CVM Circular Letter 01/2018: Guidance on Aspects to Be Observed in Preparing Financial Statements for the Fiscal Year Ended December 31, 2017

SECURITIES AND EXCHANGE COMMISSION OF BRAZIL (CVM) 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. 01/2018

Rio de Janeiro, January 10, 2018

Subject: Guidance on relevant aspects to be observed in the preparation of Financial Statements for the fiscal year ended 12.31.2017

Dear Investor Relations Director and Dear Independent Auditor,

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

It is worth recalling that the Circular Letters express the understanding of the technical areas of CVM 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 technical areas of CVM regarding operations being structured by the market, during the fiscal year, for which these technical areas deem it appropriate to alert the market to the position considered, as a rule, the most adequate.

Aiming to improve the Circular Letter of 2017 and incorporating themes considered relevant for the fiscal year ending on 12.31.2017, the Circular Letter of 2018 contains some changes compared to that of 2017. The first change concerns the former items 2 ("Forfait" Operations), 3 (Operations with FIP), and 4 (Operations with FIDC), which have become part of a new topic called "Capital Structure Management," as sub-items 2.1, 2.2, and 2.3. Another change was the inclusion of new themes, respectively in new items 9 and 10, namely, "Deferred IRPJ and CSLL" and "Cash Equivalent – LFTs."

In this sense, for the fiscal year ended on 12.31.2017, the themes to be addressed are as follows:

"True and fair view"
Capital Structure Management;
"Impairment" tests – CPC n. 01;
Disclosures - Explanatory Notes;
Financial Instruments;
Revenue Recognition – POC: IFRS n. 15 x IFRIC n. 15;
Business Combinations;
Change in accounting policies;
Deferred IRPJ and CSLL;
Cash Equivalent – LFTs.
"True and Fair View"
It is never too much to remember that 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 disclosed. The unsystematic application of IFRSs or its biased application leads to situations where the investor may be misled; situations where the investor is led to misinterpret a certain economic reality, whose reporting has been carried out in a distorted manner. Such situations cannot be admitted for accounting information provided by public companies.

CVM has already expressed its concern with this aspect, namely: the risk of transactions and/or economic events being reported with the exaggerated contours of their legal form. Not by chance, it issued Advisory Opinion CVM n. 37/2011, of 09.22.2011, which in summary requires that the "true and fair view" always be observed in the accounting treatment to be dispensed. It is worth reproducing below a passage from the cited regulation:

"... the accounting regulator expressly recognizes that accounting standards must be subordinate to the principles of true and fair representation 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 fair. 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 regarding the application of the "true and fair override." Applying it implies exercising judgment; judging in exceptional and critical situations. And this posture is perfectly understandable, as professional risks increase enormously (especially litigation risks).

On the other hand, CVM is perfectly aware of the "other side of the coin." And the following caveat must be made: the "true and fair override" provided for in accounting standards should not be used indiscriminately. It must be applied in exceptional situations. And it can never serve to mislead; it cannot serve less noble purposes, such as the management of accounting information.

In these exceptional cases, the role played by independent auditors is justified more than ever. That is where their capital importance lies for the quality of information to be disseminated in the market. Auditors must evaluate with diligence and skepticism the cases of "override," whether the exceptional circumstance imposes its adoption or whether it is not the case for its adoption.

Notwithstanding, it is never too much to remember that it is the primary responsibility of the company's administration and those responsible for governance to adopt accounting policies in conformity with the requirements of accounting standards.

If the adoption of the "true and fair override" is deemed appropriate, wide and unrestricted disclosure must be given, as provided for in items 19 and 20 of Pronouncement CPC n. 26, reproduced below:

"19. In extremely rare circumstances, in which management concludes that compliance with a requirement of a Technical Pronouncement, Interpretation, or Advisory Opinion 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 provision 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 Advisory Opinion of the CPC or in accordance with item 19, it must disclose:
(a) that management concluded that the financial statements present fairly the financial position and equity, performance, and cash flows of the entity; (b) that it applied the Applicable Technical Pronouncements, Interpretations, and Advisory Opinions of the CPC, except for the non-application of a specific requirement for the purpose of obtaining appropriate representation; (c) the title of the Technical Pronouncement, Interpretation, or Advisory Opinion of the CPC that the entity did not apply, the nature of this exception, including the treatment that the Technical Pronouncement, Interpretation, or Advisory Opinion 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 Technical Pronouncement, Interpretation, or Advisory Opinion of the CPC in effect in each item in the financial statements that would have been reported if the unapplied requirement had been complied with." (we emphasize)

It is imperative to assert that 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 stake, increasing enormously the risk of adverse selection by investors. In this regard, the "true and fair override," when well applied, is a valuable regulatory instrument.

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 financial statements as a whole.

Capital Structure Management
2.1. "Forfait" Operations
In the course of recent fiscal years, some public companies have spontaneously restated their financial statements with the aim of adequately reflecting the so-called "forfait," "confirming," or "risco sacado" operations, or also called "securitization of accounts payable"1, through which the purchasing company, called the "anchor company," contracts a bank and sets up with it a scheme for advance payment to its registered suppliers 2.

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 "suppliers" operating liability; its inventory is inflated and the gross margin with sales is distorted.

With this expedient, 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 the "suppliers" liability to present value, when appropriate, without the proper segregation of interest embedded in the operation to be appropriated in the result, in accordance with Technical Pronouncement CPC n. 12. Balance Sheet - BS, Income Statement - IS, and Statement of Cash Flows - SCF fail to meet the condition of faithful representation.

The purchasing company is incentivized to proceed this way because it would be able to evade contractual "covenants" (such as interest coverage ratio or onerous indebtedness index, for example).

In short, what must definitely not occur is the distorted presentation of the transaction; economic substance must prevail over legal form. In the concrete case, it is unequivocal 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. Thereby, there are evasions of usual "covenants," such as, for example: EBITDA/Indebtedness; EBITDA/Interest; Indebtedness/Equity.

It is worth remembering that there are still some public companies that, although they have specific platforms on the worldwide computer network for registration and for guiding their suppliers on how to proceed to carry out "forfait" operations, did not disclose anything regarding these operations in their financial statements, if they had transactions of this material nature.

1 Term coined by a representative of the Office of The Chief Accountant of the USSEC, in a lecture delivered at the 2004 National Conference of the AICPA. "securitization of accounts payable". Available at: https://www.sec.gov/news/speech/spch120604rjc.htm.
"Large company seeks credit to shield suppliers". Valor Econômico Newspaper. 01.12.2016.

2.2. Operations with FIP
The operation known 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 controlling company, 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 3.

Additionally, the FIP and the holding or subholding company 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 held equity participation - "fair value" - and the updated cost value of the held equity participation (CDI variation plus a "spread," adjusted for distributed dividends) 4. The transaction of alienation in the market is made at the "fair value" of the held equity participation. Even to characterize that the "market view" was applied, in the concrete case, in pricing the held equity participation.

The FIP, in turn, intends to keep the acquired equity participation in its portfolio for a given period, say 5 years, after which it will place said lot on the market. If the sale of the equity participation to the market occurs below the updated cost of the held equity participation (purchase price updated by CDI variation plus a "spread" and discounted for distributed dividends), the holding or subholding company (controller) must return the difference to the FIP. On the other hand, if the sale to the market occurs above the updated cost of the held equity participation, the profit will be shared between the controller and the FIP 5.

Formally, this operation has been recognized in the accounting of the holding or subholding 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, equity participation). First, because there is, by the controller, continuous involvement and retention of substantial risks and benefits associated with the equity participation (distributed dividends are deducted from the interest charged by the FIP and any profit on the alienation is shared by the FIP with the controller), and second, 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 having a guarantee which is the equity participation to be alienated in the market.

3 This is an arrangement that can have other variants, such as, for example, the holding selling participation in the sub-holding, which in turn holds participation in the operating company.
4 There may also be other nuances here. The FIP can be the issuer of a call option for the seller of the equity participation, whose exercise is motivated by an economic compulsion clause. Or the FIP can acquire (become the holder of) a put option on the same equity participation acquired, whose issuer is the holding or subholding company.
5 Once again, it is worth warning that there may be other nuances; other contractual arrangements. For example, the holding or sub-holding 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.

There is relevant distortion in the reported economic reality in the case. The controller fails to appropriately recognize the Result with Equity Method and held equity participation; the controller does not recognize the "Loans" Liability and the respective Financial Expense in the IS; the controller recognizes in a distorted manner and outside the appropriate period of competence the gain or loss on capital with the alienation of the equity participation. BS, IS, and SCF fail to meet the condition of faithful representation.

2.3. Operations with FIDC
Regarding the structuring of FIDCs of which we are aware, some managers (banks) would be offering companies certain products, which would result in the "derecognition" of their assets (receivables), without the recognition of liability to which they would be subject 6.

The delineated proposal consists of an FIDC that would have an intermediate quota between the senior quotas (which are placed in the market for qualified investors) and the subordinated quotas proper, called juniors (which are subscribed by the assignor of the receivables). This intermediate quota has been called the mezzanine quota.

The junior subordinated quota would represent a small portion of the FIP's equity (2%, for example), while the mezzanine quota would represent a portion equivalent to the historical losses with default in the company's receivables portfolio (7%, for example). The mezzanine subordinated quota would, in this case, be subscribed by a bank or an investor, being a risk operation. On the other hand, very likely, the risk to which the bank would be exposed with the subscription of the mezzanine subordinated quota would be included in the interest "spread" to be practiced when discounting the "alienated" receivables to the FIDC. The mezzanine subordinated quotas would have the following characteristics: they would absorb losses, only after eventual losses consume the junior subordinated quotas. The junior subordinated quotas would be subscribed by the assignor of the receivables. The assignors would even commit to providing resources to the fund to serve as a "cushion," to cover operating costs and other eventualities (portfolio "default" problems). After redemption and amortization of all quotas of the Fund, this "cushion," if not used, would return to the assignor.

In essence, in the case at hand, the assignor would continue to retain the risks arising from the "alienated" receivables portfolio and would derive the economic benefits generated by it. Even if the assignment of credit rights is made without co-obligation, without right of recourse, which initially indicates a transfer of risks and benefits of the receivables by the assignor.

In essence, by subscribing the junior subordinated quotas, the assignor (company) would provide a guarantee. If the historical losses in the receivables portfolio exceed well the mezzanine subordinated quotas subscribed by the bank or by an investor, it is more than likely that there would be the consumption of the "cushion" provided by the assignor. The assignor would retain a considerable portion of risk with the portfolio's default. First, because it would be paying in advance for the risk of the subordinated quotas, since the bank would discount the receivables at a rate contemplating a "spread" that would reflect the credit risk with the receivables. Thus, the alienated receivables would be "risk-adjusted." And second, because it would still be providing additional guarantees, through subscription of junior subordinated quotas, in an amount higher than the historical loss with the portfolio (the assignor offers a "cushion," as already treated).

Moreover, there would still be continuous involvement of the assignor with the transaction, since the remuneration of the senior, mezzanine, or junior quotas would be by a post-fixed rate (CDI plus various "spreads" for each category of quota), remuneration that would return to the assignor (holder of the junior subordinated quota, regardless of the name to be used), in case no default occurs.

For a definitive sale of receivables, the assignor cannot have any management, involvement, or future settlement with the titles sold to the FIDC. It cannot be exposed to the risks arising from the alienated asset nor can it derive the economic benefits generated by it. The guidance given regarding this by CPC 38 (IAS39) must be observed in its entirety. There should be no "derecognition" of the asset (receivables) by the assignor company, and there must be recognition of the liability, for the resources raised with the FIDC.

Objectively, for a sale of receivables to be definitive, company administrators must verify if the "derecognition" criteria provided for in CPC 38 (IAS39) are being met. Moreover, when a structured vehicle is used, it is up to the company administrators to judge whether there is a need to consolidate this vehicle entity.

"Impairment" Tests – CPC n. 01
The "impairment" theme continues to be a concern for the technical areas of CVM regarding its financial reporting. In a survey published on its website involving 546 public companies 7, Ibracon revealed that 32% of Public Companies presented "impairment" as one of the main audit issues (PAAs) identified in the fiscal year ended on 12.31.2016, representing the PAA of highest observed frequency.

It is important to highlight the need to carry out "impairment" tests for tangible and intangible assets, especially "goodwill," and, if the case, to recognize impairment losses timely. After all, acquisitions of equity participations carried out 05 fiscal years ago, for example, indicative of future profits above expected, may not present the same foundations in the current period.

7 Available at:
http://www.ibracon.com.br/ibracon/Portugues/downloadFile.php?parametro=Li4vLi4vaWJyYWNvbi91cGxvYWQvZG9jdW1lbnRvLzE0OTcwMzQ4NjRlc3R1ZG9fcGFhc18wOTA2MjAxNy5wZGY=

It is in this regard that the issue of “disclosure” gains relevance. Adequate disclosure must be provided in explanatory notes attached to the financial statements. CPC No. 01, in its items 126-141, requires that certain disclosures be made that are relevant for the understanding of users of the financial statements. An example is the estimates used to measure the recoverable amount (RA) of a cash-generating unit (CGU) that contains goodwill for future profitability or an indefinite-lived intangible asset, whose book value is significant compared to the total book value of the goodwill or indefinite-lived intangible asset recognized by the company. For this specific situation regarding estimates, CPC No. 01, in its item 134, requires, among others, that the following information be included in the list of information to be provided:

(i) each key assumption on which management has based its cash flow projections (if value in use is the basis for the RA of the CGU) or fair value methodology (if fair value less costs to sell is the basis for the RA of the CGU).

(ii) description of the approach used by management to determine the value on which the key assumptions are based;

(iii) the period over which management projected cash flows and, when a period greater than five years is used for a value in use estimate, an explanation of why a longer period is justified;

(iv) the growth rate used to extrapolate cash flow projections, beyond the period covered by the most recent budget or forecast;

(v) the discount rate applied to cash flow projections; and

(vi) if a possible and reasonable change in a key assumption on which management has based its determination of the RA of the CGU could result in a book value exceeding its RA:

the amount by which the RA of the CGU exceeds its book value;
the value on which the key assumption is based; and
the new value on which the key assumption must be based, after incorporating any effects derived from this change in other variables used to measure the recoverable amount, in order for the RA of the CGU to equal its book value.

We draw attention to the need to observe the bases for estimates of future cash flows, which are described in items 33 to 38 of CPC No. 01, mainly with regard to the reasonableness and substantiation of the projections used, taking into account, among other aspects, the budgets approved by the Company’s management and consistency with results presented in the past.

Additionally, we emphasize that the recoverable amount must be estimated for the individual asset and, “if it is not possible to estimate the recoverable amount for the individual asset, the entity must determine the recoverable amount of the cash-generating unit to which the asset belongs,” as verified in item 66 of CPC No. 01.

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

Disclosures - Explanatory Notes

Technical Guidance OCPC No. 07 - Disclosure in Financial Reporting for General Purpose, approved by CVM Resolution No. 727/14, proved to be pioneering with respect to the preparation of explanatory notes by aggregating in a single document the basic requirements for preparation and disclosure to be observed when disclosing general-purpose financial reports.

The primary objective “of this Guidance was to clarify and reinforce that, in the financial statements and respective explanatory notes, relevant information (and only that) which actually assists users, considering existing regulations, be disclosed, without the minimum requirements existing in each Pronouncement issued by this CPC being neglected.”

It is worth highlighting, furthermore, the provision in its item 4, where it is highlighted that OCPC 07 consolidates the requirements contained in documents issued by the CPC and in the Law, without altering them.

Thus, at no time can it be argued that the aforementioned document encourages or relaxes the non-application of certain legal requirements, specifically those described in Law No. 6.404/76, which continues with its provisions fully in force and with mandatory compliance required.

It is worth noting additionally that this conflict is addressed in item 23 of CPC No. 26, which determines the prevalence of legal requirements added by the disclosure of adjustments to be made in the financial statements that management deems necessary for a faithful representation.

“23. 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, but the existing regulatory structure prohibits the non-application of the requirement, the entity must, to the greatest extent possible, reduce the identified inadequate aspects in strict compliance with the Technical Pronouncement, Interpretation, or Guidance of the CPC by disclosing:

(a) the title of the Technical Pronouncement, Interpretation, or Guidance of the CPC in question, the nature of the requirement, and the reasons that led management to conclude that compliance with this requirement would make the financial statements so misleading and conflict with the objective of the financial statements established in the Conceptual Framework for Preparation and Disclosure of Financial Reporting; and

(b) for each period presented, the adjustments of each item in the financial statements that management concluded were necessary to obtain an appropriate representation.” (we underline)

4.1. Application of item 38 of OCPC No. 07

The positive effects of the application of Guidance CPC No. 07 - Disclosure in Financial Reporting for General Purpose, approved by CVM Resolution No. 727/14, could be observed during the filing of financial statements, due since their issuance. Certainly, there is still much to advance in its application and the consequent improvement in the quality and volume of explanatory notes. In this regard, it is appropriate to reproduce item 38 of the aforementioned guidance:

“38. The entity’s management must, in the statement of conformity, affirm that all relevant information specific to the financial statements, and only that, is being disclosed, and that it corresponds to that used by them in their management.” (we underline)

Thus, it is relevant to recall this obligation for the management of the publicly held company to sign a statement of conformity, in accordance with item 38 of OCPC No. 07, reproduced above.

4.2. Elucidative vs. Non-Elucidative Explanatory Notes

The theme of disclosure in explanatory notes is a recurring issue and has been the object of constant monitoring by the technical areas of the CVM. The adoption of IFRSs in our domestic regulatory environment promoted a considerable increase in the volume and complexity of explanatory notes attached to the financial statements of publicly held companies. Professional and academic forums have been held with the purpose of discussing the problem and seeking solutions.

Excessive and unreasonable volumes of information consume time and resources of preparers and users of the financial statements, a fact that compromises the effectiveness of disclosure. The critical issue presented is: What is the ideal cutoff point and what is the appropriate formatting for the type of disclosure intended to be made?

What continues to be observed is the formal character with which the subject has been treated by the management of some companies. The so-called “check-list” approach, according to which the information required by a Technical Pronouncement of the CPC must be provided, even if it does not constitute relevant information for the company reporting it.

The technical areas of the CVM understand that informing in a non-elucidative manner and mentioning a subject that has no relevant impact on the financial statements of the company reporting the information is providing a disservice. Information to be provided in an explanatory note, as a rule, must be relevant, elucidative, and complementary (not substitutive) to the prepared financial statements.

In this sense, the guidance to be given is that administrators of publicly held companies effectively exercise a value judgment regarding what should be disclosed in an explanatory note, considering the existing disclosure requirements. What is relevant and appropriate in terms of information for users of the financial statements to make the best decision between holding, acquiring, or alienating securities.

It is true that by abandoning a “checklist” approach in favor of a judgment approach, preparers of financial statements incur a higher cost, as they must justify their choices to independent auditors and potentially to the capital markets regulator. This is the cost incurred when exercising judgment and applying materiality criteria for “disclosure” requirements.

It is worth noting that the auditor seeks to evaluate whether the information required in a pronouncement is being met, with the management of the company establishing the level of disclosure deemed appropriate. Thus, if the company wishes to provide more information, without prejudice to the minimum quantitative and qualitative disclosures, it is not up to the auditor to modify their opinion due to this fact.

4.3. Sources of Uncertainty

CPC No. 26, which deals with the presentation of Financial Statements, in its items 125-133 guides regarding sources of uncertainty in estimates, for which adequate disclosures must be provided by the company’s management.

In its item 125, it is written as follows:

“125. The entity must disclose, in the explanatory notes, information regarding assumptions about the future and other main sources of uncertainty in estimates at the end of the reporting period that pose a significant risk of causing material adjustments to the accounting values of assets and liabilities over the next fiscal year. With respect to these assets and liabilities, the explanatory notes must include elucidatory details regarding:

(a) their nature; and

(b) their book value at the end of the reporting period.”

And in item 129 of CPC No. 26, the following guidance is given:

“129. The disclosures described in item 125 must be presented in a manner to help users of the financial statements understand the judgments management has made regarding the future and other main sources of uncertainty in estimates. The nature and extent of the information to be disclosed vary according to the nature of the assumptions and other circumstances. Examples of these types of disclosures are as follows:

(a) the nature of the assumptions or other uncertainties in estimates;

(b) the sensitivity of the accounting values to the methods, assumptions, and estimates underlying the respective calculation, including the reasons for this sensitivity;

(c) the expected resolution of uncertainty and the variety of reasonably possible outcomes over the next fiscal year regarding the accounting values of the affected assets and liabilities; and

(d) an explanation of changes made to the assumptions adopted in the past regarding these assets and liabilities, in case the uncertainty remains unresolved.” (our underlining)

The technical areas of the CVM understand that these disclosures are particularly relevant when they involve estimates for material values of provisions in general (for contingencies arising from administrative or judicial proceedings, for the dismantling of long-maturity assets, among others), asset recovery values, fair values in general, and long-term obligations with a high degree of uncertainty (such as post-employment benefit obligations).

The aforementioned Ibracon survey indicated the theme “contingencies” as a PAA present in 26% of Companies in 2016 and representing the 3rd item with the highest frequency observed.

4.4. Judgment of the Company’s Management – “Going Concern”

CPC No. 26 in its items 25-26 emphasizes that the entity’s financial statements must be prepared on the assumption of its continuity. When management becomes aware, in making its assessment, of relevant uncertainties related to events or conditions that may cast significant doubt on the entity’s ability to continue operating in the foreseeable future, these uncertainties must be disclosed.

In this sense, the technical areas of the CVM highlight the importance of company administrators making this judgment and proceeding with its adequate disclosure. It is important to mention, still in this context, that the new audit report highlights in more detail the responsibilities of management regarding the assessment of continuity.

The Ibracon survey indicated the “operational continuity assumption” as a PAA present in 18% of Companies in 2016.

4.5. New Accounting Standards: CPC No. 47, CPC No. 48, and CPC No. 06-R2 (IFRS No. 16)

Considering the entry into force of new accounting pronouncements, with provision for fiscal years starting on January 1, 2018 (CPC No. 47 and CPC No. 48) and January 1, 2019 (CPC No. 06-R2), the administrators of the affected publicly held companies must evaluate and consider the potential impact of these new standards on the company’s financial statements.

Although IFRSs provide for early adoption as an option for company administrators, in Brazil, regulatory entities, and in the specific case of the capital markets, the CVM, have prohibited this early adoption, to safeguard comparability between companies in the same sector.

In this sense, CPC No. 23, in its items 30-31, requires that certain disclosures be made when there is no early adoption (in the Brazilian case, this applies to all companies). Below are produced the aforementioned normative devices:

“30. When the entity does not early adopt a new Pronouncement, Interpretation, or Guidance already issued, but not yet mandatory, the entity must disclose:

(a) such fact; and

(b) available or reasonably estimable information that is relevant to assess the possible impact of the application of the new Pronouncement, Interpretation, or Guidance on the entity’s financial statements in the period of initial application.

In complying with item 30, the entity must proceed with the disclosure:

(a) the title of the new Pronouncement, Interpretation, or Guidance;

(b) the nature of the change or changes imminent in accounting policy;

(d) the date on which it plans to initially apply the Pronouncement, Interpretation, or Guidance; and

(e) the assessment of the impact that the initial application of the Pronouncement, Interpretation, or Guidance is expected to have on the entity’s financial statements or, if this impact is not known or reasonably estimable, the explanation regarding this impossibility.” (we underline)

Regarding the new accounting pronouncement that deals with Revenue from Contracts with Customers – CPC No. 47, it is important to point out that the “core principle” on which the document is conceptually based, “an entity recognizes revenue to depict the transfer of goods and services promised to its customers, in an amount that reflects the consideration the entity expects to receive in exchange for said goods and services.”

Companies must be prepared in terms of information systems and internal controls, protocols, and operational routines to meet the new revenue standard. In this sense, it is never too late to recall the five steps for proper application of the regulation:

Identification of the contract with the customer;
Identification of performance obligations provided for in the contract;
Determination of the transaction price;
Allocation of the transaction price to the identified performance obligations;
Recognition of revenue according to the fulfillment of performance obligations.

The Ibracon survey indicated the theme “Revenue” as a PAA present in 29% of Companies in 2016, being the 2nd item with the highest frequency observed.

As for the new leasing pronouncement – CPC No. 06-R2, which strictly impacts the financial statements of lessee publicly held companies, it is worth emphasizing the need for administrators of these companies to pay attention to the adequate evaluation of their lease contracts, whose object is real estate and/or other assets (“right-of-use assets”) included in the scope of the standard (items 3-4), used in the realization of their corporate purpose. Objectively, they must evaluate whether they are included in the standard, requiring consequently the recognition of assets and liabilities arising from these contracts.

Similarly, the undesirable effect of contractual changes carried out and which intend to promote the evasion of the standard must be highlighted (for example, the fixing of terms for contracts less than 1 year in principle, in a less careful reading of the standard, would entail the application of §5 of the standard, which qualifies “short-term leases,” whose assets and liabilities arising from contracts may not be recognized accounting-wise). Now, a 1-year lease contract, renewable recurrently for 10 years, essentially produces an effect similar to a 10-year lease contract. In this sense, the orientation given regarding this by CPC No. 06-R2 must be observed in its entirety.

For the purposes of capital markets regulation, such fact may be considered “misleading,” which is a very serious matter. Not by chance, the concept of “leasing term” in the standard takes into consideration the probability of exercising contractual renewal options (“extension options”), for the purpose of delimiting the contract term (see IFRS No. 16, §§BC 91-B97 and §§BC 152-159).

Regarding the new pronouncement for financial instruments – CPC No. 48, topic 5 of this Circular Letter addresses this matter.

9 Economically, the entity may even have an incentive to renew the contract.

Financial Instruments

5.1. Application of the Concept of “Economic Compulsion”

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

The technical areas conducted research on the positions of the IFRS IC and concluded that decisively there was no manifestation whatsoever by the IFRS IC in 2006, but rather discussions carried out by the interpretive committee (which is worth noting, does not create standards) were reported to the IASB Board. And the IASB Board deemed it appropriate to assert two things: (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. Economic compulsion, by itself (in isolation), cannot be used for the purpose of classifying an item as a liability; (2) the IASB Board emphasized what is obvious, and already present in much of its standards, IAS No. 32 requires an assessment of the economic substance of the contractual arrangement.

IAS No. 32 (RedBook, “consolidated with full early application”, 2017), in its §20, deals with economic compulsion in the qualification of a Financial Liability, defining direct and indirect obligations in terms and conditions of contracts. In the “Basis for Conclusions” section, §BC9, the IASB Board unravels the controversy arising from the mentioned device. In broad lines, the IASB Board manifests itself in the sense that a financial instrument may establish an obligation indirectly through its terms and conditions (“Implicit obligations”, §20).

It does not seem economically sensible for obligations contractually transformed into rights; formally characterized as faculties subject to the issuer’s free will. For example, the obligation to deliver cash, to satisfy the payment of dividends or interest, becomes an option to be exercised by the issuer. And what about the holder of the security? Does it bear risks without a premium in return? It does not seem very sensible, within an economic rationality.

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 reproduced passages of the “staff paper,” two are the conclusions:

(1) some market agents are encouraging issuers to treat debt instruments as equity instruments, 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 stated in Circular Letter CVM/SNC/SEP No. 01/2013, the technical areas of the CVM 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 Compound Financial Instruments 10 or not. What cannot be admitted is for issuers to practice the so-called “capital structure management,” a procedure inadmissible in the view of CVM’s technical areas, given its legal mandate.

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

It is relevant to highlight that the IASB is conducting a research project to regulate the matter, with a “discussion paper”11 expected to be released in the first half of 2018.

5.2. Hedge Accounting – CPC n. 38/IAS n. 39 and CPC n. 48/IFRS n. 09

With the entry into force, starting from the fiscal year beginning on January 1, 2018, of CPC n. 48, which mirrors IFRS n. 9 in Brazil, two “hedge accounting” models will coexist simultaneously: the CPC n. 38 model and the CPC n. 48 model 12.

Finally, the “hedge accounting” model becomes another accounting choice for management: either it elects Chapter 6 of IFRS n. 9 or maintains the provisions of IAS n. 39, applicable to the matter. And the models are distinct (IFRS n. 9 x IAS n. 39), in terms of designation of hedge relationships, eligible hedging items, and effectiveness tests. By way of illustration, the table below identifies some differences between the two models:

10 A compound instrument is a non-derivative instrument that contains elements of liability (“liability”) and equity (“equity”).
IAS32, §§ 28-32, AG30- AG35.
11 Available at: http://www.ifrs.org/projects/work-plan/financial-instruments-with-characteristics-of-equity/ 12 EXCERPTS FROM IFRS n. 9 – HEDGE ACCOUNTING:
IN10. In November 2013 the IASB added to IFRS 9 the requirements related to hedge accounting. These requirements align hedge accounting more closely with risk management, establish a more principle-based approach to hedge accounting and address inconsistencies and weaknesses in the hedge accounting model in IAS 39. In its discussion of these general hedge accounting requirements, the IASB did not address specific accounting for open portfolios or macro hedging. Instead, the IASB is discussing proposals for those items as part of its current active agenda and in April 2014 published a Discussion Paper Accounting for Dynamic Risk Management: a Portfolio Revaluation Approach to Macro Hedging. Consequently, the exception in IAS 39 for a fair value hedge of an interest rate exposure of a portfolio of financial assets or financial liabilities continues to apply. The IASB also provided entities with an accounting policy choice between applying the hedge accounting requirements of IFRS 9 or continuing to apply the existing hedge accounting requirements in IAS 39 for all hedge accounting because it had not yet completed its project on the accounting for macro hedging. (emphasis added)
6.1.3 For a fair value hedge of the interest rate exposure of a portfolio of financial assets or financial liabilities (and only for such a hedge), an entity may apply the hedge accounting requirements in IAS 39 instead of those in this Standard. In that case, the entity must also apply the specific requirements for the fair value hedge accounting for a portfolio hedge of interest rate risk and designate as the hedged item a portion that is a currency amount (see paragraphs 81A, 89A and AG114–AG132 of IAS 39). (emphasis added)
7.2.21 When an entity first applies this Standard, it may choose as its accounting policy to continue to apply the hedge accounting requirements of IAS 39 instead of the requirements in Chapter 6 of this Standard. An entity shall apply that policy to all of its hedging relationships. An entity that chooses that policy shall also apply IFRIC 16 Hedges of a Net Investment in a Foreign Operation without the amendments that conform that Interpretation to the requirements in Chapter 6 of this Standard. (emphasis added)

IAS n. 39	IFRS n. 09
Prospective and retrospective hedge effectiveness (“threshold” 80%-125%)	Prospective hedge effectiveness: “forward-looking model” (§§ B.6.4.12, §§BCE198-BCE199) Non-derivative IF as hedging instrument only for foreign exchange risk factor

“Hedge accounting” is an optional accounting policy that allows eliminating or reducing volatility in results, and when applied, it must observe specific rules and must not be used as a means to legitimize the deferral of foreign exchange losses nor earnings management.

CVM’s technical areas warn that any change in the “hedge accounting” policy (migration from IAS n. 39 to IFRS n. 9) to be made by the company’s management must be justified in a note attached to the financial statements, guided by the improvement of information to be provided. And all necessary documentation to support “hedge accounting” procedures must be prepared “ex ante” the accounting recognition, as expressly provided in CPC n. 38, item 88a and CPC n. 48, item 6.4.1. “b”, reproduced below:

“88. A hedge relationship qualifies for hedge accounting according to items 89 to 102 if, and only if, all the following conditions are met:
(a) at the inception of the hedge, there is formal designation and documentation of the hedge relationship and the entity’s risk management objective and strategy for undertaking the hedge. This documentation must include identification of the hedging instrument, the covered position or transaction, the nature of the risk to be hedged, and how the entity will assess the effectiveness of the hedging instrument in offsetting changes in fair value or cash flows of the hedged item attributable to the hedged risk; (...)” (emphasis added)

“6.4.1. A hedging relationship qualifies for hedge accounting only if all the following criteria are met:

13 IF – financial instrument; FVTPL – fair value through profit or loss.

(...)
(b) at the inception of the hedging relationship, there is formal designation and documentation of the hedging relationship and the entity’s risk management objective and strategy for undertaking the hedge. This documentation must include identification of the hedging instrument, the hedged item, the nature of the risk being hedged, and how the entity must assess whether the hedging relationship meets the hedge effectiveness requirements (including its analysis of sources of hedge ineffectiveness and how to determine the hedge ratio); (...)” (emphasis added)

Because it is a high-risk area, whether for “earnings management” practices or for tax planning purposes, independent auditors must dedicate special attention to the topic, verifying if the hedge accounting policy is faithfully reflecting the operational practice carried out by the company. Objectively, it is the responsibility of the independent auditor to verify and judge whether the “hedge accounting” policy adopted by the company (i) meets the current normative provisions and (ii) faithfully reflects the economic reality to be reported, a fundamental characteristic of accounting information.

5.3. “Impairment” Test of Financial Instruments – CPC n. 48/IFRS n. 09

With the entry into force, starting from the fiscal year beginning on January 1, 2018, of CPC n. 48, in addition to a new “hedge accounting” model, a new approach for “impairment” of financial instruments is also being proposed. The incurred loss approach is abandoned and the expected loss approach is elected.

There are still, within the expected loss approach, two proposed models: a more robust and complex, probabilistic model, called the 3-stage model, aimed primarily at financial institutions, according to which the credit deterioration of the asset issuer calibrates the amount of expected losses, thereby promoting earnings smoothing. And another simpler model, generally recognized by the market as the “provision matrix” model, aimed primarily at non-financial institutions, according to which the amount of expected losses is defined “ad hoc”. The provision matrix can, for example, specify fixed provision rates depending on the number of days a customer’s receivable is overdue, as per guidance given in item B5.5.35 of CPC n. 48.

The 3-stage model can be illustrated in the figure below.

Expected loss model (“expected credit loss”):
Expected Loss/Default for the next 12 months | Expected Loss/Default for the entire life of the IF ---|--- Effective interest rate on the amortized cost of the IF (without “impairment” adjustment) | Effective interest rate on the amortized cost of the IF (without “impairment” adjustment) Effective interest rate on the amortized cost of the IF (with “impairment” adjustment) | Recognition of Expected Loss: | Recognition of Interest Revenue:
Stage 1 | Stage 2 | Stage 3
Deterioration in credit quality since original recognition | | Expected Loss/Default for the entire life of the IF | |

The “provision matrix” model is reproduced below, based on illustrative example n. 12 of the standard.
Simplified Approach – “Lifetime expected credit loss”: commercial receivables or contractual assets, within the scope of IFRS n. 15 and lease receivables, within the scope of IAS n. 17 [IFRS9, 5.5.15] Provision Matrix ("Aging List") Current | Up to 30 days | 31 to 60 days | 61 to 90 days | More than 90 days ---|---|---|---|--- "Default rate" | 0.30% | 1.60% | 3.60% | 6.60% | 10.60% LTECLA Cost Current | 15,000,000 | 45,000 Up to 30 days | 7,500,000 | 120,000 31 to 60 days | 4,000,000 | 144,000 61 to 90 days | 2,500,000 | 165,000 More than 90 days | 1,000,000 | 106,000 Total | 30,000,000 | 580,000 | 1.93% Receivable Delay | Receivable Illustrative Example n. 12, IE74-IE77

It must be affirmed that the 3-stage model, although aimed primarily at financial institutions, can be used by non-financial institutions, if higher quality information is to be produced, when the non-financial institution presents a portfolio of commercial receivables, within the scope of CPC n. 47/IFRS n. 15, that contains a significant financing component. As well highlighted by CPC n. 48, in its item 5.5.15, letter “a” “ii”, the election of the 3-stage model or the “aging list” model becomes an accounting choice of the company’s management.

A sector that can potentially avail itself of the 3-stage model, in the view of CVM’s technical areas, due to its characteristics, is the real estate development sector, holder of a portfolio of commercial receivables, within the scope of CPC n. 47/IFRS n. 15, with a significant financing component.

Still regarding the “impairment” test, for the fiscal year ending on 31.12.2017, those open companies that have in their financial asset portfolios some securities issued by companies undergoing judicial reorganization, must proceed with the “impairment” test, according to the dictates set forth in CPC n. 38.

Revenue Recognition – POC: IFRS n. 15 x IFRIC n. 15

With the entry into force, in the fiscal year beginning on January 1, 2018, of the new Technical Pronouncement CPC n. 47, mirrored in IFRS n. 15, the revenue recognition of contracts with customers now has a new normative discipline, based on the transfer of control of a good or service, whether this transfer is observed at a specific point in time (“at a point in time”) or over time (“over time”), according to the satisfaction or not of the so-called contractual “performance obligations”.

It is important to highlight what is provided in item 33 of CPC 47, which specifies the fundamental characteristics for the existence of control over an asset:
33. (..). Control of the asset refers to the ability to determine the use of the asset and to obtain substantially all the remaining benefits from the asset.
Control includes the ability to prevent other entities from directing the use of the asset and obtaining benefits from that asset. The benefits of the asset are the potential cash flows (inflows or savings in outflows) that can be obtained directly or indirectly (...)

It is the understanding of CVM’s technical areas that the adoption of one or the other accounting policy will be a function of adequate contractual analyses by the company’s management, in line with the dictates of the standard. For the specific case of the real estate development sector, the maintenance of the revenue recognition method called POC (“over time”) or adoption of the “keys” method (“at a point in time”), for example, will result from this evaluation.

In this regard, among the list of normative acts to be revoked with the entry into force of the new pronouncement, it is worth highlighting ICPC n. 02 – Construction Contracts of the Real Estate Sector, mirrored in IFRIC n. 15, which caused much controversy and discussion in the Brazilian regulatory environment, resulting even in the issuance of OCPC n. 4 – Application of Technical Interpretation n. 02 to Brazilian Real Estate Development Entities.

It is verified that it is common practice in the real estate sector that the percentage of work evolution is measured from the percentage of cost incurred relative to the total budgeted cost for the undertaking. This criterion requires company administrators to adopt the necessary measures so that internal controls regarding the preparation and continuous and timely review of construction budgets and their integration with the accounting system are adequate to such a procedure.

Attention is drawn, given the relevance of the mentioned controls, to the fact that, as a rule, any deficiencies and recommendations regarding internal controls, concerning construction budgets and revenue recognition, present in the detailed report prepared by their independent auditors, must be reported in section 5.3 of the Reference Form. Regardless of whether the auditors have pointed out deficiencies or suggested recommendations, administrators must comment on the degree of efficiency of such controls, indicating any measures adopted for their improvement.

Furthermore, due to the revenue recognition criterion by the percentage of completion (POC) method and due to possible variations in the predictability of construction budgets, which may lead to the need for adjustments in values recognized as revenues, the company must present, in a note, the value relating to results to be appropriated, informing the value of sales made and the respective costs to be incurred (or construction commitments) not reflected in the financial statements.

The Accounting Pronouncements Committee - CPC, in 2016, constituted a working group – GT destined to evaluate the impacts of the new standard on the Real Estate Development sector. This group was constituted by representatives of the profession – CFC, academia - FIPECAFI, independent auditors - IBRACON, open companies - ABRASCA, sector companies – ABRAINC and CVM’s technical areas. The results of the discussions and recommendations were forwarded to the CPC, which in a meeting dated 02.12.2016 decided by majority to position itself in the sense that the revenue recognition method called POC or the method called keys is perfectly aligned with IFRSs, depending on the contractual analyses of each operation.

CVM’s technical areas, especially the Superintendence of Accounting Standards and Auditing, affirm that a high level of discrepancies observed in the sector, or even the non-existence of a reliable and effective internal control system, do not call into question the POC method itself, but rather the recognition or not of revenue. This recognition is conditioned by the degree of reliability regarding the entity’s ability to generate cash flows from the recognized revenue. It is important to highlight this issue, as it is the reason for CVM’s existence to ensure the quality of information disseminated in the market, avoiding that users in general, investors, and other interested parties are misled.

OCPC n. 04 (R1), with text adapted to normative changes, was in public hearing during the year 2017 and the process was suspended by decision of the CPC due to a consultation formulated to the IASB Interpretations Committee – IFRS IC on the application or not of POC in certain contracts in the Brazilian environment. While the discussion process of OCPC 04 is not concluded and in order to allow normative predictability, avoid informational harm to the Brazilian capital market, and avoid troubles to the accounting and treasury departments of companies, CVM’s technical areas guide the market to observe what is provided in the currently valid OCPC n. 04, approved by CVM Resolution n. 653/2010, applying the adjustments that may be necessary due to the validity of IFRS n. 15 for 01.01.2018, when preparing the financial statements of real estate development entities in Brazil for fiscal years ending on or after 31.12.2017.

Business Combinations
7.1. Business Combinations when there is a remaining participation of non-controlling shareholders, with simultaneous issuance of put options and call options on these shares 14

Recently, acquisition operations of entities have been observed, structured as follows:

14 In international literature, the expression “NCI put” (Non-controlling interests put options) is commonly used, although put (“put”) and call (“call”) options are usually issued.

acquisition of a percentage of shares sufficient to obtain control;
simultaneous issuance of put options (from the acquirer to the remaining/non-controlling shareholders) and call options (from the remaining/non-controlling shareholders to the acquirer) on the percentage of shares not acquired (in concrete cases, acquisition of the remaining balance);
generally, the exercise price of the options (call and put) takes as reference a multiple of adjusted EBITDA.

It is emphasized that the accounting treatment for put and call options issued on the remaining participation of non-controlling shareholders fits into a situation of absence of guidance from IAS n. 32, regarding the counterpart of the liability to be recognized 15, a scenario in which Management must select an accounting policy that results in relevant accounting information with faithful representation (CPC 23, item 10).

For the selection and application of accounting policies, CPC n. 23 (items 11 and 12) provides for the following hierarchy: 1) approved CPC documents that deal with similar matters; 2) criteria and concepts contained in the Conceptual Framework; 3) other sources, for example, standards issued by other standard-setting bodies, as long as they are not conflicting with items 1 and 2. In any case, detailed disclosures must be made regarding the judgments made by Management during the process of selecting the appropriate accounting policy.

Among the various points to be considered in defining the accounting policy, the following deserve emphasis:
i) thorough analysis regarding the moment of transfer of substantive rights linked to the remaining shares in the hands of non-controlling shareholders, with detailed disclosures regarding the judgments made; ii) justification of the understanding that the recognition and measurement of equity items in the individual and consolidated statements (assets, liabilities, equity) faithfully represent the economic substance of the transaction; and iii) the use of goodwill/discount account in capital transactions, in the exercises of the options, instead of the Fair Value Adjustment account, as provided in item 69 of ICPC n. 09.

It is never too much to remember that if the company’s management decides to make a change in an accounting policy, it must observe what is prescribed in item 14 of CPC n. 23, reproduced below:

“14. An entity shall change an accounting policy only if the change:
(a) is required by a Pronouncement, Interpretation or Guidance; or (b) results in reliable and more relevant information in the financial statements about the effects of transactions, other events or conditions about the

15 CPC n. 39 (IAS n. 32), in its item 23, is silent regarding the treatment to be given to the counterpart of the recognition of the liability arising from a “non controlling interest - NCI put option”.

position and financial performance, or cash flows of the entity." (we emphasize) Finally, it is worth noting that the IASB is currently working on the project "Financial Instruments with Characteristics of Equity – FICE". With the completion of this project, the expectation is that there will be a normative provision in the IFRSs dealing with options issued on Non-Controlling Interests - NCI.

7.2. Measurement Period - "Goodwill" or Gain from a Bargain Purchase
The measurement period for business combination transactions, given the complexity involved and sometimes the scarcity of available information, contemplates, as provided for in CPC n. 15, a period of up to one year.
It is important to emphasize that this one-year provision is for the initial accounting to be completed, when there is a lack of relevant information at the date of initial recognition. CPC n. 15 is reproduced below, in its item 45.

"When the initial accounting of a business combination is incomplete by the end of the reporting period in which the combination occurred, the acquirer must, in its financial statements, report provisional values for items whose accounting is incomplete. During the measurement period, the acquirer must retrospectively adjust the provisional values recognized at the acquisition date to reflect any new information obtained about facts and circumstances existing at the acquisition date, which, if known at that date, would have affected the measurement of the recognized values. During the measurement period, the acquirer must also recognize additional assets or liabilities when new information is obtained about facts and circumstances existing at the acquisition date, which, if known at that date, would have resulted in the recognition of those assets and liabilities at that date. The measurement period ends as soon as the acquirer obtains the information it was seeking about facts and circumstances existing at the acquisition date, or when it concludes that no more information can be obtained. However, the measurement period cannot exceed one year from the acquisition date." (we emphasize)

Regarding the measurement period, CPC n. 15, in its item B67, "a", requires that the following information be disclosed in the notes to the financial statements when the accounting of the business combination is incomplete:

"When the initial accounting of a business combination is incomplete (see item 45) and, consequently, certain assets, liabilities, non-controlling interests or items of consideration transferred, as well as the respective amounts recognized in the financial statements for the combination, have been determined only provisionally, the following must be disclosed:
(i) the reasons why the initial accounting of the business combination is incomplete; (ii) the assets, liabilities, equity interests or items of consideration transferred for which the initial accounting is incomplete; and (iii) the nature and amount of any adjustment in the measurement period recognized during the reporting period, in accordance with item 49".

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

7.3. CVM Instruction n. 319/99 x ICPC n. 09
Some market participants have consulted the technical areas of the CVM to know how to proceed regarding the accounting treatment to be adopted for reverse mergers, given the command of ICPC n. 09, in its item 77, after the second revision to which it was submitted.
It is important to highlight that this provision deals with transactions between entities under common control in general, not being circumscribed exclusively to business combinations between entities under common control nor to reverse mergers. Thus, item 77 states:

"77. While the Accounting Pronouncements Committee does not issue a Technical Pronouncement or Interpretation that comprehensively regulates the way in which transactions between entities under common control should be treated (which is why items 44 to 47 were suppressed), the existing regulation by the entity's regulatory body must be applied." (we emphasize)

In Brazil, the topic of business combinations between entities under common control has always had much of its economic motivation supported by tax planning. Corporate reorganizations that sometimes aim exclusively to reduce the tax burden of companies, through the opportunity for tax avoidance offered by tax legislation.
A widely practiced operation in our environment, which received names in the specialized literature of the area as "reverse merger" or "second-generation reverse merger", had the primary objective of creating internal goodwill 16, an unrealized profit in a transaction with equity interests.

Internal goodwill, for the purposes of individual and consolidated financial statements, is prohibited by international accounting standards. And it simply does not exist because the goodwill generated internally and recognized by one of the companies involved originates from the capital gain or profit recognized by another of the companies involved. There are no independent third parties interested in carrying out an operation without favoritism, validating the goodwill.

16 These operations found support in tax legislation, Law 10.637/02, art. 36, a provision already revoked by Law 11.196/05.
Fines by the Brazilian Federal Revenue Service – RFB for these operations have even been discussed in administrative courts – CARF (http://carf.fazenda.gov.br/sincon/public/pages/index.jsf), questioning the tax deductibility of internal goodwill (on this subject see 1402-01.080 Ruling, 1402-01.078 Ruling, 1201-000.689 Ruling, 1101-000.710 Ruling, 1101-000.709 Ruling, 1101-000.708 Ruling).

The CVM in the past, in the 1st generation of "reverse merger" or "reverse merger" operations, with goodwill validated by independent third parties, did regulate the issue within the scope of publicly held companies, with a view to preventing non-controlling shareholders from being prejudiced in dividends to which they would be entitled. Thus was the obligation to constitute the provision for asset integrity, created by CVM Instruction n. 319/99, modified by CVM Instruction n. 349/01. Thus was also the prohibition of capitalizing the special goodwill reserve without the corresponding amortization of the goodwill that gave rise to it. By reviewing the Technical Pronouncement CPC n. 15, mirrored in IFRS 3, which deals with business combinations, it is found that the topic of business combinations between entities under common control is outside its scope (CPC 15, item 2c and items B1-B4). And nor has it been regulated, so far by the IASB, the way in which such operations should be treated accounting-wise. The Accounting Pronouncements Committee in 2015 created a working group to deal with these operations - GT transactions between entities under common control - which has not yet taken a position on the subject.

The technical areas of the CVM, with the understanding guided by the principle of "substance over form" (CVM Orientation Opinion n. 37/2011), and supported by the guidelines given by CPC n. 36 regarding change of control and in CPC n. 15 itself, advocate for the analysis of a business combination considering a broad view. Even if there is no control corporate relationship between the companies involved in the combination, but if they are subject to the same corporate control, such an operation is not within the scope of Technical Pronouncement CPC n. 15. For the technical areas of the CVM, it is appropriate to apply the "Predecessor Cost Basis" method when a business combination between entities under common control is at stake.

Regarding the provisions of CVM Instruction n. 319/99 aimed at the accounting treatment of reverse mergers, these remain fully in force and must be applied when the specific case involves a reverse merger, in the manner then regulated. The administrators of the companies involved, together with their legal consultants and independent auditors, must evaluate the relevance and timeliness of applying said provisions of the standard. However, in cases where there is no interposition of a "vehicle" company, the original investor is incorporated, and where the economic foundations that gave rise to the goodwill remain valid, the same should be maintained in its entirety and should be treated according to the conditions originally established. In this case, the constitution of the provision mentioned in CVM Instruction n. 349/01 may be unnecessary or even inappropriate. It is worth noting that the exception mentioned above should not be understood in a generalized way. There may be situations where, even if a "vehicle" company has not been created, there may be the recognition of an asset and an increase in equity without economic substance, a fact that imposes the need to constitute the provision determined by CVM Instruction n. 349/01.

Change in Accounting Policies
The Technical Pronouncement CPC n. 23 defines criteria for the selection and change of accounting policies, along with the accounting treatment and disclosure of changes in accounting policies, changes in accounting estimates, and corrections of errors.
Considering the objective of the pronouncement to improve the relevance and reliability of the entity's financial statements, and above all, to allow its comparability 17 over time with the financial statements of other entities, we draw attention to the need to disclose all relevant information for understanding the adjustments made, including with regard to the reasons why the application of a new accounting policy, if applicable, provides reliable and more relevant information. On this subject, CPC n. 23, in its item 14, states as follows regarding the change in accounting policies:

"14. The entity shall change an accounting policy only if the change:
(a) is required by a Pronouncement, Interpretation or Orientation; or (b) results in reliable and more relevant information in the financial statements about the effects of transactions, other events or conditions regarding the position and financial performance, or cash flows of the entity."

It is imperative to say that the fact that accounting pronouncements issued by the CPC sometimes allow the adoption of more than one different accounting policy does not imply that the company's administration would have the prerogative of migrating from one policy to another, at the whim of changes in economic circumstances, opportunistically to meet specific interests. This is the case, for example, of investment properties. CPC n. 28, in its item 31 states as follows:

"The Technical Pronouncement CPC 23 – Accounting Policies, Change in Estimate and Correction of Error states that a voluntary change in accounting policy should only be made if the change results in a more appropriate presentation of the operations, other events or conditions in the entity's financial statements. It is highly unlikely that a change from the fair value method to the cost method will result in a more appropriate presentation." (we emphasize)

17 It is important to highlight the structural break of a time series of accounting variables (periods in which practices changed; which errors were corrected), so that inferences regarding trends are not compromised, avoiding that decisions are mistakenly taken.

Deferred IRPJ and CSLL
The topic "Deferred IRPJ and CSLL" is always sensitive for the technical areas of the CVM for financial reporting purposes. Both its recognition and its adequate disclosure deserve special attention from preparers of financial statements and independent auditors. Not by chance, it is recurrently on the radar of monitoring by the technical areas of the CVM.
Regarding the topic, the Ibracon research indicated the "Realization of Deferred Income Tax" as a PAA present in 21% of Companies in the year 2016, being the 5th item with the highest frequency observed.
It is important to highlight that CVM Instruction n. 371/02 is fully in force and fully convergent with CPC n. 32, with regard to the definition of the foreseeable time horizon to be used in estimating the probability of future taxable profits against which deferred tax assets may be offset. There is no contradiction between the two standards, but rather a dialogue between them whose practical effect lies, precisely, in specifying that the analysis of the probability of generating future taxable profit, provided for in item 36 of CPC n. 32, is limited to the maximum horizon of 10 years 18, allowed by CVM Instruction n. 371/02. In fact, instead of a conflict between the norms, what exists is greater rigor in CVM Instruction n. 371/02 regarding the time period capable of ensuring a reliable estimate of the probability of the existence of future taxable profits in an amount sufficient to offset the deferred tax asset. It is never too much to reiterate that for "disclosure" purposes, CVM Instruction n. 371/2002, of 27.06.2002, requires that the following information be disclosed in the notes to the financial statements, without prejudice to the disclosures required by CPC n. 32:
I - estimate of the portions of realization of the deferred tax asset, discriminated year by year for the first 5 (five) years and, from then on, grouped in maximum periods of 3 (three) years, including for the portion of the deferred tax asset not recorded that exceeds the realization period of 10 (ten) years referred to in item II of art. 2º; II - effects resulting from eventual alteration in the expectation of realization of the deferred tax asset and respective foundations, as provided for in art.4º; and III - in the case of newly constituted companies, or in the process of operational restructuring or corporate reorganization, description of administrative actions that will contribute to the future realization of the deferred tax asset.

18 This horizon will not always be reasonable for some sectors, such as the concessions sector. Good sense and appropriate judgment must guide the procedures to be adopted by preparers and independent auditors on the subject.

Cash Equivalent - LFTs
The technical areas of the CVM became aware of disparate classification that has been given to LFTs, classified by some companies as cash equivalents and by others not. At first, there would be a conflict with what CPC n. 3 (IAS n. 7) prescribes when classifying the LFT as a cash equivalent.
In the understanding of the technical areas, two issues would need to be addressed to settle the matter:
Is the public debt market in Brazil actually organized? In short, does it present liquidity (active primary and secondary markets, with market participants acting in price formation – interest rates in this case), transparency of business practices and predictability of auctions carried out by the National Treasury, so as to allow the exit of a holder at any time without substantial loss of market value?
The classification of a security as a cash equivalent, in accordance with CPC n. 3 (IAS n. 7), must meet two conditions: maturity and immediate convertibility into cash, without substantial loss of market value. Should the device of CPC n. 3 (IAS n. 7) be applied by its literal interpretation? And if the security is considered in the list of assets managed via the treasury activity of the institution?

In this sense, considering the first question, we carried out a study to understand the dynamics of the public debt market in Brazil. We also collected evidence regarding the business carried out, protocols provided for and other rules delineated, in order to verify if they are indeed being consistently observed in practice, without structural breaks in time series.

Regarding the public debt market in Brazil, we are led to conclude, by the evidence collected, that it is an extremely organized market, with the active participation of financial institutions in price formation, as per recurrent auctions carried out by the Treasury. Moreover, there are active negotiations in the secondary market for these securities.

Auctions and secondary market negotiations are operated through an electronic system made available by the Central Bank of Brazil, namely: the Special Settlement and Custody System - SELIC (http://www.bcb.gov.br/htms/selic/selicintro.asp?idpai=SELIC), through financial institutions duly authorized to operate, namely: banks, savings banks, securities brokerage firms, securities distribution firms, credit, financing and investment companies and real estate credit companies. Other legal entities and individuals can participate in auctions and business through the financial institutions authorized to operate.

There is also a system of "dealers" accredited by the National Treasury, whose mission is to promote the development of the primary and secondary markets for federal public debt securities (a kind of "market-makers"). Currently there is a total of 12 "dealers", of which 10 are banks and 2 are independent brokers or distributors. The performance of these "dealers" is monitored and evaluated every 6 months, with the replacement of those with the worst performance. This fact guarantees competitiveness, primary and secondary markets and consequently liquidity for the issued securities.

Regarding auctions, they mirror the dynamics of the management of Federal Public Debt – DPMF. Through them, the Treasury finances itself (to cover budget deficits) and seeks to improve its debt profile (expand the average "maturity" of the DPMF).
There are 3 competitive modalities ("1st round"), namely: (1) traditional auction – which are sales auctions and have the main function of refinancing the DPMF. LTNs, NTN-Fs and LFTs are auctioned, through the selection of proposals via the best price criterion, being settled at their respective values; (2) swap auction – which aims to lengthen the debt profile and thus improve the DPMF indicators, through the swap of securities with shorter maturities for longer NTN-Bs. It is another exit option for the holder of federal public securities and (3) purchase auction – which aims to allow the early redemption of securities, guaranteeing more liquidity to the holder of federal public securities. They are executed for the purchase of NTN-Bs and NTN-Fs.

There are also non-competitive offers (2nd round), when the "dealer" system is activated, after the sale of at least 50% of the lot offered in the competitive auction (1st round). Each "dealer" is assigned a percentage of the volume offered in the 2nd round. Non-competitive offers are part of the benefits and obligations structure of the "dealers".

In general, traditional auctions are conducted at 3af (sale of NTN-Bs with biweekly periodicity) and 5af (LTNs offered weekly and NTNs and LFTs offered biweekly). Swap and redemption auctions have quarterly periodicity. The quantity of securities offered in auctions is based on demand prospecting carried out by the National Treasury Secretariat - STN with "dealer" institutions, via collection of purchase intentions in terms of quantity and rate.

After the end of the auction, the National Treasury Secretariat - STN analyzes the proposals received, establishing parameters for quantities and rates to be accepted, having as reference, among other factors: (i) Unit Price of the security in the secondary market; (ii) interest rate curve extracted from DI futures contracts (term structure of interest rates) and (iii) consensus obtained with treasury desks of financial institutions in the final minutes of the auction. The date of financial settlement of the auction is D+1, carried out through the Central Bank's Reserve Transfer System - STR, to which Selic is interconnected. That is, counterparty "default" risk tends to zero.

At the beginning of each year, the National Treasury Secretariat – STN establishes an auction calendar for the entire year, and for each auction date a decree of the National Treasury Secretariat – STN is issued with specific conditions to be observed in the offer, rules and protocols of the auction and characteristics of the securities offered.

Observing the historical series of auctions carried out by the National Treasury Secretariat – STN, in the period from 2000 to 2017, we found that auctions have been systematically carried out. There is also information on historical series of business in the secondary market obtained by BACEN.

By way of illustration of DPMF values, according to data from the Monthly Report on DPMF of August 2017, there is a stock of R$3,286.43 billion in securities issued for DPMF

internally, of which 32.76% are LFTs, and R$117.57 billion in titles issued for external DPMF. In this sense, there is no doubt regarding the regular functioning and viability of the public debt market in Brazil.

In response to the 1st question, there is no contrary evidence that allows us to conclude differently regarding the fact that the public debt market in Brazil is organized, presents liquidity, with transparency of the transactions carried out and predictability of the auctions conducted by the STN, possesses an active secondary market, allowing the exit of a holder of these titles at any time, without substantial loss of market value.

Moving to the 2nd question, we reproduce below an excerpt from CPC n. 3 (IAS n. 7), in its items 6 and 7:

“6. Cash equivalents are short-term, highly liquid financial investments that are readily convertible into known amounts of cash and that are subject to an insignificant risk of changes in value.
7. Cash equivalents are held for the purpose of meeting short-term cash commitments and not for investment or other purposes. For an investment to be qualified as a cash equivalent, it must have immediate convertibility into a known amount of cash and be subject to an insignificant risk of changes in value. Therefore, an investment normally qualifies as a cash equivalent only when it has a short-term maturity, for example, three months or less, from the date of acquisition. Investments in equity instruments (equity) are not included in the concept of cash equivalents, unless they are, substantially, cash equivalents, such as in the case of redeemable preferred shares that have a defined redemption period and whose term meets the definition of short-term.”
(we underline)

This is a matter for judgment by preparers of financial statements, in the understanding of the CVM technical areas, aiming at the production of quality information that faithfully represents the economic reality to be reported. It does not seem appropriate to interpret the above provisions in an excessively formal manner, understanding that every title whose maturity exceeds 3 months does not qualify for classification as a cash equivalent.

It seems to us that considering the management's intention in the management of these titles and their effective cash management model are the significant points to be addressed. If not, let us see a hypothetical situation. Two companies, both use LFTs for treasury management, allocating them to “trading” positions. Company “A” carries out this treasury management directly, issuing buy and sell orders in the market. Company “B” carries out this management indirectly, through a retail fixed-income fund, whose portfolio is administered by a third party, being composed predominantly of LFTs, and whose shares do not have any lock-up period, as defined in the regulations.

By the literal interpretation of the standard, Company “A” could not classify its LFTs as cash equivalents, even though it carries out active treasury management with them. Company “B” would be fully able to frame its shares (which are nothing more than a mirror of the LFTs) as cash equivalents, since these shares are readily redeemable. Such formalistic interpretation does not seem to make much sense. Would the companies have to incur transaction costs (creation of a fund) to account faithfully for their treasury activity?

For the CVM technical areas, the critical aspect to be considered is any inconsistency regarding the accounting classification of LFTs for accounting recognition purposes - IAS 39 (CPC n. 38), namely “held to maturity” x “held for trading”, vis-à-vis its measurement method given its classification as a cash equivalent.

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

Sincerely,

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

Signed original by
GUSTAVO DOS SANTOS MULÉ
Superintendent of Corporate Relations
In Exercise

CVM Circular Letter 01/2018: Guidance on Aspects to Be Observed in Preparing Financial Statements for the Fiscal Year Ended December 31, 2017

Lineage: Amended

Timeline