Circular Letter CVM/SIN/SNC 01/2012: Guidance on Duties and Responsibilities of Administrators and Independent Auditors in Preparing and Disclosing Accounting Information of Credit Rights Investment Funds (FIDC)

CIRCULAR LETTER/CVM/SIN/SNC NO. 01/2012
Rio de Janeiro, December 4, 2012
Subject: Guidance on the duties and responsibilities of administrators and independent auditors in the preparation and disclosure of accounting information of Credit Rights Investment Funds ("FIDC").

Dear Sirs,

This Circular Letter aims to guide administrators and independent auditors of FIDCs regarding certain procedures that must be executed concerning the credit rights held by the funds.

FIDC administrators bear primary responsibility for the proper recognition of income from credit operations, classification, existence, and correct measurement of the respective credit rights, as well as for the preparation of financial statements.

Administrators are also responsible for providing auditors with all necessary information so that they can perform their audit procedures adequately with a view to the timely issuance of their audit report on the financial statements. In this regard, it is worth recalling the duties and responsibilities of administrators provided for in Articles 26 to 28 of CVM Instruction No. 308/1999.

Independent auditors of FIDCs are responsible for issuing an opinion on whether the financial statements have been prepared, in all material respects, in accordance with the financial reporting framework applicable to FIDCs.

To achieve this objective, the independent auditor must perform certain procedures regarding the credit rights held by the funds, as part of their examination of the annual financial statements of FIDCs, regardless of the adoption of other necessary procedures for issuing an opinion in the audit report.

Based on Article 20 of CVM Instruction No. 308/99, independent auditors must observe the standards issued by the Federal Council of Accounting – CFC. Under this framework, we emphasize that, as stated in item 11 of NBC TA 200, approved by CFC Resolution No. 1,203/09, when conducting the audit of financial statements, one of the general objectives of the independent auditor is to "obtain reasonable assurance that the financial statements as a whole are free from material misstatement, whether caused by fraud or error, thereby enabling the auditor to express an opinion on whether the financial statements have been prepared, in all material respects, in accordance with the applicable financial reporting framework."

Furthermore, according to item 17 of the same Resolution, "to obtain reasonable assurance, the auditor must obtain appropriate and sufficient audit evidence to reduce audit risk to an acceptably low level and, thereby, enable him to draw reasonable conclusions on which to base his opinion." Thus, we remind you that item A10 of NBC TA 500, approved by CFC Resolution No. 1,217/09, provides for the requirement that the auditor perform, among others, substantive procedures, including tests of details and analytical procedures, as transcribed below:

A10. As required and further explained by NBC TA 315 and NBC TA 330, audit evidence for obtaining conclusions to support the auditor's opinion is obtained by performing:
(a) risk assessment procedures; and
(b) additional audit procedures, which encompass:
(i) tests of controls, when required by auditing standards or when the auditor so chooses; and (ii) substantive procedures, including tests of details and substantive analytical procedures (our emphasis).

We understand that, in the audit of FIDC financial statements, for the auditor to obtain reasonable assurance that the financial statements as a whole are free from material misstatement, it is necessary to certify the adequate existence and valuation of credit rights in the portfolio, as well as the adequate establishment of provisions for losses on these credit rights.

Therefore, we believe that to obtain comfort regarding the adequate existence and valuation of credit rights, in addition to evaluating the internal controls of the administrator and custodian related to these activities and, when applicable, testing their effectiveness, the auditor must perform the following substantive procedures, among others deemed necessary by the auditor:

(i) Send external confirmations, when applicable, in accordance with CFC Resolution No. 1,219/09; (ii) Inspect the entirety, a representative sample, or specific items of credit rights, and check the assignment contract and the physical documents that prove the backing of these credit rights; (iii) Check whether the respective credit rights meet the eligibility criteria defined in the investment policy, when applicable; (iv) Select the entirety, a representative sample, or specific items of credit rights to perform recalculation based on the terms of the assignment contract; (v) Analyze the adequacy of income from credit operations earned during the fiscal year, noting that, in the case of loss provisions, interest income must be recognized by applying the interest rate on the net book value of the provision, as stated in paragraph AG93 of CPC 38, approved by CVM Deliberation No. 604/09; (vi) Validate the classifications of operations, as required by Art. 3 of CVM Instruction No. 489/11; and (vii) Evaluate the reasonableness of the rate charged in the assignment. We understand that, even if the charged rate meets the profitability parameters of senior shares, there may be a risk that the rate does not adequately reflect the credit risk of the credit rights to be assigned to the FIDC, and therefore may be overvalued or undervalued relative to such parameter.

With reference to item (ii) above, we emphasize that, if third-party work contracted by the custodian is used to verify the backing of credit rights by sampling, the auditor must check and document in their working papers, among other procedures deemed necessary: (a) whether the contracted third party is independent of the custodian and any participant in the FIDC structure; (b) whether the methodology for calculating the sample and selecting items used by the third party, and set forth in the Fund Regulations, is consistent with their audit methodology; and (c) the impact, on their audit, of deviations found by the contracted third party.

Regarding comfort on the adequate establishment of provisions for losses on these credit rights, the auditor must verify if this provision was calculated based on the provisions of Chapter III of CVM Instruction No. 489/11. In this sense, among other procedures that may be deemed necessary, the following stand out:

(i) Validation of policies that define events considered "evidence of impairment of asset value" - According to Art. 11 of CVM Instruction 489/11, "Whenever there is evidence of impairment of the fund's assets, evaluated at cost or amortized cost, a loss provision must be recorded." Such evidence is not always identifiable, meaning that the operation does not need to be overdue or the debtor in bankruptcy proceedings for a provision to exist. Evidence of impairment of asset value can also be verified through analysis of historical data for credits with similar risk characteristics, or by the deterioration of the debtor's risk classification, as well as by other factors, which must be defined by management and validated by the audit, according to the characteristics of their credit assets.

(ii) Confirm that no loss provision is recognized from the initial date of operations until it is understood that there is evidence of impairment - At the moment the fund acquires the credit asset for a certain value, it is understood that management believes it will receive back a value that allows shareholders to obtain at least the expected return rate; otherwise, the operation would not be made. The establishment of the provision must therefore occur only when, at a later moment, there is evidence of impairment of asset value relative to what was expected at the initial moment. The determination of this moment must be in line with the description in the previous item. Thus, the auditor must confirm that the fund does not establish provisions for newly granted operations until there is evidence of impairment of these assets.

(iii) Comparison of past provisions with the loss history (net of recoveries) and analysis of significant divergences - To validate the methodology used by the fund, the auditor must evaluate the comparison of past provisions, calculated using the same methodology, with the respective loss history, net of recoveries. Since the estimation of the provision involves judgment and various factors outside the fund's control, divergences may occur between the provision values and the actually lost values. If such divergences are significant (positive or negative), it is necessary to understand the reasons that led to such divergences and whether this fact indicates a problem with the methodology or a change in scenario between the moment of provision measurement and the moment the event resulting in the loss occurred.

(iv) Validation that the net book value of provisions is represented by the expected cash flow for the respective operations discounted at present value by the applicable rates, as determined in Art. 12 of CVM Instruction 489/11 - The auditor must perform tests on the methodology used, on the calculation base, and on the calculation itself to ensure that, regardless of the methodology used for measuring the provision, its value is represented by the difference between the book value of the asset before the change in estimate and the present value of the new expected cash flow, determined in accordance with Art. 12 of CVM Instruction 489/11.

(v) Validation of criteria for segregation of homogeneous groups used in the estimation of expected cash flows on a collective basis, when applicable, as determined by Art. 15, §3 of CVM Instruction 489/11 - For expected cash flows measured by groups of assets, the auditor must ensure that the assets of each group have similar credit risk characteristics, as stated in Art. 15, §3 of CVM Instruction 489/11. That is, all those assets whose expected cash flows are measured by the same loss percentage must have the same credit risk, considering factors such as economic activity, type of guarantee, default history, current default, among others. A single operation or debtor may change groups from one period to another if the considered risk characteristics change (e.g., the debtor moves from one delay bracket to another, the economic sector where the debtor operates is in crisis, etc.).

(vi) Validation of the historical base and methodology used as parameters for determining expected loss percentages on collective bases - Normally in collective analyses, to measure expected loss percentages (net of recoveries), loss histories for each homogeneous group are used. The auditor must validate the historical bases used, both in values and in risk characteristics and default behavior, ensuring that the methodology is indeed resulting in an asset value that represents the expected cash flow discounted at present value.

(vii) Evaluation of qualitative adjustments (or their absence) in the measurement of the provision on a collective basis, due to changes in reality at the measurement date of the provision relative to the period used in the history that served as the basis for defining provision rates - The auditor must evaluate if the provision measurement is taking into account changes that have occurred between the current situation and the situation existing during the historical period used as the basis for measurement (e.g., changes in the economic environment, such as those brought by the financial crisis; different types of operations; change in the profile of debtors, among others). If the provision has no qualitative adjustment because it is understood that there has been no change relative to the situation existing in the history used as the basis for estimating losses, the auditor must validate this understanding.

(viii) Validation of estimated cash flows on individual bases for a sample of contracts, considering the negotiation situation, credit risk, guarantees, financial situation of debtors, among other applicable factors, as the case may be - Normally, significant credits with loss indicators are evaluated individually to measure the expected value. The auditor must validate this analysis, verifying if all factors related to the capacity and probability of payment of each debtor were considered and if the provision correctly results in the net book value of the operation represented by the expected cash flow discounted at present value.

(ix) Analysis of the method used (on individual or collective bases) to verify if it is the one that produces the best estimate for each case and does not result in double counting of credit losses, according to Art. 15 §2 of CVM Instruction 489/11;

(x) Evaluation of how fund management considers in their risk analyses the information provided by the assignor regarding common debtors.

Finally, we alert that, based on Article 8, paragraph 4, of CVM Instruction No. 356/01, the independent auditor must examine the quarterly reports of the FIDC prepared by the administration, upon conducting their audit in these funds. We understand that the performance of this examination must be done jointly with the annual audit of the FIDC financial statements, documented in the auditor's working papers, and must include, among other procedures deemed necessary, the following: (i) the evaluation of the impact that the information contained in these reports may have on their audit; (ii) the comparison of the information and data disclosed in these reports with the information disclosed in the FIDC financial statements; and (iii) the measures taken in case of discrepancies.

Sincerely,

(Signed Original)
Francisco José Bastos Santos
(Signed Original)
José Carlos Bezerra da Silva
Superintendent of Institutional Investor Relations Superintendent of Accounting Standards and Auditing