarily restricted if the use of the grant funds is limit- ed to specific areas of study or restricted to be used in future periods. The net asset restrictions are released when the funds are used for the limited purpose. Revenue from pri- vate grants that are not restricted to purpose or future peri- ods is recognized as unrestricted revenue. For grants which are determined to be exchange transac- tions, revenue is recognized as the related costs are incurred. Funds received in advance for these grants are recorded as deferred revenue on the statement of financial position. Inventory Inventories are stated at the lower of cost or net realizable value and include supplies, work-in-process, and finished goods for the publication activities of the NAS. The majority of the NAS' inventory of publications and sup- plies resides at the National Academy Press (NAP). NAP uses the full absorption costing methodology in pricing finished products. This methodology includes all direct printing cost and indirect cost. Property and Equipment Depreciation of the NAS's buildings and equipment is computed on a straight-line basis using the following lives: buildings - 40 to 50 years building and leasehold improvements - lesser of the remaining life of the building or estimated useful life of improvement furniture & equipment - 4 to 10 years. Improvements to leased facilities are amortized over the remaining life of the lease. The Einstein Memorial sculp- ture is not depreciated. Use of Estimates The preparation of these financial statements in confor- mity with 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 disclosure of contingent assets and liabilities as of the date of the financial statements. Actual results could dif- fer from those estimates. Comparative Financial Statements The financial statements include certain prior year summa- rized comparative information in total but not by net asset class. Such information does not include sufficient detail to constitute a presentation in conformity with generally accepted accounting principles. Accordingly, such infor- mation should be read in conjunction with NAS's financial statements for the year ended June 30, 1995, from which the summarized information was derived.

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NOTE 3: PROPERTYAND EQUIPMENT Property and equipment as of June 30 are as follows: Land Buildings and Improvements Furniture and Equipment Leasehold Improvements ($ in thousands) 19961995 $ 369$ 369 12,27912,267 26,13523,218 6,2386,200 $ 45,021$ 42,054 Less: Accumulated depreciation and amortization 2S,702 26,693 $ 16,319 $ 15,361 The NAS is the custodian of certain property and equip- 1997 ment that is owned by the U.S. Government and is fur- As nished to the NAS for work under government contracts. 1999 The cost for these assets, which is not reflected in the 2000 accompanying balance sheets, was approximately 200 $560,000 for the years ended June 30, 1996 and 1995. NOTE 4: COMMITMENTS NAEF Loans The NAS has a series of 5-year loans from the NAEF for the acquisition of equipment. These loans are to be repaid in equal installments at an interest rate determined by the Secretary of the Treasury in accordance with P.L. 92-41 (5.875% as of June 30, 19961. The loan obligation consists of a $0.9 million current liability included in accounts payable and accrued expenses and a $0.7 million long term liability included in other liabilities on the statement of financial position as of June 30, 1996. Total interest expense for 1996 and 1995 was $168,000 and $ 129,000, respectively. The loan repayment schedule is as follows: ($ in thousands) Fiscal Year Payment 997 $ 1,000 998 718 ,718 (108 $ 1,610 Leases The NAS is committed to several noncancelable leases for office space and equipment. In 2007, the NAS may exer- cise a f~ve-year renewal option on a building lease. If the NAS should exercise the option, the annual rentals will be based upon the then market rental for comparable office space within Washington, D.C. Under the five year option, title of the property will pass to NAS in 2012. Future minimum rental payments due under noncancelable leases are as follows: ($ in thousands) June 30 Minimum Rental Payments $ 7,574 7,399 7,026 4,894 4,s7s 27,6ss $59,123 Rental expense for 1996 and 1995 amounted to $8.3 mil- lion and $9.1 million, respectively. NOTE 5: EMPLOYEE BENEFITS Pension Plans The NAS has an insured, non-contributory, defined contri- bution pension plan covering substantially all of its employees. The plan is intended to qualify under Section 401(a) of the Internal Revenue Code and uses Teachers Insurance and Annuity Association/College Retirement Equities Fund (TIAA/CREF) group retirement annuity contracts as the investing vehicle. Employees under this plan vest immediately. The NAS intends to seek a favor- able determination letter from the Internal Revenue Ser- vice on the qualification of this plan under Section 401(a) of the Internal Revenue Code. In addition, the NAS also has a voluntary employee con- tribution retirement plan that is funded solely by employee contributions made on a pre-tax, salary-reduction basis under Section 403(b) of the Internal Revenue Code. The investing vehicles under this voluntary plan are retirement annuity contracts issued by TIAA/CREF and mutual funds offered by the Vanguard Group, Inc. 39

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Pension expense in 1996 and 1995 amounted to $5.0 mil- lion and $5.1 million, respectively. The NAS's policy is to fund pension benefits as they are earned. The NAS's nor- mal retirement age is 65, but there is no mandatory age for retirement. Deferred Compensation The NAS holds long-term investments as part of a deferred compensation arrangement for certain employees. The fair value of these investments is approximately $4.9 million as of June 30, 1996, and is reported in other assets. The relat- ed obligation is included in accrued employee benefits on the statement of financial position. Post-retirement Benefit is The NAS provides certain health care and life insurance benefits for retired employees. All employees may become eligible for these benefits if they reach normal retirement age while working for the NAS and meet certain service requirements. These benefits for retirees are provided by an insurance company whose premiums are determined on an experience rated basis. The plan is contributory for employees who retire after January 1, 1990. Employees contribute 25% of the monthly premium. The NAS has elected to recognize the initial post-retirement benefit obligation over a period of 20 years. The accrued post- retirement benefit obligation is reported as accrued employee benefits on the statement of financial position. The post-retirement benefit cost for 1996 includes the fol- lowing components. ($ in thousands) Life Insurance Health Benefits Benefits $ 6 $ 38 Service cost (with interest) Interest cost Amortization of transition obligation26 Totalexpense$ 70 405 $ 1,325 Total 286$ 292 634672 431 $ 1,395 The status of the NAS's post-retirement benefit obligation is summarized as follows as of June 30, 1996: 40 ($ in thousands) Life Insurance Health Benefits Benefits Accumulated Postretirement Benefit Obligation: Retirees Fully Eligible Actives Other Actives Total APB O Plan Assets Funded Status(510) Unrecognized Net Gain(9) Unrecognized Transition Obligation463 Accrued Postretirement Benefit Cost Totals $ (440) (21) (49) (510) (5,756)(6,196) (557)(578) (2,545)(2,594) - (8,858)(9,368) (8,858)(9,368) (115)(124) 7,2997,762 $ (56) (1,674) (1,730) The discount rate used to calculate the accumulated post- retirement benefit obligation was 7.75%. The trend rates for growth in health care costs used in calculating the accu- mulated post-retirement benefit obligation was 13.2% for employees under age 65 and 1 l.5~o for employees 65+ in fiscal 1995, declining gradually to 5.8% for both employ- ee groups. The health care cost trend rate assumption has a significant impact on the post-retirement benefit cost and obligation. A one percentage point increase in the assumed health care cost trend rate for each year would increase the accumulated post-retirement benefit obliga- tion by approximately 12~o, or $1.1 million. Post-employment Benefits The NAS also provides post-employment benefits to for- mer or inactive employees before retirement. The liability for these benefits is calculated on an actuarially deter- mined basis over the years the employees become eligible. The total 1996 post-employment benefit expense was approximately S366,000. NOTE 6: CONTRIBUTIONS RECEIVABLE Pledged contributions are included in the other current receivables on the statement of financial position. Contrib- utors have pledged to provide support in the following future periods: ($ in thousands) Fiscal Year Totals 1997 $ 165 1998 2,539 Contributions Receivable $ 2,704

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In addition, a donor has conditionally pledged a contribu- tion of $750,000 to be paid when the NAS raises the required matching funds. NOTE 7: LINE OF CREDIT The NAS has a $5.0 million unsecured line of credit from Nationsbank with interest at prime. The NAS has not drawn on this line of credit since its inception in 1994. NOTE 8: CHARITABLE GlFTANNUITY The NAS has arrangements with donors in which the donor contributes assets in exchange for a promise to receive a fixed amount for a specified period of time. The NAS received charitable gift annuities with a fair market value of $224,302 and recorded a liability of $102,423 rep- resenting the present value of future cash flows expected to be paid to the annuitants. Assets are recognized based on the fair market value of the donated asset. The discount rate used to project present value of cash out flow is based on the IRS discount rate applicable at the date of the gift. NOTE 9: DIRECT AND INDIRECT PROGRAM EXPENSES Program expenses for 1996 as classified as follows: ($ in thousands) Scientific and Engineering Personnel Transportation Research Board Institute of Medicine Engineering and Technical Systems Behavioral and Social Sciences and Education Geosciences, Environment & Resources Physical Sciences, Math & Applications International Affairs Commission on Life Sciences Science, Mathematics & Engineering Education Policy Division National Sciences Resource Center National Academy of Engineering Board on Agriculture Other Strategic Highway Research Program Total up 50,193 40,874 14,127 11,012 10,381 10,054 9,879 8,026 7,020 3,644 3,275 2,816 2,082 994 907 236 $ 175,520 NOTE 10: INDIRECT COSTS The NAS received fixed indirect rates for fiscal year 1996. The overhead rate was 63.0% and the general and admin- istrative (G & A) rate was 18.7~o. Overhead was assessed against direct salaries, accrued leave, fringe benefits, and services provided by outside contractors (e.g., temporary personnel agencies, consultants) on NAS property, and G & A was assessed against direct costs and overhead less subcontract costs and stipends. Therefore, both the over- head and G & A rates were applied to projects incurring direct salaries and other direct costs such as travel. If a project did not require direct salaries, such as a travel grant program, a subcontract/flow-through administration rate of 2.8% was applied. Certain other activities, such as off-site work (not performed on NAS property), were assessed at a reduced overhead rate of 24.0%. NOTE 11: INVESTMENTS Short-term investments and Endowment and Trust invest- ments consist of the following as of June 30, 1996: ($ in thousands) Short-term investmentsCostFair Value Merganser Capital(FixedIncome)$ 28,136$ 28,136 Bankers Trust (Fixed Income)100100 $ 28,236$ 28,236 Endowment and locust investmentsCost Cash Equivalents Bonds and Notes Real Estate Mortgage Equity Securities ($ in thousands) $ 4,684 41,416 13,818 90,293 $150,211 $ 4,684 41,067 13,818 134,634 $194,203 Vanguard equity funds comprise approximately $51 mil- lion of the total equity securities funds. The real estate mortgage represents funds loaned to the owners of certain office buildings to rehabilitate them for occupancy by NAS. This is a 20-year mortgage secured by these buildings. Fair value is approximated by the appraised value for insurance purposes. Fair value for other investments is determined based on quoted market prices, except for private placements, where the value is determined by the portfolio manager. Fair values of all other financial instruments approximate the reported val- ues due to the immediate or short-term maturity. 41

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Investment income is reported net of investment advisory fees of approximately $120,000 in 1996. NOTE 12: RESTRICTED NETASSETS Temporarily restricted net assets are available for the fol- lowing purposes as of June 30, 1996. ($ in thousands) Program$ 22,493 Prizes and awards10,486 Woods Hole Facility496 Total$ 33,475 Permanently restricted net assets are invested in perpetuity. The income generated by these assets is to be used to sup- port donor-specified programs or general activities of the NAS. As of June 30, 1996, the NAS held the following per- manently restricted net assets, classified by the purpose for which the income is to be used. ($ in thousands) Program Prizes and awards Total 42 $ 67,859 2,301 $ 70,160

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ASOFJULY1, 1996 OFFICERS Bruce Alberts, President Jack Halpern, Vice President Peter H. Raven, Home Secretary F. Sherwood Rowland, Foreign Secretary Ronald L. Graham, Treasurer FINANCE COMMITTEE Ronald L. Graham, Chair Bruce Alberts Elkan R. Blout David M. Kipnis Lawrence R. Klein Robert C. Merton Paul A. Samuelson Howard E. Simmons, Jr. BUDGETAND INTERNAL AFFAIRS COMMITTEE Ronald L. Graham, Chair Ellis B. Cowling Marye Ann Fox Jack Halpern David M. Kipnis Richard N. Zare AUDITING COMMITTEE Elkan R. Blout, Chair Ellis B. Cowling David Kipnis FINANCIAL MANAGEMENT STAFF Archie L. Turner, Chief Financial Officer Therese Swetnam, Director of Accounting Office . . 43

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