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IlI. Financial Condition

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Report of the Auditing Committee of the National Academy of Sciences Dear Dr. Alberts: In accordance with Bylaw V-6 of the National Academy of Sciences, the firm of KPMG Peat Marwick LLP was retained to conduct an audit of the accounts of the Treasurer for the fiscal year ended June 30, 199S, 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 ELKAN R. BLOUT, Chair ELLIS B. COWLING DAVID M. KIPNIS National Academy of Sciences Auditing Committee Dr. Bruce Alberts, President National Academy of Sciences Washington, D.C. 40

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Independent Auditor's Report National Academy of Sciences Auditing Committee We have audited the accompanying statement of financial position of the National Academy of Sciences (NAS) as of June 30, 1998, and the related statements of activities and cash flows for the year then ended. These financial statements are the responsibility of the NAS's management. Our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audit in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. 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 audit provides a reasonable basis for our ~ oplmon. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of the National Academy of Sciences as of June 30, 1998, and its changes in net assets and its cash flows for the year then ended in conformity with generally accepted accounting ~ prlnclp. ~es. October 23, 1998 Washington, D.C. KPMG PEAT MARWICK LLP 41

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EXHIBIT A Statement of Financial Position of the National Academy of Sciences Year Ended Kline 30, 1998 (With Comparative Information for 1997) ($ in thousands) 1998 1997 ASSETS Current Assets Cash and cash equivalents Short-term investments (note 3) Accounts receivable - U.S. government Other receivables (note 5) Inventories of publications and supplies Prepaid expenses and other $ 100 34,074 26,307 5,469 1,874 972 $ 62 26,917 28,718 4,689 1,837 645 Total Current Assets $ 68,796 $ 62,868 Einstein Memorial Property and equipment (note 4) Other assets (note 10) Endowment and Trust Investment Pool (note 3) Total Assets LIABILITIES AND NET ASSETS Current Liabilities Accounts payable and accrued expenses Deferred revenue (note 6) Other liabilities $ 1,723 16,961 6,202 263,193 $ 1,723 15,514 5,659 231,848 $356,875 $317,612 $ 16,016 20,428 1,722 $ 15,853 13,368 3,638 Total Current Liabilities$ 38,166$ 32,859 Long-Term Liabilities Funds held on behalf of others (note 3)$ 18,423$ 10,593 Accrued employee benefits (note 10)7,8949,695 Other liabilities (note 12)153616 Total Liabilities$ 64,636$ 53,763 Net Assets Unrestricted$124,186$117,185 Temporarily restricted (note 7)95,63775,659 Permanently restricted (note 7)72,41671,005 Total Net Assets$292,239$263,849 Total Liabilities and Net Assets See accompanying notes to the financial statements. 42 $356,875 $317,612

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EXHIBIT B Statement of Activities of the National Academy of Sciences Year Ended dime 30, 1998 (With Summarized Information for 1997) ($ in thousands) 1998 Temporarily Unrestricted Restricted Permanently 1997 Restricted Totals Totals REVENUES, GAINS, AND OTHER SUPPORT Government contracts and grants$153,386$ $ $153,386$144,540 Private contracts and grants 13,836 6,939 20,775 22,297 Other contributions 5,951 1,4117,362 6,313 Fees and publications 12,513 12,513 11,947 Investment income (note 3) 13,473 21,057 34,530 44,246 Other 2,803 2,803 3,096 Net assets released from restrictions 8,018 (8,018) Total revenues, gains, and other support $209,980 $19,978$ 1,411$231,369 $232,439 EXPENSES Programs (notes) $183,121 $ $ $183,121 $175,081 Management and general 18,746 18,746 19,740 Fund raising 1,112 1,112 1,414 Total expenses $202,979 $ $ $202,979 $196,235 Changein net assets before cumulative effect of $ 7,001 $19,978 $ 1,411 $ 28,390 $ 36,204 change in accounting principles Cumulative effect of change in accounting 44,056 principles (note 2) Changein net assets $ 7,001 $19,978 $ 1,411 $ 28,390 $ 80,260 Net assets at beginning of the year 117,185 75,659 71,005 263,849 183,589 Net assets at end of the year $124,186 $95,637 $72,416 $292,239 $263,849 See accompanying notes to the financial statements. 43

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EXHIBIT C Statement of Cash Flows of the National Academy of Sciences Year Ended dime 30, 1998 (With Comparative Information for 1997) ($ in thousands) 1998 1997 CASH FLOWS FROM OPERATING ACTIVITIES Change in net assets Adjustments to reconcile change in net assets to net cash provided by operating activities Depreciation and amortization Gain on sale of securities Unrealized (gain) loss on securities Loss on sale of property and equipment Decrease (increase) in accounts receivable - U.S. government (Increase) decrease in other receivables Increase in inventories of publications and supplies Increase in prepaid expenses and other current assets Increase in other assets Increase in accounts payable and accrued expenses Increase in other current liabilities Increase in deferred revenue (Decrease) increase in other liabilities Net cash provided by operating activities CASH FLOWS FROM INVESTING ACTIVITIES Purchase of property and equipment Proceeds from sale of equipment Sale or maturity of investments Purchase of investments Net cash used by investing activities CASH FLOWS USED BY FINANCING ACTIVITIES Payments on financing agreement Net increase (decreased in cash and cash equivalents Cash and cash equivalents at beginning of the year Cash and cash equivalents at end of the year Supplemental data Interest paid on obligations See accompanying notes to the financial statements. 44 $ 28,390 3,789 (18,710) 1,365 117 2,411 (780) (37) (327) (543) 163 86 7,060 (2,902) 20,082 $ 80,260 4,042 (4,023) (70,191) (6,073) 1,630 (198) (598) 3,561 1,845 648 10,903 (5,519) 166 678,557 (691,246) (18,042) (3,237) 145,871 (152,369) (9,735) (2,002) 38 (1,357) (189) 62 251 $ 100 $ 62 $ 235 $ 252

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Notes to the Financial Statements Dine 30, 1998 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 cooperative society of distinguished scholars engaged in scientific or engineering research, dedicated to the furtherance of sci- ence 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 busi- ness 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 on a wide cross section of the nation's leading scientists and engi- neers for advisory services to government agencies and the Congress. To respond effectively to both the disciplinary concerns of the research community and the complex interdisciplinary problems facing American society, the NRC is organized into 10 major units that are responsible for most study activities Commission on Behavioral and Social Sciences and Education; Commission on Engineer- ing and Technical Systems; Commission on Geosciences, Environment, and Resources; Commission on Life Sci- ences; Commission on Physical Sciences, Mathematics and Applications; Office of International Affairs; Office of Scientific and Engineering Personnel; Board on Agricul- ture; Transportation Research Board; and Center for Sci- ence, Mathematics, and Engineering Education. The finan- cial activity and results of the NRC are included in the NAS's financial statements. Institute of Medicine The Institute of Medicine (IOM), established in 1970, conducts studies of policy issues related to health and medicine. It issues position statements on these policies; cooperates with the major scientific and professional soci- eties in the field; identifies qualified individuals to serve on study groups in other organization units; and dissemi- nates information to the public and the relevant profes- sions. The IOM was established as a separate membership organization within the NAS. The IOM's Policy Division is responsible to the Executive Office of the National Research Council. The financial activity and results of the IOM are included in the NAS's financial statements. 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 its members. The NAE shares with the NAS the responsibility for advising the federal government on scientific issues. The financial activity and results of the NAE are not included in the NAS's 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 its goals. 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 12 to the financial statements. The National Academies' Corporation The National Academies' Corporation (TNAC) was sepa- rately incorporated in January 1986 as a not-for-profit corporation for the purpose of constructing and maintain- ing a study and conference 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, NRC, IOM, and NAE. The NAS and the NAEF are 50/50 joint investors of TNAC. The finan 45

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cial activity and results of TNAC are not included in the NAS's financial statements. NOTE 2: SUMMARY OF SIGNIFICANT ACCOUNTING POLICES Basis of Accounting 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 classified and reported as follows: Permanentlv restricted: Net assets subject to donor-im posed 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-im- posed stipulations that may or will be met either by actions of the NAS and/or the passage of time. When a donor restriction expires, temporarily restricted net assets are reclassified as unrestricted net assets. Unrestricted: Net assets arising from exchange transac- tions and unexpended contributions that are not subject to donor-imposed stipulations. Contributions subject to donor-imposed stipulations that are met in the same year as received are reported as unrestricted revenue. Cash and Cash Equivalents The NAS considers excess cash that is invested in over- night government-backed repurchase agreements and de- mand deposits to be cash equivalents. Investments The NAS's equity and certain debt securities are reported at their fair values, based on quoted market prices. The NAS's investments in real estate mortgages are recorded at cost. Changes in the fair value are recognized in the statement of activities. Unrealized and realized gains and losses on investments are reported as changes in unre- stricted net assets unless otherwise specified by the donor. 46 The NAS adopted this basis of accounting in 1997. The effect of this change is reported as a cumulative effect of change in accounting principle on the statement of activi- ties. The NAS holds certain short-term investments for pro- gram and operational liquidity requirements. Endowment and trust investments are pooled for long-term 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 when- ever new money is contributed or withdrawals are made. Income earned that is not reinvested does not affect the PCU value. - Contributions 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. Contracts and Grants A major portion of the NAS's activities are performed under cost-reimbursable contracts with the U.S. govern- ment. The largest concentrations in federal contracts are the Department of Transportation (approximately 22%) and the Department of Defense (approximately 16%~. It is the policy of the NAS to record these contracts as ex- change transactions and to recognize revenue as costs are incurred. The costs associated with U.S. government con- tracts are subject to audit by the Defense Contract Audit Agency, which has completed its examinations through June 30, 1996. Activities supported by individuals or private organiza- tions are generally financed by grants to the NAS.

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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 use of the grant funds is limited 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 private grants that is not restricted to purpose or future periods is recognized as unrestricted revenue. Deferred Revenue For grants and contracts that are determined to be ex- change transactions, 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 r. ~ . . Nancy position. Inventories 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's inventory of publications and supplies reside with the National Academy Press (NAP). NAP uses the full absorption costing methodology in pricing finished products. This methodology includes all direct printing and indirect costs. 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 and 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 re- quires management to make certain estimates and assump- tions. 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 differ from those estimates. Reclassircahons Certain amounts included in the 1997 financial informa- tion have been reclassified to conform to the 1998 presen- tation. NOTE 3: INVESTMENTS Short-term investments and endowment and trust invest- ments consisted of the following as of June 30, 1998: Short-term investments Investments reported at fair value: ($ in thousands) Vanguard Admiral Fund Vanguard Fixed-Income Securities NASA Federal Credit Union Endowment and trust investments Investments reported at fair value: Cash equivalents Bonds and notes Equity securities Real estate mortgage $16,958 17,016 100 $34,074 ($ in thousands) $ 2,624 67,247 181,089 $250,960 12,233 $263,193 Vanguard equity funds comprise approximately $120 mil- lion of the total equity securities funds. Fair value for real estate mortgage investments approxi- mated $24 million on June 30, 1998, and is determined by comparative analysis of like location and properties. Fair value for other investments is determined based on quoted market prices. TNAC utilizes the NAS's endowment and trust investment pool as a means to invest certain assets. These TNAC investments participate 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 obligation to TNAC for these funds held in trust, which total $18.4 million as of June 30, 1998,is reported as funds held on behalf of others on the statement of financial position. 47

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Investment income is reported net of investment expenses of approximately $115,000 in 1998 and is comprised of the following: Interest and dividend income Net gains on investments ($ in thousands) $17,184 17,346 $34,530 NOTE 4: PROPERTY AND EQUIPMENT Property and equipment as of June 30, 1998, are as follows: Land Buildings and improvements Furniture and equipment Leasehold improvements Less: Accumulated depreciation and amortization 1 1 ($ in thousands) $ 369 13,465 27,656 6,839 $48,329 31,368 $16,961 The NAS is the custodian of certain property and equip- ment that is owned by the U.S. government and is fur- nished to the NAS for work under government contracts. The cost for these assets, which is not reflected in the accompanying statements of financial position, was ap- proximately $359,000 as of June 30, 1998. NOTE 5: CONTRIBUTIONS RECEIVABLE Pledged contributions are included as other receivables on the statement of financial position. Donors have pledged to provide support in the following future periods: Years Ending June 30 1999 2000 - 2004 ($ in thousands) Totals $3,136 668 $3,804 NOTE 6: DEFERRED REVENUE Deferred revenue consisted of the following as of June 30, 1998: Advances from private contracts Advances on U.S. government contracts Subscription publications 48 ($ in thousands) $13,310 3,118 4,000 $20,428 NOTE 7: RESTRICTED NETASSETS Temporarily restricted net assets are available for the following purposes as of June 30, 1998: Programs Prizes and awards Woods Hole facility ($ in thousands) $69,257 23,592 2,788 $95,637 Permanently restricted net assets are invested in perpetuity. The income generated by these assets is to be used to sunnort donor-specified programs or general activities of the NAS. As of June 30, 1998, the NAS held the following permanently restricted net assets, classified by the purpose for which the income is to be used: Programs Prizes and awards NOTE 8: PROGRAM EXPENSES ($ in thousands) $69,104 3,312 $72,416 Program expenses for 1998 are summarized as follows: Scientific and Engineering Personnel Transportation Research Board Institute of Medicine Engineering and Technical Systems Behavioral and Social Sciences and Education Geosciences, Environment, and Resources Physical Sciences, Mathematics, and Applications International Affairs Commission on Life Sciences Science, Mathematics, and Engineering Education Policy Division National Sciences Resource Center National Academy of Engineering Board on Agriculture Other NOTE 9: INDIRECT COSTS ($ in thousands) $43,757 39,582 15,446 10,205 12,813 10,351 11,517 6,074 19,326 4,002 3,683 1,152 3,058 1,064 1,091 $183,121 The NAS received fixed indirect cost rates for fiscal year 1998 on its federal contracts and grants. The overhead rate was 61.88%, and the general and administrative (G&A) rate was 18.69%. Overhead was applied to direct salaries, accrued leave, fringe benefits, and services provided by outside contractors (e.g., temporary personnel agencies, consultants) on NAS property. G&A was applied to direct

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costs and overhead less subcontract costs and stipends. Therefore, both the overhead 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 1.95% was applied. Certain other activities, such as off-site work (not performed on NAS property), were assessed at a reduced overhead rate of 34.12%. NOTE 10: EMPLOYEE BENEF TS Pension Plans The NAS has an insured, noncontributory, defined contri- bution pension plan covering substantially all of its em- ployees. 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 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, the NAS has a voluntary employee con- tribution retirement plan that is funded solely by employee contributions made on a pretax salary-reduction basis un- der Section 403(b) of the Internal Revenue Code. The in- vesting vehicles under this voluntary plan are retirement annuity contracts issued by TIAA/CREF and mutual funds offered by the Vanguard Group, Inc. Pension expenses in 1998 amounted to $5.4 million. The NAS's policy is to fund pension benefits as they are earned. The NAS's normal 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 was approximately $6.2 million as of June 30, 1998, and is reported in other assets. The related obligation is included as accrued employee benefits on the statement of financial position. Postretirement Benefits The NAS provides certain health care and life insurance benefits for retired employees. All employees may become eligible for these benefits if they reach normal retirement age while working for the NAS and meet certain service requirements. These benefits for retirees are provided by an insurance company whose premiums are determined on an experience-rated basis. The plan is contributory for employees who retire after January 1, 1990. Employees contribute 25% of the monthly premium. The NAS has elected to recognize the initial Postretirement benefit obli- gation over a period of 20 years. The accrued post- retirement benefit obligation is reported as accrued em- ployee benefits on the statement of financial position. The Postretirement benefit cost for 1998 includes the following components: Service cost (with interest) Interest cost Amortization of transition obligation Expected return on plan assets ($ in thousands) Life Insurance Health Benefit Benefit Total $ 6 $ 268$ 274 39 697736 26 406432 - (120)(120) $1,251$1,322 $71 The status of the NAS Postretirement benefit obligation is summarized as follows as of June 30, 1998: Accumulated Postretirement Benefit Obligation Retirees Fully eligible actives Other actives Total APB O Plan assets Funded status (531) Unrecognized net gain 120 Unrecognized transition obligation 411 ($ in thousands) Life Insurance Health Benefits Benefits Total ($468) (16) (47) (531) ($6,911)($7,379) (456)(472) (2,289)(2,336) (9,656)(10,187) 3,3773,377 (6,279)(6,810) (513)(393) 6,4886,899 $ ($ 304)($ 304) 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 accumulated Postretirement benefit obligation were 11.1 % for employees under age 65 and 9.8% for employees 65+ in fiscal year 1998, declining gradually to 5.8% for both employee groups. The health care cost trend rate assump- tion has a significant impact on the Postretirement benefit cost and obligation. A one percentage point increase in the assumed health care cost trend rate for each year would 49

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increase the accumulated postretirement benefit obligation by approximately 12%, or $1.2 million. Postemployment Benefits The NAS also provides certain postemployment benefits to former or inactive employees prior to their eligibility for retirement benefits. The liability for these benefits is calculated on an actuarially determined basis over the years the employees become eligible. The total 1998 post- employment benefit gain was approximately $156,000. NOTE If: [INK OF CREDIT The NAS has a $5.0 million unsecured line of credit from NationsBank with an interest rate at prime of 6%. As of June 30,1998, the outstanding balance on the line of credit was $1.5 million, which is included in other current liabilities in the accompanying statement of financial position. Total interest expense for 1998 was $82,000. NOTE 12: COMMITMENTS NAEF Loans The NAS has a series of long-term loans from the NAEF for the acquisition of equipment. These loans are to be 50 repaid in equal installments at an interest rate determined by the Secretary of the Treasury in accordance with P.L. 92-41 (7.00% as of June 30, 19981. The loan obligation consists of a $50,000 note that is included in other liabilities as of June 30, 1998. Leases The NAS is committed to several noncancelable operating leases for office space and equipment. In 2007 the NAS may exercise a five-year renewal option on a building lease. If the NAS should exercise the option, the annual rentals will be based on the then market rental for compa- rable office space in Washington, D.C. Provided that the NAS exercises its renewal option, title to the property will pass to the NAS at the end of the five-year option period. Future minimum rental payments due under noncancelable operating leases are as follows: Year Ending June 30 1999 2000 2001 2002 2003 Thereafter ($ in thousands) Minimum Rentals $7,444 5,088 4,737 4,669 4,628 20,598 $47,164 Rental expense for 1998 amounted to $7.0 million.

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AS OF JULY 1, 1998 OFFICERS Bruce Alberts, President Jack Halpern, Vice-President Peter H. Raven, Home Secretary Sherwood Rowland, Foreign Secretary Ronald Graham, Treasurer FINANCE COMM ITEE Ronald Graham, Chair Bruce Alberts Elkan R. Blout Mildred Dresselhaus David M. Kipnis Lawrence R. Klein William Rutter Paul A. Samuelson TOM Representative: Gail Warden BUDGET AND INTERNAL AFFAIRS COMMITTEE Ronald Graham, Chair Marye Anne Fox Ralph E. Gomory Jack Halpern David M. Kipnis William Rutter AUDITING COMM ITEE Elkan R. Blout, Chair David M. Kipnis Robert Wurtz FINANCIAL MANAGEMENT STAFF Archie L. Turner, Chief Financial Officer Therese Swetnam, Director of Accounting Office 51