Circular-Office CVM/SNC/SEP No. 01/2016

SECURITIES AND EXCHANGE COMMISSION OF BRAZIL (CVM) Seven of September Street, 111/2-5th and 23-34th Floors – Center – Rio de Janeiro - RJ – ZIP: 20050-901 – Brazil Tel.: (21) 3554-8686 - www.cvm.gov.br CIRCULAR-OFFICE/CVM/SNC/SEP No. 01/2016 Rio de Janeiro, February 18, 2016 Subject: Guidance on relevant aspects to be observed in the preparation of Financial Statements for the fiscal year ended December 31, 2015

Dear Investor Relations Director and Dear Independent Auditor,

The Circular-Offices issued jointly by the Superintendence of Corporate Relations – SEP and the Superintendence of Accounting Standards and Auditing - SNC aim to guide the preparation of financial statements and have been considered an effective instrument by the CVM's technical areas to safeguard the quality of information disseminated in the market.

With the issuance of Circular-Office CVM/SNC/SEP No. 01/2013, the SNC and SEP expressed to the market the understanding of their technical body regarding how certain topics, then enumerated, should be treated, in light of the application of IFRSs, in order to guide the preparation of Financial Statements for December 31, 2012.

At that time, it was understood that some guidelines should be given for the correct application of IFRSs by publicly-held companies and their independent auditors, in order to reduce or eliminate conflicts and deviations observed during that 2012 fiscal year. About 3 years later, it is necessary to issue new guidance.

It is worth remembering that Circular-Offices express the understanding of the CVM's technical areas regarding the adequate accounting representation of an economic event reflected in the financial statements of companies. Their topics originate from deviations identified and information obtained by the CVM's technical areas regarding operations that are being structured, throughout the fiscal year, for which these technical areas deem it convenient to alert the market about the considered position, as a rule, more adequate.

In this sense, for the fiscal year ended December 31, 2015, the topics to be treated are as follows:

“True and fair view”;
“Forfait” operations;
Other transactions of which there is knowledge;
Application of the concept of “Economic Compulsion”;
“Impairment” tests; and
Application of item 38 of OCPC 07.

It is important to highlight that the Company's Management and those responsible for its Corporate Governance have the primary responsibility for evaluating the topics addressed in this Circular-Office, with Independent Auditors having the role of scrutinizing them with all the diligence, skepticism, and responsibility usual to their activity.

“True and fair view”

The two conceptual pillars on which accounting information is based are relevance and faithful representation. If accounting information is not relevant or does not faithfully represent the reality that must be reported, it should not be provided. The unsystematic application of IFRSs or its biased application leads to situations where the investor may be led to misinterpret a certain economic reality, whose reporting has been done in a distorted manner. This type of situation cannot be admitted for accounting information provided by publicly-held companies.

The CVM has already expressed its concern with this aspect, namely: the risk of transactions and/or events being reported with exaggerated contours of their legal form. Not by chance, it issued Advisory Opinion CVM No. 37/2011, of September 22, 2011, which, in summary, requires that the “true and fair view” always be observed in the accounting treatment to be dispensed. It is worth reproducing the following passage from the cited regulation:

“(…) the accounting regulator expressly recognizes that accounting standards must be subordinate to the principles of true and fair representation (true and fair view) and the primacy of substance over form. That is, not only must economic effects prevail over form, regardless of legal treatment, but it is imperative, in the new accounting framework, that the representation of economic reality be true and appropriate. So imperative that, even in the case of conflict with issued standards, the preponderance must be of adequate representation. These are the central pillars of this new framework.”

In this context, we still observe resistance by professionals regarding the application of the “true and fair view”. Applying it implies exercising judgment; judging in exceptional and critical situations, which can be quite challenging in certain situations.

On the other hand, the technical areas are aware that, at times, the principle of true and fair representation is used inadequately, distorting the economic essence of the transaction and inducing the user of the information to error. Thus, the technical areas understand that the “true and fair override”1 provided in Pronouncement CPC No. 26 should not be used indiscriminately, but rather applied in exceptional situations.

1 Applicable when the adoption of a standard collides with the adequate representation of economic reality. In this case, economic reality must prevail and the standard ceases to be applied.

Regarding this subject, Livne and McNichols 2 gathered interesting empirical evidence in a study promoted with 707 cases of the “true and fair view” – TFV rule of UK GAAP, invoked by 307 companies from the United Kingdom. They concluded, among other things, that companies that invoke more costly “overrides” 3 present weaker financial performance, which suggests the use of the institute by UK managers for the purpose of managing accounting information. However, companies that invoke the “override” to avoid the amortization of goodwill or the depreciation of investment properties do not present financial statements with less informative content 4.

In the same sense, Telles et al 5, when analyzing some public cases involving IFRS overrides, in France, Germany, and the United Kingdom, conclude, among other things, that broad and extensive disclosure must be given in explanatory notes when its adoption occurs.

Therefore, when considering the adoption of the “true and fair override” appropriate, broad and unrestricted disclosure must be given, as provided for in items 19 and 20 of Pronouncement CPC No. 26, reproduced below:

“19. In extremely rare circumstances, in which management concludes that compliance with a requirement of a Technical Pronouncement, Interpretation, or Guidance of the CPC would lead to such a misleading presentation that it would conflict with the objective of the financial statements established in the Conceptual Framework for Preparation and Disclosure of Financial Reporting, the entity will not apply this requirement and will follow the provisions of item 20, unless this procedure is strictly prohibited from a legal and regulatory point of view.

When the entity does not apply a requirement of a Technical Pronouncement, Interpretation, or Guidance of the CPC or in accordance with item 19, it must disclose:

2 Livne, G.; McNichols, M. An Empirical Investigation of the True and Fair Override. Working paper AAA Annual Meeting, 2002.
3 “The greater the support for the standard, the larger the cost of the departure”. As involved costs are enumerated: investigation by the accounting compliance supervisor, FRRP – Financial Reporting Review Panel; conflicts with independent auditors; penalty by market analysts via reduction of target prices; litigation with institutional investors, among others.
4 “The finding that more costly overrides are invoked by firms with weaker financial performance suggests that UK managers have used the flexibility available to them for reasons not intended by the rules. (...). In contrast, firms invoking an override to avoid amortization of goodwill or depreciation of investment properties do not provide less informative financial statements.”
5 Telles, S.V. et al. True and Fair Override: Characteristics of its practical adoption. Fipecafi Journal. Sept. 2015. p. 36-50.

(a) that management concluded that the financial statements appropriately present the financial position and equity, performance, and cash flows of the entity; (b) that it applied the applicable Technical Pronouncements, Interpretations, and Guidance of the CPC, except for the non-application of a specific requirement with the purpose of obtaining appropriate representation; (c) the title of the Technical Pronouncement, Interpretation, or Guidance of the CPC that the entity did not apply, the nature of this exception, including the treatment that the Technical Pronouncement, Interpretation, or Guidance of the CPC would require, the reason why this treatment would be so misleading and would conflict with the objective of the financial statements, established in the Conceptual Framework for Preparation and Disclosure of Financial Reporting, and the treatment actually adopted; and (d) for each period presented, the financial impact of the non-application of the CPC Technical Pronouncement, Interpretation, or Guidance in force in each item in the financial statements that would have been reported if the unapplied requirement had been complied with.” (we underline)

It is imperative to assert that the CVM has a legal mandate to fulfill, namely: to ensure that all and any relevant information is provided faithfully, timely, and equitably, in order to guarantee a fair formation of prices of financial assets traded in the market. Acting otherwise puts the health of the market at risk, greatly increasing the risk of adverse selection by investors. In this regard, the “True and Fair View” – TFV or “True and Fair Override” - TFO, when well applied, is a valuable regulatory instrument.

It is our understanding that the primary responsibility for discussing this topic lies with the Company's Management and those responsible for its Corporate Governance.

On the other hand, in these exceptional cases, the role played by independent auditors is more justified than ever, who must evaluate with diligence and skepticism these cases of “override”, whether the exceptional circumstance imposes its adoption or not.

“Forfait” operations

It has come to our knowledge that some companies in Brazil have carried out the so-called “forfait”, “confirming”, or “risco sacado” operations, or also called “securitization of accounts payable”6, through which the purchasing company, called the “anchor company”, hires a bank and sets up with it a scheme for advance payment to its registered suppliers 7.

Formally, the selling company (supplier) issues an invoice that contemplates the term to be financed by the bank, but does not recognize the sale in its accounting at present value. And with this, it presents a higher EBITDA. The purchasing company, in turn, does not recognize an onerous liability with the Bank, but the operating liability “suppliers”; its inventory is inflated and the gross margin with sales is distorted.

With this measure, the purchasing company manages to distort its real financial situation. It fails to recognize financial expenses in the result, as in addition to not recognizing the onerous liability “financing”, it does not adjust to present value the “suppliers” liability, without the proper segregation of interest embedded in the operation to be appropriated in the result, in accordance with Technical Pronouncement CPC No. 12. Balance Sheet - BS, Income Statement - IS, and Statement of Cash Flows - SCF cease to meet the condition of faithful representation 8.

Depending on the transaction carried out, which may include longer terms than usual for the acquisition of inventory, the purchasing company may be incentivized to proceed this way because it could escape contractual “covenants” (interest coverage ratio or onerous indebtedness index, for example). It may be common in many transactions, the use of lines and credit limits with banks of the purchasing companies (“anchor companies”) to support the referred operation, since the credit limit may be pre-approved by the bank to thus enable the transaction, and after the cash payment to the supplier by the bank indicated by the purchasing company, all financial relationship will be between the purchasing company and the bank.

6 Term coined by a representative of the Office of The Chief Accountant of US SEC, in a lecture delivered at the 2004 AICPA National Conference. “securitization of accounts payable”. (https://www.sec.gov/news/speech/spch120604rjc.htm) 7 “Large company seeks credit to shield suppliers”. Valor Econômico Newspaper. 12.01.2016.
8 It is important to analyze the effects at cut-off dates (ITRs), as the PV and appropriations may have material and consequently relevant impact.

Transactions of this nature must be disclosed in explanatory notes attached to the financial statements, which must include: the bases used by the company's management, both that in the supplier position and that in the purchaser position for the decision to practice the inclusion of a financial institution (bank) to enable the “forfait transaction”; conditions of negotiations with banks, financial cost, use of limits and credit lines; and the conclusion for the definition of accounting records, among other information considered important for the conclusion reached.

Considering the scenario described above, the distorted presentation of the transaction is irregular, and economic substance must prevail over legal form. The understanding of the technical areas is that there was a financing of the purchasing company of merchandise or capital goods by a banking institution. The onerous liability must be recognized as such in the balance sheet and the debt service (interest and other charges) must be appropriated timely and exponentially in the result, according to the effective interest curve.

Other transactions of which there is knowledge

Here it is appropriate to mention two operations of which there is knowledge, one involving a complex contractual arrangement with a FIP – Participating Investment Fund, and another aimed at the structuring of FIDCs.

3.1. Operations with FIP

The operation of which there is knowledge in the Brazilian market with FIP, whose accounting treatment results in distortion of the information to be provided, concerns the sale of equity participation with an embedded swap contract.

This operation is contractually defined in such a way that the controller (holding company or subholding) of an operating company alienates to an exclusive closed-end fund – FIP (usually having a bank as a quota holder, although this configuration is irrelevant for the accounting treatment of the operation) – equity participation held in the operating company 9.

Additionally, the FIP and the controller enter into a swap contract through which they will exchange future cash flows arising from the difference observed, on a future date, between the market sale value of the equity participation held by the FIP - “fair value” - and the cost value of the acquired equity participation updated (for example, by the variation of CDI plus a spread, adjusted by distributed dividends) 10.

9 This is an arrangement that may have other variants, such as the holding selling participation in the subholding, which in turn holds participation in the operating company.
10 Again, there may be other nuances. The FIP may issue a call option for the seller of the equity participation, whose exercise is motivated by a clause of economic compulsion. Or the FIP may acquire (become the holder of) a put option on the same equity participation acquired, whose issuer is the holding or subholding.

The future alienation transaction in the market will be made at the “fair value” of the equity participation held by the FIP, even to characterize that the “market view” was applied, in the concrete case, in the pricing of the held equity participation.
The FIP, in turn, intends to keep the acquired equity participation in its portfolio for a given period, after which it will put said batch up for sale in the market. If the sale of the equity participation to the market occurs below the cost of the originally acquired equity participation updated 11, the controller must return the difference to the FIP. On the other hand, if the sale to the market occurs above the cost of the held equity participation updated, the profit will be shared between the controller and the FIP 12.

Formally, this operation could have been idealized to be recognized in the controller's accounting as an effective sale of equity participation, although the economic essence indicates that it is a financing transaction with an asset given as collateral (in this case, the equity participation). First, because there is, by the controller, continuous involvement and retention of substantial risks and benefits associated with the equity participation (the distributed dividends are deducted from the interest charged by the FIP and the eventual profit on the alienation is shared by the FIP with the controller, so that the original seller of the participation to the FIP guarantees a minimum fixed income for the FIP during a period). Secondly, because the only risk to which the FIP is exposed is the credit risk of the controller (reflected in the spread practiced in the operation), in addition to what it has as collateral the equity participation to be alienated in the market.

There is, in this case, relevant distortion of the economic reality reported by the controller, which (i) recognizes, at the time of sale, a result on the sale of the participation; (ii) fails to appropriately recognize the Result with Equity Method and held equity participation; (iii) does not recognize the Liability “Loans” and the respective Financial Expense in the IS; and (iv) recognizes in a distorted manner and outside the appropriate period of competence the gain or loss of capital with the alienation of the equity participation.

In the opinion of the technical areas, given this scenario, BS, IS, and SCF cease to meet the condition of faithful representation.

11 Purchase price updated by the variation of CDI plus a spread and discounted by dividends distributed and received by the FIP during the period in which the participation was held.
12 Once again, it is worth warning that there may be other nuances; other contractual arrangements. For example, the holding or subholding may have preference in the repurchase of the equity participation, a fact that is also irrelevant for defining the accounting treatment to be given to the operation.

3.2. Operations with FIDC

Regarding the structuring of Credit Rights Investment Funds (“FIDCs”), it was found that some managers (banks) are offering companies certain products, resulting in the “derecognition” of their assets (receivables), without the recognition of liability to which they would be subject 13.

FIDCs can issue different classes of quotas, which are characterized by conferring distinct economic rights. Senior quotas are those that do not subordinate to others for purposes of amortization and redemption, and, therefore, present a yield target, with fixed remuneration – for example, CDI plus a spread. In turn, subordinate quotas are those that subordinate to seniors for the mentioned effects.

It is common, in some structures, the creation of two classes of subordinate quotas, known in the market as “mezzanine” and “junior”. The “mezzanine” subordinate quotas correspond to an intermediate class, since they only subordinate to seniors, thus presenting pre-defined yield, and “seniority” in relation to “junior” subordinates. The “junior” subordinate quotas are subject to senior and “mezzanine” quotas, being remunerated by a variable value corresponding to the residual balance of what remains from the payment of the other classes 14.

In the observed structures, the assignor of the receivables (company) is obliged to acquire “junior” subordinate quotas, responding, preferably, for eventual defaults of the acquired credits, absorption of eventual FIDC expenses and/or adjustments of interest rate differences (pre-fixed to discount the receivables transferred to the FIDC and the post-fixed rate which is the remuneration defined for senior quotas), so that a fixed remuneration to senior and “mezzanine” quota holders is ensured. Therefore, the value of “junior” quotas is generally calculated according to the loss history resulting from default in the company's receivables portfolio (7% of the portfolio value, for example).

Through the subscription of these quotas, the assigning company commits, in addition, to provide resources to the fund to serve as a “cushion”, to cover operating costs and other eventualities (portfolio default problems – for example, transfer the receivables to the fund with a discount of a pre-fixed interest rate higher than that which remunerates senior quotas, in order to generate a “cushion” to absorb any eventual FIDC expense).

Furthermore, it is provided that, after the redemption or amortization of the senior quotas of the Fund, this “cushion”, if not used, returns to the assignor.

13 We also have knowledge of similar operations with CRAs (Agricultural Receivables Certificates), through which certain contractual arrangements are made that promote the emergence of a “fiduciary estate” (an economic entity, without CNPJ), in the mold of a “SILO” (IFRS 10).
14 It is important to emphasize that the nomenclature to be given to the different classes is irrelevant for the accounting treatment treated here, economic substance observed must always prevail.

SECURITY AND EXCHANGE COMMISSION OF BRAZIL
Sete de Setembro Street, 111/2-5th and 23-34th Floors – Center – Rio de Janeiro - RJ – ZIP Code: 20050-901 – Brazil Tel.: (21) 3554-8686 - www.cvm.gov.br CIRCULAR LETTER/CVM/SNC/SEP No. 01/2016 – page 09

In this context, the company's receivables are acquired by the FIDC, discounted at a rate that includes a spread reflecting credit risk. Furthermore, through the subscription of "junior" subordinate quotas in an amount greater than historical losses with the portfolio, the transferor is providing guarantees for the transaction.

Therefore, in the case at hand, essentially, the transferor continues to retain the risks arising from the receivables portfolio and earns the economic benefits generated by it, even though the assignment of credit rights is made without co-obligation or without recourse.

Moreover, there is still continuous involvement of the transferor with the transaction, since the remuneration of the senior and "mezzanine" quotas is given by a post-fixed rate, and in the event that the FIDC's credit portfolio performs without the occurrence of default, part of the remuneration returns to the subordinate holder, in this case, the transferor company, through the relationship existing between the FIDC's quota classes, as discussed above.

In view of the above, it is concluded that, for a definitive sale of receivables, the transferor cannot have any future management, involvement, or settlement with the titles sold to the FIDC. It cannot be exposed to the risks arising from the alienated asset, nor can it earn the economic benefits generated by it. There should be no, therefore, the "derecognition" of the asset (receivables) by the transferor company, and it is necessary to recognize the corresponding liability for the resources raised with the transfer of the receivables to the FIDC.

Application of the Concept of "Economic Compulsion"

It has been observed, among some agents, the understanding that economic compulsion should not be taken into consideration for the purpose of classifying financial liabilities within the distinction between liability elements and equity. This understanding would reside in a supposed manifestation of IFRIC, in a consultation formulated for the said interpretative committee in the year 2006 (IASB Update June 2006, p. 4).

The technical areas conducted research on the positions of IFRIC and concluded that there was no manifestation by IFRIC in 2006, but rather the discussions carried out by the interpretative committee were reported to the IASB Board, which, it should be noted, does not create standards.

Thus, within the scope of the IASB Update June 2006, the IASB Board asserted that:
(1) for the purpose of qualifying an item as a financial liability, contractual obligations established explicitly or implicitly (economic compulsion), through the conditions and terms of the financial instrument, must be considered. Thus, economic compulsion, by itself, cannot be used in isolation for the purpose of classifying an item as a liability; (2) IAS 32 requires an assessment of the economic substance of the contractual arrangement.

For its part, IAS 32 (RedBook, “consolidated with full early application”, 2015), in its §20, deals with economic compulsion in the qualification of a Financial Liability, by defining direct and indirect obligations in terms and contractual conditions. In the “Basis for Conclusions” section, §BC9, the IASB Board unravels the controversy arising from the mentioned provision. In general lines, the Board admits the prevailing understanding that a financial instrument can establish an obligation indirectly through its terms and conditions (“Implicit obligations”, §20).

It does not seem economically sensible that events that characterize an obligation of fact are contractually transformed into rights and qualified as faculties subject to the free will of the issuer. As an example, the case is highlighted where the obligation to deliver cash to satisfy the payment of dividends or interest becomes an option to be exercised by the issuer. In this situation, the holder of the security would be running risks without a premium in return.

It is also interesting to bring to light the “staff paper” produced by the technical body of the IASB, dated March 18-22, 2013, titled: “Guidance to support the definition of a liability— economic compulsion, constructive obligations and contractual obligations”.

From the reading of the “staff paper”, two are the conclusions: (1) some market agents are encouraging issuers to treat debt instruments as equity securities, classifying them in Equity - E, thereby distorting the economic reality to be reported; and (2) such procedure, apparently, is on the radar of the IASB technical body.

As already pointed out in Circular Letter CVM/SNC/SEP No. 01/2013, the CVM's technical areas have great concern with this issue, the distinction between a liability item and equity, especially considering the creativity, quality, and sophistication of new financial products, whether they are classified as Composite Financial Instruments 15 or not.

This practice is observed particularly in the current moment when some companies present a high degree of indebtedness, the costs to raise capital are high, and the reduction of the level of economic activity is a reality. There is, therefore, a favorable environment for issuers to practice the already called “capital structure management”, a procedure considered irregular.

“Impairment” Tests

Market expectations for the year 2016, as revealed by the Focus Bulletin – Market Report of 31.12.2015 16, are indicative of the need to carry out “impairment” tests. There are inflationary expectations and rising interest rates. There is also an increase in risk premiums in Brazil, with the loss of investment grade.

15 A composite instrument is a non-derivative instrument that contains elements of liability and equity. IAS32, §§ 28-32, AG30- AG35.
16 http://www.bcb.gov.br/pec/GCI/PORT/readout/R20151231.pdf

For its part, certain sectors of the industry in Brazil are being more affected.
And this evidence can also be corroborated empirically by the price level observed in the securities of these companies. The informational efficiency of the capital market imposes the timely pricing of economic events. There are also companies that operate in the commodities segment, whose prices in the international market are falling.

In this sense, given the current economic scenario, with various external evidences suggesting uncertainties regarding the recovery of capital invested in assets, it is important to highlight the need to carry out “impairment” tests for tangible and intangible assets, especially “goodwill”, and, if the case arises, to recognize devaluation losses in a timely manner. Adequate disclosure must be provided in the explanatory notes.

Application of item 38 of OCPC 07

The positive effects of the application of Guidance CPC 07 - Disclosure in the Reporting of General Purpose Financial Reports, approved by CVM Resolution No. 727/14, even if incipient, could already be perceived when preparing the accounting statements of the social year ended on 31.12.2014. Certainly, there is still much to advance in its application and the consequent improvement of the quality and volume of the explanatory notes.

However, a point identified as absent in most of those statements concerns the mandatory application provided for in item 38 of the said guidance:

“38. The entity's administration must, in the note of conformity declaration, affirm that all relevant information specific to the accounting statements, and only they, are being disclosed, and that they correspond to those used by it in its management.” (we underline)

Thus, it is relevant to recall this obligation for the administration of the publicly-held company to subscribe to a conformity declaration, in accordance with item 38 of OCPC 07 reproduced above, this declaration to be submitted to the scrutiny of Independent Auditors.

Fernando Soares Vieira
Superintendent of Corporate Relations

José Carlos Bezerra da Silva
Superintendent of Accounting Standards and Audit

Circular-Office CVM/SNC/SEP No. 01/2016

Lineage: Amended

Timeline