CVM Circular Letter 01/2019: Guidance on Financial Statement Aspects for the Fiscal Year Ended December 31, 2018

COMISSÃO DE VALORES MOBILIÁRIOS
Rua Sete de Setembro, 111/2-5º e 23-34º Andares – Centro – Rio de Janeiro - RJ – CEP: 20050-901 – Brasil Tel.: (21) 3554-8686 - www.cvm.gov.br CIRCULAR LETTER/CVM/SNC/SEP No. 01/2019 Rio de Janeiro, January 11, 2019 Subject: Guidance on relevant aspects to be observed in the preparation of Financial Statements for the fiscal year ended December 31, 2018

Dear Investor Relations Director and Dear Independent Auditor,

The Circular Letters issued jointly by the Superintendency of Accounting Standards and Audit - SNC and the Superintendency of Corporate Relations - SEP 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.

It is worth recalling that the Circular Letters 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 being structured by the market, during the fiscal year, for which these technical areas deem it appropriate to alert the market about the considered, as a rule, more adequate position.

Aiming to improve the 2018 Circular Letter and incorporating themes considered relevant for the fiscal year ending on December 31, 2018, the 2019 Circular Letter contains some changes compared to the 2018 version. These concern the inclusion of two new themes, namely: "Some Aspects of Leasing Contracts – IFRS 16" and "ICMS calculation base for PIS and COFINS".

In this sense, for the fiscal year ended on December 31, 2018, the themes to be addressed are as follows:

1. "True and fair view"

2. Capital Structure Management;

3. "Impairment" Tests – CPC No. 01;

4. Disclosures - Explanatory Notes;

5. Financial Instruments;

6. Revenue Recognition by Real Estate Development Companies: IFRS No. 15;

7. Business Combinations;

8. Change in accounting policies;

9. Deferred IRPJ and CSLL;

10. Cash Equivalent – LFTs;

11. Some Aspects of Leasing Contracts – IFRS No. 16;

12. ICMS in the PIS and COFINS calculation base.

13. "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 their 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 open companies.

The 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 did it issue Advisory Opinion CVM No. 37/2011, of September 22, 2011, which in summary always requires that the "true and fair view" be observed in the accounting treatment to be dispensed. It is worth reproducing below a passage from the cited normative:

"... 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 the economic effects prevail over the form, regardless of the legal treatment, but it is imperative, in the new accounting system, that the representation of economic reality be true and appropriate. So imperative that, even in the case of conflict with the issued standards, the preponderance must be of the adequate representation. These are the central pillars of this new system."

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, the 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

1 Technical Pronouncement CPC 26 (R1), Items 19 to 24.

mislead; it cannot serve for 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. Its capital importance lies there for the quality of the 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 not.

Nevertheless, 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 considered appropriate, wide and unrestricted disclosure must be given, as provided for in items 19 and 20 of Technical Pronouncement CPC No. 26, reproduced below:

"19. In extremely rare circumstances, in which the administration 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 the 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.

20. 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:
    (a) that the administration concluded that the financial statements present appropriately 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 for 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 the 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 Guidance of the CPC in force in each item in the financial statements that would have been reported if the unapplied requirement had been fulfilled." (we emphasize)

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 implies putting the health of the market at stake, enormously increasing 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 financial statements audited as a whole.

INDEX

2. Capital Structure Management
   2.1. "Forfait" Operations
   In the course of recent fiscal years, some open companies have spontaneously reapplied 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"2, 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 3.

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 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 No. 12. Balance Sheet - BS, Income Statement - IS and Statement of Cash Flows - SCF cease 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" (interest coverage ratio or onerous debt ratio, 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 goods or

2 Term coined by a representative of the Office of The Chief Accountant of the USSEC, in a lecture delivered at the 2004 AICPA National Conference. "securitization of accounts payable". Available at: https://www.sec.gov/news/speech/spch120604rjc.htm.
"Large company seeks credit to shield suppliers". Valor Econômico Newspaper. 12.01.2016.

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, evasion of usual "covenants" occurs, for example: EBITDA/Debt; EBITDA/Interest; Debt/Equity.

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

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 controller, holding company or subholding, of an operating company alienates to an exclusive closed 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 4.

Additionally, the FIP and the holding company or subholding 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) 5. 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 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, say 5 years, after which it will place said batch on the market. If the sale of the equity participation to the market takes place 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 company or subholding (controller) must return the difference to the FIP. On the other hand, if the sale to the market takes place above the updated cost of the held equity participation, the profit will be shared between the controller and the FIP 6.

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 the 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.

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 competence period the capital gain or loss with the alienation of the equity participation.

BS, IS and SCF cease to meet the condition of faithful representation.

2.3. Operations with FIDC
Regarding the structuring of FIDCs known to us, some managers (banks) would be offering companies certain products, which would result in the "derecognition" of their assets (receivables), without the recognition of the liability to which they would be subject 7.

The proposed scheme 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 so-called subordinated quotas, 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 FIDC's Equity (2% for example), while the mezzanine quota would represent a portion equivalent to the historical losses with default in the company's portfolio of receivables (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 receivables "alienated" 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" portfolio of receivables and would reap the economic benefits generated by it. Even

7 We are also aware 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 No. 10).

although the assignment of credit rights is made without co-obligation, without 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 portfolio of receivables well exceed 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, for 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 occur at a post-fixed rate (CDI plus various "spreads" for each category of quota), remuneration that would return to the assignor (holder of junior subordinated quota, regardless of the name to be used), in case default does not occur.

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 reap the economic benefits generated by it. The guidance given regarding this by CPC No. 48 (IFRS No. 9) must be observed in its entirety. There should be no, therefore, the "derecognition" of the asset (receivables) by the assigning company and there must be the recognition of the liability, for the resources raised with the FIDC.

Objectively, for a sale of receivables to be definitive, the administrators of the companies must verify if the "derecognition" criteria provided for in CPC No. 48 (IFRS No. 9) are being met. Moreover, when a structured vehicle is used, it is up to the administrators of the company to judge whether there is a need to consolidate this vehicle entity.

INDEX

3. "Impairment" Tests – CPC No. 01 (R1)
   The "impairment" theme continues to be a concern for the CVM's technical areas regarding its financial reporting. In a survey published on its website involving 546 open companies 8, Ibracon revealed that 29% of Open Companies presented "impairment" as one of the main Audit Issues (PAAs) identified in the fiscal year ended December 31, 2017, representing one of the 3 most frequent items. It is important to highlight the need to proceed with impairment tests

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

"impairment" for tangible and intangible assets, especially "goodwill" and, where applicable, recognizing impairment losses promptly. After all, acquisitions of equity interests carried out five past fiscal years ago, for example, indicative of future profits above expected, may not present the same foundations in the current period.

Companies must proceed to evaluate whether there is any indication that an asset may have suffered impairment, in light of external and internal sources of indications contained in item 12 of CPC 01 (R1).

Additionally, companies must consider the reasonableness of the premises used, considering the provisions contained in item 33 of said pronouncement.

We draw attention to the need for documentation of the test and for the consistency of the premises, parameters, and sources of information used, preferably through their detailed description in the companies' accounting policy manuals.

It is in this particular that the issue of "disclosure" gains relevance. Adequate disclosure must be provided in explanatory notes attached to the financial statements. CPC n. 01 (R1), in its items 126-136, 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 from future profitability expectations or an intangible asset with an indefinite useful life, whose book value is significant compared to the total book value of the goodwill or the intangible asset with an indefinite useful life recognized by the company. For this specific situation of estimates, CPC n. 01, in its item 134, requires, among others, that the following be considered in the list of information to be provided:

(i) each key premise 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 of disposal 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 premises are based, indicating whether the information contained in the explanatory notes is being presented in nominal or real terms;

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

(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 the cash flow projections; and

(vi) whether a possible and reasonable change in a key premise on which management has based its determination of the RA of the CGU could result in a book value higher than its RA:

• the amount by which the RA of the CGU exceeds its book value;

• the value on which the key premise is based; and

• the new value on which the key premise 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 n. 01, mainly with regard to the reasonableness and justification 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 n. 01.

INDEX

4. Disclosures - Explanatory Notes

Technical Guidance OCPC n. 07 - Disclosure in the Reporting of General Purpose Financial Reports, approved by CVM Resolution n. 727/14, proved to be pioneering with regard 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 accounting statements and their respective explanatory notes, relevant information (and only that information) that actually assists users is disclosed, considering the existing regulations, without the minimum requirements existing in each Accounting Pronouncement issued by this CPC failing to be met".

It is also worth highlighting what is provided in its item 4, where it is highlighted that OCPC n. 07 consolidates the requirements contained in documents issued by the CPC and 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, more specifically, those described in Law n. 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 n. 26, in which the prevalence of the legal requirement is determined, added to 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 accounting statements established in the Conceptual Framework for Preparation and Disclosure of Financial Reports,

but the current regulatory structure prohibits the non-application of the requirement, the entity must, to the greatest extent possible, reduce the identified inadequate aspects in the 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 accounting statements so misleading and would conflict with the objective of the accounting statements established in the Conceptual Framework for Preparation and Disclosure of Financial Reports; and

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

4.1. Application of item 38 of OCPC n. 07

The positive effects of the application of Guidance CPC n. 07 - Disclosure in the Reporting of General Purpose Financial Reports, approved by CVM Resolution n. 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 said guidance:

"38. The entity's management must, in the declaration of conformity note, affirm that all relevant information specific to the accounting statements, and only that information, is being disclosed, and that it corresponds to that used by it in its management." (we underline)

Thus, it is relevant to remember this obligation for the management of the publicly held company to sign a declaration of conformity, in accordance with item 38 of OCPC n. 07, reproduced above.

4.2. Elucidative vs. Non-Elucidative Explanatory Notes

The theme of disclosure in explanatory notes is recurrent 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 the 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 that arises is: What is the ideal cut-off 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 repercussion in the financial statements of the company reporting the information is rendering a disservice. Information to be provided in an explanatory note, as a rule, must be relevant, elucidative, and complementary (not substitutive) to the financial statements prepared.

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 be able 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, the preparers of the financial statements incur a higher cost, as they now have to justify their choices to their independent auditors and potentially to the capital markets regulator. It is the cost incurred when exercising judgment and applying materiality criteria for "disclosure" requirements9.

It is worth emphasizing 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 it deems appropriate. Thus, if the company wants to provide more information, without prejudice to the minimum quantitative and qualitative disclosures, it is not up to the auditor to modify its opinion as a result of this fact.

We highlight the need for the Company to review its explanatory notes, especially in the "main accounting practices" section, so as not to transcribe excerpts of standards and dedicate this section to the description of specific practices adopted by the Company.

4.3. Sources of Uncertainty

CPC n. 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 have a significant risk of causing a material adjustment to the book values of assets and liabilities over the next

9 A good accounting policy can help reduce costs in this regard, by parameterizing some measures and defining "ex-ante" the procedures to be followed in the disclosure process for financial reporting purposes. Ideally, the accounting policy should also be submitted to the scrutiny of independent auditors in the planning phase of their work and filed with the Regulator via Reference Form - FR (endowing it with wide publicity).

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 n. 26, the following guidance is given:

"129. The disclosures described in item 125 must be presented in a way to help users of the accounting statements understand the judgments that management has made regarding the future and about other main sources of uncertainty of the 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 the estimates;

(b) the sensitivity of the book 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 book 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."

(underlines ours)

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 dismantling of long-maturing 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 already mentioned Ibracon survey indicated the theme "contingencies" as a PAA present in 29% of Companies in 2017 and representing one of the 3 items with the highest frequency observed. Regarding this theme, the technical areas of the CVM draw attention to the examination of facts and circumstances that may indicate the need for the timely establishment of a provision, instead of disclosing a contingent liability in an explanatory note.

4.4. Judgment of the Company's Management – "going concern"

CPC n. 26 in its items 25-26 emphasizes that the entity's financial statements must be prepared on the assumption of its continuity. When management is 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 12% of Companies in 2017.

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 financial statements audited as a whole. It is worth emphasizing that auditors must observe NBC TA 570 – Operational Continuity.

INDEX

5. Financial Instruments

5.1. Application of the Concept of "Economic Compulsion"

It has been observed, among some agents, the understanding, in a very tight synthesis, that economic compulsion should not be taken into consideration for the purpose of classifying financial liabilities (distinction between liability 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 the discussions carried out by the interpretative committee (which is good to note, 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) must be considered, through the conditions and terms of the financial instrument. 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 n. 32 requires an evaluation of the economic substance of the contractual arrangement.

IAS n. 32 (RedBook, "consolidated with full early application", 2017), in its §20, deals with economic compulsion in the qualification of a Financial Liability, by defining direct and indirect obligations in contractual terms and conditions. In the "Basis for Conclusions" section, §BC9, the IASB Board untangles the controversy arising from the mentioned provision. In general lines, the IASB Board manifests itself in the sense that a financial instrument can establish an obligation indirectly through its terms and conditions ("Implicit obligations", §20).

It does not seem economically sensible that obligations are 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 run risks without a premium in return? It does not seem to make much sense, within an economic rationality.

As already emphasized in previous Circular Letters, the technical areas of the CVM have great concern with this issue, the distinction between an item of liability and equity, especially considering the creativity, quality, and sophistication of new financial products, whether they are classified as Composite Financial Instruments 10 or not. What cannot be admitted is that issuers practice the so-called "capital structure management", a procedure inadmissible in the view of the technical areas of the CVM, given its legal mandate.

It is worth emphasizing that the IASB published in June 2018 a Discussion Paper on "Financial Instruments with Characteristics of Equity – FICE" – DP/2018/1, with a deadline for receiving comments until 07.01.2019. The CVM's Superintendency of Accounting Standards and Auditing forwarded its suggestions and criticisms regarding the document in a timely manner.

Such documents may be consulted publicly on the IASB website.

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

With the entry into force, 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 model of CPC n. 38 and the model of CPC n. 48 11.

Finally, the "hedge accounting" model becomes yet another accounting choice of 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 39), in terms of designation of hedge relationships, eligible objects for the hedge, and effectiveness tests. By way of illustration, the table below identifies some differences between the two models:

10 A composite instrument is a non-derivative instrument that contains elements of liability and equity. IAS32, §§ 28-32, AG30- AG35.

11 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. (we underline)

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). (we underline)

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. (we underline)

IAS 39 IFRS 9
Prospective and retrospective hedge effectiveness (“threshold” 80%-125%) Prospective hedge effectiveness: “forward-looking model” (§§ B.6.4.12, §§BCE198-BCE199) Non-derivative IF as a hedging instrument only for foreign currency risk factor Non-derivative IF as a hedging instrument for other risk factors, if it is measured at FVTPL (§§BCE189-BCE190) Maturity differences allowed between hedging IF and hedged item, when the IF maturity is shorter (hedging IF “rollover” policy allowed). However, IF maturity longer than the hedged item is prohibited. No mention, s.m.j., of maturity differences. Adjustments to hedge relationships are prohibited, after designation, with the exception of “rollover” policy. Adjustments to hedge relationships are permitted, after designation, without being considered “discontinuation” of the original hedge relationship (§§BCE200-BCE201) Prohibition of designating net positions as hedged items Permissibility of designating net positions as hedged items (it is not macro-hedge) Applicable to fair value hedge for macro hedge of static interest rate portfolio Not applicable to fair value hedge for macro hedge of static interest rate portfolio. In this case, use IAS 39 “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. The technical areas of CVM warn that the eventual change in “hedge accounting” policy (migration from IAS 39 to IFRS 9) to be made by the company’s management must be justified in an explanatory 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 38, item 88a and CPC 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 of 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 position or transaction being hedged, the nature of the risk being 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)

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

“6.4.1. The hedging relationship qualifies for hedge accounting only if all of the following criteria are met:
(...)
(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)

Given that it is a high-risk area, whether for “earnings management” practices or for tax planning purposes, independent auditors must dedicate special attention to the subject, verifying whether the company’s “hedge accounting” accounting policy faithfully reflects 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 regulatory 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 48/IFRS 9
With the entry into force, starting from the fiscal year beginning on January 1, 2018, of CPC 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 adopted.

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 a “smoothing” of results. 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 in an “ad hoc” manner. 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 48.

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

Expected credit loss model:
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 no. 12 of the standard.
Simplified Approach – “Lifetime expected credit loss”:
commercial receivables or contractual assets, within the scope of IFRS no. 15 and lease receivables, within the scope of IAS no. 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 no. 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 better quality information is to be produced, when the non-financial institution presents a portfolio of commercial receivables, within the scope of CPC 47/IFRS 15, that contains a significant financing component. As CPC 48 well points out, in its item 5.5.15, letter “a” “ii”, the choice of the 3-stage model or the “aging list” model becomes an accounting choice of the company’s management.

A sector that may 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 47/IFRS 15, with a significant financing component.

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6. Revenue Recognition by Real Estate Development Companies:
   IFRS 15
   Regarding this, reading Circular Letter CVM SNC/SEP no. 02/2018, of 12.12.2018, is recommended.
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7. Business Combinations
   7.1. Business Combinations when there is a remaining participation of non-controlling shareholders, with simultaneous issuances of put options and call options on these shares 13
   Recently, acquisition operations of entities have been observed, structured as follows:

• acquisition of a percentage of shares sufficient to obtain control;
• simultaneous issuances 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 an adjusted EBITDA multiple.

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 32, regarding the counterpart to be recognized for the liability 14, a scenario in which Management must select an accounting policy that results in relevant and faithfully represented accounting information (CPC 23, item 10).

For the selection and application of accounting policies, CPC 23 (items 11 and 12) provides for the following hierarchy: 1) approved CPC documents that deal with similar subjects; 2) criteria and concepts contained in the Conceptual Framework; 3) other sources, for example, standards issued by other regulatory bodies, as long as they do not conflict 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:

13 In international literature, the expression “NCI put” (Non-controlling interests put options) is commonly used, although usually both put options and call options are issued.
14 CPC 39 (IAS 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”.

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 individual and consolidated statements (assets, liabilities, equity) faithfully represent the economic substance of the transaction; and iii) the use of goodwill/premium account in capital transactions, in the exercises of the options, instead of the Revaluation Reserve account, as provided in item 69 of ICPC 09.

It is worth remembering that if the company’s management decides to make changes in an accounting policy, it must observe what is prescribed in item 14 of CPC 23, reproduced below:

“14. An entity shall change an accounting policy only if the change:
(a) is required by a Standard, 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 on the entity’s financial position and financial performance, or cash flows.” (emphasis added)

Finally, it is worth highlighting, as already pointed out in this circular, that the IASB published in June 2018 a Discussion Paper on “Financial Instruments with Characteristics of Equity – FICE” – DP/2018/1, with a deadline for receiving comments ending on 07.01.2019. The CVM’s Superintendence of Accounting Standards and Auditing sent its suggestions and criticisms about the document in a timely manner, which can be consulted publicly on the IASB website. With the conclusion of this project, the expectation is that there will be a regulatory 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 operations, given the complexity involved and sometimes the scarcity of available information, contemplates, as provided in CPC 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 15 is reproduced below, in its item 45.

“When the initial accounting for a business combination is incomplete at the end of the reporting period in which the combination occurs, 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 values recognized. 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 more information cannot be obtained. However, the measurement period cannot exceed one year from the acquisition date.” (emphasis added)

Regarding the measurement period, CPC 15, in item B67, “a”, requires that the following information be disclosed in the explanatory notes, when the accounting of the business combination is incomplete:

“When the initial accounting for 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 for 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.”

7.3. CVM Instruction 319/99 x ICPC 09
Some market agents have consulted the technical areas of CVM to know how to proceed regarding the accounting treatment to be adopted for reverse mergers, given the command of ICPC 09, in its item 77, after the second revision it was submitted to.

It is important to point out 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 must be treated (which is why items 44 to 47 were suppressed), the existing regulation by the entity’s regulatory body must be applied.” (emphasis added)

In Brazil, the theme of business combinations between entities under common control has always had much of its economic motivation supported by tax planning. Corporate reorganizations that aim, at times, exclusively to reduce the tax burden of companies, through the opportunity for tax avoidance offered by tax legislation.

An operation widely practiced 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 15, 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 practicing an operation without favors, validating the goodwill.

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 open companies, with the aim of 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 319/99, modified by CVM Instruction 349/01.

Thus was also the prohibition of capitalizing the special reserve of goodwill without the corresponding amortization of the goodwill that gave rise to it.

By reviewing the Technical Pronouncement CPC 15, mirrored in IFRS 3, which deals with business combinations, it is found that the theme of business combinations between entities under common control is outside its scope (CPC 15, item 2c and items B1-B4). Nor has the IASB regulated, up to now, the way in which such operations must 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 CVM, with the understanding supported by the principle of “substance over form” (CVM Orientation Opinion 37/2011), and supported by the orientations given by CPC 36 regarding change of control and in CPC 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 15. For the technical areas of CVM, it is appropriate to apply the method of

15 These operations found support in tax law, Law 10.637/02, art. 36, a provision already revoked by Law 11.196/05.
RFB Audits of these operations reached administrative courts – CARF (http://carf.fazenda.gov.br/sincon/public/pages/index.jsf), questioning the fiscal deductibility of internal goodwill (regarding this, 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).

“Predecessor Cost Basis”16 when a business combination between entities under common control is at stake.

Regarding the provisions of CVM Instruction 319/99 aimed at the accounting treatment of reverse mergers, these remain fully in force and must be applied when the concrete 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 pertinence and opportunity of applying said provisions of the standard.

However, in cases where there is no interposition of a “vehicle” company, and the original investor is merged, 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 349/01 may be unnecessary or even improper.

It is worth noting that the above-mentioned exception 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 349/01.

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8. Change in Accounting Policies
The Technical Pronouncement CPC 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 the understanding of 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.

Regarding this, CPC 23, in its item 14, states as follows regarding the change in accounting policies:

“14. An entity shall change an accounting policy only if the change:
(a) is required by a Standard, Interpretation or Orientation; or

16 This method consists of considering as the measurement basis for the assets and liabilities of the acquired business the existing accounting values.
It therefore considers the acquisition cost recorded in the last change of control.
17 It is important to highlight the structural break of a time series of accounting variables (periods in which practices changed; that errors were corrected), so that inferences regarding trends are not compromised, avoiding that decisions are mistakenly taken.

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(b) result in reliable and more relevant information in the financial statements regarding the effects of transactions, other events, or conditions concerning the entity's financial position, performance, or cash flows.”

It is imperative to state that the fact that pronouncements issued by the CPC (Accounting Pronouncements Committee) sometimes allow the adoption of more than one different accounting policy does not imply that the company’s administration has the prerogative to migrate from one policy to another, at the whim of changing economic circumstances, opportunistically to serve specific interests. This is the case, for example, with investment properties.

CPC No. 28, in its item 31, states as follows:

“The Technical Pronouncement CPC 23 – Accounting Policies, Changes in Accounting Estimates and Errors states that a voluntary change in accounting policy should be made only if the change results in a more appropriate presentation of the entity’s operations, other events, or conditions in the 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.” (our emphasis)

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9. Deferred IRPJ and CSLL

The topic “Deferred IRPJ and CSLL” is always sensitive for the CVM’s technical areas for financial reporting purposes. Both its recognition and adequate disclosure deserve special attention from preparers of financial statements and independent auditors. Not by chance, it is recurrently on the radar of the CVM’s technical areas’ monitoring.

Regarding this topic, the Ibracon research indicated “Realization of Deferred Income Tax” as a PAA (Priority Accounting Area) present in 18% of Companies in 2017, being the 5th item with the highest observed frequency.

It is important to highlight that CVM Instruction No. 371/02 is fully in force and fully convergent with CPC No. 32, regarding 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, the practical effect of which lies precisely in specifying that the analysis of the probability of generating future taxable profit, provided for in item 36 of CPC No. 32, is limited to the maximum 10-year horizon 18 allowed by CVM Instruction No. 371/02.

In fact, instead of a conflict between the regulations, there is greater rigor in CVM Instruction No. 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 late to reiterate that for “disclosure” purposes, CVM Instruction No. 371/2002, of 27.06.2002, requires that the following information be disclosed in the explanatory notes, without prejudice to the disclosures required by CPC No. 32:

I - estimate of the portions of realization of the deferred tax asset, broken down 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 10 (ten) year realization period referred to in item II of art. 2;

II - effects resulting from any change in the expectation of realization of the deferred tax asset and respective grounds, as provided in art. 4; and

III - in the case of newly constituted companies, or in the process of operational restructuring or corporate reorganization, a description of the administrative actions that will contribute to the future realization of the deferred tax asset.

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10. Cash Equivalents - LFTs (Treasury Notes)

The CVM’s technical areas have become aware of disparate treatment given to LFTs (Treasury Notes), classified by some companies as cash equivalents and by others not. Initially, there would be a conflict with what CPC No. 3 (IAS No. 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:

1. Is the market for public bonds in Brazil indeed organized? In short, does it present liquidity (primary and secondary markets active, 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, in a manner that allows the exit of a holder at any time without substantial loss of market value?

2. The classification of a bond as a cash equivalent, in accordance with CPC No. 3 (IAS No. 7), must meet two conditions: maturity term and immediate convertibility into cash, without substantial loss of market value. Should the provision of CPC No. 3 (IAS No. 7) be applied by its literal interpretation? And what if the bond is considered in the list of assets managed via the institution’s treasury activity?

In this sense, considering the first question, we carried out a study to understand the dynamics of the market for public bonds in Brazil. We also collected evidence regarding transactions performed, protocols established, and other rules delineated, in order to verify if they are indeed consistently observed in practice, without structural breaks in time series. This study is contained in Circular Letter CVM/SNC/SEP No. 01/2018.

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

Answering the 1st question, there is no contrary evidence that allows us to conclude differently regarding the fact that the market for public bonds in Brazil is organized, presents liquidity, with transparency of business practices and predictability of auctions carried out by the STN (National Treasury), has an active secondary market, allowing the exit of a holder of these bonds at any time, without substantial loss of market value.

Moving to the 2nd question, we reproduce below an excerpt from CPC No. 3 (IAS No. 7), in its items 6 and 7:

“6. Cash equivalents are short-term, highly liquid investments that are readily convertible to known amounts of cash and which 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 4 CPC_03(R2) qualify 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, for example, redeemable preferred shares that have a defined redemption period and whose term meets the definition of short-term.”

(our emphasis)

This is a matter for the judgment of preparers of financial statements, in the understanding of the CVM’s technical areas, aiming to produce 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 bond whose maturity term exceeds 3 months does not qualify for classification as a cash equivalent.

It seems to us that considering the administration’s intention in managing these bonds 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” performs this treasury management directly, issuing buy and sell orders in the market. Company “B” performs this management indirectly, through a retail fixed-income fund, whose portfolio is managed by a third party, composed predominantly of LFTs, and whose shares have no lock-up period, as defined in the regulations.

Under the literal interpretation of the rule, Company “A” could not classify its LFTs as cash equivalents, even though it performs active treasury management with them. Company “B” would be fully entitled to classify 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 companies have to incur transaction costs (creation of a fund) to account faithfully for their treasury activity?

For the CVM’s technical areas, the critical aspect to be considered is any inconsistency regarding the accounting classification of LFTs for accounting recognition purposes - IFRS 9 (CPC No. 48), namely, classified as subsequently measured at amortized cost (CPC No. 48, §4.1.2) x classified as subsequently measured at fair value through other comprehensive income (CPC No. 48, §4.1.2A) or through profit or loss (CPC No. 48, §4.1.4), vis-à-vis its measurement method given its classification as a cash equivalent.

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11. Some Aspects of Leasing Contracts – IFRS No. 16

The entry into force on 01.01.2019 of the new pronouncement dealing with the recognition, measurement, presentation, and disclosure of leasing contracts will impose many implementation challenges, both for the administrators of open companies and for their independent auditors.

In this sense, the CVM’s technical areas understand it is imperative to elucidate some aspects of the standard that may not be very clear. Reading the standard, its implementation guide, its transition guide, its illustrative examples, and, no less important, the section containing the Basis for Conclusions of IFRS 16, the latter not incorporated by the Accounting Pronouncements Committee into the body of the standard, is fundamental for the adequate application of the pronouncement.

A first aspect, which in the view of the CVM’s technical areas should be emphasized, concerns the scope of the standard. It covers any and all contracts that fit the identification provided in §9, namely, a contract is a lease (sub-lease), or contains a lease (sub-lease), if it transfers the right of control of the use of an identified asset, for a term (“lease-term”), in exchange for a consideration. This classification is independent of the legal form given to the contract, or the nomenclature attributed to the operation, whether qualified as leasing, rental, or lease, for example.

And to assess whether a contract transfers the right of control of the use of an identified asset, for a term (“lease-term”), the company’s administration, in accordance with §B9 of the pronouncement, must assess whether, throughout the usage period, the customer jointly holds the following rights: (i) the right to obtain substantially all economic benefits arising from the use of the identified asset and (ii) the right to direct the use of the identified asset.

It is important that the administrators of open companies and their auditors devote special attention to reading §§B9-B31, during the contract evaluation process. Said paragraphs deal, among other aspects, with substantive substitution rights by the provider of the leased asset (which disqualifies the right to use an identified asset), portions/parts with usage capacity of assets that may qualify as an identified asset, rights to obtain economic benefits arising from use, and rights to direct use.

Regarding its scope, the standard does not cover right-of-use assets in a lease or sub-lease, when intended to explore mineral resources, oil and gas, and similar non-regenerative resources; biological assets treated in IAS 41; concession services treated in IFRIC 12; licenses for the use of intellectual property treated in IFRS 15, and licensing agreements covering intangibles treated in IAS 38, generally linked to the film and artistic industries. On the other hand, right-of-use assets of companies belonging to these industries, which do not fit the exception rule, such as, for example, a rented or leased building housing the company’s administration, must be subject to the treatment provided by the pronouncement.

The exception rules for applying the pronouncement to eligible contracts comprise, for recognition purposes: (i) short-term leasing contracts (“duration” of the contract less than or equal to 12 months), not thus considering contracts with a purchase option 19 and (ii) low-value leasing contracts, when the underlying asset is new, with an indicative limit of US$5,000 set by the pronouncement, which guided the decisions reached by the Board in terms of magnitude in 2015 (information extracted from the “Basis for Conclusions” section of the standard, in its §BC100). For recognition and measurement purposes, materiality judgment must always be applied (information extracted from the “Basis for Conclusions” section of the standard, in its §§BC84-BC86), observing the guidelines of the Conceptual Framework and IAS 1 20.

Regarding the contract term (its “duration”), and consequently its measurement (considerations provided for in the optional period), it must contemplate the non-cancellable period, understood as that in which both parties to the contract can require its fulfillment coercively (“the period for which the contract is enforceable”), plus the optional period, understood as that in which options to extend or terminate the contract may be, respectively, exercised or not exercised, based on the assumption that the lessee has reasonable certainty of exercising or not exercising these options.

In judging this reasonable certainty of exercising or not exercising these options, the company’s administration and its independent auditors must consider all relevant facts and circumstances that create economic incentives (treated more appropriately in §§B34-B41 of the standard’s implementation guide) for exercising or not exercising these options. The company’s administration and its independent auditors, in judging this issue, must refer to the non-exhaustive examples of the pronouncement enumerated in §B37 of the implementation guide.

19 In Appendix A of IFRS 16, in the concept of short-term lease, the pronouncement categorically excludes contracts with a purchase option. “a lease that contains a purchase option is not a short-term lease.”

20 “...if a lessee’s leasing activities are material to its financial statements, but the effect of measuring lease liabilities on a discounted basis is not material, the lessee would not be required to measure lease liabilities on a discounted basis and could instead, for example, measure them on an undiscounted basis.”

The company’s administration must re-evaluate its judgment regarding the “duration” of the contract, whenever a significant event or a significant change in circumstances occurs that (i) is within the lessee’s control and (ii) affects the judgment of its reasonable certainty of exercising an option not previously included in the determination of the lease term (and its measurement) or of not exercising an option previously included. As highlighted in the Basis for Conclusions of the standard, in its §BC185, to reach a good conclusion in this evaluation, the IASB Board understands that there must be an appropriate balance of the two conditions referred to. Independent auditors must pay attention to this.

Other issues, which in the view of the CVM’s technical areas deserve elucidation, reside in the initial measurement of the right-of-use asset and the lease liability and their subsequent measurements.

Thus, the initial cost of the right-of-use asset must include, on the commencement date 21:

(i) the amount obtained from the initial measurement of the lease liability;

(ii) plus any lease payment made before or on the commencement date (“commencement date”);

(iii) reduced by any lease incentives received;

(iv) plus any initial direct costs (incremental costs obtained with the leasing, without which they would never have been incurred) and

(v) plus estimated costs of dismantling and removing the underlying asset to the contract and restoring the conditions of the location where it was used or restoring the conditions of the underlying asset, required by the terms and conditions of the contract, unless such costs are incurred to produce inventories (§24 of the standard).

As for the initial measurement of the lease liability, on the commencement date (“commencement date”), the payments provided for in the contract, not settled on that date, must be discounted to present value by the implicit interest rate, if this is readily determinable, or in the case of its impossibility, by the lessee’s incremental borrowing rate on that date. The following are included in these payments:

(i) fixed lease payments provided for in the contract (including those supposedly variable, which in substance are fixed, according to the implementation guide’s guidance, in its §B42);

21 Here it is worth highlighting the difference between the initial date of the contract (“inception of a lease”) and the initial measurement and recognition date (“commencement of lease”), clarified in the “Basis for Conclusions” section of the standard, in its §§BC141-BC144. The initial measurement and recognition date (“commencement of lease”) is the date from which the underlying assets become available to the lessee for use (control is only obtained at this moment). In a very tight summary, if the measurement and recognition moment occurred on the initial contract date (“inception of a lease”), and there were changes in lease terms and conditions between that date and the date when the assets are made available to the lessee (“commencement of lease”), gains and losses would be originated by the initial recognition of the contracts, something that should not occur in the view of the Board members of the IASB.

(ii) variable lease payments, which depend on a rate or index;

(iii) expected amounts to be paid by the lessee for guaranteed residual values;

(iv) exercise prices of purchase options for the underlying assets (in the case of reasonable certainty of their exercise) and

(v) penalties for exercising the option to terminate the lease (if the lease term definition considers the exercise of this option by the lessee).

The subsequent measurement of the right-of-use asset considers three models, namely: the cost model (adopted in initial recognition); the fair value model, only for those assets qualified as investment property, in accordance with IAS 40; and the revaluation model, currently prohibited in Brazil. The cost model, for its subsequent measurement, must include the initial cost reduced by accumulated depreciation and “impairment” losses and adjustments arising from remeasurements of the lease liability capable of adjusting the right-of-use asset.

The subsequent measurement of the lease liability considers the increase in the liability balance to reflect incurred interest; the reduction of the liability balance to reflect payments made, and adjustments to the liability balance by remeasurement, to reflect any re-evaluation or modifications of the lease or to reflect payments in substance revised fixed.

After initial recognition and measurement, the lessee must recognize in the period’s profit or loss the interest incurred on the liability and the variable lease payments, not included in the measurement of the lease liability, in the period in which the events or conditions serving as triggers for such payments occur 22.

The remeasurement of the lease liability must be carried out with the right-of-use asset as the counterpart, unless its amount has been reduced to zero, and the additional adjustment implies a reduction, in which case the counterpart of the remeasurement will pass through the Income Statement. The remeasurement of the lease liability may occur with the review of the discount rate used or with its maintenance.

When a change in the lease term occurs, resulting from a required re-evaluation, or there is a change in the assessment of the purchase option for the underlying asset, the remeasurement of the lease liability will also imply a review of the discount rate employed. And this will observe the same principle adopted for identifying the initial discount rate: first, the definition of the implicit rate for the remaining lease term, if

22 Variable lease payments of a contract may result from (i) price changes, due to changes in market rates and changes in the value of an index; (ii) the lessee’s performance with the underlying asset and (iii) the use of the underlying asset by the lessee. The variable payments of categories “ii” and “iii” are those included in this accounting treatment required, namely, with the counterpart in the demonstration of the period’s profit or loss. In this sense, the lease liability arising from future performance with the use of the underlying asset (such as a volume “X” of sales obtained in a rented property) or arising from the use of the underlying asset beyond the limit fixed contractually (such as, for example, a mileage limit, fixed contractually, for leased vehicles) will have as a counterpart an expense in the Income Statement. The section of the standard “Basis for Conclusions”, in its §§BC163-BC169, deals with the theme in greater detail.

This is promptly determinable, or, in the event of its impossibility, by the lessee's incremental borrowing rate at the date of remeasurement.

On the other hand, when there is a change in the expected amounts of guaranteed residual values of the underlying assets, or when there is a change in variable lease payments that depend on a rate or index, the remeasurement of the lease liability will not imply a review of the discount rate used, adopting the same initial discount rate in the remeasurement, unless the change in variable payments results from a change in floating interest rates 23.

Regarding the change in variable lease payments that depend on a rate or index, it is worth highlighting that variations in exchange rates, in the case of lease liabilities in foreign currency, are not subject to adjustment in the right-of-use asset.

Although the change in the exchange rate can be considered a form of variable lease payment, similar to those that depend on an index or rate, the IASB Board deemed it appropriate not to give specific treatment in IFRS 16.

The IASB Board's decision was to elect IAS 21 to provide the appropriate accounting treatment for the lease liability in foreign currency. And in this case, since the lease liability in foreign currency is a monetary item, the counterpart of its subsequent measurement must pass through the Income Statement. Further clarification regarding this can be obtained in the Basis for Conclusions section of the standard, in its §§ BC 196-199.

Finally, for the modifications adopted in lease contracts, which result simultaneously (i) in an increase in the scope of the contract, through the inclusion of rights of use for one or more underlying assets, and (ii) in an increase in the contract consideration, proportionally or in an amount compatible with individual prices resulting from the increase in contractual scope, and reflect any appropriate adjustments to the peculiar circumstances of the contract, the lessee must treat these modifications as a separate lease 24.

INDEX

12. ICMS in the calculation base for PIS and COFINS

A topic that gained importance in 2018, especially after decisions issued by lower courts, in line with a statement by the Federal Supreme Court – STF – published in 2017 25, which considered it unconstitutional to include ICMS in the calculation base for PIS and COFINS contributions, concerns the accounting treatment to be adopted for the recognition of the effects of these decisions by open companies.

As reported by the specialized press, since the STF decided in 2017 on the unconstitutionality of ICMS in the calculation base for PIS and COFINS contributions, "several courts began to apply the decision, including panels of the Superior Court of Justice (STJ)" 26.

Notwithstanding the understanding of the Attorney General's Office of the National Treasury – PGFN, which alleges that the courts must wait for the analysis of an appeal – declaration of embargoes – already presented to the STF, for clarifications regarding the STF decision and to establish the modulation of the effects of this decision (from when it should be applied and in what manner), processes related to the topic have advanced and even become final. This was observed with the case of a process that became final in the Federal Regional Court of the 3rd region (SP and MS), according to the full text of the ruling published on 09.05.2018 27, although the PGFN may still file a rescissory action to reverse the decision, depending on the STF's modulation.

In a monocratic decision 28, issued on 09.08.2018, STF Minister Celso de Melo denied follow-up to Complaint 30996, filed by the Union against another ruling of the Federal Regional Court of the 3rd region 29. In the complaint, the Union asked that the process be suspended until a final decision by the STF in Extraordinary Appeal - RE n. 574.706, that is, until the modulation of the effects of this decision. According to Minister Celso de Melo, the STF's jurisprudence is that, for the application of a decision issued in RE with general repercussion, it is not necessary for the process to become final or for any modulation of effects.

There are also situations where taxpayers reversed unfavorable judicial decisions and obtained the right to exclude ICMS from the calculation base for PIS and COFINS contributions.

As reported by the specialized press 30, three of the five TRFs (2nd, 3rd, and 4th Regions) have already admitted rescissory actions, filed by taxpayers, to annul decisions that had become final.

The technical areas of the CVM understand that the accounting treatment to be granted to the matter must be evaluated by administrators of open companies and their independent auditors in light of what IAS 37 prescribes. Contingent assets, as a general principle, are never recognized, in accordance with §31 of IAS 37, being only disclosed in the notes to the financial statements, when it is probable that economic benefits will enter, in accordance with §34 of IAS 37. Recognized provisions may be fully or partially reversed, provided that what is prescribed in §59 of IAS 37 is observed. And provisions must be recognized when the conditions of §§14-26 of IAS 37 are present.

Thus, a good judgment of value must be carried out on a case-by-case basis. There are cases of processes that have become final in lower courts, but for which the PGFN still has the right to file rescissory actions to reverse the decisions (a right subject to a statute of limitations), depending on the STF's modulation. There are also cases that are still proceeding in the courts. There are also cases with previously unfavorable decisions to taxpayers that were reversed. There are cases with decisions favorable to taxpayers who obtained the right to tax compensation for improperly collected values 31, and there are cases with decisions favorable to taxpayers, but who did not obtain the right to tax compensation 32.

In the view of the CVM's technical areas, it is indispensable to have good disclosure in the notes regarding the decisions taken by the company's administration, as well as the bases on which they are based, and the effects of these decisions on the balance sheet, the income statement, and the cash flow statement. Independent auditors must exercise all skepticism inherent in the exercise of the function in judging the decisions taken by the company's administration and their effects on the financial statements, stating so when appropriate in their report.

The concern of the CVM's technical areas is regarding the risk of "misleading," the consequences of which are extremely harmful to investors in the Brazilian capital market and require the action of the Regulatory Body.

Finally, we remind you that independent auditors must be attentive to all aspects treated here, as well as others, stating so in their reports issued regarding deviations that, in their judgment, cause relevant distortion in the audited financial statements as a whole.

INDEX

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

https://www2.trf4.jus.br/trf4/processos/visualizar_documento_gedpro.php?local=trf4&documento=9453204&hash=73b1ac9f538e299e60b6175599f7a89c

32 http://web.trf3.jus.br/acordaos/Acordao/BuscarDocumentoGedpro/7008039

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23 In the section on "Basis for Conclusions" of the standard, in its §BC195, the reasons why the IASB Board decided to review the discount rate for remeasurement of the lease liability, when there is a change in variable lease payments, resulting from changes in floating interest rates, are set out. The chosen approach sought consistency with the accounting treatment required by IFRS 9 in the measurement of financial liabilities with floating interest rates, subsequently measured at amortized cost.

24 For modifications not qualified as a separate lease, the accounting treatment to be observed is provided in §§45-46 of IFRS 16. In the Basis for Conclusions section of the standard, in its §§ BC200-205, the IASB Board explains the reasons why it decided to proceed in this manner regarding modifications to a lease contract. Although the previous standard IAS 17 did not address the issue, with IFRS 16 the Board understood that the adoption of specific treatment ("a general framework for accounting for lease modifications") would be useful, especially because these modifications are frequent for many types of contracts.

25 In an extraordinary appeal dealing with the matter, Extraordinary Appeal n. 574.706, with general repercussion recognized, reported by Minister Cármen Lúcia, the STF ministers decided, on 15.03.2017, by 6 votes to 4, to exclude ICMS from the calculation base for the PIS and COFINS contribution. The full text of the ruling was published on 02.10.2017 (http://www.stf.jus.br/portal/processo/verProcessoPeca.asp?id=312859807&tipoApp=.pdf)

26 Jornal Valor Econômico of 31.07.2018.

27 http://web.trf3.jus.br/acordaos/Acordao/BuscarDocumentoGedpro/6809338

28 http://www.stf.jus.br/arquivo/cms/noticiaNoticiaStf/anexo/rcl30996.pdf

29 http://web.trf3.jus.br/acordaos/Acordao/BuscarDocumentoGedpro/6809512

30 Jornal Valor Econômico of 17.12.2018.