Analyzing and Interpreting Disclosures on Equity Method Investments
Assume Caterpillar, Inc. (CAT) reports investments in affiliated companies, consisting mainly of its 50% ownership of Shin Caterpillar Mitsubishi, Ltd. Caterpillar reports those investments on its balance sheet at $572 million, and provides the following footnote in its 10-K report.
Investments in unconsolidated affiliated companies
Our investments in affiliated companies accounted for by the equity method consist primarily of a 50% interest in Shin Caterpillar Mitsubishi Ltd. (SCM) located in Japan. Combined financial information of the unconsolidated affiliated companies accounted for by the equity method (generally on a three-month lag, e.g., SCM results reflect the periods ending September 30) was as follows:
| Years Ended December 31 (Millions of Dollars) | 2011 | 2010 | 2009 |
| Results of operations: | |||
| Sales | $ 4,007 | $ 4,420 | $ 4,140 |
| Cost of sales | 3,210 | 3,526 | 3,257 |
| Gross profit | $ 797 | $ 894 | $ 883 |
| Profit | $ 157 | $ 187 | $ 161 |
| Caterpillar’s profit | $ 74 | $ 81 | $ 73 |
Sales from SCM to Caterpillar of approximately $1.67 billion, $1.81 billion and $1.73 billion in 2011, 2010 and 2009 respectively, are included in the affiliated company sales. In addition, SCM purchased $268 million, $273 million and $282 million of products from Caterpillar in 2011, 2010 and 2009, respectively.
| December 31 (Millions of Dollars) | 2011 | 2010 | 2009 |
| Financial position: | |||
| Assets | |||
| Current assets | $ 2,062 | $ 1,807 | $ 1,714 |
| Property, plant and equipment-net | 1,286 | 1,119 | 1,120 |
| Other assets | 173 | 176 | 194 |
| 3,521 | 3,102 | 3,028 | |
| Liabilities | |||
| Current liabilities | 1,546 | 1,394 | 1,348 |
| Long-term debt due after one year | 269 | 309 | 318 |
| Other liabilities | 393 | 145 | 188 |
| 2,208 | 1,848 | 1,854 | |
| Ownership | $ 1,313 | $ 1,254 | $ 1,174 |
| Caterpillar’s investment in unconsolidated affiliated companies, December 31 (millions of dollars) |
2011 | 2010 | 2009 |
| Investment in equity method companies | $ 572 | $ 542 | $ 540 |
| Plus: Investment in cost method companies | 16 | 20 | 25 |
| Investment in unconsolidated affiliated companies | $ 588 | $ 562 | $ 565 |
(a) What assets and liabilities of unconsolidated affiliates are included on CAT’s balance sheet as a result of the equity method of accounting for those investments?
Assets = Answer 572 ($ millions)
Liabilities = Answer 0($ millions)
(b) Do the liabilities of the unconsolidated affiliates affect CAT directly?
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 not liabilities for the investor.
The liabilities of the investee company are liabilities for the investor.
(c) How does the equity method impact CAT’s ROE and its RNOA components (net operating asset turnover and net operating profit margin)? (Indicate whether each statement is true or false.)
The equity method arguably omits assets and liabilities from CAT’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
There is no effect on CAT’s ROE and RNOA as a result of its use of the equity method.
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