EXPLANATORY NOTE TO CVM INSTRUCTION NO. 59/86.

Ref.: CVM INSTRUCTION NO. 59, of December 22, 1986, which provides for the mandatory preparation and publication of the statement of changes in equity by publicly held companies.

Law No. 6,404, of December 15, 1976, in its art. 186, establishes the main items of the statement of accumulated profits or losses and, in § 2 of the same article, allows for the inclusion of this statement in the statement of changes in equity, if it is prepared and published by the company.

Considering that the complete disclosure of the equity and results of the publicly held company is of fundamental importance for decisions to buy or sell securities, the Securities and Exchange Commission (CVM) opted to make the preparation and publication of the statement of accumulated profits or losses mandatory, starting from the fiscal year ending on December 31, 1986.

The Instruction suggests a model for presenting the statement of changes in equity containing a minimum of information that must be disclosed within specific groupings, according to their nature.

1. UPDATED REALIZED CAPITAL

This grouping, required solely for the purpose of demonstrating changes in equity, comprises the capital subscribed by shareholders, minus the portion not yet paid in, plus the non-capitalized portion of the monetary correction of the realized capital.

If the company has authorized capital, it must inform this fact in an explanatory note, with the specifications provided in articles 186 and 176, § 5, letter f of Law No. 6,404/76, insofar as applicable.

2. CAPITAL RESERVES

Capital reserves represent actual increases in the company's assets that were not originated from profits earned in its operations, as they do not represent the effects of its own efforts, but rather contributions from shareholders or third parties to the company's equity with the aim of providing resources for capital (in the broad sense), including government contributions in the form of subsidies for tax incentives.

§ 1 of article 182 of the Law enumerates the increases that are classified as capital reserve: premium on the subscription of shares, premiums on the issuance of debentures, proceeds from the alienation of beneficiary shares and subscription bonuses, donations, and subsidies for investment.

§ 2 of the article mentions that the result of the monetary correction of the realized capital will be recorded (and not classified) as "capital reserve" while it is not capitalized, that is, until it is formalized, through a statutory amendment voted on by shareholders in a general meeting, the update of the monetary expression of the capital.

This is the recognition that such portion is part of the capital, only not integrated into it due to the necessary legal formality. Therefore, in the statement of changes in equity, this portion will be part of the updated realized capital grouping.

Regarding donations and subsidies, some additional comments are necessary.

Donations received by the company may be in goods (real estate, furniture) or rights. The accounting of donated goods, with a capital reserve account as the counterpart, must be done at market value, i.e., the cost it would take to acquire the donated good.

Regarding subsidies received by the company, they can be classified into two different types: investment subsidies and operating subsidies.

Investment subsidies are registered accounting-wise as capital reserves.

They usually refer to values from which the company benefits by way of refund, exemption, or reduction of taxes due, or values received intended for the expansion of its activities, in the form of investments for fixed capital or working capital. This is the case, for example, of the refund of IPI or ICM and temporary exemption from income tax as a regional or sectoral incentive.

Operating subsidies consist of financial aid commonly received periodically by the company to cover its expenses, insufficiently covered by the revenues from its operations (tariffs). They are, accounting-wise, classified as extraordinary revenue. A typical example is the case of Brazilian railways.

3. REVALUATION RESERVES

The accounting record of asset revaluation must be done in accordance with the guidelines contained in the pronouncement approved by CVM Deliberation No. 27, of 05.02.86.

According to the concept contained in said Deliberation, "revaluation means the adoption of market value for the revalued assets, abandoning the principle of corrected cost".

Since asset revaluations can take place both in the controlling/investing company and in the controlled/invested companies, this grouping is divided into:

• revaluation reserve of own assets; and
• revaluation reserve of assets of affiliates/controlled companies.

The company must disclose, through explanatory notes to its financial statements, the various information about revaluations carried out on its assets and those of its controlled/affiliated companies, always paying attention to the principles emanating from CVM Deliberation No. 27.

Especially in cases of using such reserves to increase share capital or compensate accumulated losses, the company must observe the obligation to always inform, in explanatory notes to its financial statements, what the balance of this reserve would be if it had been written off exclusively due to the realization of the assets to which it refers.

It is worth noting that the hypothesis of using these reserves to compensate for accumulated losses is conditioned by the non-existence of profit reserves and capital reserves, in that order.

In revaluations carried out from the effective date of CVM Deliberation No. 27, the respective realized portions must be transferred to Accumulated Profits.

4. PROFIT RESERVES

These are reserves constituted from the allocation of the net profit of the fiscal year, by proposal of the company's management bodies to the shareholders' meeting.

The profit reserves legally provided for are:

• legal reserve;
• statutory reserves;
• contingency reserves;
• profit reserve to be realized; and
• retention of profits.

Legal Reserve - Its objective is to ensure the integrity of share capital and can only be used to compensate for losses or increase capital.

Statutory Reserves - These are reserves constituted according to the provisions contained in the company's bylaws. According to article 194 of Law No. 6,404/76, the company may create this type of reserve provided that, for one:

• it indicates, in a precise and complete manner, the purpose for which it was created;
• it fixes the criteria for determining the annual portion of net profit that will be allocated to the constitution of the reserve; and
• it establishes the maximum limit for the constitution of the reserve.

It should be noted that the annual portion of net profit to be allocated to the constitution of the reserve cannot prejudice the payment of the mandatory minimum dividend. Therefore, such portion is influenced by this legal limitation for its constitution, even though the "quantum" that would be due to it is provided for in the bylaws.

Such reserves are normally created to meet specific operational characteristics, and their creation is not admitted for purposes already met by other reserves and much less for provisions such as: occasional losses, doubtful debts, lawsuits, labor indemnities.

Contingency Reserves - They are constituted with the objective of compensating, in a future fiscal year, the decrease in profit resulting from a loss with a probability of occurring, being such loss capable of being monetarily measured (art. 195 of Law No. 6,404/76).

The occurrence of such loss may result, for the company, in a substantial reduction of its profit or even entry into a range of losses.

Prudently, the constitution of this reserve, prejudicing the distribution of the mandatory dividend, seeks to avoid a situation of financial imbalance, which would occur if dividends were distributed in a fiscal year, given the probability of reduction of profits or even the occurrence of losses in a future fiscal year, due to foreseeable extraordinary events.

Since it constitutes a postponement in the payment of dividends, the constitution of this reserve must obey § 1 of article 195 of Law No. 6,404/76, that is, the proposal made by the management bodies must indicate the cause of the loss and justify, with well-founded reasons of caution, the constitution of this reserve.

The use of this reserve is even recommended in the case of certain business branches, directly subject to natural or cyclical phenomena, such as: frosts, droughts, floods. This is also the case of companies that, for other defined reasons, operate with highly profitable periods, followed by periods with low profitability or even losses, as long as such situation is foreseeable.

It can also be constituted in cases of temporary (abnormal, extraordinary) suspension of production and, consequently, losses due to non-recurrent, non-repetitive paralysis, due to replacements or equipment repairs caused by damage, strikes, lack of raw material supplies, for relatively long periods.

However, there are cases where the applicable rule is the constitution of a contingency provision and not a contingency reserve.

With the aim of dissipating any doubts regarding the applicability of the constitution of reserves or contingency provisions, we set forth below the characteristics of each one. The main foundations for the constitution of the contingency reserve are:

• to cover potential or extraordinary (non-repetitive) losses not yet incurred, by segregating a portion of profits that would be distributed as dividends;
• it represents an allocation of the net profit of the fiscal year, counterpart of the accumulated profits account, therefore its constitution does not affect the result of the fiscal year;
• whether the expected event occurs or not, the constituted portion will, in a future fiscal year, be reversed to accumulated profits, integrating the calculation base for the purpose of paying the dividend and the loss, if it actually occurs, is recorded in the result of the fiscal year;
• it is an account integrated into equity, in the profit reserve grouping.

Regarding the contingency provision, its particularities are:

• its purpose is to cover losses or expenses, whose triggering event has already occurred, but there has not yet been the corresponding disbursement or loss. In accordance with the accrual basis, however, it is necessary to make the accounting record;
• it represents an appropriation to the result of the fiscal year, counterpart of extraordinary losses, expenses or costs, and its constitution normally influences the result of the fiscal year or production costs;
• it must be constituted regardless of whether the company ultimately presents a profit or loss in the fiscal year;
• since the event that served as the basis for its constitution has already occurred, there is, in principle, no reversal of the values recorded in this provision. The small surplus or insufficiency is due to the estimated calculation made at the time of constitution;
• it is not subject to monetary equity update (art. 185, Law No. 6,404/76) but rather to that resulting from the nature of the event that originated it;
• finally, if the probability is difficult to calculate or if the value is not measurable, there is a need for an explanatory note clarifying the fact and mentioning such impossibilities.

Examples include: doubtful debts, contractual indemnities, tax or labor contingencies, etc.

Retention of Profits - Legally called retention of profits (article 196 of Law No. 6,404/76), this reserve sometimes appears under different names: reserve for profit expansion, reserve for investment plan, etc. It may also be included in the Accumulated Profits account, provided that its legal basis is justified in an explanatory note.

The proposal for its constitution must come from the company's management bodies, justified by a capital budget, fixed or circulating.

It cannot be constituted to the detriment of the payment of the mandatory minimum dividend.

The retention of profits aims to justify the non-distribution of larger portions of profit as dividends, that is, the non-payment of a dividend higher than the mandatory minimum, given the company's resource needs due to its budgetary plan.

Profit Reserve to be Realized - It results from the application of article 197 of Law No. 6,404/76. Both its constitution and its realization must be the subject of an explanatory note to the financial statements, clarifying the parameters used by the company due to the nature of the items comprising the profits to be realized.

Other Profit Reserves - Other profit reserves may be included in this grouping, and their nature must be justified in a note, such as the special dividend reserve, the excess exhaustion reserve, the reserve on profit from the sale of real estate, etc.

5. ACCUMULATED PROFITS OR LOSSES

Legally, shareholders have the right to receive, as a mandatory dividend, at least the portion of profits established in the bylaws.

This dividend, stipulated in the bylaws, must be the minimum remuneration due to the shareholder.

The remaining portion of profit, after allocations to profit reserves and payment of the mandatory dividend, must also be allocated.

In this case, the applicable allocations would be for retention of profits, duly justified by a capital budget, or for payment of dividends complementary to the mandatory minimum.

Thus, the understanding of the CVM is that, in the case where the bylaws stipulate a mandatory minimum dividend, the total net profit of the fiscal year must have its allocation defined, and no indiscriminate retentions in the accumulated profits account are allowed.

The normal allocations of the net profit of the fiscal year are:

• to profit reserves;
• for payment of dividends, including complementary to the mandatory minimum; and, finally,
• for retention of profits, via a specific profit reserve.

Under these conditions, the existence of a final balance in accumulated profits is only justified when resulting from:

• a balance already existing prior to the effective date of Law No. 6,404/76; and
• fractions of cents, not included in the dividend declaration per share.

In the event of a loss, it must be absorbed by accumulated profits, profit reserves, and the legal reserve, in that order. If a balance still remains, its absorption may be made with capital reserves, except for the monetary correction of capital reserve.

Adjustments of Prior Fiscal Years - The CVM understands that these adjustments must be carefully analyzed. Thus, they will be considered as adjustments of prior fiscal years only those resulting from a change in accounting criterion or rectification of an error attributable to a prior fiscal year, provided they cannot be attributed to subsequent events (art. 186, § 1 Law No. 6,404/76). The change in accounting criterion originates from operational conditions, whether due to internal factors - decision of the administration itself - or external factors - Practical changes in the market, in the process of improving the quality of information or in changes in legislation. The law limits the possibility of the administration influencing results through changes in accounting practices, therefore it is treated as an adjustment to the portion that should have been included or excluded from equity in the previous year if the criterion then adopted were in force. Therefore, modifications that determine the adoption of new criteria, whose consequences cannot be assessed in comparison with criteria adopted previously, cannot be considered as adjustments of prior fiscal years.

Regarding an error attributable to a prior fiscal year, it can only be characterized when it is an accounting made in a manner different from what would be adequate, given the documents, information, and circumstances existing at the time. They result from significant arithmetic errors in the treatment of correct basic data, for any reason, or from misinterpretation. Therefore, adjustments of provisions constituted, due to inadequate assessment of estimated risks or insufficient information existing at the time of their constitution, do not fit. Thus, adjustments related to the provision for doubtful debt collection, income tax provision, and others that, when constituted, are done within criteria and information that could be obtained, are not included as adjustments of prior fiscal years. These normal adjustments to such provisions are an integral part of the result of the fiscal year in which they are detected and accounted for. Adjustments of prior fiscal years must be subject to broad and clear disclosure in an explanatory note, in which their nature and foundations are specified.

6. TREASURY SHARES

The acquisition of shares of its own issuance by the company does not represent an investment, configuring itself better as a return of invested capital.

Consequently, in addition to being considered in the model of the statement of changes in equity a column for recording the balance of this type of operation, its disclosure and presentation in the balance sheet must be done deductively from the equity account that represented the source of the resources applied in its acquisition.

The provisions regarding the acquisition, by a publicly held company, of shares of its own issuance, are contained in CVM INSTRUCTION NO. 10, of 14.02.80, including those related to the content of the explanatory notes that must be disclosed on the subject.

This Explanatory Note is an integral part of CVM INSTRUCTION NO. 59, of 22.12.86, and therefore, it is mandatory for publicly held companies to adopt all concepts issued herein.

Signed original by

LUIS OCTÀVIO DA MOTTA VEIGA
President