III. Financial Condition

Auditing Committee

June 7, 2017

Dr. Marcia McNutt

President

National Academy of Sciences

Dear Dr. McNutt:

In accordance with paragraph 11 of section II of the Bylaws of the National Academy of Sciences, the firm of Grant Thornton 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, 2016, 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

Claude R. Canizares, Chair
Susan Gottesman
Ronald L. Graham
Brian W. Matthews
Jeremiah P. Ostriker

Grant Thornton LLP
1250 Connecticut Ave NW, Suite 400
Washington, DC 20036-3531

T 202.296.7800
F 202.833.9165
GrantThornton.com
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REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS

To the Auditing Committee of

National Academy of Sciences

We have audited the accompanying financial statements of the National Academy of Sciences ( NAS ), which comprise the statement of financial position as of December 31, 2016, and the related statements of activities and cash flows for the year 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 accounting principles generally accepted in the United States of America; 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.

Auditor’s responsibility

Our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audit 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 auditor s 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 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 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.

Grant Thornton LLP
U.S. member firm of Grant Thornton International Ltd

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

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, 2016, and the changes in its net assets and its cash flows for the year then ended in accordance with accounting principles generally accepted in the United States of America.

Other matter

The financial statements of the National Academy of Sciences as of and for the year ended December 31, 2015 were audited by other auditors. Those auditors expressed an unmodified opinion on those 2015 financial statements in their report dated May 27, 2016.

Washington, DC

June 7, 2017

NATIONAL ACADEMY OF SCIENCES
Statements of Financial Position
As of December 31, 2016 and 2015
(in thousands)

The accompanying notes are an integral part of these financial statements.

NATIONAL ACADEMY OF SCIENCES
Statements of Activities
Years ended December 31, 2016 and 2015
(in thousands)

The accompanying notes are an integral part of these financial statements.

NATIONAL ACADEMY OF SCIENCES
Statements of Cash Flows
For the years ended December 31, 2016 and 2015
(in thousands)

The accompanying notes are an integral part of these financial statements.

NATIONAL ACADEMY OF SCIENCES
Notes to the Financial Statements
December 31, 2016 and 2015

1. ORGANIZATION

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.

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 major divisions:

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

NRC activities are under the control of the NAS governance structure and, therefore, are included in the NAS financial statements.

National Academy of Medicine

The Institute of Medicine (“IOM”), which was established in 1970, has been reconstituted as the National Academy of Medicine (“NAM”) effective June 1, 2015. NAM is a separate membership organization within NAS, and issues position statements on policy issues related to health and medicine, 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. The financial activities and results of NAM are included in the NAS financial statements.

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.

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Basis of Accounting

Net assets, revenues, gains, and losses are classified based on the existence or absence of donor-imposed restrictions. Accordingly, the 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.

Cash Equivalents

NAS reports liquid, temporary investments purchased with original maturities of three months or less as cash equivalents.

Investments

Investments are stated at fair value. Changes in the fair value of investments are reported within investment income (loss) in the accompanying statements of activities.

Purchases and sales of securities are reflected on a trade-date basis. Gains and losses on sales of securities are based on average cost and are recorded in the accompanying statements of activities in the period in which the securities are sold. Dividends are accrued based on the ex-dividend date. Interest is recognized as earned.

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 non-federal 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 or construct 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 creditworthiness 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.

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 $262.3 million and $396.2 million as of December 31, 2016 and 2015, respectively. The unpaid balance due for each agreement is reflected in contributions and other receivables, net (current) and contributions receivable, net (long-term) in the accompanying statements of financial position.

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, 2016 and 2015, the Department of Transportation provided 36% and 40%, respectively, of NAS’ government contract and grant revenues.

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

Contracts receivable consisted of $19.1 million of billed receivables, $44.6 million of unbilled receivables, and $3.3 million of indirect costs under-recovered on federal contracts and grants as of December 31, 2016. Contracts receivable consisted of $29.2 million of billed receivables, $52.9 million of unbilled receivables, and $1.8 million of indirect costs under-recovered on federal contracts and grants as of December 31, 2015.

Allowances are recorded for estimated uncollectible contracts and grants based upon management’s judgment and analysis of the creditworthiness of the sponsoring organization, past collection experience, and other relevant factors. As of December 31, 2016 and 2015, NAS has an allowance for estimated uncollectible contracts and grants of $4.7 million and $2.0 million, respectively, which is reported net of contracts receivable in the accompanying statements of financial position.

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.

Split-Interest Agreements

Charitable gift annuity agreements are classified as other assets and other long-term liabilities in the accompanying 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, 2016 and 2015, NAS had charitable gift annuity assets of $2.7 million. NAS has recorded a liability of $1.8 million at December 31,

2016 and 2015 representing the present value of estimated future cash payments to annuitants based on the annuitants’ life expectancies.

Deferred Revenue

For both federal and non-federal 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 accompanying statements of financial position.

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 upon examination. NAS does not believe its financial statements include any uncertain tax positions.

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.

Recently Adopted Accounting Pronouncements

In January 2016, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2016-01, Financial Instruments-Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities (ASU 2016-01). The amendments within ASU 2016-01 eliminate the requirement to disclose the fair value of financial instruments measured at amortized cost for entities that are not public business entities. ASU 2016-01 is effective for fiscal years beginning after December 15, 2018 for entities that are not public business entities and early adoption is permitted. NAS has elected to early adopt this accounting pronouncement for the year ended December 31, 2016. Therefore, the fair value of the NAS bonds payable as of December 31, 2016 and 2015 has not been disclosed.

In April 2015, the FASB issued ASU 2015-03, Interest - Imputation of Interest (ASU 2015-03), to simplify the presentation of debt issuance costs related to a recognized debt liability. Under these new requirements, previously capitalized debt issuance costs will be presented as a direct reduction from the carrying value of the respective debt liability, consistent with debt discounts. The guidance requires retrospective application and is effective for fiscal years beginning after December 15, 2015. During fiscal 2016, NAS adopted ASU 2015-03, and accordingly, reclassified its unamortized deferred financing costs totaling $2.3 million and $2.4 million as of December 31, 2016 and 2015, respectively, as a reduction of its bonds payable in the accompanying statements of financial position. The disclosures in note 13 are presented accordingly.

In May 2015, the FASB issued ASU 2015-07, Disclosures for Investments in Certain Entities that Calculate Net Asset Value per Share (or its Equivalent) (ASU 2015-07). ASU 2015-07 removes the requirement to categorize, within the fair value hierarchy, investments for which fair values are estimated using the net asset value practical expedient provided by Accounting Standards Codification (“ASC”) 820, Fair Value Measurement (ASC 820). Disclosures about investments in certain entities that calculate net assets value per share are limited under ASU 2015-07 to those investments for which the entity has elected to estimate the fair value using the net asset value practical expedient. ASU 2015-07 is effective for entities (other than public business entities) for fiscal years beginning after December 15, 2015, with retrospective application to all periods presented. Early application is permitted. NAS elected to adopt ASU 2015-07 in fiscal 2015. The disclosures in note 4 are presented accordingly.

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.

Reclassifications

Certain amounts from the prior year have been reclassified to conform to the current year presentation. Except for the effects of the adoption of ASU 2015-03, there were no changes to total assets, liabilities, net assets, revenues, expenses or changes in net assets as previously reported in the fiscal 2015 financial statements.

3. INVESTMENTS

Investments, which are reported at fair value, consist of the following as of December 31, 2016 and 2015 (in thousands):

The National Academies’ Corporation (TNAC, see Note 15), a related entity, invests certain of its assets in the NAS 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 $12.1 million and $11.2 million as of December 31, 2016 and 2015, respectively, is reported as funds held on behalf of others in the accompanying statements of financial position. The funds held on behalf of others liability equals the investments held in NAS’ investment pool on behalf of TNAC.

Investment income (loss) is reported net of investment expenses of approximately $806,000 and $1,026,000 for the years ended December 31, 2016 and 2015, 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. ASC 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:

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.

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 following table presents NAS’ fair value hierarchy for those assets measured at fair value on a recurring basis at December 31, 2016 (in thousands):

The following table presents NAS’ fair value hierarchy for those assets measured at fair value on a recurring basis at December 31, 2015 (in thousands):

The following table presents the nature and risk of assets with fair values estimated using NAV held at December 31, 2016 and 2015 (in thousands):

1. 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.
2. 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.
3. This class includes investments in multistrategy, multivehicle 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. At December 31, 2016, $20 million of assets in this category was held by two funds as cash pending investment on January 1, 2017.
4. 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. 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 9 years.
5. This class includes several global private equity funds with diverse portfolios consisting primarily of venture capital funds, leveraged buyout funds, midstage growth capital funds, assets of healthcare companies, and international private equity funds. These investments are focused on several industries including, but not limited to, insurance, services, and consumer-related industries. 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 9 years.

6. This class includes several domestic private equity funds, which invest 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. 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 10 years.

5. PROPERTY AND EQUIPMENT, NET

Property and equipment as of December 31, 2016 and 2015, is comprised of the following (in thousands):

Depreciation and amortization expense was approximately $7.9 million and $8.3 million for the years ended December 31, 2016 and 2015, respectively.

6. CONTRIBUTIONS RECEIVABLE, NET

Contributions not yet collected are included in contributions and other receivables, net (current) and contributions receivable, net (long-term) in the accompanying statements of financial position, and mature as follows (in thousands):

As of December 31, 2016 and 2015, 88% and 95%, respectively, of contributions receivable were due from two corporations. NAS does not believe there is any significant risk associated with collection of these receivables.

At December 31, 2015, the discount on contributions receivable was approximately $9,837,000 at rates ranging from 0.73% to 6.75% and the allowance for uncollectible contributions was approximately $704,000.

During the year ended December 31, 2016, NAS entered into an agreement with a donor to give up to $10 million. The gift is conditioned on receipt of matching gifts for one of NAS’ endowment funds. NAS has recorded revenue totaling approximately $1.7 million for the year ended December 31, 2016, the extent to which the conditions on the pledge have been met.

7. DEFERRED REVENUE

Deferred revenue consisted of the following as of December 31, 2016 and 2015 (in thousands):

8. LINES OF CREDIT

Until September 2016, NAS was party to a $45 million line of credit from Wells Fargo, which bore interest at LIBOR plus 0.55% (1.31% and 0.97% as of December 31, 2016 and 2015, respectively). In September 2016, NAS renewed its line of credit with Wells Fargo for $45 million from October 1, 2016 through January 31, 2017, for $25 million from February 1, 2017 through August 31, 2017, and for $45 million from September 1, 2017 through September 30, 2017. The renewed line of credit bears interest at LIBOR plus 0.55% and expires on September 30, 2017. NAS is also party to a $15 million line of credit from TD Bank, which bears interest at LIBOR plus 0.55% (1.17% and 0.79% as of December 31, 2016 and 2015, respectively) and expires on August 31, 2017. 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, 2016 and 2015 totaled approximately $107,000 and $190,000, respectively.

9. TEMPORARILY RESTRICTED NET ASSETS

Temporarily restricted net assets were available for the following purposes as of December 31, 2016 and 2015 (in thousands):

Temporarily restricted net assets were released from restriction for the following purposes during the years ended December 31, 2016 and 2015 (in thousands):

10. ENDOWMENT

Permanently Restricted Net Assets

The income generated by permanently restricted net assets is available to support donor-specified programs and general operations. As of December 31, 2016 and 2015, NAS held the following permanently restricted net assets, classified by the purpose for which the income is to be used (in thousands):

Endowment Assets

The NAS endowment consists of 127 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 solely comprises donor-restricted endowment funds. The investments of the endowment are included in the NAS 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 for expenditure 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 its permanent endowment, (b) the original value of subsequent gifts to its permanent endowment, and (c) accumulations to its 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 its 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 endowment fund 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, 2016 are as follows (in thousands):

Changes in endowment assets for the fiscal year ended December 31, 2015 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, 2016, there was one endowment fund with a fair value below the original value of the gift. At December 31, 2015, there were eight endowment funds with a fair value below the original value of the gift. These deficiencies were primarily a result of unfavorable market fluctuations that occurred shortly after the investment of new permanently restricted contributions. Subsequent gains that restore the fair value of the assets of the endowment fund to the required level are classified as an increase in unrestricted net assets.

11. PROGRAM EXPENSES

Program expenses for the years ended December 31, 2016 and 2015 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 $3.3 million and $1.8 million as of December 31, 2016 and 2015, respectively. The under recovery is included in the contracts receivable, net balance in the accompanying statements of financial position.

13. BUILDING PROJECT AND FINANCING

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, DC 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):

Years ending December 31:

Interest expense on the bonds payable for 2016 and 2015 totaled $3.7 million and $3.5 million, respectively.

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 one-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 loss on the change in the fair value of its swap agreement of $18,000 and a gain of $211,000, for the years ended December 31, 2016 and 2015, 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 $143,000 and $161,000 as of December 31, 2016 and 2015, respectively, and is included in other assets in the accompanying statements of financial position.

Pertaining to the swaption and resultant variable-to-fixed interest rate swap, NAS recorded a gain on the change in the fair value of approximately $1.5 million and $0.9 million for the years ended December 31, 2016 and 2015, 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 $7.5 million and $9.0 million as of December 31, 2016 and 2015, respectively, and is included in other current liabilities and other long-term liabilities in the accompanying statements of financial position.

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.

14. EMPLOYEE BENEFITS

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, 2016 and 2015, amounted to approximately $12.2 million and $11.7 million, respectively. NAS policy is to fund pension benefits as they are earned. NAS normal retirement age is 62, but there is no mandatory age for retirement.

Deferred Compensation

NAS holds investments as part of a frozen deferred compensation arrangement for certain employees. The fair value of these investments totaled approximately $855,000 and $833,000 as of December 31, 2016 and 2015, respectively, which is reported within other assets in the accompanying statements of financial position. The related obligation is included in accrued employee benefits in the accompanying statements of financial position. Deferred compensation investments are held in debt and equity mutual funds along with some U.S. Treasury securities, all of which are valued using Level 1 inputs. The deferred compensation obligation to employees is equal to the fair value of the investments held.

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 five 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 five 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, 1992. 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 accompanying 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, 2016 and 2015 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 years ended December 31, 2016 and 2015 (in thousands):

The assumptions used to determine net periodic benefit cost for the years ended December 31, 2016 and 2015 are as follows:

The assumptions used to calculate the accumulated postretirement benefit obligation for the years ended December 31, 2016 and 2015 are as follows:

The trend rate for growth in healthcare costs was assumed to decline gradually beginning in 2017 to 4.5% in the year 2038 for under age 65 and for over age 65 for the year ended December 31, 2016. 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, 2015.

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, 2016 and 2015, 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, 2016 (in thousands):

The following table presents the fair value hierarchy for the postretirement benefit plan assets at December 31, 2015 (in thousands):

The methods and assumptions used to estimate the fair value of each class of financial instrument are further discussed in Note 4.

NAS expects to contribute to the Plan the actuarially determined net periodic cost for 2017, which is approximately $1.3 million.

The following benefit payments, which reflect future services, are expected to be paid in future years as noted, as of December 31, 2016 (in thousands):

The measurement date of the plan assets and benefit obligations for 2016 and 2015 is December 31, 2016 and 2015, respectively.

15. RELATED-PARTY TRANSACTIONS

National Academy of Engineering Fund

The National Academy of Engineering Fund (“NAEF”) is a separately incorporated tax-exempt organization established by NAE to raise funds to support its goals. The financial activities and results of NAEF are not included in the NAS financial statements.

NAS performs certain activities in connection with fund-raising by NAEF. NAS collected a total of $4.3 million and $3.2 million in 2016 and 2015, respectively, on behalf of NAEF. NAS disbursed $4.3 million and $3.4 million to NAEF from these collected amounts in 2016 and 2015, respectively. Amounts collected but not yet remitted to NAEF are included in other current liabilities in the statements of financial position.

The National Academies’ Corporation

The National Academies’ Corporation (“TNAC”) was separately incorporated in 1986 as a tax-exempt 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, NAM, and NAE. The financial position and results of TNAC are not consolidated in the NAS financial statements. NAS manages the operations of the Beckman Center.

Employees

The NAS Council has authorized an agreement providing a noninterest-bearing, collateralized advance to an employee in connection with the purchase of the employee’s residence. The agreement between the parties was executed in April 2013. The agreement 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 the receivable totaled $1.5 million at December 31, 2016 and 2015, respectively, and is included in other assets in the accompanying statements of financial position.

An agreement authorized by the NAS Council in May 2005 to provide a noninterest-bearing, collateralized advance to an employee in connection with the purchase of that employee’s residence terminated during 2016.

The estimated present value of that receivable was $2.3 million at December 31, 2015 and was included in other current assets in the statement of financial position.

16. COMMITMENTS AND CONTINGENCIES

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):

Years ending December 31,

Rental expense totaled approximately $563,000 and $403,000 for the years ended December 31, 2016 and 2015, respectively.

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, 2010. 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

Effective May 1, 2017, NAS refinanced the Series 2008A and Series 2009A revenue bonds. The bonds remain direct bank purchases with Wells Fargo Municipal Capital Strategies LLC and TD Bank, N.A., respectively. Both agreements include an extension of the mandatory repurchase date from December 2020 to May 2027.

NAS has evaluated subsequent events from the statement of financial position date through June 7, 2017, the date at which the financial statements were issued, and determined that there are no other items to disclose.

OFFICERS

Marcia McNutt, President

Diane E. Griffin, Vice President

Susan Wessler, Home Secretary

John Hildebrand, Foreign Secretary

William H. Press, Treasurer

FINANCE COMMITTEE

William H. Press, Chair

Elwyn R. Berlekamp

Maureen Cropper

David Donoho

Robert Engle

Ronald L. Graham

Marcia McNutt

Jose A. Scheinkman

James H. Simons

William W. Stead

BUDGET AND INTERNAL AFFAIRS COMMITTEE

William H. Press, Chair

Sylvia T. Ceyer

Fred H. Gage

Diane E. Griffin

Peter S. Kim

Margaret M. Murnane

Randy W. Schekman

AUDITING COMMITTEE

Claude R. Canizares, Chair

Susan Gottesman

Ronald L. Graham

Brian W. Matthews

Jeremiah P. Ostriker

FINANCIAL MANAGEMENT STAFF

Didi Salmon, Chief Financial Officer

Laura Douglas, Controller

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