Question

Analyzing and Interpreting Disclosures on Equity Method Investments
Cummins Inc. (CMI) reports investments in affiliated companies, consisting mainly of investments in nine manufacturing joint ventures. Cummins reports those investments on its balance sheet at $958 million, and provides the following financial information of its investee companies in a footnote to its 10-K report:

Equity Investee Financial Summary
	As of and for the years ended December 31
$ millions	2015	2014	2013
Net sales	$5,946	$7,426	$7,799
Gross margin	1,265	1,539	1,719
Net income	521	630	690
Cummins’ share of net income	$273	$330	$325
Royalty and interest income	42	40	36
Total equity, royalty and interest income from investees	$315	$370	$361
Current assets	$2,458	$2,476
Noncurrent assets	1,539	1,667
Current liabilities	(1,796)	(1,875)
Noncurrent liabilities	(284)	(420)
Net assets	$1,917	$1,848
Cummins’ share of net assets	$958	$956

(a) What assets and liabilities of unconsolidated affiliates are omitted from Cummins’ balance sheet as a result of the equity method of accounting for those investments?

Assets = $Answer million

Liabilities = $Answer million

(b) Do the liabilities of the unconsolidated affiliates affect Cummins directly?

The liabilities of the investee company are not liabilities for the investor.

The creditors of the investee company have recourse to the assets of the investor in the event of default.

The liabilities of the investor company are liabilities of the investee.

The liabilities of the investee company are liabilities for the investor.

(c) How does the equity method impact Cummins’ ROE and its RNOA components (net operating asset turnover and net operating profit margin)?

There is no effect on CMI's ROE and RNOA as a result of its use of the equity method. AnswerTrueFalse

The equity method arguably omits assets and liabilities from CMI's balance sheet, and omits sales and expense from its income statement (compared with the assets, liabilities, sales and expenses that would be recorded with consolidation). Therefore, RNOA would be affected. AnswerTrueFalse

Because equity method investments are reported at fair value, assets are likely overstated. AnswerTrueFalse

Net income and stockholders' equity are the same whether the equity method or consolidation is used, so ROE is the same. AnswerTrueFalse

Answer 1

(a) Since Cummins reports its investments in affiliates using equity method of accounting, it reports its economic interest in these affiliates as a non-current asset on its Balance Sheet, represented by its proportionate share in the affiliates’ equity and earnings.

Thus the assets and liabilities of these affiliates are not actually reported on Cummins’ balance sheet.

Assets and liabilities of affiliates omitted from Cummins’ Balance Sheet:

Assets = (Current assets $2,458 million + Noncurrent assets $1539 million) = $3,997 million

Liabilities = (Current liabilities $1,796 million + Noncurrent liabilities $284 million) = $2,080 million

(b) The liabilities of the unconsolidated affiliates do not affect Cummins directly, unless it has legally guaranteed these liabilities. If the affiliates failed, however, if the investment in these affiliates is necessary from the standpoint of Cummins’ business strategy, then it may end up having to support the failing investees, as it may otherwise find it hard to enter similar future ventures.

Thus, legally, the liabilities of the investee companies are not liabilities of Cummins; there may however be an effective liability in the above situation.

Answer: The liabilities of the investee company are not liabilities for the investor.

(c) There is no effect on CMI's ROE and RNOA as a result of its use of the equity method. Answer: False

The equity method arguably omits assets and liabilities from CMI's balance sheet, and omits sales and expense from its income statement (compared with the assets, liabilities, sales and expenses that would be recorded with consolidation). Therefore, RNOA would be affected. Answer: True

Because equity method investments are reported at fair value, assets are likely overstated. Answer: False

Net income and stockholders' equity are the same whether the equity method or consolidation is used, so ROE is the same. Answer: True