Explanatory Note to CVM Instruction 235

Ref.: CVM Instruction No. 235, of March 23, 1995, which provides for the disclosure of the market value of financial instruments by public companies.

I - INTRODUCTION

The current stage of development of the international financial market has facilitated the emergence of new mechanisms that allow various economic agents to develop new strategies for raising and applying resources, protecting against price variations of their assets and liabilities, reducing operational costs, and diluting risks.

These mechanisms are conventionally referred to as "new financial instruments," with a representative part being the so-called "derivatives."

The emergence of new financial instruments is explained by several authors as resulting from certain theories, known as "Theories of Financial Innovations," highlighting the following:

a) Regulation Theory - considers that, with the market subject to excessive regulation, agents tend to react and create, through technical devices, new financial instruments supported by "loopholes" in the regulation. This procedure generates new regulation and, consequently, new creation, forming a cycle in which agents (savers, borrowers, and intermediaries), in the interval between the creation of the new instrument and its regulation, will enjoy its benefits.

b) Theory of Innovation Induced by Links - considers that in this case, excessive regulation is only one factor (link), with other internal and external factors existing, such as: intensified competition within the banking industry and between it and the capital market; the development of financial systems oriented towards the market to the detriment of systems focused on intermediaries; the existence of strong market demand due to the excess of monetary capital spread throughout the world; technological progress that stimulates the development of competitiveness (at the same time that this pressure stimulates technological development), etc.

c) Instability Theory - is based on the company's ability to survive in economic environments in a constant process of structural transformations, characterizing financial innovation as a form of protection against risks and uncertainties resulting from the instability produced by these changes.

With the pronounced growth of this market, the growing concern on the part of entities, governmental or otherwise, and specialists, regarding the effectiveness of current accounting methods for recording and disclosing these operations and the capacity for control and supervision of this market, has also been perceived.

Recent episodes occurring abroad demonstrate the urgent need for a higher level of "disclosure" regarding the use of financial instruments (including "derivatives") by public companies, which should be of special attention to the company's administration and its independent auditors.

In Brazil, as happens in the international market, we have witnessed, in recent years, a growing offer of these new instruments and a quite pronounced development of this market, noting that we already have, in traded volume, a futures exchange that is among the five largest in the world.

II - FINANCIAL INSTRUMENTS - DEFINITIONS

The United Nations Organization (UN), through its Intergovernmental Working Group of Experts on Accounting Standards (ISAR), defined Financial Instruments as any "contract that gives rise to a financial asset (recorded or not) in one company and a financial liability or equity instrument (also recorded or not) in another company." This definition is also considered by the IASC (International Accounting Standards Committee), the body responsible for harmonizing accounting practices worldwide.

In the USA, the FASB (Financial Accounting Standards Board), which is the body responsible for accounting standardization in that country, defined Financial Instruments as cash and evidence of rights over an entity or a contract that:

a) imposes on an entity an obligation (1) to deliver cash or another financial asset to a second entity or (2) to exchange financial instruments on potentially unfavorable terms with the second entity;

b) when transferring to the second entity a contractual right (1) to receive cash or another financial asset from the first entity or (2) to exchange financial instruments on potentially favorable terms with the first entity.

Regarding the definition of "derivatives," we can say that they are financial assets whose value results (derives) from the value of another asset, and derivatives can be standardized and traded in organized secondary markets or be an "ad hoc" contract between the parties.

Some of the main types of derivatives are forward contracts, futures (such as: stock indices, interest rates and exchange rates, price indices, "commodities"), call and put options, "warrants," "swap" operations (exchange of financial results), etc.

This Instruction, by determining the disclosure in explanatory notes of the market value of financial instruments (art. 1), opts for the definition of the UN and IASC, emphasizing that this disclosure must be made, regardless of whether the financial instrument is recorded or not as an asset or liability in the balance sheet of the public company (art. 2).

For greater clarity in the definition, in paragraphs 1 and 2, of article 2, financial instruments are divided into financial assets and liabilities, with a financial asset of an entity characterized as:

a) cash equivalents - resources in cash, banks, and immediate liquidity applications;

b) contractual rights receivable in currency or in financial instruments of another entity;

c) contractual right to exchange financial results or financial instruments with another entity - such as "swap" operations, convertible debentures, etc.;

d) title representing participation in the equity of another entity - such as shares, quotas, subscription bonuses for shares.

Financial liabilities are characterized as a contractual obligation to:

a) pay a certain amount in currency or financial instruments - loans and fixed-income passive operations, for example; and

b) exchange financial results or financial instruments with another entity - passive "swap" operations, for example.

III - MARKET VALUE

The definition of the market value of financial instruments is made in art. 3. The concept contained in item I of this article presupposes the existence of an active market where there is the possibility of negotiation by any participant, in which it is presupposed the existence of buyers and sellers (directly or through specialized intermediaries) willing and knowledgeable about the subject (market), in a transaction without favoritism ("arm's length transaction") and, furthermore, whose price is regularly disclosed.

These characteristics presuppose the existence of Stock Exchanges or an organized market, in which financial instruments are regularly traded or in which the parameters for determining their price are freely determined.

In the absence of an active market and, consequently, a quote for a given financial instrument, the Instruction provides (item II of article 3) that the value to be disclosed, in explanatory notes, may be obtained in two ways:

a) based on the quote, in an active market, of another financial instrument of similar nature, term, and risk; or

b) in the absence of a quote, based on the present value of future cash flows, adjusted by the prevailing interest rate in the market for financial instruments of similar nature, term, and risks.

For certain assets, due to their peculiar characteristics, there may not be a market value in the above forms (letters "a" and "b"). This should not constitute a factor preventing the company's administration from judiciously seeking another method of evaluation and determination of its market value. In this case, an estimate of the market price should be used, which may be based on asset pricing models, such as Black-Scholes and binomial models. Regardless of the criterion adopted, it is important that it be applied consistently and that the premises be disclosed in a way that allows users of financial information to interpret this information.

Therefore, market value as defined in the instruction is quite broad, not restricted only to financial instruments traded in active secondary markets.

Due to their peculiar characteristics and being subject to specific rules, the exclusion of some financial instruments (article 4) is permitted, such as accounts payable or receivable, insurance contracts, shares and quotas of companies that do not have a market value, pension and social security plans, and leasing contracts (this requiring a new form of accounting to reflect its economic essence).

IV - LINKED OPERATIONS

The provisions contained in article 5 and its items seek to preserve the Principle of "Substance Over Form," as prescribed in the Basic Conceptual Structure of Accounting approved by CVM Deliberation No. 29/86.

The operations treated in article 5 are basically those in which a financial institution alienates public debt securities (used as currency for privatization), whose market value is below their unit price (UP), adopting as the value of the business the UP of the day, without considering, therefore, the discount recognized by the market. This alienation is made in conjunction with a credit operation, through which the buyers of the aforementioned securities have a medium to long-term period to settle the operation, assuming contractual interest rates below those practiced by the market.

In this case, the formal aspect of the operations would be as follows: interest would be accounted for over the months and years according to the contracted rates, producing revenue below market for financial institutions and expenses, on the other hand, for the companies acquiring the securities, also below normal market levels, logically undervalued, with the following reflections on asset evaluation:

a) financial institutions would recognize an unreal positive result from the sale of those assets, in the present, against an undervalued financial revenue to be recorded in the future. Therefore, it would be the anticipation of a positive result in this fiscal year to the detriment of future results, or the non-recognition of an effective loss, conceptualizing it as an asset;

b) companies located at the other end of these operations would be overvaluing their assets, including assets eventually acquired with these securities, in the case of their use in the privatization program, in exchange for an also overvalued liability, with lower financial expenses in the future, possibly accompanied by lower results produced by the aforementioned assets.

From an accounting or economic substance point of view, the operation was carried out at market value, but formalized in a way to distort this reality, with a loan at a low enough rate to compensate for the higher value of alienation of the securities.

The correct accounting procedure, for the transactions of alienation/purchase of securities, linked with a loan operation, following this line, would be presented as follows:

a) financial institutions would recognize as revenue from the alienation of securities, to determine the result of the transaction, a value equivalent to the difference between the book value and the market value. The asset of the credit operation would be accounted for by this same value. With the existence of a credit operation contract of higher value, it would be adjusted by the amount corresponding to the difference between the unit price - UP of the alienated securities and the market value, a figure equivalent to the discount, to be appropriated to revenue over the contract period, adopting, for this purpose, the calculation criterion, exponential or linear, most appropriate to the circumstances;

b) companies, located at the other end of the operation, would also recognize the received assets at the market value at the time of the transaction and the debt assumed in the same amount. Regarding the contractual value of the liability, there would be a reduction account, whose value would also be considered, over the life of the contract, as an increase in nominal financial expense.

V - OTHER PROVISIONS

Regarding the disclosure in explanatory notes of the market value of financial instruments, there are basically two ways to do it:

a) the first would be to include in a specific note only the accounts subject to this disclosure, separating them into financial assets and liabilities, recorded and unrecorded (in equity accounts), and comparing their market values with book values;

b) the second alternative would be the preparation of a supplementary statement of the balance sheet in which assets, liabilities, and consequently, equity, would be determined based on this market value.

In both cases, the criteria and processes adopted for determining the market value (art. 1, sole paragraph) must be described, as well as the policies adopted by the company and the risks involved with operations in the derivatives market.

CVM Instruction No. 235/95 applies to quarterly information - ITR and to the financial statements of public companies closing from June 1995, inclusive.

It is further clarified that the new procedures to be adopted by public companies were the subject of a public hearing, with the participation through suggestions and comments from the main segments of the market, such as Abrasca, Abamec, Ibracon, CFC, FIPECAFI, Febraban, etc.

Original signed by
THOMÁS TOSTA DE SÁ
President