Analyzing and InterpretingAnalyzing and Interpreting Disclosures on Equity Method Investments

Cummins Inc. reports investments in affiliated companies, consisting mainly of investments in six manufacturing joint ventures. Cummins provides the following financial information on its investee companies in a footnote to its $10-$K report.

For years ended December $31$

Equity Investee Financial Summary, $ millions $201820172016$

Net sales $$7,352$ $$7,050$ $$5,654$

Gross margin $1,3731,4221,182$

Net income $647680499$

Cummins$$ share of net income $$336$ $$308$ $$260$

Royalty and interest income $584941$

Total equity, royalty and interest income from investees $$394$ $$357$ $$301$

Current assets $$3,401$ $$3,416$

Noncurrent assets $1,4491,379$

Current liabilities $(2,669)(2,567)$

Noncurrent liabilities $(218)(237)$

Net assets $$1,963$ $$1,991$

Cummins$$ share of net assets $$1,144$ $$1,116$

$($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. Answer

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

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

Net income and stockholders' equity are the same whether the equity method or consolidation is used, so ROE is the same. Answer Disclosures on Equity Method Investments

Cummins Inc. reports investments in affiliated companies, consisting mainly of investments in six manufacturing joint ventures. Cummins provides the following financial information on its investee companies in a footnote to its $10-$K report.

For years ended December $31$

Equity Investee Financial Summary, $ millions $201820172016$

Net sales $$7,352$ $$7,050$ $$5,654$

Gross margin $1,3731,4221,182$

Net income $647680499$

Cummins$$ share of net income $$336$ $$308$ $$260$

Royalty and interest income $584941$

Total equity, royalty and interest income from investees $$394$ $$357$ $$301$

Current assets $$3,401$ $$3,416$

Noncurrent assets $1,4491,379$

Current liabilities $(2,669)(2,567)$

Noncurrent liabilities $(218)(237)$

Net assets $$1,963$ $$1,991$

Cummins$$ share of net assets $$1,144$ $$1,116$

$($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. Answer

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

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

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