Board of Governors Financial Statements

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NOTES TO FINANCIAL STATEMENTS AS OF AND FOR THE YEARS ENDED DECEMBER 31, 2006 AND 2005

(1) Structure

The Federal Reserve System was established by Congress in 1913 and consists of the Board of Governors (Board), the Federal Open Market Committee, the twelve regional Federal Reserve Banks, the Federal Advisory Council, and the private commercial banks that are members of the System. The Board, unlike the Reserve Banks, was established as a federal government agency and is supported by Washington DC based staff numbering approximately 1,800, as it carries out its responsibilities in conjunction with other components of the Federal Reserve System.

The Board is required by the Federal Reserve Act to report its operations to the Speaker of the House of Representatives. The Act also requires the Board, each year, to order a financial audit of each Federal Reserve Bank and to publish each week a statement of the financial condition of each such Reserve Bank and a consolidated statement for all of the Reserve Banks. Accordingly, the Board believes that the best financial disclosure consistent with law is achieved by issuing separate financial statements for the Board and for the Reserve Banks. Therefore, the accompanying financial statements include only the results of operations and activities of the Board. Combined financial statements for the Federal Reserve Banks are included in the Board's annual report to the Speaker of the House of Representatives.

(2) Operations and Services

The Board's responsibilities require thorough analysis of domestic and international financial and economic developments. The Board carries out those responsibilities in conjunction with other components of the Federal Reserve System. The Board also supervises and regulates the operations of the Federal Reserve Banks, exercises broad responsibility in the nation's payments system, and administers most of the nation's laws regarding consumer credit protection. Policy regarding open market operations is established by the Federal Open Market Committee. However, the Board has sole authority over changes in reserve requirements, and it must approve any change in the discount rate initiated by a Federal Reserve Bank.

The Board also plays a major role in the supervision and regulation of the U.S. banking system. It has supervisory responsibilities for state-chartered banks that are members of the Federal Reserve System, bank holding companies, foreign activities of member banks, and U.S. activities of foreign banks.

(3) Significant Accounting Policies

Basis of Accounting--The financial statements have been prepared on the accrual basis of accounting.

Revenues--Assessments for operating expenses and additions to property are based on expected cash needs.

Issuance and Redemption of Federal Reserve Notes--The Board incurs expenses and assesses the Federal Reserve Banks for currency printing, issuance, retirement, and shipping of Federal Reserve Notes. These assessments and expenses are separately reported in the statements of revenues and expenses because they are passed through the Board account and are not Board operating transactions.

Property, Equipment, and Software--The Board's property, buildings, equipment, and software are stated at cost less accumulated depreciation and amortization. Depreciation and amortization is calculated on a straight-line basis over the estimated useful lives of the assets, which range from 3 to 10 years for furniture and equipment, 10 to 50 years for building equipment and structures, and 2 to 10 years for software. Upon the sale or other disposition of a depreciable asset, the cost and related accumulated depreciation or amortization are removed from the accounts and any gain or loss is recognized.

Art Collections--The Board has collections of works of art, historical treasures, and similar assets. These collections are maintained and held for public exhibition in furtherance of public service. Proceeds from any sales of collections are used to acquire other items for collections. As permitted by Statement of Financial Accounting Standards Number 116, Accounting for Contributions Received and Contributions Made, the cost of collections purchased by the Board is charged to expense in the year purchased and donated collection items are not recorded. The value of the Board's collections has not been determined.

Estimates--The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.

Reclassifications--Certain 2005 amounts have been reclassified to conform with the 2006 presentation.

Implementation of FASB Statement No. 158, Employers' Accounting for Defined Benefit Pension and Other Postretirement Plans--The Board initially applied the provisions of FASB Statement No. 158, Employers' Accounting for Defined Benefit Pension and Other Postretirement Plans, at December 31, 2006. This accounting standard requires recognition of the overfunded or underfunded status of a defined benefit postretirement plan in the Balance Sheets, and recognition of changes in the funded status in the years in which the changes occur through comprehensive income. The transition rules for implementing the standard require applying the provisions as of the end of the year of initial implementation with no retrospective application.

(4) Property and Equipment

(5) Accumulated Retirement Benefits

The following information provides disclosure requirements contained in Statement of Financial Accounting Standards No. 132, Employers' Disclosures about Pensions and Other Postretirement Benefits.

Substantially all of the Board's employees participate in the Retirement Plan for Employees of the Federal Reserve System (System Plan). The System Plan is a multi-employer plan which covers employees of the Federal Reserve Banks, the Board, and the Office of Employee Benefits. No separate accounting is maintained of assets contributed by the participating employers. The Federal Reserve Bank of New York acts as a sponsor of the System Plan, and the costs associated with the Plan are not redistributed to other participating employers.

Employees of the Board who became employed prior to 1984 are covered by a contributory defined benefits program under the System Plan. Employees of the Board who became employed after 1983 are covered by a non-contributory defined benefits program under the System Plan. Contributions to the System Plan are actuariallydetermined and funded by participating employers. Based on actuarial calculations, it was determined that employer funding contributions were not required for the years 2006 and 2005, and the Board was not assessed a contribution for these years. Because the plan is part of a multi-employer plan, information as to vested and nonvested benefits, as well as plan assets, as it relates solely to the Board, is not readily available.

Effective January 1, 1996, Board employees covered under the System Plan are also covered under a Benefits Equalization Plan (BEP). Benefits paid under the BEP are limited to those benefits that cannot be paid from the System Plan due to limitations imposed by Sections 401(a)(17), 415(b), and 415(e) of the Internal Revenue Code of 1986.

A relatively small number of Board employees participate in the Civil Service Retirement System (CSRS) or the Federal Employees' Retirement System (FERS). These defined benefit plans are administered by the U.S. Office of Personnel Management, which determines the required employer contribution levels. The Board's contributions to these plans totaled $334,000 and $324,000 in 2006 and 2005, respectively. The Board has no liability for future payments to retirees under these programs and is not accountable for the assets of the plans. Employees of the Board may also participate in the Federal Reserve System's Thrift Plan. Board contributions to members' accounts are based upon a fixed percentage of each member's basic contribution and were $8,964,000 and $8,617,000 in 2006 and 2005, respectively.

(6) Accumulated Postretirement Benefits

The following information provides disclosure requirements contained in Statement of Financial Accounting Standards No. 106, Employers' Accounting for Postretirement Benefits Other Than Pensions.

The liability and costs for the postretirement benefit plan were determined using discount rates of 5.75 percent as of December 31, 2006 and 2005. Unrecognized losses of $2,145,920 as of December 31, 2005 result from changes in the discount rate used to measure the liabilities. The assumed salary trend rate for measuring the increase in postretirement benefits related to life insurance was an average of 4.50 percent.

The above accumulated postretirement benefit obligation is related to the Board-sponsored life insurance programs. The Board has no liability for future payments to employees who continue coverage under the federally sponsored life and health programs upon retiring. Contributions for active employees participating in federally sponsored health programs totaled $9,607,000 and $8,933,000 in 2006 and 2005, respectively.

(7) Accumulated Postemployment Benefit Plan

The following information provides disclosure requirements contained in Statement of Financial Accounting Standards No. 112, Employers' Accounting for Postemployment Benefits.

The Board provides certain postemployment benefits to eligible former or inactive employees and their dependents during the period subsequent to employment but prior to retirement. Costs were projected using the same discount rates as were used for projecting postretirement costs. The accrued postemployment benefit costs recognized by the Board for the years ended December 31, 2006 and 2005, were $1,963,000 and $155,800, respectively.

(8) Accumulated Other Comprehensive Income

Additional detail regarding the classification of accumulated other comprehensive income is included in note 6.

(9) Other Revenues and Other Expenses

(10) Commitments and Contingencies

Leases

The Board has entered into several operating leases to secure office, training, and warehouse space for remaining periods ranging from one to four years. Minimum annual payments under the operating leases having an initial or remaining noncancelable lease term in excess of one year at December 31, 2006, are as follows:

Rental expenses under the operating leases were $193,000 in 2006 and $157,000 in 2005.

Commitments

The Board has entered into an agreement with the Federal Deposit Insurance Corporation and the Office of the Comptroller of the Currency, through the Federal Financial Institutions Examination Council (the "Council") to fund a portion of enhancements and maintenance fees for a central data repository project through 2013. Estimated Board expense to support this effort is $7.5 million.

Litigation

The Board is subject to contingent liabilities which include litigation cases. These contingent liabilities arise in the normal course of operations and their ultimate disposition is unknown. Based on information currently available to management, it is management's opinion that the expected outcome of these matters, individually or in the aggregate, will not have a materially adverse effect on the financial statements. Management believes the Board has substantial defenses and that the likelihood of an adverse judgement is remote.

One action currently pending in U.S. District Court for the District of Columbia alleges discrimination on behalf of a class of African American secretaries at the Board under Title VII of the Civil Rights Act of 1964, as amended. On January 31, 2007, the action was dismissed for failure to exhaust administrative remedies. The plaintiffs have moved to alter or amend judgment on this ruling; that motion is pending. Should the case be reinstated either as a result of the pending motion or following appeal, the Board believes it has substantial defenses and intends to defend the case vigorously.

Four additional actions are pending in the United States District Court for the District of Columbia under Title VII of the Civil Rights Act of 1964, as amended and/or the Age Discrimination in Employment Act. All four are believed to be without merit and are being vigorously contested.

Five additional matters alleging employment discrimination are currently pending administrative resolution. One case is related to, and likely will be joined with, a case currently pending in district court. In that and another case there has not yet been an investigative report. Therefore, management is unable at this time to determine the potential for a materially adverse effect on the financial statements. Management believes that the likelihood of an unfavorable outcome in the remaining three cases is remote.

(11) Federal Financial Institutions Examination Council

The Board is one of the five member agencies of the Council, and currently performs certain management functions for the Council. The five agencies which are represented on the Council are the Board, Federal Deposit Insurance Corporation, National Credit Union Administration, Office of the Comptroller of the Currency, and Office of Thrift Supervision.

(12) Federal Reserve Banks

The Board performs certain functions for the Reserve Banks in conjunction with its responsibilities for the Federal Reserve System, and the Federal Reserve Banks provide certain administrative functions to the Board.

(13) Noncash Financing Activities

In 2005, the Board billed a federal government agency $1,096,557 for rent and leasehold improvements. In 2006, the federal government agency provided equipment, software, and services valued at $392,301 to the Board and paid the balance of $704,256 in 2006. In 2006, the Board billed the same agency $143,772 for rent, and the agency provided telecommunication equipment and services valued at $124,720 to the Board and paid the balance of $19,052 in 2006.