Explanatory Note to CVM Instruction No. 247 of March 27, 1996

EXPLANATORY NOTE TO CVM INSTRUCTION NO. 247, OF 03/27/96.
Ref.: CVM Instruction No. 247, of 03/27/96, which provides for the evaluation of investments in subsidiaries and affiliates and for the preparation of consolidated financial statements.

I - INTRODUCTION
The evolution of international accounting practice, since the issuance of CVM Instructions No. 01/78 and No. 15/80, has made it imperative to review the aforementioned standards, with the objective of updating them.
With the process of market globalization and the increase in capital flows, both those directly invested in Brazil and those obtained by Brazilian entities in the international market, the need for harmonization of accounting procedures and the level of disclosure made by public companies has also grown. In this sense, the current Instruction sought not only to correct and consolidate the aforementioned Instructions No. 01/78 and No. 15/80, but also to incorporate some advances that are already part of international practices. It should be noted, however, the existence of other accounting procedures that were not covered in the present Instruction due to their legal impossibility, since the adoption of these procedures could only be done with the appropriate amendment of the corporate law (Law No. 6.404/76). Along this Explanatory Note, we will highlight some of them.

II - EVALUATION OF INVESTMENTS IN SUBSIDIARIES/AFFILIATES

1 - FROM THE EQUITY METHOD
The main change in this topic was the extension of the application of the equity method (EM) to societies equivalent to affiliate societies, as defined in the sole paragraph of article 2.
It was also stated that the EM applies to investees (subsidiaries, affiliates, and equivalents) in the country as well as abroad (art. 1).

2 - FROM AFFILIATES AND SUBSIDIARIES
International standards determine that equity method is applied to investments in subsidiaries and in other companies where there is significant influence. This significant influence is presumed when the investment represents 20% (twenty percent) or more of the voting capital of the affiliate. In cases of participation less than 20% (twenty percent), significant influence must be proven. The present Instruction, however, maintains the definition of affiliate contained in CVM Instruction No. 01/78, namely, when a society participates with 10% (ten percent) or more of the share capital of the other, without controlling it. This definition is also contained in Law No. 6.404/76, and its compatibility with the international standards mentioned above would imply an amendment to the corporate law itself. On the other hand, since there is no restriction in the aforementioned law, the concept of evaluation by the EM in investments in societies equivalent to affiliate societies was introduced (art. 2, sole paragraph). The Instruction considers equivalent to affiliates that society that participates:
a) indirectly with 10% (ten percent) or more of the voting capital of the other, without controlling it; b) directly with 10% (ten percent) or more of the voting capital of the other, without controlling it, regardless of the percentage of participation in the total capital, that is, even if this percentage is less than 10% (ten percent) of the total capital. The concept and application of the equity method are thus expanded. It should be emphasized, however, that investments in equivalent societies are also included in the concept of relevance established in article 4 of the Instruction.
Article 3 includes two new definitions of subsidiaries, namely:
a) entities constituted abroad in the form of a branch, agency, subsidiary, dependency, or representation, provided that their assets and liabilities are not, by force of specific regulation, included in the accounting of the investor; b) societies that are under common control or that are controlled by a voting agreement, regardless of the percentage of participation in the voting capital. Thus, for example, if the holding company of a certain economic conglomerate has investments in a subsidiary that holds participations (even if not relevant or not characterizing an affiliate) in other companies controlled by that holding, these investments must be evaluated by the EM.

3 - FROM THE DETERMINATION OF THE RELEVANCE OF THE INVESTMENT The present Instruction practically maintains the rules for determining the relevance of the investment. The provision referring to the relevance of investments in subsidiaries (item VI, letter “b” of CVM Instruction No. 01/78) was eliminated since all investments in subsidiaries, regardless of their relevance or not, must be evaluated by the EM (art. 4, I and II). Paragraph 2 of article 4 provides that, in determining relevance, the investor's credits against its affiliates/subsidiaries should be included. Previously, the standard referred to “credits of any nature.” Conceptually, only non-operational credits, such as advances for future capital increases and loans, should be included in this calculation. Since what is sought with this provision are investments not in the form of shares, normal operational credits, such as accounts receivable, should not be considered. Although not specifically contemplated in the Instruction, the understanding of this CVM is that the calculation of the relevance of the equity method, for reasons of simplicity, should be performed before computing the result of the respective equity method.

4 - FROM THE INVESTMENTS TO BE EVALUATED BY THE EQUITY METHOD In this topic, several provisions were included that were not covered in the previous standard, namely:
a) investments in societies equivalent to affiliate societies must also be evaluated by the EM, maintaining the conditions of relevance and influence provided for investments in affiliates (art. 5, II); b) the sole paragraph of article 5 presents a list of facts that characterize the existence of influence in the administration of the affiliate. This list is exemplary, and there may obviously be other cases not covered; c) investments in affiliates and subsidiaries that have clear and effective evidence of discontinuity should not be evaluated by the EM. These are companies that are in the process of liquidation, extinction, or that are operating under severe long-term restrictions, which prejudice their ability to transfer funds (art. 6); d) in the case of investments in subsidiaries/affiliates that are operating normally, where there is evidence of sale in the near future, the criterion of evaluation by the EM should be maintained until the date considered for the sale (art. 7); e) the sole paragraph of article 8 provides that, in the case of discontinuation of evaluation by the EM, the balances of the revaluation reserves related to the investment to be discontinued should be reversed against the respective book value of this investment. It should also be noted that the provision contained in letter “c”, of item IX, of CVM Instruction No. 01/78 was excluded from the present Instruction. That provision determined that investments in affiliates, even when not relevant or influential, were evaluated by the EM, provided that they represented, in total, 15% (fifteen percent) or more of the investor's net equity. This procedure does not cohere with the philosophy guiding the application of the EM, which is the existence of control or, more specifically, influence in the administration.

5 - FROM THE EVALUATION PROCEDURES OF INVESTMENTS BY THE EQUITY METHOD
Article 9 presents a significant change in the calculation of equity method when there are unrealized profits in the investee. Previously, this calculation contemplated the following steps: i) determination of the net equity value of the investee; ii) exclusion of the amount of unrealized results; and iii) application, on this net value, of the percentage of participation in the investee.
This method of calculation contains a conceptual error: by eliminating all unrealized results before applying the percentage of participation, we would be considering that this is an unrealized result for both the investor/parent company and the other shareholders. This is not true, because there is only the figure of “unrealized profit” in the relationship between the investor company and its subsidiaries/affiliates or between these latter. For the other partners/shareholders of the investee, the profit is effective, realized. The present Instruction contemplates a new method of calculation (art. 9, I and II): first, the percentage of participation is applied to the net equity, and from this amount, unrealized profits are subtracted. Exemplifying:
Net Equity of the subsidiary: R$ 1,200
% of participation: 60%
Unrealized Profits: R$ 200
Book Value of the Investment R$ 500
EQUITY METHOD CALCULATION
Previous: Current:

Net Equity ........................ 1,200 Net Equity ..................... 1,200 (-) Unrealized Profits . ( 200) % participation ........ 60% Adjusted Net Equity ............... 1,000 720 % participation ............... 60% (-) Unrealized Prof. .. (200)
Total of invest. .............. 600 Total of Invest. ....... 520
Book Val. Invest. . ....... 500 Book Val. Invest. ..... . 500
Res. Equiv. Pat. . ........ 100 Res. Equiv. Pat. ........ 20

Another relevant aspect to be highlighted is that, by the new Instruction, only unrealized profits are eliminated (art. 9, § 1). Losses resulting from transactions with the investor, subsidiaries, and affiliates should not be eliminated in the equity method calculation (art. 9, § 2). In the draft of the Instruction placed in public hearing, it was provided that, in the application of the equity method, the unrealized profit reflected in the result/net equity of the investor/parent company should also be eliminated. Currently, this profit is only eliminated for consolidation purposes. The aforementioned draft of the Instruction also provided that, while not realized, this profit would be recorded in a future year result account. In this case, it was sought to meet, in a broader way, the Entity Principle (not the entity in its legal concept but within the economic view of the company, which can gather several legal entities within the same economic dimension). However, although conceptually correct, article 10 of the draft placed in public hearing raised doubts about its legal foundation. Therefore, by understanding that its correct application would additionally require an amendment to the corporate law, this CVM opted to exclude it from the final version, maintaining the rule of eliminating this unrealized profit only in the consolidated statements. Paragraphs 2 and 3 of article 10 establish that, for equity method purposes, the period of coverage of the investee's financial statements must be identical to that of the investor. However, the use of non-identical periods is admitted, provided it allows the presentation of higher quality information.

6 - FROM PERMANENT LOSSES IN INVESTMENTS EVALUATED BY THE EQUITY METHOD The changes made in this topic relate to the need to establish a provision for losses, when there is a deficit liability and there is clear intention of the investor to maintain its support for the investee (art. 12, § 1). The provision for losses must be presented in the permanent assets by deduction of the book value of the investment (including therein the goodwill and unamortized bargain purchase), with the excess presented in a specific account in the liabilities (art. 1, § 2).

7 - FROM GOODWILL OR BARGAIN PURCHASE IN THE ACQUISITION OF INVESTMENT EVALUATED BY THE EQUITY METHOD Some important clarifications and changes were made in this topic. The first, and perhaps the main one, concerns the existence of goodwill/bargain purchase in the subscription of shares. Until some time ago, it was the understanding of many people that goodwill and bargain purchase only arose when there was an acquisition of the shares of a certain company (direct transaction between seller and buyer). Today, however, there is already the understanding that goodwill or bargain purchase can also arise as a result of a capital subscription. In a share subscription process, when there is a change in the percentage of participation, the understanding was that the subscribed portion that exceeded the book value of the shares constituted a capital loss in the investor (and a gain in the company whose participation was being reduced), and this loss/gain should be accounted for, in the non-operating result, as a variation in the percentage of participation. It was later verified that when this subscribed portion results, for example, from the undervaluation of the book value of the assets, there is the figure of goodwill in the investor, even if there has been no direct negotiation with third parties. Let us see this issue through an example:
01) INITIAL POSITION:
XYZ Co. (Investee)
Fixed Assets - 2,000 Capital (1,000 shares x 2.00) - 2,000 A Co. (Investor) 700 shares % of Participation = ------------------- = 70% 1,000 shares Investment XYZ - 1,400 Capital - 1,400

B Co. (Investor)
300 shares
% of Participation = ------------------- = 30% 1,000 shares Investment XYZ - 600 Capital - 600

2. Capital increase by issuance of 400 new shares fully subscribed and paid by B Co. Issue price of $ 3.00 per share, considering the market value of the assets in the amount of $ 3,000.00.
   XYZ Co.
   Cash - 1,200 Capital (1,400 shares x 2.00) - 2,800 Fixed Assets - 2,000 Goodwill Reserve - 400 ------ ------- 3,200 3,200 A Co. (Investor) 700 shares % of Participation = ------------------- = 50% 1,400 shares Previous Investment (70% of 2,000) = 1,400 Current Investment (50% of 3,200) = 1,600 ------- DIFFERENCE = 200

B Co. (Investor)
700 shares
% of Participation = ------------------- = 50% 1,400 shares Previous Investment (30% of 2,000) = 600 Payment (400 shares x 3.00) = 1,200 ------- 1,800 Current Investment (50% of 3,200) = 1,600 ------- DIFFERENCE = (200) -------

The previous understanding was that, due to the variation in the percentage of participation, the new equity method revealed a variation gain for Co. A and, consequently, a loss in Co. B, which should be accounted for immediately in the investors' results. The explanation for the loss was based on the following construction:
a) by increasing the percentage of participation from 30% to 50%, Co. B came to “gain”, relative to Co. A, 20% of the net equity prior to the increase (20% of 2,000 = 400); b) at the same time, by subscribing to the new issuance at a value above the book value, it would be delivering to Co. A 50% of the new invested value (50% of 1,200 = 600); c) therefore, Co. B would be incurring a net loss in the amount of 200 (400 - 600).

This understanding is not true. In reality, Co. B paid an additional portion due to an appreciation of the assets, which is not reflected in the accounting records of Co. XYZ. But it did not do so directly to the owners of the shares (Co. A). Therefore, what exists in this case is the figure of goodwill based on this appreciation, and this is easy to verify. Imagine that Co. XYZ had revalued its assets before the capital increase, in which case, the situation would be as follows:
XYZ Co. (Investee)
Fixed Assets - 3,000 Capital (1,000 shares x 2.00) - 2,000 Revaluation Reserve - 1,000 -------- 3,000 A Co. (Investor) Investment (70% of 3,000) - 2,100 Capital - 1,400 R. Reaval.(70% of 1,000) - 700 -------- 2,100 B Co. (Investor) Investment (30% of 3,000) - 900 Capital - 600 R. Reaval.(30% of 1,000) - 300 -------
03) CAPITAL INCREASE
XYZ Co.
Cash - 1,200 Capital (1,400 shares x 2.00) - 2,800 Fixed Assets - 3,000 R. Reaval. - 1,000 Goodwill Reserve - 400 ------- ------- 4,200 4,200 A Co. (Investor) Previous Investment (70% of 3,000) = 2,100 Current Investment (50% of 4,200) = 2,100 ------ DIFFERENCE = - 0 - ------ NOTE: In this case, we must reverse part of the revaluation reserve, previously accounted for, since Co. A “owns” only 50% of this reserve. B Co. (Investor) Previous Investment (30% of 3,000) = 900 Payment (400 shares x 3.00) = 1,200 ------ 2,100 Current Investment (50% of 4,200) = 2,100 ------ DIFFERENCE = - 0 - ------ NOTE: It can be verified in this case that there is no figure of “loss” in the investment and that, since the economic foundation supporting the goodwill was accounted for in the investee, there is also no figure of goodwill. In fact, this fact would also be evident if the revaluation was made after the issuance of the shares.

Another modification introduced by the new Instruction is that it provides for only two types of goodwill and bargain purchase with economic foundation: i) goodwill/bargain purchase resulting from the difference between the market value of the assets and their respective book value; and ii) goodwill/bargain purchase due to expectation of future results (art. 14, §§ 1 and 2). The existence of goodwill due to goodwill, intangibles, etc., is directly related to the expectation of future profitability. On the other hand, in cases of goodwill or bargain purchase without justified economic foundation, the Instruction determines that the former be immediately recognized as a loss in the result of the year (art. 14, § 5), while the bargain purchase can only be amortized upon derecognition by alienation or obsolescence (art. 14, § 4). A maximum period of 10 (ten) years was also established for the amortization of goodwill resulting from the perspective of future profitability (art. 14, § 3).

8 - FROM THE DIFFERENCE RESULTING FROM THE EVALUATION BASED ON THE EQUITY METHOD Although it is already the practice adopted until now, the Instruction makes it clear that the effective gains and losses resulting from the existence of capital reserves or prior period adjustments should be computed in the result of the year as operating revenue/expense (art. 16, I, “a”). Exchange rate variation of the investment in affiliates and subsidiaries abroad should also be considered as operating (art. 16, I, “b”).
Article 17, in consonance with the understanding that has been applied by this Commission over time, provides that, in the establishment of the reserve for realized profits, only the positive net result of the equity method can be considered as realized profit, considering, for this purpose, the algebraic sum of the result of the set of investments in subsidiaries/affiliates.

9 - FROM DIVIDENDS AND SHARE BONUSES RECEIVED BY THE INVESTOR Expanding the use of the realized portion of the reserve for realized profits, article 19, item III, provides for the possibility of its destination, after computing the mandatory dividend, to the constitution of other profit reserves, including retention in accumulated profits, or to absorb the loss of the year.

10 - FROM THE EXPLANATORY NOTES
Article 20 maintains some of the requirements of the previous Instruction, additionally requiring the following other information regarding affiliates/subsidiaries: i) guarantees, guarantees, sureties, mortgages, or pledges granted by the investor; ii) amount of dividends proposed or paid in the year; iii) equity method calculation memo; iv) criteria, discount rate, and periods used in the projection of results that justifies the existence of goodwill/bargain purchase; v) existing reciprocal participations; and vi) effects resulting from discontinued investments.

III - FROM CONSOLIDATED FINANCIAL STATEMENTS

1 - FROM THE DUTY TO PREPARE AND DISCLOSE CONSOLIDATED FINANCIAL STATEMENTS In this topic, two significant changes were made:
a) consolidation becomes mandatory for all public companies, regardless of the representativeness of the investment relative to the parent company's net equity. The CVM understands (and this is also an international position) that consolidated statements provide greater and better information, of a financial and economic nature, about the parent company, than its individual statements. Thus, exercising the power conferred by article 291, sole paragraph of Law No. 6.404/76, the CVM decided to eliminate the 30% (thirty percent) percentage contained in the previous Instruction (art. 21, I). b) also in line with international standards, the obligation of proportional consolidation in the case of investment in jointly controlled societies is being introduced (art. 21, I).

2 - FROM SUBSIDIARIES EXCLUDED FROM CONSOLIDATED FINANCIAL STATEMENTS
Article 23 establishes the cases in which subsidiaries may be excluded from consolidation, without the need for prior CVM authorization (items I and II). It also establishes that other subsidiaries may be excluded, with prior authorization, whose inclusion, at the CVM's discretion, does not represent a relevant change in the consolidated economic unit (§ 1).
Another important aspect, also in line with international practices, is that subsidiaries whose operations are of a nature different from the operations of the parent company or other subsidiaries should not be excluded from consolidation (art. 23, § 3).

EXPLANATORY NOTE TO CVM INSTRUCTION NO. 247, OF 03/27/96.

3 - PREPARATION OF CONSOLIDATED FINANCIAL STATEMENTS There have been no changes to the procedures to be adopted in consolidation.

4 - NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS The only inclusion made in this topic refers to the disclosure of the effects, on consolidated equity and results, resulting from the acquisition or sale of a controlled entity during the fiscal year, as well as the inclusion of a new controlled entity in the consolidation process, for the purpose of comparability of the consolidated statements (art. 31, III). The other requirements have been maintained.

5 - CONSOLIDATION OF FINANCIAL STATEMENTS OF JOINTLY CONTROLLED ENTITIES.
This topic provides for the procedures that must be adopted for the preparation of consolidated statements, which include jointly controlled entities (art. 32 to 34). It is also defined as a jointly controlled entity that in which no shareholder exercises, individually, the powers provided for in article 3 of the Instruction. These provisions mainly cover so-called "joint-ventures" where, through the existence of a contractual agreement and proportional participation shares, two or more entities undertake an economic activity subject to joint control.

IV - FINAL PROVISIONS
The main aspect to be highlighted is the requirement that all controlled entities included in the consolidation be audited by an independent auditor registered with the CVM. In this sense, it would be ideal for this examination to be carried out by the same auditor of the parent company; when this is not possible, it is essential that the auditor of the controlled entity makes their working papers available to the auditor of the parent company (art. 35, sole paragraph). The Instruction also provides that initial adjustments, resulting from changes in the application of the equity method, must be recorded in the period's results, as non-operational income/expense, with disclosure of the fact and the values involved (art. 38). Finally, the provisions contained in the Instruction only become mandatory for statements relating to the fiscal year ending from 12/01/96, at which time the current instructions dealing with the matter will be repealed.

Signed original by
FRANCISCO AUGUSTO DA COSTA E SILVA
President