JUNE 2023 EXAM
Question 2
This scenario relates to three requirements.
Vroom Co is an established company in the automotive industry and has been selling cars globally
for many years.
On 1 January 20X3, Vroom Co acquired 80% of Sleek Co’s $100m share capital. Sleek Co is a
company which specializes in electric vehicles. Vroom Co paid cash of $650m on 1 January 20X3
and will pay a further $300m of cash on 1 January 20X6 if Sleek Co meets certain performance
targets. At 1 January 20X3, the fair value of the $300m of consideration due to be paid on 1 January
20X6 was $210m and at 31 December 20X3 the fair value was deemed to be $160m.
Sleek Co is Vroom Co’s only subsidiary. Extracts from the Vroom Group’s consolidated statement
of profit or loss for the year ending 31 December 20X3 and from Vroom Co’s statement of profit
or loss for the year ended 31 December 20X2 are shown below.
Statement of profit or loss for the year ended 31 December:
20X3 Vroom Group (consolidated) 20X2 Vroom Co (single entity)
$m
$m
Revenue
13,450
12,200
Cost of sales
(11,150)
(9,800)
Gross profit
2,300
2,400
Operating expenses
(1,570)
Profit from operations 730
(1,460)
940
A member of the finance team has correctly calculated the capital employed figures to be as
follows:
20X3 Vroom Group (consolidated) $m 20X2 Vroom Co (single entity) $m
Capital employed 33,670
31,450
The following information is relevant:
(1) At acquisition, Sleek Co retained losses of $80m. Sleek Co also had unrecognized intangible
assets estimated to have a fair value of $250m and a useful life of ten years. The noncontrolling interest is measured at fair value, and the share price of Sleek Co at acquisition
was $6.80.
(2) Sleek Co has been correctly accounted for in the consolidated financial statements for the year
ended 31 December 20X3. Sleek Co’s individual financial statements for the period showed
revenue of $380m with losses from operations of $170m.
(3) In the face of declining global sales, Vroom Co recently undertook the decision to invest in
Sleek Co due to the new technology it made use of, particularly in relation to the research it
was undertaking regarding long battery lives and self-driving technology.
(4) During 20X3, Sleek Co continued to invest significant amounts in battery and self-driving
technology. In January 20X4 it was confirmed that the new battery technology was viable.
Sleek Co was able to patent this technology and the project entered the development phase at
this point. It is expected that this will be completed during early 20X4. Self-driving technology
is still in the research phase.
(5) Vroom Co also launched a range of after-sales service arrangements for new customers during
20X3. Due to the lower repairs required on new vehicles, these have been profitable for Vroom
Co.
Requirements
(a) Calculate the goodwill that arose on the acquisition of Sleek Co.
(4 marks)
(b) Using the preformatted table provided, calculate the following ratios for the years ended 31
December 20X3 and 31 December 20X2 for the Vroom Group and Vroom Co respectively:
- Gross profit margin,
- Operating profit margin; and
- Return on capital employed (ROCE).
(3 marks)
(c) Analyse the performance for the Vroom Group for the year ended 31 December 20X3
compared to the performance of Vroom Co for the year ended 31 December 20X2. (13 marks)
You can assume:
Gross profit margin X2 was 17·1% and X3 was 19·7%
Operating profit margin X2 was 5·4% and X3 was 7·7%
Return on capital employed X2 was 2·2% and X3 was 3·0%
ANSWERS
(a) Vroom Co
Goodwill arises on the acquisition of Sleek Co
$m
Consideration:
Cash
650
210
-----
Contingent consideration
$m
860
136
----996
-----
NCI at acquisition (20% x [100m x $6·80])
Net assets:
Share capital
Retained losses
Fair value adjustment (identifiable intangible asset)
100
(80)
250
----270
-----
Goodwill at acquisition
726
(b) Ratio calculations
Working
Gross profit
margin
Operating profit
margin
Return on capital
employed
20X3 Vroom
Group
2,300/13,450 17·1%
----730/13,450
5·4%
----730/33,670
2·2%
-----
Working
2,400/12,200
940/12,200
940/31,450
20X2
Vroom Co
19·7%
----7·7%
----3·0%
-----
(c) Comment on the performance of the Vroom group
▪ The revenue increase of $1,250m is partly due to the consolidation of Sleek Co, which
will have contributed a whole year’s revenue following the acquisition on 1 January 20X3.
▪
Sleek Co has only added $380m of revenue, suggesting there has been a substantial
increase in revenue generated by Vroom Co individually. This is likely to be due to
the increase in after-sales services introduced during the year.
▪
The gross profit margin has declined by 2·6% (19·7% – 17·1%). This seems unusual as
the new services provided by Vroom Co are described as being profitable, suggesting
that they are made at a higher margin so there are likely to be other reasons for this decrease.
▪
While we are not told the gross profit of Sleek Co, we do see that it is loss-making so it
may be that the company has generated a lower gross profit margin than Vroom Co.
▪
As Sleek Co is investing heavily in research and development, these costs may well be
included within cost of sales. We are told that the battery research only meets the
development criteria at January 20X4 and the self-driving technology is still in the
research phase and so all these costs will have been expensed in 20X3.
▪
The operating profit margin has also declined. Partly, this will be due to the factors
identified in the decrease of the gross profit margin but is likely to be due to Sleek Co
generating an operating loss.
▪
The impact of Sleek Co’s operating loss is likely to be even greater in the consolidated
financial statements due to the recognition of the internally generated intangibles at
acquisition. These will not be included in Sleek Co’s individual financial statements,
so there will be an additional amount of fair value amortisation of $25m ($250m/10
years) recorded in the consolidated statement of profit or loss. This will increase the
negative impact which Sleek Co has had on the group’s operating profit margin.
▪
The operating profit margin has not necessarily declined as much as might be expected.
This could be due to the reduction in contingent consideration. The decrease in contingent
consideration is taken through the statement of profit or loss and will result in a credit,
causing a positive impact on the profit margins.
▪
Despite the reduction in contingent consideration, there are promising signs from Sleek Co
in respect of the new battery developments. As the research was a key reason for the
acquisition, this could suggest that there could be better results to come from Sleek
Co in the future.
▪
In addition to the decrease in operating profits, there has also been an increase in capital
employed. The group now has an addition of a non-controlling interest in equity,
which did not exist in 20X2. This explains the fall in return on capital employed
(ROCE).
▪
The ROCE has decreased. Partly, this is due to the reduction in operating profits already
discussed. The decline in ROCE could also mean that Sleek Co had substantial
liabilities themselves which would now be consolidated into the group, or that
additional shares were issued to raise finance for the acquisition.
Conclusion:
The acquisition of Sleek Co has had a detrimental impact on the profitability of the group
currently, but this is not really the reason for the acquisition. The acquisition was made for
long-term strategic purposes. The recent announcement by Sleek Co regarding its
technological breakthrough does provide cause for increased optimism for future periods.
Additional points which could be made:
✓ The significant increase in Vroom Co’s individual revenue could also signify that the global
fall in demand in traditional vehicles is not as dramatic as previously feared.
✓ Whilst the reduction in contingent consideration has had a positive impact on profits, this
suggests that Sleek Co is less likely to achieve the targets set on acquisition which implies
that they have performed worse than hoped.
✓ The new announcement from Sleek Co regarding their technological breakthrough could
mean that they are now more likely to hit performance targets. If this is the case, then the
contingent consideration liability may increase, resulting in an increased expense.
✓ Although the battery technology has become viable, the self-driving technology is still in
the research phase and any further costs in this area will continue to be expensed to the
statement of profit or loss. It is not clear how much of the previous expenditure related to
this research or how close the project is to becoming viable and so there could be significant
costs going forward.
✓ Although the after-sales service arrangements are profitable just now, as more customers
move to the more reliable cars or to the electric cars sold by Sleek Co, it is possible that
the demand for these arrangements might decrease in the future which would negatively
impact revenue.