Back to basics: Consolidation—Determining the primary beneficiary

0:00Thought Leadership from PwC's National Office. Hello, and welcome back to PwC's Accounting Podcast. I'm Heather Horn. Today, we're continuing our Back to Basic series on consolidation accounting with Matt Sabatini, a Deputy Chief Accountant in PwC's National Office, and Alexander Martin, a partner in PwC's Deals Practice. In the first episode, we introduced the consolidation framework and the two consolidation models under US GAAP. Then in our second episode, we took a closer look at how to determine whether an entity is a variable interest entity or VIE. Now we're ready for the next question.

0:42If you have a VIE, who, if anyone, actually consolidates it? That means you need to identify the primary beneficiary.

0:53In today's episode, Matt and Alexander walked through the analysis, including some of the judgments that can come with assessing the power, how the economics criterion works, and a few additional considerations that can affect the conclusion. They also discuss why this isn't necessarily a one and done assessment and when companies may need to revisit their conclusions. And as I said at the introduction to the first episode, these are some of my favorite episodes we recorded, so I'm so glad you're with us today. With that, let's listen to my conversation with Matt and Alexander. Matt, Alexander, welcome back for part three of our extremely exciting podcast series about consolidations.

1:33And I know people often may think exciting and consolidations don't go together, but clearly the two of you approved that those two words do. So for this final episode, we ended with a cliffhanger last time. We got all the way through the model, except we had to not figure out who was going to consolidate the VIE. So that's what we're going to talk about today. Correct, Alexander? Yeah, exactly. And, you know, we got here by going through a couple of steps. We first made sure we were in the scope. Then we, at length, went through each of the five characteristics to make sure that we met one of them to make sure we were a VIE.

2:07So now we're at kind of what we dubbed step three. And when you really think about it and step back, we're actually now just starting the VIE model, right? Everything we've done up until now was just scoping and making sure. Otherwise, you know, we would have been in the voting model. But there's one point that I wanted to make sure that was clear because it used to confuse me when I first started consolidation as a wee lad. We have two models under GAPS. We have the voting model and the VIE model. But you only apply one, right? So once you've determined that you're in the VIE model, then you go through.

2:40And if you get to a non-consolidation answer under the VIE model, you don't then have to go circle back and check under the voting model. So there's no concept of double jeopardy in U.S. GAP, thankfully. All right. That's helpful. And I do think I got somewhat distracted there because you mentioned step three of the VIE model. And in fact, it's actually step like 23. I think if we count all the real steps, but we can go with step three if it makes you guys feel better. So, all right. With that, then I think it's an important point that you mentioned about not going back, but let's assume you are a VIE.

3:13So now let's talk about what criteria you need to think about in order to consolidate the entity. Yep. So the person that consolidates or the entity that consolidates a VIE is called the primary beneficiary or the PB, as we say for short. So in order to be the PB, you have two criteria that you have to meet. First one is what's referred to as the power criterion. So you have to have the power to direct the VIE's most significant activities. Remember, we said that would come back later. This is where it comes in. The second one is referred to as the economics criterion. So you have to be exposed to more than an insignificant amount of the entity's economics, either its upside or its downside.

3:50If you have both of those characteristics, power and economics, you're the primary beneficiary, so you get to consolidate. So we're going to go through each of those criteria and break it down, but a couple more things to clarify before we get into it. First and foremost, and this is probably more for some of the older school folks, the analysis nowadays is more qualitative. Some people, and Matt mentioned it, I think, in the last episode, that analysis used to be a complex quantitative analysis. We don't do that anymore. Second one, and most important, I think, is Highlander rules apply to the PB analysis, meaning there can be only one primary beneficiary.

4:25This one's explicit in the guidance. You can't have more than one PB. But it actually leads me to my last point here, which is that while there can't be more than one PB, that doesn't mean there has to be one. Right. So you can have instances where there's no PB and nobody would consolidate. That said, in my experience, there typically is one, but it does happen. And when that happens, it does get met with a little bit of additional scrutiny. So if you're starting to get to an answer like that, you probably want to double check your math. So I, of course, have to ask a question here because you said there can only be one.

4:57But obviously, there's multiple independent parties involved in this analysis. And so I think, well, I know my own answer, but do you see instances where more than one party concludes they're the primary beneficiary? Conceptually, no, right? It's explicit in the guidance that you can't have more than one primary beneficiary. But when you're doing the analysis, you're doing it from your perspective, technically. So you're making your own judgments based on your understanding of the entity, purpose, design, power, most significant decisions. Another investor in that same entity may come to a different conclusion.

5:32And while generally speaking, you're hoping you're going to get to a similar answer, that doesn't mean you have to. So you could have two entities coming to a different view and then both consolidating. All right. So that's probably another place, just like the case where no one concludes that the primary beneficiary, if there's more than one, also may want to check your math, or not math, but qualitative analysis. Check your memo in this case. All right. So that's extremely helpful and I think important. So now let's get into what I think is one of the most interesting parts of talking about VIEs, and that's looking at power and economics.

6:03So obviously sort of the underlying of all these entities. And Matt, maybe starting with the power criterion, I know this can get quite involved. It can. But before I get started, I just can't believe you would let Alexander get away with a Highlander reference without talking more about. I have to admit, I just did not want to go there. Yeah. So it's an obscure 1980s movie with Sean Connery, which didn't really age that well. The soundtrack is awesome, though. All right. Power. Right. So I think we're going to spend most of our time in the PB test talking about power. That's where we spend most of our time and where we get the most questions.

6:39Typically, the economics criterion, that's met by several parties, right? Lots of people can have an economic interest in a single entity. But generally, like Alex said, only one party will have power. So it is an area of significant judgment. If it wasn't, I don't think we would be doing a podcast on it. But what we've tried to do is we've tried to break the analysis down into two steps. You know how we like to break things down into steps. So now we're up to like step 30, but okay. But step one of this part. Okay, fair, fair. The first is we try to identify what the VIE's most significant activities are.

7:09Then number two, we look at those activities and we try to decide or assess how decisions around those activities are made and who makes them. So those are the two steps. And if you break it up like that, it maybe helps simplify or get your head around what can be a very judgmental area. So step number one, identifying the most significant activities. When we think about this, we're trying to think about what are the activities that most significantly affect the economic performance of a VIE? So, you know, what are the decisions or the activities that most meaningfully impact cash flows, key operating metrics, business strategy, that kind of thing?

7:43So it's basically things that would have the most impact over the fair value or the future cash flows of an entity. So when we're thinking about decisions that are more administrative or back office, those probably wouldn't be the most important activities of a VIE. Contrast that with entering into new lines of business, selecting management teams, setting compensation, negotiating larger transactions like acquisitions or divestitures. Those generally are considered significant. So, Matt, I think it's always helpful as we're thinking through this to actually give some examples of what this means in practice.

8:18So I'm guessing from all your vast experience, you could throw a few off the top of your head. Yeah. So, yeah, I mean, again, it is it is pretty industry specific because you really are trying to use judgment based on the the entity itself. Right. So your different analyses aren't necessarily going to be able to rely on other ones if they're in different industries. So a good example would be asset management. Right. So when we're thinking about what are the most important decisions that drive the success of an asset management company or a fund, generally I would think about establishing the investment strategy for the fund, deciding which investments to acquire for how much, and then when to sell those investments and for how much.

8:58So those are some of the activities that really drive whether or not a fund is going to be successful or an asset manager. Compare that to like a real estate lessor entity. What I would think about there is, all right, who are the tenants going to be? So selecting tenants, making sure they're credit worthy, making sure that we have the right terms, right, for the lease with those tenants. So the lease rates and the renewal options and everything that goes along with lease terms. And then maybe deciding what to do with the property at the end of the lease, so the residual value. So those are probably what's going to drive whether or not a lessor entity is successful in terms of its cash flows and its fair value.

9:32So you can see how they're very different in different industries. Yes. How about power plants? I was sure you were going to talk about that. Yes. We don't need to talk about them today. It's okay. Okay. I was going to ask you. Oh, I can tell you. So for a power plant, definitely the things that you would think about is who's dispatching the power, who's deciding when to operate the plant, when they're doing major maintenance. And in fact, if you would like to know more about power plants, you can look in the power and utilities guide for that. So, yeah, we also we also include in the consolidation guide itself a list of important activities by by area.

10:04Yeah. And actually, I do think that's an important point in seriousness, that if a company is trying to evaluate one of these VIEs, particularly if you're relatively new to it, but even if you've done it before, going and looking at some of those types of lists really does help your brain start to think about how what types of decisions you should be focused on. So it is very helpful to look at those lists, even if it may not be exactly what you're looking for for your specific entity. Agreed. Agreed. All right. So now we've identified those activities, hopefully without too much difficulty. What next?

10:37Right. So now we're into like step two of this, which is determining how those decisions around those activities are made. Right. What's the what's the form in which those decisions get made? How does power manifest itself? So maybe number one, right. Where does that power actually reside? So a lot of times it could be straightforward. Even in a VIE, the power could reside within the governing documents, in which case, you know, shareholders and boards make decisions. That does happen, right? Those are the easy ones, right? Because, well, easier, I'll say, never quite easy. So oftentimes with VIEs, the power might reside elsewhere, right?

11:09They might reside in a contractual arrangement, either explicitly or implicitly. So you've got to look more broadly around where does that power sit. And once you know where the power sits, you look at how decisions are made within that power construct, right? Right. So, again, a lot of times on a board, you're looking at, well, is it simple majority? Is it super majority? Is it unanimous vote to understand does one party control or is it is it really split? But again, if it's outside of a board context or equity context, how decisions are made could be way more complicated. Right. Because you could have multiple decision makers who are directing different activities over the same entity.

11:43Well, and I think, Matt, this is where it's really important to kind of loop all the way back to the beginning when Alexander talked about the history of the VIE model and how this grew up. And that's why it's so important to look more holistically at all the agreements and arrangements governing the decision making for a particular entity is because of some of the abuse and otherwise that we saw before this model got set up. Yeah, 100 percent, right? Because if we were going to just look at the equity vote on the board, why would we need a voting model? Exactly. We would just be in the voting model.

12:11Exactly. That makes a lot of sense. So once you've done these, right, you've identified which of the decisions that are most important and how those decisions are made. we're essentially and i like to use alexander's analogy here which which he taught me right you're essentially putting all of those decisions on a scale and you're weighing you know where which decisions have the most weight so it's not necessarily a matter of saying you know alexander controls two decisions and heather controls three heather consolidates right because she's got three and alexander has two right you actually have to put some weight on on those decisions so the way a scale works right is it's not based on the number of marbles you put on the scale it's based on how much heft they have.

12:48Ah, very good analogy there. Right. So it's important to consider, you know, all of these things in terms of weight and importance on these decisions to really pick who the primary beneficiary is. Yeah. And I think, Matt, you made a really good point there that often these decisions are split among multiple parties, hence why this can be very difficult. And I do like, as I said, that scale analogy. But I think there's, I see two potential issues with it. One is that sometimes it's hard to tell. The scale looks pretty even. Maybe there's a slight, you know, to one or the other. And obviously, this weighting of the decisions is not an exact science.

13:24So, I mean, you made a point. This is a qualitative analysis. So it's not like you're doing some big numerical analysis to figure out which decision is more important. So if that's the case, Alexander, what do you do? Yeah. And to your point, sometimes it's readily apparent, right? It's easy. okay, this person controls, and then you go through the remainder of the steps. And then other times, most times, again, selection bias, when we see it, it's because the scale keeps teetering close to even in an event where that happens. Because there are instances where power would be shared. So that does happen.

13:59But as I met, it gets met with a little bit of additional scrutiny, right? And it's, hey, make sure you put everything on the scale and did you calibrate it correctly. But maybe I can talk about a couple of scenarios to kind of illustrate the point on when it would make sense that power is shared, meaning nobody controls versus other ones where the scale is going to tip one way or another. Maybe back to Matt's asset management venture that now we're both in together. So let's just boil it down and say we have two significant decisions. We're deciding which investments to get into and then when to sell them.

14:31If in maybe construct A, we say that both of us have to agree on both of those decisions, then we'd say, well, power is shared. Neither one of us can control, right? Therefore, neither one of us have power over the entity itself. But now maybe let's switch a little bit and say, well, Matt controls the decision of which investments to get into. And I control the decision of when we sell them. Now it gets a little bit harder to your point, right? It's like, okay, well, which one's more important, right? Because you might have one person look at it and say, well, hey, they're both equally important.

15:02You can have another person say, well, no, So maths are more important. I could look at it and say, well, mine are more important. In scenarios like that, where we're controlling different decisions, there is some practice literature and some speeches which basically say, hey, we know it's hard. But in those types of scenarios, one is going to be a little bit more important than the other. So you've got to make a call because the scale's not going to come up even when they're different decisions. Agreed. It can be very complicated and very judgmental, right? And it's not just the areas that Alexander pointed out.

15:31There are some other key areas of judgment that we are faced with in this part of the analysis. There are a couple of paragraphs in, we call them 38F and 38G, and they deal with the notion of sponsorship and the notion of disproportionate economics, right? And they really are trying to put a substance overlay over your primary beneficiary analysis, like situations where the economics are so disproportionate to one of the investors, you would expect that investor to want power. Makes sense, right? You want to control the decisions that affect your return because you're so disproportionately high.

16:05So where legal agreements or stated powers are different from what you would expect in those situations, you might want to approach it with increased skepticism. And the sponsorship notion is when all of the decisions are made up front or almost all of them are made up front, so you have a real special purpose entity, sometimes you would weigh those more heavily if there are very few ongoing decisions. So you might have an ongoing decision which is more administrative and try to argue that party has power. But in those situations, you may want to put more weight on the decisions that were made up front as part of the purpose and design of the entity.

16:33So that's one area. The other area that comes up, and we don't have to go into a ton of detail because this will be in part seven of our podcast, is kickout rights. So if removal rights or kickout rights are held by one party that's involved with the entity, generally that's enough to overcome a power held by another party, right? But again, that has to be a unilateral kickout right held by one party. And it needs to be substantive, meaning there can't be any significant barriers for that party to exercise the kick-out rights. All right. But I think the key to all of this, because there's a lot of detail we just ran through, it really loops all the way back to understanding all the agreements with these entities and then really thinking about what are these significant decisions, laying that all out, and then walking through this.

17:17Because without that, it's going to be really easy to make, honestly, a wrong decision about which party is the primary beneficiary here. Exactly. Okay, so let's keep going then. So we talked about power. I know that in and of itself could have been like a three-part podcast, but guys did a good job keeping it pretty short. But so now let's think then about economics. So we've identified the party who has the power. So now we have to consider where the economics lie. Right. And this part is going to be a little bit more straightforward than the power. Like I mentioned earlier, multiple parties can have an economic interest in an entity.

17:50Right. So you don't have to just find one. What you're really looking for is you as a variable interest holder. Do you have an interest that exposes you to potentially significant economic upside or economic downside? That's the economics test. So I did throw a couple of buzzwords in there. Right. So one being significant. So what does that mean? And I'm not going to tell you what that means. Of course not. Of course not. But I am going to tell you, right, there are places in GAAP that use the word significant. Practice has evolved when we're trying to assess what is significant. I'd say generally speaking, if you're over 10 % in terms of potential exposure on the downside or the upside, we would call that significant.

18:29If you're below 10 % but close to 10%, you know, there's going to be some significant judgment involved. But once you get further enough below 10%, I think most people conclude it's not significant enough. So when you're at 9.9, right, generally you're round to 10? Sure. But, you know, where does the line? Well, and even so, I mean, again, these are estimates that we're talking about are projected amounts. So there has to be some gray anyway, because it's going to depend on the accuracy of these projections you're looking at, right? Correct. So the other word I threw in the initial description, I think, was potentially exposed to.

19:05So the reason we throw that in is because you don't get to include probability in this part of the analysis. So it doesn't matter kind of how senior or subordinate you are in the capital structure. If you have a capital investment as your variable interest, what matters is that you could be exposed to a significant amount of upside or downside on the entity. So I think that's interesting because it does cast a little bit of a wider net in terms of who might have potentially significant economics. So can you give an example of that, Matt? Yeah. So you might think like back to the old days where we're doing expected losses.

19:35It really mattered how senior in the capital structure you were. So subordinate equity interest would have way more exposure to expected losses the way it's defined in the model. But the way we define it here in the PPE test is even if you have a 10 percent tranche of the capital structure, but it's the most senior. So you're a senior lender and it's collateralized by the assets of the entity. So your chances of losing on your loan are very, very small. You still could. Right. So if you're 10 percent of the total capital structure in the most senior position, you'd still have potentially significant economics.

20:04So, again, just to reiterate there, it doesn't matter that that 10 percent is multiplied by like a 0.01 percent probability. You just say it's 10 percent. So they have a significant economic. And the reason why that's not overly punitive in this model is because the chances of you having a 10 percent slice of the most senior interest and also having power are very small. Right. Because generally power goes to the more residual or the more exposed tranches of an investment. So, yes, you might have significant economics, but you won't meet both criteria to be the primary beneficiary in most cases.

20:39And then, Matt, as you're thinking about this, whose perspective am I taking when I'm thinking about how significant it is? Right. So you're always going to be taking the perspective of the VIE, right? So you're an investor in the VIE. And is your exposure to upside or downside significant relative to the VIE size, not your size? So you can be the largest entity in the world and try to argue I don't have any chance of consolidating a VIE because I'm so big. But that's not how it works. It's relative to the size of the VIE. All right. That's helpful. So then now let's say I've gone through that.

21:10So let's assume I've met both power and the economics criteria. Great. Then I'm the primary beneficiary. But what if I go through this assessment and I determine that I don't meet both conditions? Then what? So you're not done. There actually is one last step. I'll almost call it like a hidden or forgotten step because this is one where I think people, I've seen it where people just stop and erroneously, you know, end the game too early. But if no single party meets both characteristics, you have to then consider the impact of any related parties. So you have to look at the investor group and determine whether they meet a related party group using the definition in ASC 850.

21:50and you would also lump in this concept of de facto agents, which is defined in ASC 810. So things like employees, officers, board members of the entity, or a party that got its interest as a loan or a contribution from the entity. So you're basically looking at the investor group and saying, hey, I get that no single party meets it, but when we lump them all together, do they meet both characteristics? If so, there's this whole separate framework, which I don't think we'll get into. Again, we'll save that for part seven, but there's a separate framework, which basically could yield a result to say, well, one of the members of the related party group has to consolidate the entity.

22:26This is really meant to, again, back to both of your points, is zooming out, right, and saying, okay, well, I can't get too myopic on my analysis, right? I need to look at the big picture. And it's kind of meant to capture structuring, but it also is just making sure we're getting the right answer. And sometimes you get to an interesting answer that you wouldn't know you got to if you didn't know to do this last step. So basically, then, if I'm setting up an entity, I can't split all my rights into separate subsidiaries and say, oh, none of them control the entity. Exactly. And the reason I don't want to get into this whole cobweb, if you will, of analysis is because it is different depending on how the entity's governed.

23:07And then there's a lot of incremental rules because there's been standard setting that's happened over the past couple of years and they kind of changed how to do it. And so there's just a lot to go through. But at the end of the day, I think when you step back, it's, hey, are things separated such that we're getting to basically a wrong answer? All right, that's helpful. And so then let's assume now I don't have both power and economics and I don't have, I don't fall into this, I'll call it related party trap. Then I don't consolidate, correct? Yes, that's right. So we wouldn't have to consolidate, but there are still specific disclosures that we have to make because we have a variable interest in an unconsolidated VIE.

23:44There's also, if you do consolidate, there's incremental disclosures on top of that. And these are mostly qualitative and some quantitative stuff, but it's really trying to get at you disclosing what your involvement is in the VIE, even if you don't consolidate it. Also, last point is that there are some specific rules. If you are the primary beneficiary and you're consolidating, there's rules around the initial consolidation of an entity that is a VIE. So if the entity, it depends on if it's a business or not. So if the VIE meets the definition of a business, you're generally just going to apply the business combinations guidance and ASC 805.

24:20But if the VIE is an asset, you know, and it's deemed to be a VIE asset acquisition, then it's actually a really weird hybrid model. So it's not exactly business combinations guidance, and it's not exactly the asset acquisition model that we talked about a while back on the podcast. It's some hybrid where you're taking some elements of one and some elements of another. But the interesting part is since you don't recognize goodwill, but you may have a gain running through the P &L, which is just not very intuitive if you haven't done the model before. Definitely not. So actually then maybe follow-up question on that.

24:57Once you get through the first year of the consolidation or the initial consolidation, then are there significant differences between consolidating under a VIE model versus under a voting interest model or not really? It's not, it's not my favorite word is wonky, right? But it's not wonky like an equity method investment or something like that. It's really more the initial consolidation, but based on how you've done, if you have like non-controlling interests and things like that, sometimes a measurement, you'll still have to do that, but it'll be a little bit closer to the business combinations guidance.

25:28Yeah. And I also think there is this element for a company, if they don't hold equity interests and they wind up consolidating, that also is sort of like a mind game just to kind of think through what that looks like. And then I think that goes back to the point you made, or we should at least talk about that there are incremental disclosures, which can sometimes help fill in some of those gaps there. All right. So now that we've kind of gone through the whole model after step 53, is there anything else then that our listeners should be thinking about before we wrap up this series. Yeah, maybe one last reminder that the VIE model is not a set it and forget it type model.

26:07So for the primary beneficiary assessment, that's continual. So you may have concluded that you have a variable interest in a VIE and that you are not the primary beneficiary. You should reassess every reporting period, whether anything has changed such that you are now the primary beneficiary. Same with the opposite. If you were the primary beneficiary in your initial analysis, you should reassess that every reporting period to make sure nothing's changed, that would change the answer. As for whether or not the entity you're involved with is a VIE, those have to be reconsidered, but that's more trigger-based.

26:36So you actually have to find an event that is defined in the guidance, right? You would have to find a change to the purpose and design of the VIE that would necessitate a reassessment of whether or not it is a variable interest entity. So Matt, from your experience, or Alexander, you as well, do you often see where this reconsideration that you need to do each period does result in a change in the primary beneficiary? Or even in that case, is it more because there's been some change in the underlying structure or otherwise? Yeah. I mean, for the most part, I think you'd have to see a change in the underlying structure or change in the entity itself to really change who's going to consolidate it.

27:15But it does come up, right? So you could see a situation where contractual rights have a life and they lapse. So that could be something where nothing changed in the contract because it was set up front. But now you're all of a sudden you have power. Or something could get triggered, I guess, in a contract. Exactly. That could change things. Exactly. There could have been a contingency built in up front to your decision making rights or to a kick out right that now has lapsed or has been achieved. And that could change the answer. Yeah. And or if you were building an asset that went into operation.

27:43So now I'm actually thinking of many different things. So maybe that wasn't the best question. But I do think it's an important point that you want to make sure you have the controls in place to do that. That's right. So, of course, I think we're close to the end, but I can't end things without asking for some final words of wisdom. So I think I've asked this every episode of this series, but just from your perspective and maybe honing in, in particular on this step, any final thoughts or words of wisdom for people who are trying to deal with this? And Alexander, I can start with you. Yeah, I'd say probably tying it all together, even with the other episodes, and you'd mentioned it several times.

28:18it is a little bit of a pain to kind of do that upfront homework or it feels that way, but it really does help streamline things across the whole analysis. And it kind of protects you from maybe getting to an incorrect answer, because as we kind of talked about the scale analogy, especially when things are getting close, you need to make sure that you have everything on there. So I'd say just don't forget doing the upfront homework. And many times when you do that, the answer kind of becomes more readily apparent. Yeah, I think that oftentimes when people are approaching their consolidation analysis, they forget about the history lesson that I think we went into in the first episode as to why the VIE model exists and the type of entities it was really meant to address.

28:59And I think that's important to think about while you're evaluating an entity for consolidation. Think about the purpose and design of the entity. Think about all the substantive terms and features and don't let non-substantive terms really get in the way of your analysis. And it's really less about legal form and more about substance of rights, economics and decision making that you should let drive your analysis. Yeah. And actually, if I put those two things together, then if I take a step back and think about it, if I make sure I fully understand the purpose and all of the various aspects of my entity, and then I understand the rights and powers and everything else.

29:34If I do all of that before I start trying to go through the steps of this, it actually will be a much easier thing versus to have to keep circling back and realizing that something got missed. So for the two of you together, that's excellent advice individually as well. So anyway, as always, so nice to have you guys on. And thanks so much for joining me today. Thanks. That's our show for today. Tune in next week for more fresh episodes so that you never miss any of our audio content. follow the PwC Accounting Podcast wherever you listen to your podcasts. And to stay up to date on all our latest accounting and reporting news, sign up for our newsletter at viewpoint.pwc.com.

30:18From Thought Leadership at PwC, I'm Heather Horn. Thanks for tuning in.

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