Report of the Treasurer for the Year Ended December 31, 2014 (2015)

III. Financial Condition

     June 2, 2015

Dr. Ralph J. Cicerone

President

National Academy of Sciences

Dear Dr. Cicerone:

In accordance with paragraph 11 of section II of the Bylaws of the National Academy of Sciences, the firm of KPMG LLP was retained by the Auditing Committee on behalf of the Council to conduct an audit of the accounts of the Treasurer for the year ended December 31, 2014, and to report to the Auditing Committee.

The independent accountants have completed their audit and submitted their report. In accordance with paragraph 13 of section II of the Bylaws, the Auditing Committee has reviewed the report and recommends to the Council that it be accepted and that the opinion of the independent accountants be published with the report of the Treasurer.

Respectfully submitted,


Auditing Committee

Robert H. Wurtz, Chair
Claude R. Canizares
Susan Gottesman
Ronald L. Graham
Brian W. Matthews

Independent Auditors’ Report

The Auditing Committee

National Academy of Sciences:

Report on the Financial Statements

We have audited the accompanying financial statements of the National Academy of Sciences (NAS), which comprise the statements of financial position as of December 31, 2014 and 2013, and the related statements of activities, and cash flows for the years then ended, and the related notes to the financial statements.

Management’s Responsibility for the Financial Statements

Management is responsible for the preparation and fair presentation of these financial statements in accordance with U.S. generally accepted accounting principles; this includes the design, implementation, and maintenance of internal control relevant to the preparation and fair presentation of financial statements that are free from material misstatement, whether due to fraud or error.

Auditors’ Responsibility

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 audit to obtain reasonable assurance about whether the financial statements are free from material misstatement.

An audit involves performing procedures to obtain audit evidence about the amounts and disclosures in the financial statements. The procedures selected depend on the auditors’ judgment, including the assessment of the risks of material misstatement of the financial statements, whether due to fraud or error. In making those risk assessments, the auditor considers internal control relevant to NAS’ preparation and fair presentation of the financial statements in order to design audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of NAS’ internal control. Accordingly, we express no such opinion. An audit also includes evaluating the appropriateness of accounting policies used and the reasonableness of significant accounting estimates made by management, as well as evaluating the overall presentation of the financial statements.

We believe that the audit evidence we have obtained is sufficient and appropriate to provide a basis for our audit opinion.

KPMG LLP is a Delaware limited liability partnership, the U.S. member firm of KPMG International Cooperative (“KPMG International”), a Swiss entity.

Opinion

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 December 31, 2014 and 2013, and the changes in its net assets and its cash flows for the years then ended in accordance with U.S. generally accepted accounting principles.

May 22, 2015

NATIONAL ACADEMY OF SCIENCES

Statements of Financial Position

December 31, 2014 and 2013

(In thousands)

See accompanying notes to financial statements.

NATIONAL ACADEMY OF SCIENCES

Statements of Activities

Years ended December 31, 2014 and 2013

(In thousands)

See accompanying notes to financial statements.

NATIONAL ACADEMY OF SCIENCES

Statements of Cash Flows

Years ended December 31, 2014 and 2013

(In thousands)

See accompanying notes to financial statements.

NATIONAL ACADEMY OF SCIENCES

Notes to

Financial Statements

December 31, 2014 and 2013

(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.

(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). The NRC draws 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 performs its studies and workshops through the following six major divisions:

• Behavioral and Social Sciences and Education
• Earth and Life Studies
• Engineering and Physical Sciences
• Policy and Global Affairs
• Transportation Research Board
• Gulf Research Program

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 independent program activities and activities through the NRC. The results of both 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. TNAC is controlled by NAS and NAEF. The financial position and results of TNAC are not consolidated in the NAS financial statements. NAS manages the operations of the Beckman Center. TNAC contributed $16,610 to the NRC for the year ended December 31, 2013, to be spent on programs conducted in whole or in part at the Beckman Center. No such contributions were made for the year ended December 31, 2014.

(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.

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. 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 are substantially met.

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 is limited to specific areas of study or is designated for use in future periods.

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. These inputs represent Level 3 inputs in the fair value hierarchy. The carrying value of contributions receivable approximates fair value because of the relatively short maturity of these assets.

NAS performs certain activities in connection with fundraising by NAEF. NAS collected a total of $5.4 million and $6.3 million in 2014 and 2013, respectively, on behalf of NAEF. NAS disbursed $6.2 million and $5.4 million to NAEF from these collected amounts in 2014 and 2013, respectively. Amounts collected but not yet remitted to NAEF are included in other current liabilities in the statements of financial position.

Gulf Research Program revenue relates to two agreements between NAS and BP Exploration and Production, Inc. (BP) and Transocean Deepwater Inc. (Transocean), respectively. As a result of separate plea agreements between those corporations and the federal government related to the 2010 Deepwater Horizon disaster, NAS was asked to establish a program focused on human health and environmental protection in the Gulf of Mexico. BP will pay $350.0 million over five years, and Transocean will pay $150.0 million over four years, to fund this 30-year, $500.0 million program. The present value of these payments in 2013 was $471.4 million, which was recognized as revenue in that year. The present value of the balance of these payments is $452.9 million and $464.4 million as of December 31, 2014 and 2013, respectively. The unpaid balance due for each agreement is reflected in contributions and other receivables (current) and contributions receivable (long-term) in the statements of financial position.

(e) Contracts and Grants

The majority of NAS activities are performed under cost-reimbursable contracts and grants with the U.S. government. For the years ended December 31, 2014 and 2013, the Department of Transportation provided 44% and 48%, respectively, of NAS government contract and grant revenue.

NAS records federal contracts and grants as exchange transactions, recognizing revenue as recoverable costs are incurred. Revenues from nonfederal contracts and grants classified as exchange transactions are also recognized as recoverable costs are incurred.

Contracts receivable consisted of $16.6 million of billed receivables, $55.0 million of unbilled receivables, and $6.4 million of indirect costs under recovered on federal

contracts and grants as of December 31, 2014. Contracts receivable consisted of $21.1 million of billed receivables and $49.0 million of unbilled receivables as of December 31, 2013.

(f) 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. Inventories are included in other current assets in the statements of financial position.

(g) Property and Equipment

Depreciation of NAS buildings and equipment is computed on a straight-line basis using the following lives:

The Einstein Memorial sculpture is valued at cost and is not depreciated. Work-in-progress is not depreciated until the related assets are placed in service. Capitalized software is amortized over its depreciable life when it is ready for its intended use and placed in service.

(h) Split-Interest Agreements

Charitable gift annuity agreements are classified as other assets and other long-term liabilities in the statements of financial position. Periodically, NAS pays a fixed amount of the assets to the beneficiary designated by the donor. Upon termination of an annuity, the remainder interest in the assets is available for use by NAS as restricted or unrestricted assets in accordance with the donor’s designation. At December 31, 2014 and 2013, NAS had charitable gift annuity assets of $2.8 million and $2.9 million, respectively. NAS has recorded a liability of $1.8 million and $1.6 million at December 31, 2014 and 2013, respectively, representing the present value of estimated future cash payments to annuitants based on the annuitant’s life expectancy.

(i) 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.

(j) Income Taxes

NAS is exempt from federal income taxes under Section 501(c)(3) of the Internal Revenue Code, except for unrelated business income. NAS recognizes the effect of income tax positions only if those positions are more likely than not of being sustained. NAS does not believe its financial statements include any uncertain tax positions.

(k) 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.

(l) 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.

(3) INVESTMENTS

Investments, which are reported at fair value (except as noted), consisted of the following as of December 31, 2014 and 2013 (in thousands):

TNAC, a related entity, invests certain of its assets in the NAS long-term investment pool. TNAC investments participate in the investment pool proportionally with all other funds in this pool.

The NAS obligation to TNAC for these funds held in trust, which totaled approximately $11.6 million and $11.1 million as of December 31, 2014 and 2013, respectively, is reported as funds held on behalf of others in the statements of financial position.

Investment income is reported net of investment expenses of approximately $735,000 and $709,000 for the years ended December 31, 2014 and 2013, respectively, and is comprised of the following (in thousands):

(4) FAIR VALUE MEASUREMENTS

Fair value is defined as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. Financial Accounting Standards Board Accounting Standards Codification Topic 820 establishes a fair value hierarchy, which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. The standard describes three levels of inputs that may be used to measure fair value:

Level 1: Quoted prices in active markets for identical assets or liabilities.

Level 2: Observable inputs other than Level 1 prices such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities.

Level 3: Unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities.

The following discussion describes the valuation methodologies used for financial assets measured at fair value. The techniques utilized in estimating the fair values are affected by the assumptions used, including discount rates and estimates of the amount and timing of future cash flows. Care should be exercised in deriving conclusions about NAS’ business, its value or financial position based on the fair value information of financial assets presented below.

Fair value estimates are made at a specific point in time, based on available market information and judgments about the financial asset, including estimates of timing, amount of expected future cash flows and the credit standing of the issuer. In some cases, the fair value estimates cannot be substantiated by comparison to independent markets. In addition, the disclosed fair value may not be realized in the immediate settlement of the financial asset. Furthermore, the disclosed fair values do not reflect any premium or discount that could result from offering for sale at one time an entire holding of a particular financial asset. Potential taxes and other expenses that would be incurred in an actual sale or settlement are not reflected in amounts disclosed.

The following methods, assumptions, and inputs were used to estimate the fair value of each class of financial instruments:

The carrying value of cash equivalents such as money market funds approximates the fair value because of the short maturity of these investments. These amounts are disclosed in Level 1.

NAS’ fixed maturity investments (bonds and notes) include U.S. Treasury securities, mortgage-backed securities, corporate bonds, and mutual funds that invest in these types of securities. Other than U.S. Treasury securities and mutual funds, these investments generally do not trade on a daily basis. The fair value estimates of such debt securities are based on prices provided by NAS’ investment managers and custodian bank. Both the investment managers and the custodian bank use a variety of pricing sources to determine market valuations. Each designate specific pricing services or indexes for each sector of the market based upon the provider’s expertise. NAS’ debt securities portfolio is highly liquid, which allows for a high percentage of the portfolio to be priced through pricing services. Accordingly, the estimates of fair value for such debt securities are included in Level 2 inputs. The estimated values of U.S. Treasury securities and debt mutual funds are based on actively traded market prices and are accordingly included in the bonds and notes amount in Level 1.

Fair values of exchange-traded equity securities and mutual funds that invest in equity securities have been determined by NAS from observable market quotations on major trade exchanges. Accordingly, such equity securities are disclosed in Level 1.

Fair value of alternative investments including private equity securities and hedge funds is based on the alternative investment fund managers’ net asset value (NAV). Private equity investments are comprised of limited partnership interests. Valuations provided by alternative investment fund managers include estimates, appraisals, assumptions and methods that are reviewed by management. When necessary, NAS adjusts NAV for contributions and distributions subsequent to the latest NAV valuation date when calculating fair value. NAS analyzes the NAVs provided by alternative investment fund managers on a regular basis considering relevant economic and market conditions, applicable benchmarks and our

understanding of the nature and related risks of the investments. Since the most significant valuation inputs are not observable in the marketplace, the alternative investment valuations are disclosed in Level 2 or Level 3. The distinction is that those funds which are available for redemption in the near term at NAV are included in Level 2.

Charitable gift annuity investments and deferred compensation investments are held in debt and equity mutual funds along with some U.S. Treasury securities, all of which are included in Level 1. The deferred compensation obligation to employees is equal to the fair value of the investments held and is disclosed in the same levels as the investment assets.

NAS has interest rate swap agreements covering the variable-rate bonds payable. The fair value of the swaps are determined using pricing models based on observable market data such as prices of instruments with similar maturities and characteristics, interest rate yield curves, and measures of interest rate volatility. The value was determined after considering the potential impact of collateralization and netting agreements, adjusted to reflect nonperformance risk of both the counterparty and NAS. Accordingly, the interest rate swaps are included in Level 2.

The funds held on behalf of others liability approximates the investments held in NAS’ long-term investment pool on behalf of TNAC. Therefore, the liability is disclosed in the same levels as the investment assets.

NAS’ policy is to recognize transfers between levels of the fair value hierarchy as of the end of the reporting period in which the event or change in circumstances occurred. There were no transfers among levels during 2014. During 2013 certain amounts were transferred from level 3 to level 2 due to the ability to redeem the investments within the near term as of December 31, 2013 and certain amounts were transferred from level 2 to level 3 due to investment of cash held by the fund manager at December 31, 2012.

The following table presents NAS’ fair value hierarchy for those assets and liabilities measured at fair value on a recurring basis at December 31, 2014 (in thousands):

The following table presents NAS’ fair value hierarchy for those assets and liabilities measured at fair value on a recurring basis at December 31, 2013 (in thousands):

The following table presents the changes in Level 3 assets measured at fair value on a recurring basis for the year ended December 31, 2014 (in thousands):

The following table presents the changes in Level 3 assets measured at fair value on a recurring basis for the year ended December 31, 2013 (in thousands):

Gains and losses included in changes in net assets are presented in investment income in the statements of activities. Level 3 assets had unrealized gains of approximately $4.9 million and $2.5 million, respectively, for the years ended December 31, 2014 and 2013.

The following table presents the nature and risk of assets with fair values estimated using NAV held at December 31, 2014 (in thousands):

Notes:

(a) This category relates to long-short equity hedge funds comprised of equity investments in U.S. large cap. Each of these funds buys investments long and sells short with the ability to use leverage. These funds can also invest in derivative instruments such as forward, futures and option contracts. The fair values of the investments in this category have been estimated using the net asset value per share of the investments. All of the investments in this category are redeemable within the near term from December 31, 2014.

(b) This category relates to a long-short equity hedge fund comprised of equity investments in Non-U.S. developed countries. This fund buys investments long and sells short with the ability to use leverage. This fund can also invest in derivative instruments such as forward, futures and option contracts. The fair value of the investment in this category has been estimated using the net asset value per share of the investment. The investment in this category is redeemable within the near term from December 31, 2014.

(c) This class includes investments in multi-strategy, multi-vehicle hedge funds with the objective of maximizing long-term, risk-adjusted returns and capital appreciation by investing in securities, investment funds, discretionary accounts, and investment partnerships across a broad range of marketable and alternative asset classes. Asset classes include domestic and international marketable equity securities, hedged equity, real estate, natural resource, fixed income, and private equity and absolute return strategies, primarily focused in the United States. The fair values of the investments in this class have been estimated using the NAV per share of the investments. Approximately $29.8 million of investments in this category are redeemable within the near term from December 31, 2014.

(d) This class includes an investment in a single strategy hedge fund focused on undervalued fixed income securities. Investments held by this fund consist of U.S. government agency mortgage-backed securities and derivatives, primarily in the form of collateralized mortgage obligations. Securities are generally held in the portfolio as long as interest rates and repayment rates are unfolding as anticipated. The majority of the investment return is expected to come from trading mortgage-backed securities in an attempt to maximize interest income. The fair value of the investment in this class has been estimated using the NAV per share of the investment. The investment in this category is redeemable within the near term from December 31, 2014.

(e) This class includes several private equity funds that invest in equity, debt or debt-oriented instruments, primarily in privately held companies which own or contractually control operating entities located in the People’s Republic of China and India. Investments held in India primarily include equity securities of “early to early growth stage” companies in multiple sectors, except real estate. The fair values of these investments have been estimated using the NAV of NAS’ ownership

interest in partners’ capital. These investments can never be redeemed with the funds. Instead, the nature of the investments in this class is that distributions are received through liquidation of the underlying assets of the funds. It is estimated that the underlying assets of the funds will be liquidated over 1 to 8 years.

(f) This class includes several global private equity funds with diverse portfolios consisting primarily of venture capital funds, leveraged buyout funds, mid-stage growth capital funds, and international private equity funds. These investments are focused on several industries including, but not limited to, insurance, services, and consumer-related industries. The fair values of these investments have been estimated using the NAV of NAS’ ownership interest in partners’ capital. These investments can never be redeemed with the funds. Instead, the nature of the investments in this class is that distributions are received through liquidation of the underlying assets of the funds. It is estimated that the underlying assets of the funds will be liquidated over 1 year.

(g) This class includes several domestic private equity funds which make investments in domestic equity securities, warrants or other securities that are generally not actively traded at the time of investment. These investments are focused on several industries including, but not limited to, insurance, financial services, consumer-related, and communications. The fair values of these investments have been estimated using the NAV of NAS’ ownership interest in partners’ capital. These investments can never be redeemed with the funds. Instead, the nature of the investments in this class is that distributions are received through liquidation of the underlying assets of the funds. It is estimated that the underlying assets of the funds will be liquidated over 1 year.

(5) PROPERTY AND EQUIPMENT

Property and equipment as of December 31, 2014 and 2013, is comprised of the following (in thousands):

(6) 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 (in thousands):

As of December 31, 2014 and 2013, 95% and 95%, respectively, of contributions receivable was due from two corporations. NAS does not believe there is any significant risk associated with collection of these receivables.

At December 31, 2013, the discount on contributions receivable was approximately $29,108,000 at rates ranging from 0.73% to 6.75% and the allowance for uncollectible contributions was approximately $845,000.

(7) DEFERRED REVENUE

Deferred revenue consisted of the following as of December 31, 2014 and 2013 (in thousands):

(8) LINES OF CREDIT

Until March 2014, NAS was party to a $55 million line of credit from Wells Fargo, which bore interest at LIBOR plus 0.55%. In March 2014, NAS renewed its line of credit with Wells Fargo for $45 million. The renewed line of credit bears interest at LIBOR plus 0.55% and expires on June 30, 2015. NAS is also party to a $15 million line of credit from TD Bank, which bears interest at LIBOR plus 0.55% and expires on August 31, 2015. NAS has pledged and granted to each bank a security interest in NAS’ gross revenues.

Interest expense related to the lines of credit for the years ended December 31, 2014 and 2013, was approximately $143,000 and $304,000, respectively.

(9) TEMPORARILY RESTRICTED NET ASSETS

Temporarily restricted net assets were available for the following purposes as of December 31, 2014 and 2013 (in thousands):

Temporarily restricted net assets were released from restriction for the following purposes during the years ended December 31, 2014 and 2013 (in thousands):

(10) ENDOWMENT

(a) Permanently Restricted Net Assets

The income generated by permanently restricted net assets is available to support donor-specified programs. As of December 31, 2014 and 2013, NAS held the following permanently restricted net assets, classified by the purpose for which the income is to be used (in thousands):

(b) Endowment Assets

The NAS endowment consists of approximately 120 individual funds established to support general operations, sponsored research and advisory programs, prizes and awards, and the operations of the Woods Hole facility. The endowment is comprised solely of donor-restricted endowment funds. The investments of the endowment are included in the NAS long-term investment pool, as described in note 3.

Interpretation of Relevant Law

NAS has interpreted the District of Columbia “Uniform Prudent Management of Institutional Funds Act of 2007” (the Act) as requiring NAS, absent explicit donor stipulations to the contrary, to act in good faith and with the care that an ordinarily prudent person in a like position would exercise under similar circumstances in making determinations to appropriate or accumulate endowment funds, taking into account both its obligation to preserve the value of the endowment and its obligation to use the endowment to achieve the purposes for which it was donated. NAS classifies as permanently restricted net assets (a) the original value of gifts donated to the permanent endowment, (b) the original value of subsequent gifts to the permanent endowment, and (c) accumulations to the permanent endowment required by the applicable donor gift instrument. The remaining portion of donor-restricted endowment funds that are not classified as permanently restricted are classified as temporarily restricted net assets until those amounts are appropriated for expenditure by NAS. In making a determination to appropriate or accumulate, NAS adheres to the standard of prudence prescribed by the Act and considers the following factors:

1. The duration and preservation of the endowment fund;
2. The purposes of the institution and the endowment fund;
3. General economic conditions;
4. The possible effect of inflation or deflation;
5. The expected total return from income and the appreciation of investments;
6. Other resources of the institution; and
7. The investment policy of the institution

Return Objectives and Strategies

NAS has adopted an investment and spending policy for endowment assets that is designed to provide a predictable stream of funding to programs supported by the endowment while seeking to protect the real purchasing power of the assets from inflation. Accordingly, NAS has adopted guidelines which feature a material commitment to equity and equity-like investments.

The asset allocation guidelines are as follows:

NAS has adopted a spending policy that limits the annual spending to 5% of the three-year average fair value of the participating funds in the endowment portfolio. This is consistent with NAS’ objective to maintain the purchasing power of the endowment assets held in perpetuity as well as to provide additional real growth through new gifts and investment return.

Changes in endowment assets for the fiscal year ended December 31, 2014 are as follows (in thousands):

Changes in endowment assets for the fiscal year ended December 31, 2013 are as follows (in thousands):

Funds with Deficiencies

From time to time, the fair value of assets associated with individual donor-restricted endowment funds may fall below the original value of the gift donated to the permanent endowment. Deficiencies of this nature are reported as unrestricted net assets. At December 31, 2014 and 2013, there were no endowment funds with a fair value below the original value of the gift.

(11) PROGRAM EXPENSES

Program expenses for the years ended December 31, 2014 and 2013 are summarized as follows (in thousands):

(12) 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 over recovers on its indirect costs during the year, a liability is recorded. If NAS under recovers, a receivable is recorded.

NAS has a cumulative net under recovery of approximately $6.4 million and a net over recovery of $0.8 million as of December 31, 2014 and 2013, respectively. The under recovery is included in the contracts receivable balance and the over recovery is included in the deferred revenue balance in the statements of financial position.

(13) BUILDING PROJECT AND FINANCING

(a) Building Project Revenue Bonds

In January 1999, the District of Columbia issued Series 1999A, Series 1999B, and Series 1999C tax-exempt revenue bonds on behalf of NAS. Proceeds from the sale of the revenue bonds financed the cost of the acquisition of 44,250 square feet of land and related construction of an office building, as well as paid certain costs of issuing the bonds. This building consolidates most of NAS’ program activities into one location.

In June 2008, the District of Columbia issued Series 2008A tax-exempt revenue bonds in the amount of $66,325,000 on behalf of NAS. The proceeds were used to refund the Series 1999B and Series 1999C revenue bonds, as well as pay certain costs of issuing the bonds.

In April 2009, the District of Columbia issued Series 2009A tax-exempt revenue bonds in the amount of $57,500,000 on behalf of NAS. The proceeds were used to refund the Series 1999A revenue bonds, as well as pay certain costs of issuing the bonds.

In May 2010, the District of Columbia issued Series 2010A tax-exempt revenue bonds in the amount of $59,550,000 on behalf of NAS. These bonds were sold to finance the cost to restore the NAS headquarters building on Constitution Avenue in Washington, D.C. and pay for certain costs of issuance. The restoration was completed in 2012.

In December 2012, NAS remarketed the Series 2008A and 2009A bonds as direct bank purchases. The Series 2008A bonds were purchased by Wells Fargo Municipal Capital Strategies LLC; the Series 2009A bonds were purchased by TD Bank, N.A. Both agreements stipulate mandatory repurchase in December 2020 at which point NAS could renew the direct purchase agreements, remarket the bonds, or repurchase the bonds. NAS is obligated under the revenue bonds as follows (in thousands):

The serial and term bonds represent unsecured general obligations of NAS.

Interest on the 2008A and 2009A bonds is payable monthly. Interest on the 2010A bonds is payable semiannually every April 1 and October 1.

The term bonds maturing on April 1, 2035, and April 1, 2040, are subject to mandatory redemption by operation of sinking fund installments. Installment payments for the term bond maturing April 1, 2035, begin on April 1, 2031, and range from $2.4 to $2.9 million per year through the maturity date. Installment payments for the term bond maturing April 1, 2040, begin on April 1, 2036, and range from $3.1 to $3.8 million per year through the maturity date.

Scheduled maturities and sinking fund requirements are as follows (in thousands):

The carrying value of bonds payable in the financial statements was approximately $3.7 million and $0.9 million less than fair value as of December 31, 2014 and 2013, respectively. NAS estimated the fair value of bonds payable through valuations provided by an independent financial institution. If measured at fair value in the statement of financial position, the bonds payable would be categorized as Level 2 in the fair value hierarchy.

Interest expense on the bonds payable for 2014 and 2013 totaled $3.6 million and $3.6 million, respectively.

(b) Interest Rate Swaps

In October 1999, NAS entered into a swap agreement, with an effective date of February 1, 2000, relating 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 Securities Industry and Financial Markets Association (SIFMA) Municipal Swap Index. NAS amended the agreement for the 2005 – 2020 period by agreeing to give up the benefit of any 30-day period during which the SIFMA 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.

NAS entered into this fixed-to-variable swap agreement to manage its exposure to interest rate changes. The fixed-rate debt obligations exposed 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 May 2009, NAS entered into an additional swap agreement as a result of a counterparty exercising a

swaption related to the Series 1999A Revenue Bonds. The variable-to-fixed swap requires NAS to pay 5.00% on a notional amount of $55 million and to receive a floating rate equal to 67% of 1-month LIBOR plus 0.41%.

NAS entered into this variable-to-fixed swap agreement in order to preserve the synthetic variable rate achieved through the 1999 swap agreement once the fixed-rate Series 1999A bonds were refunded with the variable-rate Series 2009A bonds.

With regard to the fixed-to-variable interest rate swap, NAS recorded a gain on the change in the fair value of its swap agreement of $164,000 and $7,000, for the years ended December 31, 2014 and 2013, respectively, which is included in other income in the accompanying statements of activities. The fair value of the interest rate swap was recorded as an asset of $372,000 and $208,000 as of December 31, 2014 and 2013, respectively, and is included in other assets in the statements of financial position.

Pertaining to the swaption and resultant variable-to-fixed interest rate swap, NAS recorded a loss on the change in the fair value of approximately $662,000 for the year ended December 31, 2014 and a gain of approximately $4,278,000, for the year ended December 31, 2013, respectively, which is included in other income in the statements of activities. The fair value of the swap is recorded as a liability of approximately $10.0 million and $9.3 million as of December 31, 2014 and 2013, respectively, and is included in other current liabilities and other long-term liabilities.

(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 funding vehicles under the plan consist of group investments issued by Teachers Insurance and Annuity Association (TIAA) and College Retirement Equities Fund (CREF), known collectively as TIAA-CREF, as well as mutual funds issued by TIAA-CREF, Vanguard Fiduciary Trust Company, and other third-parties. 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 funding vehicles under the plan consist of group investments issued by TIAA and CREF, as well as mutual funds issued by TIAA-CREF, Vanguard Fiduciary Trust Company, and other third-parties.

Pension expense for the years ended December 31, 2014 and 2013, amounted to approximately $11.7 million and $12.0 million, respectively. The NAS policy is to fund pension benefits as they are earned. The NAS normal retirement age is 62, but there is no mandatory age for retirement.

(b) Deferred Compensation

NAS holds long-term investments as part of a frozen deferred compensation arrangement for certain employees. The fair value of these investments was approximately $1.2 million and $1.7 million as of December 31, 2014 and 2013, respectively, 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 10 years of service for life insurance 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’ long-term disability 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 benefit plan is contributory for health insurance purposes for employees who retired on or 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 in the statements of financial position.

Postretirement changes other than net periodic benefit cost are as follows (in thousands):

Items not yet recognized as a component of net periodic benefit cost at December 31, 2014 and 2013 are as follows (in thousands):

The estimated amounts, measured at year-end, that are expected to be recognized in the net periodic benefit cost over the next fiscal year for the postretirement benefit plan are as follows (in thousands):

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 year ended December 31, 2014 and 2013 (in thousands):

The assumptions used to determine net periodic benefit cost for the years ended December 31, 2014 and 2013 are as follows:

The assumptions used to calculate the accumulated postretirement benefit obligation for the years ended December 31, 2014 and 2013 are as follows:

The trend rate for growth in healthcare costs was assumed to decline gradually beginning in 2016 to 4.5% in the year 2029 for under age 65 and to 4.5% in the year 2023 for over age 65 for the year ended December 31, 2014. The trend rate for growth in healthcare costs was assumed to decline gradually beginning in 2016 to 5% in the year 2021 for under age 65 and to remain at 5% for over age 65 for the year ended December 31, 2013.

The healthcare cost trend rate assumption has a significant impact on the postretirement benefit costs and obligations. The effect of a 1% increase in the assumed healthcare cost trend rate would have resulted in the following effects (in thousands):

The effect of a 1% decrease in the assumed healthcare cost trend rate would have resulted in the following effects (in thousands):

NAS postretirement benefit plan asset allocations at December 31, 2014 and 2013, by asset class are as follows:

The investment objective of the Plan is to produce a rate of return over the long term that will provide for fund growth, protect 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. The Plan assets are invested with a long-term growth strategy, with a 70% equity guideline.

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.

The following table presents the fair value hierarchy for the postretirement benefit plan assets at December 31, 2014 (in thousands):

The following table presents the fair value hierarchy for the postretirement benefit plan assets at December 31, 2013 (in thousands):

The methods and assumptions used to estimate the fair value of each class of financial instrument are further discussed in footnote 4, Fair Value Measurements.

NAS expects to contribute to the Plan the actuarially determined net periodic cost for 2015, which is approximately $1.1 million.

The following benefit payments, which reflect future services, are expected to be paid in future years as noted, as of December 31, 2014 (in thousands):

The measurement date of the plan assets and benefit obligations for 2014 and 2013 is December 31, 2014 and 2013, respectively.

(15) RELATED-PARTY TRANSACTIONS

The NAS Council has authorized two agreements providing noninterest-bearing, collateralized advances to two employees in connection with the purchase of each employee’s residence. The agreements between the parties were executed in May 2005 and April 2013. The agreement executed in May 2005 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. That 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 agreement executed in April 2013 will terminate upon the first to occur of the date the individual ceases to occupy the property as principal residence, sale of the property, or the end of the individual’s employment with NAS. The estimated present value of both receivables is $3.8 million and $3.8 million at December 31, 2014 and 2013, respectively, and is included in other assets in the statements of financial position.

An agreement authorized by the NAS Council in May 2007 to provide a noninterest-bearing, collateralized advance to an employee in connection with the purchase of that employee’s residence terminated during 2013.

(16) COMMITMENTS AND CONTINGENCIES

(a) Leases

NAS is committed to one noncancelable operating lease for space. Future minimum rental payments due under the noncancelable operating lease are as follows (in thousands):

Rental expense amounted to approximately $401,000 and $394,000 for the years ended December 31, 2014 and 2013, 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, 2006. A contingency exists relating to unexamined periods and final settlements of examined periods to refund any amounts received in excess of allowable costs. Management is of the opinion that no material liability will result from such audits.

(17) SUBSEQUENT EVENTS

NAS has evaluated subsequent events from the statement of financial position date through May 22, 2015, the date at which the financial statements were available to be issued, and determined that there are no other items to disclose.

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OFFICERS

Ralph J. Cicerone, President

Diane E. Griffin, Vice President

Susan Wessler, Home Secretary

John Hildebrand, Foreign Secretary

Jeremiah P. Ostriker, Treasurer

FINANCE COMMITTEE

Jeremiah P. Ostriker, Chair

Elwyn R. Berlekamp

Ralph J. Cicerone

Maureen Cropper

David Donoho

Robert Engle

Ronald L. Graham

BUDGET AND INTERNAL AFFAIRS COMMITTEE

Jeremiah P. Ostriker, Chair

Diane E. Griffin

Richard P. Lifton

Margaret M. Murnane

Randy W. Schekman

Maria Zuber

AUDITING COMMITTEE

Robert H. Wurtz, Chair

Claude R. Canizares

Susan Gottesman

Ronald L. Graham

Brian W. Matthews

FINANCIAL MANAGEMENT STAFF

Didi Salmon, Chief Financial Officer

Laura Douglas, Controller