Circular Letter CVM/SNC/SEP No. 02/2019: Guidance on Relevant Aspects of CPC 06 (R2) - IFRS 16 for Lessee Financial Statements

SECURITIES AND EXCHANGE COMMISSION OF BRAZIL
Rua Sete de Setembro, 111/2-5th and 23-34th Floors – Center – Rio de Janeiro - RJ – CEP: 20050-901 – Brazil Tel.: (21) 3554-8686 - www.cvm.gov.br CIRCULAR LETTER/CVM/SNC/SEP No. 02/2019 Rio de Janeiro, December 18, 2019 Subject: Guidance on relevant aspects of CPC 06 (R2) - IFRS 16 to be observed in the preparation of Financial Statements of Leasing Companies, for the social year ended 31.12.2019

Dear Investor Relations Director and Dear Independent Auditor,

The technical areas of the CVM have observed that the interim financial statements of open companies for the year 2019 have been presenting diversity in the application of certain provisions contained in Technical Pronouncement CPC 06 (R2), which mirrors IFRS 16 in Brazil.

These divergences, in some cases conflicting with what the standard itself prescribes, led the CVM's technical areas to develop studies on the subject in order to prepare guidance that simultaneously (1) disseminates information that is relevant and faithfully represents the economic reality to be reported, for decision-making by its users, in line with the legal mandate imposed on the CVM, (2) is supported by the standard, so as to respect full compliance with CPC 06 (R2) – IFRS 16, (3) is adequate to general principles to be applied when using Discounted Cash Flow - DCF techniques for accounting measurement purposes, and, no less importantly, (4) is shaped to the Brazilian economic environment.

In this sense, the following points are to be elucidated:

1. Conceptual Aspects of CPC 06 (R2);

2. Incremental Borrowing Rate - IBR;

3. PIS and COFINS to be recovered – Accounting Treatment;

4. PIS and COFINS embedded in the Lease Liability – Accounting Treatment;

5. Disclosure – Explanatory Note.

6. Conceptual Aspects of CPC 06 (R2)
   A first conceptual aspect, which is extremely critical for the application of the standard, is stated in the very first paragraph, which asserts that lessors and lessees must provide information that is relevant and faithfully represents the economic reality to be reported. Indeed, fundamental attributes of all accounting information, as prescribed by the new Conceptual Framework for Financial Reporting (and prescribed by the previous one), in its paragraph 2.5. We reproduce below paragraph 1 of CPC 06 (R2):

“This pronouncement establishes the principles for the recognition, measurement, presentation and disclosure of leases. The objective is to ensure that lessees and lessors provide relevant information, so that they faithfully represent these transactions. This information provides the basis for users of financial statements to assess the effect that leases have on the entity’s financial position, financial performance and cash flows” (our emphasis).

This guideline from the standard is fully aligned with the mission that the CVM must perform. Breaking informational asymmetries and working to disseminate them democratically and timely, by ensuring that all relevant information is publicly disclosed to all investors. And mitigating the risk of “misleading,” whose consequences are extremely harmful to capital market investors, by requiring companies and other issuers to provide information that faithfully portrays the economic reality to be reported, within the best technique appropriately employed and without any bias.

Another conceptual aspect of the standard resides in the measurement basis to be applied to the right-of-use asset and the lease liability. The cost approach must be used as the value basis. And in the case of the Brazilian legal environment, historical cost as a value basis, limited to the recoverable amount.

The reasons that motivated the IASB board to decide thus originate in the usefulness of such information, insofar as it ensures measurement consistency by accounting for the right-of-use asset and lease liability in a manner analogous to similar assets and liabilities, and originates in the manifested desire to protect an attribute of improvement of accounting information, namely, comparability. Thus it is elucidated in the “Basis for Conclusions” section of IFRS 16, in its §BC145 1.

Relevant to highlight that in the translations of IFRSs and their internalization into the domestic regulatory environment, the “Basis for Conclusions” section is not incorporated into the body of the pronouncements, although said section is indispensable for understanding the rationale of the standards and the motivations that guide the choices made by the IASB board.

In the case of the right-of-use asset, the cost approach allows for a measurement basis consistent with that applied to many other non-financial assets that are within the scope of CPC 27 (IAS 16) and CPC 04 (IAS 38). The measurement basis tied to cost also provides, for many contracts within the scope of IFRS 16, a reasonable approximation of the fair value of the right-of-use at the initial measurement date. Thus it is asserted in the “Basis for Conclusions” section of IFRS 16, in its §BC148 2.

For the case of the lease liability, the cost approach is observed through the discounting of contractually stipulated payments using the implicit rate identified at the initial measurement date, if readily determinable. And the reason for this choice lies in the objective of the IASB board with this expedient: to reflect the manner in which the contract is priced between the parties. Thus it appears in the “Basis for Conclusions” section of IFRS 16, in its §BC160 3.

And to arrive at the implicit rate, one must calculate the internal rate of return (IRR) of the contract, appropriately employing the general principles directed toward the use of the discounted cash flow – DCF technique. And said general principles for the use of the DCF technique contained in the literature, in broad lines, thus guide:

General Principles
All general principles below govern the application of any present value technique used for accounting measurement (a) cash flows and discount rates reflect assumptions that must be applied to pricing the asset or liability; (b) cash flows and discount rates take into account only factors attributable to the asset or liability being measured; (c) to avoid double counting or omission of the effects of risk factors, discount rates reflect assumptions that are consistent with those inherent in the cash flows. For example, the discount rate that reflects uncertainty in expectations regarding future defaults is appropriate when using contractual loan cash flows (i.e., discount rate adjustment technique). One should not apply this same rate when using expected cash flows (i.e., probability-weighted) (i.e., expected present value technique), since expected cash flows already reflect assumptions about uncertainty regarding future defaults; instead, a discount rate compatible with the risk inherent in the expected cash flows should be used; (d) assumptions about cash flows and discount rates must be internally consistent. For example, nominal cash flows, which include the effect of inflation, must be discounted at a rate that includes the effect of inflation. The nominal risk-free interest rate includes the effect of inflation. Real cash flows, which exclude the effect of inflation, must be discounted at a rate that excludes the effect of inflation. Similarly, after-tax cash flows must be discounted using an after-tax discount rate. Pre-tax cash flows must be discounted at a rate consistent with these cash flows; (e) discount rates must be consistent with the underlying economic factors of the currency in which the cash flows are denominated”. (our emphasis)

It is noted the imperative need to observe all the previously enumerated principles so that the results obtained with the use of the Discounted Cash Flow model are not incorrect. Adopt either the traditional cash flow model or the expected cash flow model, paying attention to the model used so as to avoid the double counting mentioned in letter “c”. Cash flows in line with discount rates, so as to ensure the internal consistency of the model, as highlighted in letter “d” (nominal flow with nominal rate or real flow with real rate, for example). And discount rates in consonance with the currency through which flows are denominated, according to letter “e”.

One cannot lose sight of the conceptual pillar of the standard: lessors and lessees must provide information that is relevant and faithfully represents the economic reality to be reported. The improper use of DCF techniques contributes to “misleading,” since the financial calculation will be incorrect. It is an objective non-compliance with the standard.

Although the “benchmark” of the standard is the use of the implicit rate for initial measurement at cost of the right-of-use asset and lease liability, in many contracts it may not be possible to obtain it. Such difficulty derives from the informational asymmetries existing between lessors and lessees, considering that only lessors possess sufficient information to estimate the residual value of the underlying asset at the end of the contract and the possible tax effects arising, as well as information regarding initial direct costs incurred by lessors. In this case, the standard requires the application of the Incremental Borrowing Rate. Thus it appears in the “Basis for Conclusions” section of IFRS 16, in its §BC161 4.

IFRS16. §BC145. The IASB decided to require a COST MEASUREMENT basis for the RIGHT-OF-USE ASSET and LEASE LIABILITY, with cost measured by reference to THE PRESENT VALUE of the lease payments. The IASB concluded that this approach will provide useful information to users of financial statements. This is because it is consistent with the approach used to measure other similar assets and liabilities and thus is expected to result in more comparable information than other approaches. The IASB also concluded that using a cost measurement basis will be less costly for preparers than other approaches (our emphasis).

IFRS16. §BC148. The IASB considered whether a lessee should initially measure the right-of-use asset at fair value, which may provide more relevant information about the economic benefits to be derived from use of the underlying asset. However, initial measurement of a right-of-use asset at cost is CONSISTENT with the measurement of many other non-financial assets, such as assets within the scope of IAS 16 and IAS 38. Measuring right-of-use assets on a basis similar to that used to measure the underlying asset maintains the comparability of amounts reported for leased and owned assets, which contributes to the usefulness of the information provided to users of financial statements. Furthermore, measuring the right-of-use asset at cost is less complex and less costly for entities than measuring that asset at fair value, because there often is not an active market for right-of-use assets. The IASB thinks that, for many leases, a cost measurement basis will also provide a REASONABLE APPROXIMATION of the fair value of the right-of-use asset at the commencement date (our emphasis).

IFRS16. §BC160. The IASB’s objective in specifying the discount rate to apply to a lease is to specify a rate that reflects how the contract is PRICED. With this in mind, the IASB decided that, if READILY DETERMINABLE by the lessee, a lessee should use the interest rate implicit in the lease (our emphasis).

2. Incremental Borrowing Rate - IBR
   The incremental borrowing rate, as defined in Appendix A of CPC 06 (R2), is the interest rate that the lessee would have to pay when borrowing, for a similar term and with similar collateral, the resources necessary to obtain the asset with a value similar to the right-of-use asset in a similar economic environment.

Objectively, if the lessee were to finance the acquisition of an asset similar to that of the right-of-use, with similar value and under the same contractual and economic conditions of the lease, what would be its funding rate? This is the incremental borrowing rate - IBR (“incremental borrowing rate”) required by CPC 06 (R2).

The incremental borrowing rate – IBR must be a function of the lessee’s credit risk, the term of the lease (or rental) contract, the nature and quality of the guarantees offered, and the economic environment in which the transaction occurs, as elucidated in the “Basis for Conclusions” section of IFRS 16, in its §BC161, already cited. Moreover, the lessee should preferably start from a rate that is readily observable, from which it must make the necessary adjustments to arrive at its incremental borrowing rate – IBR.

Thus it appears in the “Basis for Conclusions” section of IFRS 16, in its §BC162 5.

Now, what rate is readily observable in Brazil? In Brazil, both the real base interest rate and the nominal base interest rate are readily observable. On the other hand, neither the real incremental borrowing rate nor the nominal incremental borrowing rate are readily observable. They need to be constructed from the base interest rate 6.

However, the standard explicitly prohibits, in item 27(b), the use of indices or projected rates in determining lease payments included in the measurement of the lease liability. Projection techniques should not be adopted, even if the lessee has reliable macroeconomic information. The lessee should not estimate future inflation in the initial measurement of its lease liability. One of the reasons for such a decision by the IASB board lies in the concern with the comparability of information produced between jurisdictions, between those with and those without the ability to adopt projection techniques. Another reason rests on the cost-benefit analysis of the information to be produced. Thus it appears in the “Basis for Conclusions” section of IFRS 16, in its §BC166 7.

The prohibition on projection techniques is not restricted to the initial measurement of the liability. It also reaches its remeasurement, which must incorporate only the effect of current inflation when it is actually incorporated into cash flows, i.e., when the adjustment to lease payments takes effect (period of contractual “reset”). Such a normative requirement appears in item 42(b) of CPC 06 (R2) 8 and the respective rationale is found in the “Basis for Conclusions” section of IFRS 16, in items §BC188 9, §BC189 10 and §BC190 11.

IFRS16. §BC161. The interest rate implicit in the lease is LIKELY to be similar to the lessee’s incremental borrowing rate in many cases. This is because both rates, as they have been defined in IFRS 16, take into account the CREDIT STANDING of the lessee, the LENGTH of the lease, the nature and quality of the COLLATERAL provided and the ECONOMIC ENVIRONMENT in which the transaction occurs. However, the interest rate implicit in the lease is GENERALLY also affected by a lessor’s estimate of the residual value of the underlying asset at the end of the lease, and may be affected by taxes and other factors known only to the lessor, such as any initial direct costs of the lessor. Consequently, the IASB noted that it is LIKELY to be difficult for lessees to determine the interest rate implicit in the lease for many leases, particularly those for which the underlying asset has a significant residual value at the end of the lease (our emphasis).

IFRS16. §BC162. Accordingly, IFRS 16 REQUIRES a lessee to discount the lease liability using the interest rate implicit in the lease if that rate can be readily determined. If the interest rate implicit in the lease cannot be readily determined, then the lessee SHOULD use its incremental borrowing rate. In reaching this decision, the IASB decided to define the lessee’s incremental borrowing rate to take into account the terms and conditions of the lease. The IASB noted that, DEPENDING ON the nature of the underlying asset AND the terms and conditions of the lease, a lessee may be able to refer to a rate that is READILY OBSERVABLE as a starting point when determining its incremental borrowing rate for a lease (for example, the rate that a lessee has paid, or would pay, to borrow money to purchase the type of asset being leased, or the property yield when determining the discount rate to apply to property leases). Nonetheless, a lessee SHOULD ADJUST such observable rates as is needed to determine its incremental borrowing rate as defined in IFRS 16. (our emphasis).

6 It is possible to observe interest rates in Brazil, and even construct the term structure, through quotation of zero-coupon federal public bonds (LTNs) or through quotation of DI futures contracts (nominal interest coupon) and IPCA (real interest coupon) on B3.

IFRS16. §BC166. In the IASB’s view, FORECASTING TECHNIQUES could be used to determine the expected effect of changes in an index or a rate on the measurement of lease liabilities. However, forecasting changes in an index or a rate requires macroeconomic information that MAY NOT be readily available to all entities, and may result in measurement uncertainty. The IASB noted that the usefulness of the enhanced information obtained using such a forecast often might not justify the costs of obtaining it, particularly for those lessees with a high volume of leases. The IASB considered REQUIRING a lessee to use forward rates when measuring lease liabilities if those rates are readily available. However, it decided not to do so because this would reduce COMPARABILITY between those using FORWARD RATES and those not doing so. Consequently, at initial recognition, IFRS 16 requires a lessee to measure payments that depend on an index or a rate using the index or rate at the commencement date (ie a lessee does not estimate future inflation but, instead, measures lease liabilities using lease payments that assume no inflation over the remainder of the lease term). (our emphasis).

8 42. The lessee shall remeasure the lease liability, discounting the revised lease payments, if: (b) there is a change in future lease payments resulting from a change in an index or a rate used to determine those payments, including, for example, a change to reflect changes in market rental rates after the review of market rents. The lessee shall remeasure the lease liability to reflect these revised lease payments only when there is a change in cash flows (i.e., when the adjustment to lease payments takes effect). The lessee shall determine the revised lease payments for the remainder of the lease term based on the revised contractual payments.

IFRS16. §BC188 In principle the IASB is of the view that users of financial statements receive more relevant information about a lessee’s lease liabilities if the lessee updates the measurement of its liabilities to reflect a change in an index or a rate used to determine lease payments (including, for example, a change to reflect changes in market rental rates following a market rent review). For example, without such remeasurement, the measurement of the lease liability for a 20-year property lease, for which lease payments are linked to an inflation index, is unlikely to provide users of financial statements with useful information about the entity’s future cash outflows relating to that lease throughout the lease term.

10 IFRS16. §BC189 Some stakeholders expressed concerns about the cost of performing reassessments each time a rate or an index changes, and questioned whether the benefits for users of financial statements would outweigh the costs for lessees. For example, some stakeholders noted that the total expenses related to leases recognised in profit or loss by a lessee would be substantially the same, regardless of whether the lessee remeasures the lease liability for changes in an index or a rate.

Here there is an apparent conflict of CPC 06 (R2), which simultaneously requires the lessee’s incremental borrowing rate, which is its funding rate (with all risk factors incorporated), prohibits the use of projection techniques, even if the lessee has reliable macroeconomic information, and requires that the lessee provide information that is relevant and faithfully represents the economic reality to be reported.

How to reconcile all this is a challenging task for both administrators of open companies and their independent auditors. In summary, the incremental borrowing rate – IBR to be adopted must meet, in a collectively exhaustive manner, the following conditions:

1. provide users of financial statements with relevant information that faithfully represents the economic reality of the transactions to be reported (IFRS16.1);
2. in the initial measurement at cost of the right-of-use asset, there must be consistency with the measurement at cost of many other non-financial assets, such as those within the scope of IAS 16 and IAS 38 (IFRS16.BC148);
3. in the initial measurement at cost of the lease liability, it must reflect how the contract is priced between the parties (IFRS16.BC160);
4. the IBR must be a function of the lessee’s credit risk, the term of the contract, the guarantees offered, and the economic environment in which the transaction occurs (IFRS16. BC 161);
5. it can start from a readily observable rate, provided it is appropriately adjusted to the reality of the lessee (IFRS16. BC 162);
6. as projections of indices or rates in determining lease payments are prohibited – IFRS16. BC 166 (e.g., future inflation in projection or use of forward rates), in the employment of the DCF technique, assumptions about projected cash flows and discount rate must be internally consistent (IFRS Discount Rates Project).

The reason for these simplifications of CPC 06 (R2) and the rationale for the decision taken by the IASB board can be explained by the negligible difference between real interest rates and nominal interest rates of developed economies of some jurisdictions adopting IFRSs, with extremely low inflationary expectations (sometimes negative). Long-term interest rates are extremely low. Thus, the total expense with leasing/rent, in these cases, whether applying or not periodic contractual update based on an index of

11IFRS16. §BC190. In light of this feedback, the IASB decided that a lessee should reassess variable lease payments that are determined by reference to an index or a rate ONLY when there is a change in the cash flows resulting from a change in the reference index or rate (i.e., when the adjustment to the lease payments TAKES EFFECT). The IASB noted that this approach is less complex and costly to apply than requiring a lessee to reassess variable lease payments at each reporting date. This is because a lessee would typically be expected to report its financial results MORE FREQUENTLY than the occurrence of a contractual change in the cash flows of a lease with payments that depend on an index or a rate. (our emphasis).

inflation, it would supposedly be the same 12. It is our understanding of what is stated in the “Basis for Conclusions” section of IFRS 16, in its §BC189 13.

For clarification, in some quotes obtained by the CVM technical areas, a European sovereign debt title for 10 years, in August 2019, offered a rate below 0.25% p.a. in Euros (source: www.CEICDATA.com). A sovereign debt title issued by the United Kingdom also for 10 years, in August 2019, offered a rate below 0.6% p.a. in British Pounds (source: www.CEICDATA.com). In quotes obtained from Tesouro Direto and B3, on 15.08.2019, an LTN, maturing on 01.01.2025, with a little less than 6 years, offered a rate of 6.98% p.a. in Reais and a DI contract maturing on 01.07.2025, about 6 years, offered a rate of 7.02% p.a. in Reais (nominal interest). Rates 28 times and 11 times larger, respectively, than the European rate and the United Kingdom rate. The following reproduced table reflects the quotes observed at Tesouro Direto and B3 for LTNs (nominal interest rate curve), 1-day DI Futures Contracts (nominal interest rate curve) and IPCA Futures Contracts (real interest rate curve), with a date of 15.08.2019. These rates are readily observable in the Brazilian environment, as required by CPC 06 (R2).

Days Useful 252/t	Title	Maturity	Spot Rate
3	LTN01.01.2022	01/01/2022	6.02%
6	LTN01.01.2025	01/01/2025	6.98%

Days Useful 252/t	Contract	Maturity	Spot Rate
1	DI03.08.2020	03/08/2020	5.36%
2	DI01.07.2021	01/07/2021	5.73%
3	DI01.07.2022	01/07/2022	6.25%
4	DI03.07.2023	03/07/2023	6.64%
5	DI01.07.2024	01/07/2024	6.85%
6	DI01.07.2025	01/07/2025	7.02%

Days Useful 252/t	Contract	Maturity	Spot Rate
1	IPCA17.08.2020	17/08/2020	2.08%
2	IPCA17.05.2021	17/05/2021	2.06%
3	IPCA15.08.2022	15/08/2022	2.49%
4	IPCA15.08.2023	15/08/2023	2.72%
5	IPCA15.08.2024	15/08/2024	2.91%

12 The non-consideration of inflation expectations in the measurement of the lease liability results in an undervaluation of the lease liability and lease expense. It creates the figure of “profit headwind”, according to a study carried out with the numbers of the British retail multinational TESCO. The reported liability of 10.3 billion British pounds jumps to 15.2 billion British pounds, when inflation expectations obtained from the RPI (“Retail Price Index”) spot forward rate are considered. Follow link to the article: https://www.footnotesanalyst.com/beware-the-ifrs-16-inflation-headwind/ 13 IFRS16. §BC189. Some stakeholders expressed concerns about the COST of performing reassessments each time a rate or an index changes, and questioned whether the benefits for users of financial statements would outweigh the costs for lessees. For example, some stakeholders noted that the total expenses related to leases recognised in profit or loss by a lessee would be SUBSTANTIALLY the same, regardless of whether the lessee remeasures the lease liability for changes in an index or a rate. (our emphasis).

As can be seen, on the date of the quote, there was no trading of IPCA futures contracts for 6 years (a restriction that may occur in practice). Econometric techniques are available and provide the best forecasting models for each specific situation, so that one can resort to this practical measure when there is no readily observable rate for a given contractual term. But finally, which IBR to apply to lease/rental contracts when it is not readily determinable? And how to align the objectives of the standard, sometimes conflicting, with the legal duty imposed on the CVM? This was the great challenge that the CVM technical areas had to face and sought to solve in a way that the recommended rate was supported by the standard, truly reflected the company's cost of borrowing, and was shaped to the Brazilian economic environment. And reconciling the solution with the imperative need for information provided by companies not to result in “misleading”, being adequate to general principles to be applied when using Discounted Cash Flow - DCF techniques for accounting measurement purposes. Thus, considering these aspects to guide the orientation of this letter, the CVM technical areas understand that open companies acting as lessees that adopt as accounting policy the prescriptions contained in CPC 06 (R2), even being aware of the technical inaccuracies contained therein for the Brazilian environment, will use, both in the initial measurement and in the remeasurement of the lease liability, readily observed nominal rates, adjusted for the lessee's credit risk, and taking into account the term of the lease (or rental) contract and the nature and quality of the guarantees offered. This is the lessee's IBR in Brazil. The financial expense to be recognized, by accrual, in the company's income statement must reflect its incremental borrowing rate; its IBR. In the remeasurement of the lease liability, the installments must incorporate the inflation observed in the current period, according to the contractual “reset” mechanism, and will be discounted by the same IBR identified when of the initial measurement. This procedure must be dispensed with when preparing the accounting statements of the lessee company, whose selected accounting policy is oriented towards compliance with CPC 06 (R2). However, it is the understanding of the CVM technical areas that, to ensure the quality of the information to be provided in the Brazilian market and full compliance with the general principles to be applied when using Discounted Cash Flow - DCF techniques for accounting measurement purposes, lessee companies should disclose in their financial statements their lease liability, the financial expense arising from it, and the depreciation expense of the right of use, considering the flows with inflation expectations discounted by the IBR. Objectively, the lessee company must project future inflation into the flows to be discounted, so that there is no technical impropriety in the
calculation, caused by the flexibility provided for in CPC 06 (R2), and preserving, consequently, the quality of the information to be presented to investors in the Brazilian market. It should be noted that, since this is the accounting policy selected by the company's management for the preparation of its financial statements, the disclosures and other procedures required in these circumstances must also be observed, particularly in §§19-20 of CPC 26. Notwithstanding, the management of the lessee company, considering the materiality and relevance of the information brought to the market, as well as the cost restrictions of producing this information suggested to be such that they exceed the informational benefits provided by it, may judge it opportune and convenient to develop an accounting policy that better reflects, in its financial statements, the consistency of the cash flows of its lease contracts in the Brazilian economic environment. In this case, the management of the lessee company must pay attention to the disclosures and other procedures required in these circumstances, particularly in §§19-20 of CPC 26. In cases where the accounting policy selected by the company's management is different from that suggested by the CVM technical areas, the company must provide in the explanatory notes either the complete measurement described by these CVM technical areas or the minimum “inputs” necessary for users themselves to calculate these values (nominal rates adjusted for credit risk, disclosed by ranges of contract families and terms; rating agency notes, if available, by term; installments not adjusted to present value by maturity, among others). To facilitate understanding of the CVM technical areas' understanding, the following illustrative example serves as a didactic expedient:

• lease/rental contract with a term of 3 years;
• contractual installments of $100/month, with payment on Dec 31;
• observed risk-free nominal interest rate of 6.25% p.a., for a period of 3 years;
• lessee's credit “spread” of 1.0% p.a.;
• projection of average future annual inflation, for 3 years, of 3.67% p.a.;
• contractual “reset” always on Jan 01 of each year, incorporating the inflation occurred in the contractual cash flow;
• prospective adjustment of depreciation expense 14, when adjusting the right-of-use asset, due to remeasurement of the lease liability;

14 Although technically it would be more appropriate to treat it as “amortization expense of the right of use”, following the spirit of IFRS n. 16 (treatment analogous to non-financial assets within the scope of IAS n. 16) and the nomenclature taxatively suggested by the standard itself, the CVM technical areas are aligned with the required semantics, namely, to treat the amortization of the right of use as depreciation of the right of use. The spirit of the standard is to safeguard comparability with other non-financial assets, as explicitly stated in IFRS 16, §BC148, already cited in this Circular Letter.

Example Data:
Installment 100.00
Term 3 years
Nominal interest rate 6.25%
Credit spread 1.00%
Contract Reset On Jan 01
Installment payment on Dec 31
Inflation observed for each year
Inflation IPCA past Reset
Year 1 3.21% 103.21
Year 2 3.60% 106.92
Risk-free nominal interest rates readily observable in the market, according to futures contract quotes on B3 on 15.08.2019:
15/08/2019
Nominal Interest Futures
Year Contract Maturity Spot Rate
1 DI03.08.2020 03/08/2020 5.36%
2 DI01.07.2021 01/07/2021 5.73%
3 DI01.07.2022 01/07/2022 6.25%
Real Interest Futures
Year Contract Maturity Spot Rate
1 IPCA17.08.2020 17/08/2020 2.08%
2 IPCA17.05.2021 17/05/2021 2.06%
3 IPCA15.08.2022 15/08/2022 2.49%
Average annual inflation expected for 3 years 3.67% Calculation Date For the purpose of preparing the explanatory note required by the CVM technical areas, a Cash Flow projection with Future Inflation was carried out, obtained through the futures contract quote available on B3 (reliable and verifiable information):

Year	Real Flow	Future IPCA Inflation	Nominal Flow
1	100.00	3.67	103.67
2	100.00	7.47	107.47
3	100.00	11.41	111.41

15 Average annual inflation expectation, for the 3-year term, obtained by the DI01.01.2022 contract quote and the IPCA15.08.2022 contract. The average annual inflation expectation for 3 years was obtained through the calculation [(1+0.0625)/(1+0.0249) – 1] x 100.

Calculations according to CPC 06 (R2) – IFRS 16:

Installment	PV Installment	Year 1	Year 2	Year 3
1	93.24	-	-	-
2	86.94	96.24	-	-
3	81.06	89.73	99.70	-
Liability Initial Balance	261.24	185.97	99.70	-
Nominal Rate + credit spread	7.25%

Lease Liability	Year 1	Year 2	Year 3
Initial Balance	261.24	180.18	96.24
Remeasurement Adjustment Cash Flow + Past IPCA	-	5.79	3.46
Balance after Remeasurement	261.24	185.97	99.70
Financial Expense Nominal Interest	18.94	13.48	7.23
Lease Installment Cash Flow + Past IPCA	-100.00	-103.21	-106.92
Final Balance	180.18	96.24	-

According to IFRS 16
Balance Sheet, Income Statement and Cash Flow Statement according to IFRS 16:
BS: Start Year 1 End Year 1 Year 2 Year 3
Cash 500.00 400.00 296.79 189.86
Right of use 261.24 261.24 267.03 270.49
Accumulated Depreciation - - 87.08 - 177.05 - 270.49 Total 761.24 574.16 386.76 189.86 Lease Liability 261.24 180.18 96.24 - Equity Capital 500.00 Accumulated result - - 106.02 - 209.48 - 310.14 Total 761.24 574.16 386.76 189.86

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IS: Year 1 Year 2 Year 3
Depreciation Expense - 87.08 - 89.97 - 93.43
Financial Expense - 18.94 - 13.48 - 7.23
Result - 106.02 - 103.46 - 100.66
CFS - Direct Method: Year 1 Year 2 Year 3
From Cash Flows. Fin. Act.
Lease payment -100.00 -103.21 -106.92
Cash Consumed -100.00 -103.21 -106.92
Initial Balance 500.00 400.00 296.79
Final Balance 400.00 296.79 189.86
According to IFRS 16
Calculation according to the orientation of the CVM technical areas, for the purpose of preparing the explanatory note attached to the lessee's accounting statements. In summary, nominal flows (incorporating projected future inflation) discounted by the nominal rate – IBR.

Installment	PV Installment	Year 1	Year 2	Year 3
1	96.66	-	-	-
2	93.43	100.21	-	-
3	90.31	96.86	103.88	-
Liability Initial Balance	280.41	197.07	103.88	-

Lease Liability	Year 1	Year 2	Year 3
Initial Balance	280.41	197.07	103.88
Financial Expense Nominal Interest	20.33	14.29	7.53
Lease Installment -100.00	-103.21	-106.92	-
Future Inflation not incorporated in installment -3.67	-4.26	-4.49	-
Final Balance	197.07	103.88	-

Lease Installment	Cash Flow + Past IPCA	Cash Flow + Future IPCA	Future Inflation not incorporated in installment
1	100.00	103.67	-3.67
2	103.21	107.47	-4.26
3	106.92	111.41	-4.49

Explanatory Note - Nominal Flows x Nominal Rate Additionally, one of the great concerns of the CVM technical areas concerns the obtaining of the discount rate (incremental borrowing rate - IBR) by open companies acting as lessees.
How to obtain it adequately? And what procedures are independent auditors employing to obtain reasonable assurance that the IBR is appropriate and will not cause relevant distortions in the accounting statements of open companies acting as lessees?

1. consultation to banks (1, 2 or 3 institutions?) and election of that IBR judged appropriate by management?
2. construction through econometric models documented in the finance literature?
3. virtual “bookbuilding” with an “underwriter” among investors in debt securities?
   Whatever the choice of the company's management, an adequate, complete and unbiased disclosure, in the explanatory note, is fundamental for users of the accounting statements of open companies acting as lessees (among whom the CVM). And the information being verifiable/auditable.
   Independent auditors must be attentive to these aspects, manifesting themselves in their reports issued regarding deviations that, in their judgment, cause relevant distortion in the audited accounting statements as a whole.
4. PIS and COFINS to recover – Accounting Treatment
   Payments made to the lessor or landlord by the lessee or tenant company may generate the right for the lessee company to credit PIS and COFINS. For this to occur, the condition provided for in tax legislation must be met, namely, effective payment. Payments to be settled in the future do not generate this right and, consequently, the recognition of the PIS and COFINS asset to recover. In this regard, the CVM technical areas understand that the appropriate accounting treatment must take into account what tax legislation prescribes, in order to adequately portray the information. Thus, tax legislation prescribes:
   Law n. 10.833/2003 – Non-Cumulative COFINS:
   Art. 3 From the value calculated in the form of art. 2, the legal entity may deduct credits calculated in relation to: (Production of effect) (See Provisional Measure n°497, of 2010) (Regulation) (...)
   IV - rents of buildings, machines and equipment, paid to a legal entity, used in the company's activities; V - value of installments of commercial leasing operations of a legal entity, except for those opting for the Integrated System of Payment of Taxes and Contributions of Micro-enterprises and Small Businesses - SIMPLES; (Redaction given by Law n° 10.865, of 2004) (...) IN SRF n. 404/2004 – Non-Cumulative COFINS:
   CREDITS TO DEDUCT
   Art. 8 From the value calculated in the form of art. 7, the legal entity may deduct credits, determined by applying the same rate, on the values:
   (...) b) to rents of buildings, machines and equipment, paid to a legal entity, used in the company's activities; (...) d) to the installment of commercial leasing operations paid to a legal entity, except when this is an optant for Simples; (...)
   Law n. 10.637/2002 – Non-Cumulative PIS:
   Art. 3 From the value calculated in the form of art. 2, the legal entity may deduct credits calculated in relation to: Production of effect (See Law n° 11.727, of 2008) (Production of effects) (See Provisional Measure n°497, of 2010) (Regulation) (...)
   IV – rents of buildings, machines and equipment, paid to a legal entity, used in the company's activities; V - value of installments of commercial leasing operations of a legal entity, except for those opting for the Integrated System of Payment of Taxes and Contributions of Micro-enterprises and Small Businesses - SIMPLES; (Redaction given by Law n° 10.865, of 2004) (...) IN SRF 247/2002 – Non-Cumulative PIS:
   PIS/PASEP NON-CUMULATIVE CALCULATION OF CREDIT Art. 66. The legal entity that calculates non-cumulative PIS/Pasep with the rate provided for in art. 60 may deduct credits, determined by applying the same rate, on the values:
   (...)
   II - of expenses and costs incurred in the month, relating to:
   (...) b) to rents of buildings, machines and equipment, paid to a legal entity, used in the company's activities; (...) d) to the installment of commercial leasing operations paid to a legal entity, except when this is an optant for Simples; (Included by Normative Instruction SRF n° 358, of September 09, 2003) In this sense, the cost of the right of use recognized in counterpart to the lease liability, duly adjusted to present value, embeds a potential future tax credit. Thus, when depreciating the right of use, this potential future tax credit embedded in it is appropriated to the period's result as depreciation expense throughout the term of the lease contract. However, since the right of use is recorded at historical cost and the lease installments, which are the basis for tax credits, are updated according to the elapsed time, the complement of this tax credit is recognized as financial expense. Therefore, the recognition of recoverable PIS and COFINS must be recorded in counterpart to the depreciation expense of the right of use and the financial expense of the lease liability, in the period's result. It is technically inappropriate to effect the credit regarding the counterpart of the PIS and COFINS asset to recover in a specific line in the period's result, since the effects, in the result, of PIS and COFINS are already recognized in the aforementioned expense items. For the purpose of elucidating the above understanding, consider a lease liability of 5 periods, with a disbursement of $100.00 per period, discount rate of 10% per period, without inflation and PIS/COFINS rate of 9.25%. Calculation memory for accounting:

Total	1	2	3	4	5
500.00	100.00
46.25	9.25
453.75	90.75
344.01	82.50	75.00	68.18	61.98	56.35
35.06	8.41	7.64	6.95	6.32	5.74
379.08	90.91	82.64	75.13	68.30	62.09
PIS/CoFins potential
Total
Contractual Flows
Gross Cash Flow
PIS/CoFins potential (9.25%)
Right of use
Flows at present value
Right of use

Recording of PIS and COFINS to recover:
Accounting entries:
Initial recognition
D Right of use - asset 379.08
C Lease liability 379.08
Subsequent information
Depreciation of right of use
D Depreciation expense 379.08/5 75.82
C Right of use - asset 75.82
Movement of Lease Liability
Liability update
D Financial expense 37.91 31.70 24.87 17.36 9.09 C Liability 37.91 31.70 24.87 17.36 9.09 Lease payment D Liability 100.00 C Cash 100.00 Tax credit recognition D PIS/CoFins recoverable 9.25 C Depreciation Expense Right of use $35.06/5 7.01 C Financial Expense 2.24

Accounting Statements:
Balance Sheet 0 1 2 3 4 5
Asset
Cash 500.00 400.00 300.00 200.00 100.00 -
PIS/COFINS recoverable - 9.25 18.50 27.75 37.00 46.25 Right of use 379.08 303.26 227.45 151.63 75.82 - Cost 379.08 Accum. Dep. - (75.82) (151.63) (227.45) (303.26) (379.08) total 879.08 712.51 545.95 379.38 212.82 46.25 Liability
379.08 316.99 248.69 173.55 90.91 -
Lease payable 500.00 400.00 300.00 200.00 100.00 - Financial Expense to appropriate (120.92) (83.01) (51.31) (26.45) (9.09) - Equity 500.00 395.53 297.26 205.83 121.91 46.25 total 879.08 712.51 545.95 379.38 212.82 46.25

---

IS - Model practiced by companies
Depreciation expense (75.82) (75.82) (75.82) (75.82) (75.82) Fin. Exp. (37.91) (31.70) (24.87) (17.36) (9.09) PIS/CoFins 9.25 Result (104.47) (98.26) (91.43) (83.92) (75.66) IS - CVM proposal Depreciation expense (68.80) (68.80) (68.80) (68.80) (68.80) Fin. Exp. (35.67) (29.46) (22.63) (15.12) (6.85) PIS/CoFins - - - - - Result (104.47) (98.26) (91.43) (83.92) (75.66) As can be observed, the adjustments regarding recoverable PIS/COFINS, resulting from the payment of lease installments, are recorded as credits to the depreciation expense of the right of use and financial expenses. No independent and distinct item from those cited should be used to record the counterpart of the PIS/COFINS asset to recover, vis-à-vis said taxes already being contained in the mentioned expense items. Independent auditors must be attentive to these aspects, manifesting themselves in their reports issued regarding deviations that, in their judgment, cause relevant distortion in the audited accounting statements as a whole.
4. PIS and COFINS embedded in the Lease Liability – Accounting Treatment
An issue that was presented to the technical areas involves the proposal to dispense with a symmetric treatment to the lessee's lease liability in relation to the lessor's asset, highlighting in the body of the Balance Sheet of the lessee company the PIS and COFINS passed on by the lessor to the lessee company and embedded in the liability. The lease liability must be measured, at initial recognition, by the total value obtained by discounting to present value the cash flows of payments of

lease, without any segregation of taxes to be recovered, in exchange for the right-of-use asset. The liability must be linked to the counterparty of the contractual relationship, which in the case of lease/rental contracts is the lessor/landlord.

The lease/rental contract provides the lessee/tenant with a single stream of future payments regarding the lessor/landlord, constituting the basis to be used for the purpose of measuring the present value of the liability at the initial date. Therefore, to ensure (1) that relevant information is provided and faithfully represents the economic reality to be reported, (2) the consistency of the application of the standard, as well as the symmetry between the recognition of assets and liabilities, the lessor must also recognize receivables/receipts from lease/rental contracts at the total amounts receivable/received from the lessee, without segregation of PIS and COFINS taxes.

The technical areas of the CVM observed that some companies highlighted PIS and COFINS from their lease/rental liabilities, including for measurement and remeasurement purposes, as disclosed in explanatory notes attached to their ITRs for the social year of 2019. This is not regulated by the standard. This approach underestimates the lease/rental liability and consequently the right-of-use asset.

Independent auditors must be attentive to these aspects, expressing their opinion in their reports issued regarding deviations that, in their judgment, cause material misstatement in the audited financial statements as a whole.

5. Disclosure – Explanatory Note

All disclosures described below must observe the guidelines contained in Technical Orientation OCPC 07 - Disclosure in General Purpose Financial Reporting.

Entities must disclose in an explanatory note, from the initial recognition of the lease liability, an indicative table of the potential right to recover PIS/COFINS embedded in the consideration, according to the periods stipulated for payment.

In addition to the disclosures provided for in CPC 06(R2), the prescriptions described in item 33 of CPC 12 (Present Value Adjustment) must be observed.

Without prejudice to the aforementioned explanatory note disclosure requirements, the technical areas of the CVM understand that adequate tabular disclosure (§§53-54 of IFRS 16), complemented by a concise and objective descriptive disclosure, are indispensable to ensure a reasonable understanding, by users of the financial statements, of contracts within the scope of IFRS 16.

As a contribution to quality disclosure, we present a model of an explanatory note in Annex “A” to this Circular Letter.

Independent auditors must be attentive to these aspects, expressing their opinion in their reports issued regarding deviations that, in their judgment, cause material misstatement in the audited financial statements as a whole.

Finally, it should be emphasized that the effects of the application of this Circular Letter must be treated in the financial statements relating to the social year ending 31.12.2019, with the company's management responsible for judging whether or not to restate interim financial information.

Sincerely,

Signed Original by
JOSÉ CARLOS BEZERRA DA SILVA
Superintendent of Accounting Standards and Auditing

Signed Original by
FERNANDO SOARES VIEIRA
Superintendent of Corporate Relations

ANEXO A – MODEL OF EXPLANATORY NOTE

The company arrived at its discount rates, based on risk-free interest rates observed in the Brazilian market, for the terms of its contracts, adjusted to the company's reality (credit “spread”). The “spreads” were obtained through surveys with potential investors in the company's debt securities. The table below evidences the rates practiced, vis-à-vis the contract terms, as required by CPC 12, §33:

Contract Terms Discount Rate % p.a.
4 years 7.64
5 years 7.85
6 years 8.02

Contracts by Term and Discount Rate

The movement of lease liability balances is presented in the table below:

() Balance at 31.12.X0 XX
Interest for the Period XX
Current Inflation XX
Addition for new contracts XX
Paid consideration (XX)
Adjustment for Remeasurement XX
() Balance at 31.12.X1 XX
(*) Adjusted to present value at the date
Lease/Rental Liability

As required by CPC 06 (R2), §58 and CPC 40, §39, letter “a” and §B11D, the company presents in the table below the maturity analysis of its contracts, undiscounted installments, reconciled with the balance sheet balance at 31.12X1:

Installment Maturity $
20X4 XX
20X5 XX
20X6 XX
Undiscounted Values XX
Embedded Interest (XX)
Lease Liability Balance 31.12.X1 XX
Contract Maturity

The movement of the right-of-use asset balances is evidenced in the table below, according to the class of each asset, a requirement of CPC 06 (R2), §53, letters “a”, “h”, “j”:

Balance at 31.12.X0 XX
Addition for new contracts XX
Direct costs incurred XX
Estimated cost of dismantling XX
Adjustment for Remeasurement XX
Balance at 31.12.X1 XX
Expense Amortization for the period XX

Balance at 31.12.X0 XX
Addition for new contracts XX
Advance payments made XX
Incentives received (XX)
Direct costs incurred XX
Adjustment for Remeasurement XX
Balance at 31.12.X1 XX
Expense Amortization for the period XX

Right-of-Use Asset
Alfa Class
Beta Class

Below is an indicative table of the potential right to recover PIS/COFINS embedded in the lease/rental consideration, according to the periods stipulated for payment. Undiscounted balances and present value discounted balances:

Nominal
Adjusted
Present Value
XX
Cash Flows
Lease Consideration
Potential PIS/COFINS (9.25%)
“Misleading” caused by the full application of CPC 06 (R2):

The company, in full compliance with CPC 06 (R2), in the measurement and remeasurement of its lease liability and the right-of-use, proceeded to use the discounted cash flow technique without considering future inflation projected in the flows to be discounted, as prohibited by CPC 06 (R2). This prohibition generates relevant distortions in the information to be provided, given the current reality of long-term interest rates 16 in the Brazilian economic environment.

16 And considering contracts with longer terms (10, 15, 20 or 30 years) and the exponential effect of the calculations, the impacts of the differences tend to be significantly relevant.

Thus, to safeguard the faithful representation of the information, and to comply with the guidance of the CVM technical areas aiming to preserve investors in the Brazilian market, the comparative balances of the lease liability, the right-of-use, the financial expense, and the depreciation expense of the social year ended and the previous year are presented:

Analysis of the Impact of Differences
Lease Liability Final Balance Year1 Year2 Year3 IFRS 16 180.18 96.24 - Explanatory Note 197.07 103.88 - 9.37% 7.95%

Right-of-Use Net Balance Final Balance Year1 Year2 Year3 IFRS 16 174.16 89.97 - Explanatory Note 184.49 90.12 - 1.26% 7.04%

Financial Expense Year1 Year2 Year3
IFRS 16 - 18.94 - 13.48 - 7.23
Explanatory Note - 20.33 - 14.29 - 7.53
7.34% 5.97% 4.20%

Depreciation Expense Year1 Year2 Year3
IFRS 16 - 87.08 - 89.97 - 93.43
Explanatory Note - 92.25 - 90.12 - 85.63
5.93% 0.16% -8.36%

IFRS 16 Explanatory Note
Financial Expense - 39.65 - 42.15
Depreciation Expense - 270.49 - 267.99

• 310.14 - 310.14

Note. Alternatively, the company's management may provide the minimum “inputs” necessary for information users to perform their calculations and arrive at approximate results.