III. Financial Condition

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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 statements of financial position as of December 31, 2018 and 2017, 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 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 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 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.

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, 2018 and 2017, and the changes in its net assets and its cash flows for the years then ended in accordance with accounting principles generally accepted in the United States of America.

Washington, DC
June 12, 2019

NATIONAL ACADEMY OF SCIENCES

Statements of Financial Position

As of December 31, 2018 and 2017

(in thousands)

NATIONAL ACADEMY OF SCIENCES

Statements of Activities

For the years ended December 31, 2018 and 2017

(in thousands)

NATIONAL ACADEMY OF SCIENCES

Statements of Cash Flows

For the years ended December 31, 2018 and 2017

(in thousands)

NATIONAL ACADEMY OF SCIENCES

Notes to the Financial Statements

December 31, 2018 and 2017

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 membership organization 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, was 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

Recently Adopted Accounting Pronouncements

NAS adopted Accounting Standards Update (“ASU”) 2014-16, Presentation of Financial Statements of Not-for-Profit Entities (Topic 958) (“ASU 2014-16”) for the year ended December 31, 2018. This standard was issued by the Financial Accounting Standards Board (“FASB”) to improve the previous net asset classification requirements and the information presented in the financial statements and notes about a not-for-profit entity’s liquidity, financial performance, and cash flows. ASU 2016-14 reduces the number of net asset classifications from three to two: with donor restrictions and without donor restrictions. The ASU also requires not-for-profits to report expenses by functional and natural classification in one location in the financial statements or accompanying disclosures, and requires not-for-profits to report quantitative and qualitative information about management of liquidity resources and availability of financial assets.

As required by ASU 2014-16, NAS applied the requirements on a retrospective basis in the year of adoption. As a result, certain amounts presented in the prior year have been reclassified to conform to the new presentation. All amounts previously reported as “Unrestricted net assets” have been reclassified to be presented as “Net assets without donor restrictions.” Similarly, all amounts previously reported as “Temporarily restricted net assets” and “Permanently restricted net assets” have been reclassified to be presented as “Net assets with donor restrictions.” The changes in net assets have similarly been reclassified. There was no change in total net assets or total change in net assets as result of the adoption of ASU 2014-16 during 2018.

NAS also adopted ASU 2018-08, Clarifying the Scope and the Accounting Guidance for Contributions Received and Contributions Made (“ASU 2018-08”) for the year ended December 31, 2018. The FASB issued this new standard to clarify and improve the scope and the accounting guidance for contributions received and made, including guidance to help an entity evaluate whether transactions should be accounted for as contributions (nonreciprocal transactions) or as exchange (reciprocal) transactions and determine whether a contribution is conditional. As required by ASU 2018-08, NAS applied the requirements on a modified prospective basis to agreements that either are not completed as of January 1, 2018 or entered into after January 1, 2018. Upon adoption of ASU 2018-08, NAS determined that certain contracts and grants previously treated as exchange transactions meet the new definition of conditional contributions.

In May 2014, the FASB issued ASU 2014-09, Revenue from Contracts with Customers (“ASU 2014-09”), which updates numerous requirements in U.S. GAAP, eliminates industry-specific guidance, and provides entities with a single model for recognizing revenue from contracts with customers. The core principle of the new standard is that an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. ASU 2014-09 requires entities to identify contractual performance obligations and determine whether revenue should be recognized at a point in time or over time, based on when control of goods and services transfers to a customer.

On January 1, 2018, NAS adopted ASU 2014-09 using the modified retrospective method. The adoption of the standard did not have a material impact on its financial statements.

NAS has also adopted ASU 2017-07, Improving the Presentation of Net Periodic Pension Cost and Net Periodic Postretirement Benefit Cost (“ASU 2017-07”) for the year ended December 31, 2018. This standard requires that an employer report the service cost component in the same line item or items as other compensation costs arising from services rendered by the pertinent employees during the period. The other components of net benefit cost – including interest cost, expected return on plan assets, recognized prior service credit or cost, and recognized actuarial gain or loss – are required to be presented in the statement of activities separately from the service cost component. As required by ASU 2017-07, NAS applied the requirements on a retrospective basis in the year of adoption. As a result, certain amounts presented in the prior year have been reclassified to conform to the new presentation. NAS used the practical expedient allowed by the standard, so the amounts disclosed in the 2017 employee benefits note were used as the estimation basis for applying the retrospective presentation requirements.

Basis of Accounting

Net assets and changes in net assets are classified based on the existence or absence of donor-imposed restrictions. Accordingly, net assets are classified and reported as follows:

Cash Equivalents

NAS reports liquid, temporary investments purchased with original maturities of three months or less as cash equivalents. Cash equivalents managed by NAS’ investment managers as part of its long-term investment strategy are included in investments.

Restricted Cash

Restricted cash includes deposits that are legally restricted for the repayment of NAS’ outstanding bonds.

Investments

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

Property and Equipment

Depreciation of NAS’ property 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, if any, is available for use by NAS as net assets with or without donor restrictions in accordance with the respective donor’s stipulation. At December 31, 2018 and 2017, NAS had charitable gift annuity assets of approximately $3.3 million and $3.0 million, respectively. NAS has recorded a liability of approximately $2.2 million at December 31, 2018 and $1.8 million at December 31, 2017, representing the present value of estimated future cash payments to annuitants based on the annuitants’ life expectancies and other relevant factors.

Revenue Recognition

NAS generates revenues principally from: (i) contracts and grants; (ii) contributions; and (iii) fees and publications.

Contracts and Grants

The majority of NAS activities are performed under cost-reimbursable contracts and grants with the U.S. government and private entities. These contracts and grants are for various activities performed by NAS, including studies and workshops, as well as the administration of fellowship programs. For the years ended December 31, 2018 and 2017, the U.S. Department of Transportation accounted for 39% and 38%, respectively, of NAS’ government contract and grant revenues.

NAS recognizes government and private contracts and grants as either contributions or exchange transactions, depending on whether the transaction is reciprocal or nonreciprocal. For contributions, revenue is recognized when a contribution becomes unconditional. Typically, contract and grant agreements contain a right of return or right of release from obligation provision and NAS has limited discretion over how funds transferred should be spent. As such, NAS recognizes revenue for these conditional contributions when the related barrier has been overcome.

For contracts and grants treated as exchange, NAS has a right to consideration from the sponsoring organization in an amount that corresponds directly with the value to the sponsoring organization of NAS’ performance completed to date (costs incurred). For these agreements, NAS recognizes revenue in the amount to which NAS has the right to invoice. Of the total government contracts and grants, approximately 18% and 100% were considered exchange transactions for the years ended December 31, 2018 and 2017, respectively. Of the total private contracts and grants, approximately 22% and 35% were considered exchange transactions for the years ended December 31, 2018 and 2017, respectively.

Contracts and grants are generally invoiced monthly for recoverable costs incurred in the preceding month. Contracts receivable consisted of $17.8 million of billed receivables, $38.4 million of unbilled receivables, and $2.8 million of indirect costs under-recovered on federal contracts and grants as of December 31, 2018. Contracts receivable consisted of $22.4 million of billed receivables, $42.5 million of unbilled receivables, and $3.4 million of indirect costs under-recovered on federal contracts and grants as of December 31, 2017. Receivables related to revenue from exchange contracts and grants is included in contracts receivable, net in the accompanying statements of financial position. As of December 31, 2018 and 2017, NAS was owed $33.5 million and $67.0 million, respectively, on these contracts and grants.

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, 2018 and 2017, NAS had an allowance for estimated uncollectible contracts and grants of $2.8 and $4.8 million, respectively, which is reported net of contracts receivable in the accompanying statements of financial position.

For contracts and grants treated as contributions, NAS had approximately $282.3 million in unrecognized conditional contributions as of December 31, 2018. The revenue related to these awards is conditioned on incurring allowable expenditures under the terms of the agreements.

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 met.

Contributions with donor-imposed restrictions are released when a restriction expires, that is, when the stipulated time has elapsed, when the stipulated purpose for which the resource was restricted has been fulfilled, or both. For restricted contributions that were initially classified as conditional, NAS has elected to recognize the revenue in net assets without donor restrictions if the restriction is met in the same period that the revenue is recognized.

Revenues from non-federal grants qualifying as contributions are recorded by NAS upon notification of the grant award and satisfaction of all conditions, if applicable. Such grants are classified as net assets with donor restrictions 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 net assets without donor restrictions unless explicit donor stipulations specify how the donated assets must be used. Donor 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 and 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. As of December 31, 2018, BP paid $350.0 million over the prior five years, and as of December 31, 2017, Transocean paid $150.0 million over the prior 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. As of December 31, 2017, the present value of the balance of these payments due was $115.0 million, which is reflected in contributions and other receivables, net (current) in the accompanying 2017 statement of financial position. The final payment for this program was received during the year ended December 31, 2018.

Fees and Publications

NAS publishes a weekly multidisciplinary scientific journal (the Proceedings of the National Academy of Sciences, or “PNAS”), as well as reports and other publications. Subscription fees are paid in advance, and revenue from PNAS subscriptions are recognized over the subscription period, which is typically one calendar year. Page fees, paid by contributors to PNAS when their article has been accepted for publication, are recognized when the article is published.

Since the contracts for fees and publications have an original expected duration of one year or less, NAS has elected the practical expedient and not disclosed the value of unsatisfied performance obligations and expected timing for completion related to fees and publications.

Meetings

NAS holds a number of meetings throughout the year for which it collects revenue in the form of registration and exhibitor fees, the largest of which is the Transportation Research Board Annual Meeting. Revenue related to these meetings is recognized when the meeting takes place and the associated performance obligations have been fulfilled. Revenue related to these meetings totaled $7.9 million and $6.8 million for the years ended December 31, 2018 and 2017, respectively, and is reflected in other income in the accompanying statements of activities.

Since the contracts for meetings have an original expected duration of one year or less, NAS has elected the practical expedient and not disclosed the value of unsatisfied performance obligations and expected timing for completion related to fees and publications.

Deferred Revenue and Advances

For both federal and non-federal grants and contracts that are determined to be exchange transactions, revenue is recognized in the amount to which NAS has the right to invoice. Funds received in advance of being earned for these grants are recorded as deferred revenue and advances in the statement of financial position. Similarly, funds received in advance of being earned for conditional contributions are recorded as deferred revenue and advances in the statement of financial position.

Funds received in advance of being earned for exchange contracts and grants are recorded as deferred revenue and advances in the accompanying statements of financial position. As of December 31, 2018 and 2017, NAS had $29.5 million and $29.3 million in deferred revenue, respectively, for these contracts and grants. Of the $29.3 million in deferred revenue as of December 31, 2017, $11.8 million was recognized as revenue during the year ended December 31, 2018. Other changes in the balances of deferred revenue and advances were caused by normal timing differences between the satisfaction of performance obligations and payment from the sponsoring organizations.

For exchange contracts and grants, which are recognized based on the right to invoice, NAS has elected the practical expedient and not to disclose information about unsatisfied performance obligations.

For PNAS subscriptions, any subscription revenue received in advance of the subscription year is recorded as deferred revenue and advances in the statement of financial position. For PNAS subscriptions, $2.9 million in deferred revenue as of December 31, 2017 was recognized as revenue during the year ended December 31, 2018.

For meetings, any revenue received in advance of the meeting taking place is recorded as deferred revenue and advances in the accompanying statements of financial position. For meetings, $5.4 million in deferred revenue as of December 31, 2017 was recognized as revenue during the year ended December 31, 2018.

Deferred revenue and advances consist of the following as of December 31, 2018 and 2017 (in thousands):

Income Taxes

NAS follows guidance that clarifies the accounting for uncertainty in tax positions taken or expected to be taken in a tax return, including issues relating to financial statement recognition and measurement. This guidance provides that the tax effects from an uncertain tax position can only be recognized in the financial statements if the position is “more-likely-than-not” to be sustained if the position were to be challenged by a taxing authority. The assessment of the tax position is based solely on the technical merits of the position, without regard to the likelihood that the tax position may be challenged.

NAS is exempt from federal income tax under IRC section 501(c)(3), though it is subject to tax on income unrelated to its exempt purpose, unless that income is otherwise excluded by the Code. NAS has processes presently in place to maintain its tax-exempt status; to identify and report unrelated income; to determine its filing and tax obligations in jurisdictions for which it may have a nexus; and to identify and evaluate other matters that may be considered tax positions. The tax years ending December 31, 2018, 2017, 2016 and 2015 are still open to audit for both federal and state income tax purposes. NAS has determined that there are no material unrelated business activities or uncertain tax positions that require recognition or disclosure in the financial statements.

Functional Allocation of Expenses

NAS’ primary program service is conducting scientific research, convening meetings, and administering grant and fellowship programs. Natural expenses attributable to more than one functional expense category are allocated using a variety of cost allocation techniques such as square footage and time and effort.

Risks and Uncertainties

NAS invests in various investment vehicles. Investment vehicles are exposed to various risks such as interest rate, market, and credit risks. Due to the level of risk associated with these investments, it is at least reasonably possible that changes in the values of investments will occur in the near-term and that such changes could materially affect the amounts reported. NAS maintains its cash and cash equivalents in various bank accounts and money market funds that, at times, may exceed federally insured limits. NAS’ cash and cash equivalents have been placed with high credit quality financial institutions. NAS has not experienced, nor does it anticipate, losses with respect to such accounts.

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. There were no changes to total assets, liabilities, net assets, revenues, expenses or changes in net assets as previously reported in the fiscal 2017 financial statements.

3. INVESTMENTS AND 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. FASB Accounting Standards Codification Section 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 carrying value of cash equivalents such as money market funds approximates fair value because of the short maturity of these investments. These amounts are included in Level 1 of the fair value hierarchy.

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 of the fair value hierarchy. 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 of the fair value hierarchy.

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 of the fair value hierarchy.

The reported 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 its understanding of the nature and related risks of the investments. These investments are not leveled in the fair value hierarchy.

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 2018 and 2017.

Investments are held for the following purposes as of December 31, 2018 and 2017 (in thousands):

The following table presents NAS’ fair value hierarchy for those assets measured at fair value on a recurring basis at December 31, 2018 (in thousands):

The following table presents NAS’ fair value hierarchy for those assets measured at fair value on a recurring basis at December 31, 2017 (in thousands):

The National Academies’ Corporation (“TNAC”, see Note 14), 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 $12.3 million and $13.3 million as of December 31, 2018 and 2017, 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.

The following table presents the nature and risk of assets with fair values estimated using NAV held at December 31, 2018 and 2017 (in thousands):

^(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.

^(b) 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. One investment in this category cannot be redeemed prior to June 2019.

^(c) 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 7 years.

^(d) 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 7 years.

^(e) 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 8 years.

4. 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, 2017, 81% of contributions receivable were due from one corporation. This amount was received in full during the year ended December 31, 2018.

During the year ended December 31, 2017, NAS entered into agreements for two conditional contributions totaling $1.7 million. One is conditioned on receipt of matching gifts and one conditioned on the awarding of a prize. NAS recognized revenue totaling approximately $35,000 and $73,000 pertaining to these conditional contributions for the years ended December 31, 2018 and 2017, respectively.

5. PROPERTY AND EQUIPMENT, NET

Property and equipment as of December 31, 2018 and 2017, is comprised of the following (in thousands):

Depreciation and amortization expense was approximately $6.5 million and $7.0 million for the years ended December 31, 2018 and 2017, respectively.

6. LINES OF CREDIT

Until September 2018, NAS maintained an available $35 million line of credit from Wells Fargo, which bore interest at LIBOR plus 0.55% (3.06% and 2.11% as of December 31, 2018 and 2017, respectively). In September 2018, NAS renewed its line of credit with Wells Fargo for $35 million from October 1, 2018, through December 31, 2018, for $45 million from January 1, 2019 through April 30, 2019, and for $35 million from May 1, 2019 through September 30, 2019. The renewed line of credit bears interest at LIBOR plus 0.55% and expires on September 30, 2019. NAS also maintained an available $15 million line of credit from TD Bank, which bears interest at LIBOR plus 0.55% (3.07% and 2.12% as of December 31, 2018 and 2017, respectively) and expires on August 31, 2019. 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, 2018 and 2017 totaled approximately $87,000 and $115,000, respectively.

7. FINANCIAL ASSETS AND LIQUIDITY

Financial assets available for general expenditure, that is, without donor or contractual restrictions limiting their use, within one year of the date of the statement of financial position, are comprised of the following as of December 31, 2018 (in thousands):

NAS is substantially supported by cost reimbursable contracts and grants from federal and private sponsors, which includes indirect cost recovery (as further discussed in Note 11). A portion of private grants and other contributions carries donor restrictions. Because a donor’s restriction requires resources to be used in a particular manner or in a future period, NAS must maintain sufficient resources to meet those commitments to donors. Thus, certain financial assets may not be available for general expenditure within one year. As part of liquidity management, NAS has a practice to structure its financial assets to be available as its general expenditures, liabilities, and other obligations come due. In addition, NAS invests cash in excess of daily requirements in short- and long-term investments. In the event of an unanticipated liquidity need, NAS could draw upon $50 million of available lines of credit (as further discussed in Note 6). In addition, NAS has $41 million in internally designated funds, which are available for general expenditure with appropriate internal approval.

8. NET ASSETS WITH DONOR RESTRICTIONS

Net assets with donor restrictions are available for the following purposes as of December 31, 2018 and 2017 (in thousands):

Net assets were released from donor-imposed restrictions in satisfaction of the following purposes during the years ended December 31, 2018 and 2017 (in thousands):

9. ENDOWMENT

Endowment Assets

The NAS endowment consists of 128 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 net assets. 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 net assets with donor restrictions (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. Appreciation on donor-restricted endowment funds is classified in net assets with donor restrictions until such amounts are appropriated for spending by the NAS Council in a manner consistent with the standard of prudence prescribed by the Act in accordance with the Act, NAS considers the following factors in making a determination to appropriate investment earnings attributable to donor-restricted endowment funds:

1. The duration and preservation of its endowment fund;
2. The purposes of the institution and its 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 investment and spending policies for endowment assets that are 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 commitment to minimizing volatility while maximizing risk-adjusted return.

NAS’ spending policy 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 years ended December 31, 2018 and 2017 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 net assets with donor restrictions. For funds with a fair value below the original value of the gift, annual spending may be limited at the organization’s discretion until the fair value returns to the required level. At December 31, 2018, there was one endowment fund with a fair value below the original value of the gift. The original fair value of the gift was $750,000 and the fair value as of December 31, 2018 was $744,000, resulting in a deficiency of $6,000. At December 31, 2017, there were no endowment funds with a fair value below the original value of the gift. Subsequent gains that restore the fair value of the assets of the endowment fund to the required level are classified as an increase in net assets with donor restrictions.

10. PROGRAM EXPENSES

Program expenses for the years ended December 31, 2018 and 2017 are summarized as follows (in thousands):

11. RECOVERY OF INDIRECT COSTS

NAS receives indirect cost recovery on its federal contracts and grants. An overhead assessment is applied to direct salaries, accrued leave, fringe benefits, and services provided by outside contractors (e.g., temporary personnel agencies, consultants) on NAS property. A general and administrative assessment (G&A) is applied to direct costs and overhead less subcontract costs and stipends. Therefore, both the overhead and G&A rates are applied to projects incurring direct salaries and other direct costs such as travel. If a program does not require direct salaries, such as a travel grant program, a subcontract/flow-through administration rate is applied. Certain off-site work (not performed on NAS property) is assessed reduced overhead rates.

NAS bills for indirect cost recovery throughout the year based on negotiated rates. At the end of each year, NAS compares actual expenses incurred in each of its cost pools to the amounts recovered based on its billing rates. The difference is recorded as its indirect cost carryforward. If NAS 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 $2.8 million and $3.4 million as of December 31, 2018 and 2017, respectively. The under-recovery is included in the contracts receivable, net balance in the accompanying statements of financial position.

12. 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 in the amount of $130,960,000 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 to pay 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 to 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 to 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. In May 2017, NAS refinanced the Series 2008A and Series 2009A bonds with the existing banks to extend the mandatory repurchase to May 2027, at which point NAS could renew the direct purchase agreements, remarket the bonds, or repurchase the bonds.

In December 2017, the District of Columbia issued Series 2017A tax-exempt revenue bonds in the amount of $52,760,000 on behalf of NAS. The proceeds were used to advance refund a portion of the Series 2010A revenue bonds. The Series 2017A bonds were issued as direct bank purchases with Century Subsidiary Investments, Inc. III.

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 and 2017A bonds is payable semiannually every April 1 and October 1.

Scheduled maturities are as follows (in thousands):

Interest expense on the bonds payable for the years ended December 31, 2018 and 2017 totaled $3.7 million and $3.4 million, respectively.

Interest Rate Swaps

In October 1999, NAS entered into an interest-rate 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 approximately $13,000 and $108,000, for the years ended December 31, 2018 and 2017, 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 $22,000 and $35,000 as of December 31, 2018 and 2017, 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 $1.3 million and $1.4 million for the years ended December 31, 2018 and 2017, 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 $4.8 million and $6.1 million as of December 31, 2018 and 2017, 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 of the fair value hierarchy.

13. 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), as well as mutual funds issued by TIAA, Vanguard Fiduciary Trust Company, and other third parties. Participants in this plan vest immediately. NAS has received a favorable determination letter from the Internal Revenue Service 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, Vanguard Fiduciary Trust Company, and other third parties.

Pension expense for the years ended December 31, 2018 and 2017, amounted to approximately $12.4 million and $12.3 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 $862,000 and $963,000 as of December 31, 2018 and 2017, 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, which are valued using Level 1 inputs (Note 4). 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.

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, 2018 and 2017 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, 2018 and 2017 (in thousands):

The assumptions used to determine net periodic benefit cost for the years ended December 31, 2018 and 2017 are as follows:

The assumptions used to calculate the accumulated postretirement benefit obligation for the years ended December 31, 2018 and 2017 are as follows:

The trend rate for growth in healthcare costs was assumed to decline gradually beginning in 2018 to 4.5% in the year 2038 for the years ended December 31, 2018 and 2017.

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, 2018 and 2017, 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 plan assets. Plan assets are invested with a long-term growth with reduced volatility strategy.

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 of investments with similar asset allocations.

The following table presents the fair value hierarchy for the postretirement benefit plan assets at December 31, 2018 (in thousands):

The following table presents the fair value hierarchy for the postretirement benefit plan assets at December 31, 2017 (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 2019, which is approximately $892,000.

The following benefit payments, which reflect future services, are expected to be paid in future years as noted, as of December 31, 2018 (in thousands):

14. 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 fundraising by NAEF. NAS collected a total of $3.5 million and $3.7 million in 2018 and 2017, respectively, on behalf of NAEF. NAS disbursed $3.2 million and $3.8 million to NAEF from these collected amounts in 2018 and 2017, respectively. Amounts collected but not yet remitted to NAEF are included in other current liabilities in the statements of financial position.

TNAC

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, 2018 and 2017, and is included in contributions and other receivables, net, as of December 31, 2018, and other assets as of December 31, 2017, in the accompanying statements of financial position.

15. 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):

Rental expense totaled approximately $632,000 for each of the years ended December 31, 2018 and 2017.

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, 2015. 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.

In the normal course of business NAS may from time to time be subject to various claims and lawsuits. Certain lawsuits may be covered, in full or in part, by external insurance coverage. In the opinion of management, there are no lawsuits outstanding that would have a material adverse effect on the financial statements of NAS.

16. SUBSEQUENT EVENTS

NAS has evaluated subsequent events from the statement of financial position date through June 12, 2019, 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

David Donoho

Robert Engle

Mark C. Fishman

Ronald L. Graham

Marcia McNutt

Jose A. Scheinkman

James H. Simons

BUDGET AND INTERNAL AFFAIRS COMMITTEE

William H. Press, Chair

Ingrid Daubechies

Fred H. Gage

S. James Gates, Jr.

Diane E. Griffin

Caroline S. Harwood

Thomas D. Pollard

AUDITING COMMITTEE

Claude R. Canizares, Chair

Ronald L. Graham

Jeremiah P. Ostriker

Claire L. Parkinson

William W. Stead

FINANCIAL MANAGEMENT STAFF

Didi Salmon, Chief Financial Officer

Laura Douglas, Controller

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