(A free translation of the original in Portuguese) TOTVS S.A. Financial Statements December 31, 2016 and 2015

Transcription

1 TOTVS S.A. Financial Statements December 31, 2016 and 2015

2 Contents Management report and comments on company s performance... 3 Independent auditor s report on the financial statements...13 Report of the audit committee...19 Financial statements...22 Balance sheets Statement of income Statement of comprehensive income Statements of changes in shareholders equity Statements of cash flow Statements os value added Notes to the financial statements Operations Basis of Preparation and Summary of the Main Accounting Practices Business combination Financial instruments and sensitivity analysis of financial assets and liabilities Cash and cash equivalents Trade accounts receivable Stocks Taxes recoverable Income and social contribution taxes Related-party balances and transactions Investments Property, plant and equipment Intangible assets Payroll and labor obligations Loans and financing Debentures Liabilities due to investment acquisition Provision for contingencies related to legal proceedings Equity Dividends and Interest on Equity Stock option plan Segment information Earnings per share Gross sales revenue Expenses by nature Financial income and expenses Private pension plan defined contribution Commitments assumed Non-cash items Insurance coverage

3 MANAGEMENT REPORT AND COMMENTS ON COMPANY S PERFORMANCE Dear Shareholders, Pursuant to legal provisions, TOTVS S.A., the largest developer of application software, collaboration and productivity platforms, hardware and consulting services in Brazil and Latin America, submits for the appreciation of its shareholders the Management Report and the corresponding Financial Statements, accompanied by the independent auditor's opinion for the fiscal years ended December 31, 2016 and 2015, prepared in accordance with the accounting practices adopted in Brazil. MESSAGE FROM THE CHAIRMAN OF THE BOARD OF DIRECTORS In 2016, we reinforced the Company's corporate governance structure with the publication of our first Integrated Reporting and the creation of the Governance and Designation Committee. The main objectives of this committee are to evaluate the adoption of good corporate governance practices and evaluate the appointment of new members to the Board of Directors and to the Senior Executive Team of TOTVS. We renewed a part of the vice-presidents and officers in 2016, with the hiring of new executives aligned to the culture of a subscription-based company, as part of the Company's succession plan. Today, we have a collaborative, digital and results-driven team that uses technology and business knowledge to promote innovation and understands that the client success is also our success. We will continue our journey to turn TOTVS into a Single Subscription Company, developing solutions for clients of our clients and increasingly connecting people, things and businesses. As Brazil's leading technology provider, we aim to help companies to rethink the way they do business and how they can become more agile and competitive. MESSAGE FROM THE CEO TOTVS registered significant progress in its transition from the licensing model to the software subscription model in This progress is evidenced by the 21.4% growth in subscription revenue, which contributed to the stability of the software revenue in the year, despite the worsening economic scenario observed throughout the period. We made progress in integrating Bematech operations and expanded our market share in the micro segment with the launch of Bemacash, a solution that combines the management software Fly01 of TOTVS with Bematech s hardware solutions, and Fly01 Start, an agnostic application that functions as a point-of-sale integrated with the new generation of payment terminals. We also 3

4 intensified our investments in the specialization of our solutions, in mobile and cloud, developing specialized solutions for clients of our clients, thus making the management of their businesses even more efficient. We evolved in the alignment of commercial incentives related to the subscription model, as well as in the elaboration of a new marketing plan, increasingly digital, aiming to increase sales leads, especially in the subscription model. We also made progress in the development of TOTVS Digital, to be launched in the first quarter of TOTVS Digital is a completely new digital environment, focused on the interaction between TOTVS, channels, salespeople, clients, prospects and partners. The combination of these investments with the migration to subscription model and the deterioration of the Brazilian economic scenario resulted in a decrease in the Company's profitability, especially in the software and services businesses, leading to a reduction in the contribution margins and, consequently, in the Company's EBITDA in We will continue our journey to make TOTVS a Single Subscription Company, promoting the digital transformation in our clients through specialized business solutions, digital platforms, cloud infrastructure, mobility and the Internet of things. The progress made in the transition to subscription over the last 18 months, combined with the Company s investments and the opportunities in Brazil, give us the confidence that TOTVS is on the right path to resume growth and profitability in ECONOMIC SCENARIO The estimated global economic growth for 2016 indicated a deceleration compared to 2015, especially due to the slowdown of the US economy and the growth deceleration in China, which presented the lowest growth in the last 26 years. In a context of growing uncertainties about the Brexit's success in June and the elections in Germany and France in 2017, the growth in the Eurozone also slowed down in 2016, despite the good performance of the economies of Germany and Spain. Latin America was negatively impacted by the Mexican growth slowdown and the deterioration of the Brazilian economic scenario. Brazilian GDP contracted again in 2016, contributing to the closure of 1.3 million formal jobs, according to the General Register of Employed and Unemployed (Caged). Inflation measured by the IPC-A closed the year at 6.29%, the lowest rate in the last three years and below the inflation target set by the Central Bank. The Selic interest rate, which closed 2015 at 14.25%, reached 13.75% in December 2016, while the US dollar depreciated 17.7% in the year against the Real, the first annual decline since

5 The year was also marked by changes in the country's political landscape. In August, after a nine-month process, President Dilma Rousseff was permanently removed from the Presidency and replaced by the Vice-President Michel Temer. The appointment of Temer and the Lava-Jato investigation triggered many changes in the Brazilian political-economic team. Henrique Meirelles took over the Finance Ministry, replacing Nelson Barbosa, and Eduardo Cunha, then president of the Chamber of Deputies, was removed from office and replaced by Rodrigo Maia. Despite the negative effects of the economic crisis, Brazil continues to be a country with many business opportunities, with a relevant consumer market and strong and independent institutions. The reduction of internal political tensions, combined with the reduction of interest rates and inflation, sustain the expectation of recovering from the recession and resume the Brazilian economic growth for the next two years. CONSOLIDATED OPERATING AND FINANCIAL PERFORMANCE The comparability of the consolidated results for the years 2015 and 2016 is impacted by the following events: (i) the corporate reorganization with Bematech, whose results were consolidated by TOTVS in November 2015; and (ii) the sale of the wholly-owned subsidiary TOTVS Resultados em Outsourcing Ltda. ("TOTVS RO"), which had its results consolidated by TOTVS until July In 2016, net revenue totaled R$2,183,786 thousand, an increase of 14.4% over the previous year. This growth was mainly due to the consolidation of Bematech's results in When considering the 12-month Bematech result in 2015 (pro-forma), net revenue decreased by 3.5% in 2016, as shown in table below: (Pro-forma) Variation Licensing fees 167, , % Maintenance 1,000, , % Subscription 229, , % Services 541, , % Hardware 244, , % Net Revenues from services and sales 2,183,786 2,262, % The reduction in revenues from licensing fees reflects the 25.8% decrease in the number of sales. This reduction was mainly due to the following: (i) the downturn in economic activity in Brazil in 2016, which lengthened the conversion period of the sales cycle, especially among large clients; and (ii) the migration of a part of the sales pipeline of new clients to the subscription model, especially smaller clients. In the other hand, the reduction in the average ticket is mainly associated to sales to existing clients, because of the economic scenario. 5

6 The growth in maintenance revenue below the average IGP-M of 2016 was mainly due to the following factors: (i) reduction of license sales in previous periods; (ii) contract cancellations due to clients defaults; and (iii) partial contracts cancellations due to reductions in clients staff, especially large clients. The growth in subscription revenue was due to the higher share of sales to new small and medium clients, especially under the TOTVS Intera model (subscription model launched in June 2015). In addition to TOTVS Intera subscription, Bemacash sales also contributed to the growth in subscription revenue in Bemacash is a solution that combines TOTVS management software for microenterprises (Fly01 line), contracted under the subscription model, and the automation and tax hardware solutions from Bematech. Services revenue in 2016 was negatively affected by: (i) the reduction in software implementation services, due to the lower sales pace observed during the year; (ii) to the lower level of sales of consulting services; and (iii) the sale of TOTVS RO in August The reduction in hardware revenue in 2016 was mainly due to the downturn in the economic activity in Brazil and the changes in tax legislation, especially in the state of São Paulo where fiscal printer were replaced by S@T fiscal equipment, which has a lower unit value. One of the key elements of the Company's strategy is to offer specialized business solutions by segment and integrated with back office solutions and the management and business platform. Please find below the revenue breakdown by industry sector. use of these products. The Manufacturing segment accounted for 24.4% of TOTVS total net revenue in This segment contributes significantly to the integration of value chains (Ex: Distribution & Logistics, Retail and Credit). In addition, this segment has significant opportunities for adoption of digital technologies related to the era of advanced manufacturing - the so-called Industry whose purpose is to encourage the digital integration of different stages of the value chain of industrial products, from the development to the The Retail segment accounted for 23.5% of total revenue in After the corporate reorganization with Bematech, TOTVS became the largest provider of business solutions to this segment in Brazil, besides expanding its share of the microenterprises market with the Bemacash, Fly01 and Fly01 Start solutions. 6

7 When considering Bematech's 12-month results in 2015 (pro-forma), operating costs and expenses presented behavior as shown in the following table: (pro-forma) Variation Cost of Software (77,284) (83,472) -7.4% Cost of Support (130,540) (112,248) 16.3% Cost of Services (506,545) (545,771) -7.2% Cost of Hardware (162,409) (170,151) -4.6% Research and Development (326,546) (292,656) 11.6% Advertising and Marketing Expenses (47,029) (57,261) -17.9% Commercial Expenses (203,818) (188,386) 8.2% Commissions Expenses (139,639) (160,111) -12.8% General and Administrative Expenses (204,532) (228,453) -10.5% Management Fees (19,176) (29,146) -34.2% Depreciation and Amortization Expenses (128,350) (114,970) 11.6% Allowance for Doubtful Accounts (49,197) (38,791) 26.8% Government Subsidy 10,639 15, % Other revenues (expenses) 12,893 (4,209) % Custos e despesas operacionais (1,971,533) (2,009,634) -1.9% The cost of software reduction in 2016 reflects the drop in licensing fees sales and the transition to the subscription model, as partners for complementary solutions are remunerated according to the business model that TOTVS practices to its clients. The growth in support costs in the year is mainly due to the investments made in improving the customer service and support processes, involving adjustments to routines, teams and the Company's service tools. The reduction in the cost of services in 2016 is mainly a result of the lower personnel expenditure, including layoffs for the cost structure adjustments, net of the collective wage increases that occurred during the year. The decrease in hardware costs in 2016 is mainly due to the reduction in hardware sales in the year and to the appreciation of the Brazilian Real against the US dollar, which is an important variable in the cost formation of components used in the hardware production. It is worth mentioning that the cost of hardware in 2016 also includes depreciation expenses, in the amount of R$3,314 thousand (R$3,891 thousand pro-forma in 2015). The growth in research and development expenses in the year mainly reflects the wage adjustments resulting from collective bargaining agreements occurred during the year, the investments in the integration of the solutions portfolio of Bematech to TOTVS. 7

8 The year-on-year reduction in advertising expenses mainly reflects the revision of the general marketing plan of the Company and the synergies from integration of marketing activities of TOTVS and Bematech. Selling expenses and commissions jointly increased from 15.4% (pro-forma) to 15.7% of net revenue. These expenses are directly related to the change in sales mix between franchises and own branches, as well as related to the net revenue mix, due to the different levels of variable remuneration and commissioning applied to the revenue lines. The reduction in general and administrative expenses in 2016 is mainly due to the net effect of wage increases for the period and the lower amount of supplementary provision for contingencies made during the year, as a consequence of the review of the past outcomes of lawsuits and the circumstances surrounding the new proceedings in which TOTVS is the defendant. The decrease in management fees for the year resulted primarily from the optimization of the Company's administrative structure, the integration of Bematech operations, as well as the provisioning of bonuses associated to the achievement of the financial and individual goals for the executives in the period. The increase in depreciation and amortization expenses in 2016 resulted mainly from the amortization of intangible assets from the corporate reorganization with Bematech and the depreciation of investments made in infrastructure such as equipment and installations. Allowance for doubtful accounts corresponded to 2.3% of net revenue in 2016, compared to 1.7% in 2015 (pro-forma). The increase in this provision is mainly due to the additional provision of R$17,221 thousand related to the higher credit risk of a large client from the services segment. Below is a reconciliation of the profit before financial effects and consolidated equity pick and consolidated pro-forma for the year 2015: CONCILIATION OF CONSOLIDATED PRO-FORMA PROFIT 2015 (A) (B) Bematech (Nov-Dec) (C) Bematech (Jan-Dec) (A B + C) (pro-forma) Net revenue from services and sales 1,908,737 80, ,994 2,262,248 Operational costs and expenses (1,680,354) (76,374) (405,654) (2,009,634) Income before financial effects and equity pick up 228,383 4,109 28, ,614 The variation of the financial result from positive R$26,526 thousand in 2015 to negative of R$36,732 thousand in 2016 is mainly due to: (i) the change in the Company s capital structure, from a net cash position in 3Q15 to net debt in 4Q15, due to the payment of R$473,585 thousand in the corporate reorganization with Bematech in the 4Q15; (ii) the gain from the sale of the minority 8

9 interest in ZeroPaper in 1Q15; and (iii) the higher Long-term Interest Rate (TJLP) in 2016, which is used as the inflation adjustment index for the main financial costs of most financing lines and debentures. Income Tax and Social Contribution expenses decreased by 61.2% in 2016, totaling R$23,252 thousand. This reduction is mainly due to the decrease in the income before income tax and social contribution and to the greater representativeness of interest on equity when compared to income before tax and social contribution in the period. Net Income decreased by 21.9% in 2016, mainly due to: (i) the 7.1% reduction in profit before financial effects and equity pick up; (ii) the negative financial result for the year; and (iii) the reduction of expenses with Income Tax and Social Contribution. EBITDA(*) for 2016 totaled R$343,917 thousand, 7.4% lower than the Pro-forma EBITDA for Adjusted EBITDA for 2016 totaled R$358,728 thousand, 21.5% lower than the Pro-forma Adjusted EBITDA for The Adjusted EBITDA margin ended 2016 at 16.4%, compared to 20.2% in The evolvement of the subscription model, combined with labor inflation and investments in portfolio integration and customer service, essentially explain this reduction in margin. (*) EBITDA is a non-accounting measure prepared by the Company and consists of net income for the year, plus income taxes, financial expenses net of financial revenues, and depreciation and amortization. Adjusted EBITDA represents EBITDA, net of extraordinary effects related to layoffs from the organizational restructuring, additional provisions for contingencies and doubtful accounts, reversal of provision for acquisitions, gain on the sale of equity interests, provision for impairment and expenses related to the corporate reorganization with Bematech. CAPITAL MARKETS TOTVS ended the year with capital of R$541,374 thousand, same amount of At the end of 2016, the capital stock of the Company was composed of 165,637,727 common shares, with 66.9% of free float, of which 97.4% was held by institutional investors and 92.9% by foreign investors. Free float is calculated as the total number of Company shares, excluding shares owned by Management and related persons, Fundação Petrobras de Seguridade Social (PETROS) and BNDES Participações (BNDESPar), and those held in treasury. In 2016, TOTVS shares (BM&FBovespa:TOTS3) depreciated 22.5%, while the Bovespa Index (IBovespa) increased 38.9%. Average financial volume in 2016 stood at R$18.6 million/day, versus R$21.0 million registered in the last two years. 9

10 Dividends for 2015: proposed by the Board of Directors on March 15, 2016, and approved at the Ordinary General Meeting on April 26, 2016, dividends for the year totaled R$66,579 thousand, to shareholders of TOTVS as of April 26, The dividends were paid on May 11, Interest on equity for 2016: On August 1, 2016, the board of directors approved the payment of interest on equity of R$43,605 thousand to its shareholders related to the first semester of 2016, having made entitled do the benefit the shareholders of TOTVS as such on August 4, The interest on equity were paid on August 24, On December 16, 2016, the board of directors approved the payment of interest on equity of of R$40,615 thousand to its shareholders related to the second semester of 2016, having made entitled do the benefit the shareholders of TOTVS as such on December 21, The interest on equity were paid on May 10, The payment regarding the fiscal year of 2016 and were imputed to the minimum mandatory dividend in accordance with Article 34 of TOTVS Bylaws. Interest on equity for 2015: On December 18, 2015, the board of directors approved the payment of interest on equity of R$31,319 thousand for the second semester of 2015, having made entitled do the benefit the shareholders of TOTVS as such on December 21, This interest on equity was paid on January 13, The payment is for the second half of 2015 and the amount was calculated towards the minimum mandatory dividend in accordance with Article 34 of the Bylaws of TOTVS. CORPORATE GOVERNANCE Novo Mercado: TOTVS was the first Brazilian software company to join the segment that meets the highest corporate governance standards of the São Paulo Stock Exchange (BM&FBovespa). Board of Directors: TOTVS Board of Directors is composed of 9 members, of which 8 of them are external and independent members, in accordance with Novo Mercado regulations. 11 officers compose the Executive Board. The list containing the names, position and a brief resume of the Board members and Executive Officers is available on the Company s Reference Form, in Audit Committee: It is an advisory body to support the Board of Directors, and its mission is to monitor, evaluate and ensure the best operation of processes, management of internal and external audit mechanisms and controls related to risk management and consistency of financial policies with the strategic guidelines and business risk profile. Currently, the Audit Committee is composed 10

11 of 4 independent external members elected by the Board of Directors, chaired by an independent member of the Board of Directors. Remuneration Committee: assists the Board in setting compensation policies and benefits for directors, officers and participants. The company currently has 4 members elected by the Board of Directors, of which 1 is external, and is chaired by an independent member of the Board of Directors. Governance and Designation Committee: Composed of 3 members of the Board of Directors, its main duties are to promote changes in the Company's corporate governance, to evaluate the adoption of good practices and to select and appoint members to the Board of Directors and the Board of Executive Officers. Arbitration: according to Novo Mercado Regulations and the Company s Bylaws, the controlling shareholder, administrators, the Company itself and the Fiscal Council members should undertake to settle all and any dispute or controversy arising from or relating to Novo Mercado Regulations, the Novo Mercado Adhesion Agreement, Arbitration Clauses, especially, regarding its application, validity, effectiveness, interpretation, breach and their effects through arbitration. Disputes regarding the sale of the Company s control shall also be solved through arbitration. Management Statement: in accordance with subparagraphs V and VI, Article 25 - CVM Instruction 480/09, the officers of TOTVS declare that they discussed, reviewed and agreed with the views expressed in the independent auditors' report and financial statements for the fiscal year ended on December 31, RELATIONSHIP WITH INDEPENDENT AUDITORS The Company s policy on engaging services not related to external audit by independent auditors is grounded on the principles that preserve their autonomy. These principles consist of internationally accepted standards, namely: (a) auditors must not audit their own work; (b) auditors must not exercise management functions at their clients; and (c) auditors must not create conflicts of interest with their clients. Procedures adopted by the Company pursuant to item III, article 2 of CVM Instruction 381/03: The Company and its subsidiaries adopt as a formal procedure, before hiring independent auditors for professionals services not related to external audit, ensuring that the execution of these other services does not affect their autonomy and objectivity necessary for the performance of independent audit services, and obtaining the approval of their Audit Committee. In addition, formal statements are requested from the auditors regarding their autonomy in the execution of services not related to audit. 11

12 Other services were provided in addition to those related to the audit of financial statements in The fees for these services totaled R$202,614 thousand and corresponded to 15.65% of total fees related to external audit. ACKNOWLEDGEMENTS We thank all those who contributed to the success of TOTVS in 2016, especially our clients, employees, partners and shareholders. 12

13 INDEPENDENT AUDITOR S REPORT ON THE FINANCIAL STATEMENTS To the Board of Directors and Stockholders TOTVS S.A. Opinion We have audited the accompanying parent company financial statements of TOTVS S.A. ("Company"), which comprise the balance sheet as at December 31, 2016 and the statements of income, comprehensive income, changes in equity and cash flows for the year then ended, and notes to the financial statements, including a summary of significant accounting policies. We have also audited the accompanying consolidated financial statements of TOTVS S.A. and its subsidiaries (""), which comprise the consolidated balance sheet as at December 31, 2016 and the consolidated statements of income, comprehensive income, changes in equity and cash flows for the year then ended, and notes to the financial statements, including a summary of significant accounting policies. Opinion on the parent company financial statements In our opinion, the parent company financial statements referred to above present fairly, in all material respects, the financial position of TOTVS S.A. as at December 31, 2016, and its financial performance and cash flows for the year then ended, in accordance with accounting practices adopted in Brazil. Opinion on the consolidated financial statements In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of TOTVS S.A. and its subsidiaries as at December 31, 2016, and their financial performance and cash flows for the year then ended, in accordance with accounting practices adopted in Brazil and with the International Financial Reporting Standards (IFRS) as issued by the International Accounting Standards Board (IASB). Basis for opinion We conducted our audit in accordance with Brazilian and International Standards on Auditing. Our responsibilities under those standards are further described in the Auditor's Responsibilities for the Audit of the Parent Company and Financial Statements section of our report. We are independent of the Company and its subsidiaries in accordance with the ethical requirements established in the Code of Professional Ethics and Professional Standards issued by the Brazilian Federal Accounting Council, and we have fulfilled our other ethical responsibilities in accordance with these requirements. We believe that the audit evidence we have obtained is sufficient and appropriate to provide a basis for our audit opinion. 13

14 Key audit matters Key audit matters are those matters that, in our professional judgment, were of most significance in our audit of the parent company and consolidated financial statements of the current period. These matters were addressed in the context of our audit of the parent company and consolidated financial statements as a whole, and in forming our opinion thereon, and we do not provide a separate opinion on these matters. Why it is a key audit matter How the matter was addressed in the audit Measurement of revenue from consulting services or implementation software services rendered (Notes 2.8 and 24) We decided to focus on this area in our audit because the measurement of revenue from consulting or software implementation services, which represents 3% of the total revenues for 2016, requires management to use estimates and critical judgment that are mainly related to the identification of the hours to be incurred up to the conclusion of the contracted services. This matter affects the measurement of unrecognized revenue in the year, yet to be billed. Regarding the recognition of unbilled revenue, we performed the following procedures during our audit: We obtained an understanding of the main controls related to the revenue recognition and tested their effectiveness; We analyzed related documents, such as contracts and bills, and the subsequent financial settlement, which are evidence that can support the effective performance of the service, the proper accrual basis, and the correct amount of the related revenue; For the tested controls, we confirmed that the management's calculations of recognized revenue included the relevant aspects of the contracts' terms; and We inquired the Company's management and the commercial team in order to assess (i) the reasonableness of the data and criteria adopted to estimate revenue, and (ii) the uniformity of the criteria in comparison with those adopted in the previous year. In addition, we tested the comparison of this estimate with the revenue billed in the following month. We consider that the measurement of the unbilled revenue and the estimates involved in the recording in the proper period are supported by data and corresponding documents. 14

15 Why it is a key audit matter How the matter was addressed in the audit Provision for contingencies (Note 18) As disclosed in the parent company and consolidated financial statements, the Company and its subsidiaries are party to legal and administrative civil, labor, and tax proceedings filed mainly by former employees, service providers, tax and labor authorities, and customers. The total accounted for, related to proceedings whose likelihood of loss is probable, amounts to R$ 102,225 thousand. We decided to focus on this matter in our audit because of the critical judgment necessary to determine the likelihood of loss attributed to each proceeding and the estimated amount of loss for them. This judgment as well as the criteria used to establish these amounts involve consideration about the complexity of the Brazilian legislation, of the applicable case law, and of the legal system itself. Any change in projections, judgment, or criteria used to attribute the amount may significantly affect the financial statements. Regarding the provision for contingencies, we performed the following procedures during our audit, among others: We obtained an understanding of the main related internal controls and tested their effectiveness; We reviewed documents, on a sample basis, containing information related to contingent matters and with the respective proceedings involved; We obtained a confirmation from external legal advisors in order to validate the amounts as well as the likelihood of positive and/or negative outcome for each proceeding; and When necessary, we obtained a second opinion from legal advisors other than those who are working on the matters in order to compare them as well as to analyze the defense's arguments and/or thesis. Because of these procedures, we consider that the criteria used by management to measure the provision for contingencies are adequate, and that the opinions and judgment used are consistent with the assessment of legal advisors. Intangible assets, including goodwill - Impairment (Note 13.2) Management assess the impairment of intangible assets, including goodwill. This assessment requires critical judgment regarding the determination of the future cash flows, which is projected as from the business plan approved by the Board of Directors. We decided to focus on this area in our audit because this assessment involves judgment regarding the financial and economic assumptions. Regarding the measurement and presentation of intangible assets, including goodwill, in the context of an audit, we performed the following procedures, with the support of our internal experts on assessment: Understanding of the main related controls and testing of their effectiveness; Obtaining of management's business plan, as approved by the Board of Directors, regarding the acquired entity, which is the object of the generation of intangible assets and goodwill, and comparison with the assumptions used in the assessment; Comparison of the base year's balances used in the projection with the historical accounting information; Inquiring about the reasonableness of the methodology and of the main financial and 15

16 Why it is a key audit matter How the matter was addressed in the audit economic assumptions used, such as discount rates, inflation, growth of income and expenses, investment, among others; Recalculation tests involving the projections prepared by management. Our audit procedures evidenced that the assumptions used by management are reasonable and consistent with observable data and information. Other matters Statements of Value Added The parent company and consolidated Statements of Value Added for the year ended December 31, 2016, prepared under the responsibility of the Company's management and presented as supplementary information for IFRS purposes, were submitted to audit procedures performed in conjunction with the audit of the Company's financial statements. The presentation of these Statements of Value Added is required by the Brazilian corporate legislation for listed companies. For the purposes of forming our opinion, we evaluated whether these statements are reconciled with the financial statements and accounting records, as applicable, and if their form and content are in accordance with the criteria defined in Technical Pronouncement CPC 09 - "Statement of Value Added". In our opinion, these Statements of Value Added have been properly prepared in all material respects, in accordance with the criteria established in the Technical Pronouncement, and are consistent with the parent company and consolidated financial statements taken as a whole. Other information accompanying the parent company and consolidated financial statements and the auditor's report The Company's management is responsible for the other information that comprises the Management Report. Our opinion on the parent company and consolidated financial statements does not cover the Management Report, and we do not express any form of audit conclusion thereon. In connection with the audit of the parent company and consolidated financial statements, our responsibility is to read the Management Report and, in doing so, consider whether this report is materially inconsistent with the financial statements or our knowledge obtained in the audit or otherwise appears to be materially misstated. If, based on the work we have performed, we conclude that there is a material misstatement in the Management Report, we are required to report that fact. We have nothing to report in this regard. 16

17 Responsibilities of management and those charged with governance for the parent company and consolidated financial statements Management is responsible for the preparation and fair presentation of the parent company financial statements in accordance with accounting practices adopted in Brazil and of the consolidated financial statements in accordance with accounting practices adopted in Brazil and with the IFRS as issued by the IASB, and for such internal control as management determines is necessary to enable the preparation of financial statements that are free from material misstatement, whether due to fraud or error. In preparing the parent company and consolidated financial statements, management is responsible for assessing the ability of the Company and its subsidiaries to continue as going concerns, disclosing, as applicable, matters related to going concern and using the going concern basis of accounting unless management either intends to liquidate the Company and its subsidiaries or to cease operations, or has no realistic alternative but to do so. Those charged with governance are responsible for overseeing the financial reporting process of the Company and its subsidiaries. Auditor's responsibilities for the audit of the parent company and consolidated financial statements Our objectives are to obtain reasonable assurance about whether the parent company and consolidated financial statements as a whole are free from material misstatement, whether due to fraud or error, and to issue an auditor's report that includes our opinion. Reasonable assurance is a high level of assurance, but is not a guarantee that an audit conducted in accordance with Brazilian and International Standards on Auditing will always detect a material misstatement when it exists. Misstatements can arise from fraud or error and are considered material if, individually or in the aggregate, they could reasonably be expected to influence the economic decisions of users taken on the basis of these parent company and consolidated financial statements. As part of an audit in accordance with Brazilian and International Standards on Auditing, we exercise professional judgment and maintain professional skepticism throughout the audit. We also: Identify and assess the risks of material misstatement of the parent company and consolidated financial statements, whether due to fraud or error, design and perform audit procedures responsive to those risks, and obtain audit evidence that is sufficient and appropriate to provide a basis for our opinion. The risk of not detecting a material misstatement resulting from fraud is higher than for one resulting from error, as fraud may involve collusion, forgery, intentional omissions, misrepresentations, or the override of internal control. Obtain an understanding of internal control relevant to the audit in order to design audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the internal control of the Company and its subsidiaries. Evaluate the appropriateness of accounting policies used and the reasonableness of accounting estimates and related disclosures made by management. 17

18 Conclude on the appropriateness of management's use of the going concern basis of accounting and, based on the audit evidence obtained, whether a material uncertainty exists related to events or conditions that may cast significant doubt on the ability of the Company and its subsidiaries to continue as going concerns. If we conclude that a material uncertainty exists, we are required to draw attention in our auditor's report to the related disclosures in the parent company and consolidated financial statements or, if such disclosures are inadequate, to modify our opinion. Our conclusions are based on the audit evidence obtained up to the date of our auditor's report. However, future events or conditions may cause the Company and its subsidiaries to cease to continue as going concerns. Evaluate the overall presentation, structure and content of the parent company and consolidated financial statements, including the disclosures, and whether the parent company and consolidated financial statements represent the underlying transactions and events in a manner that achieves fair presentation. Obtain sufficient appropriate audit evidence regarding the financial information of the entities or business activities within the Group to express an opinion on the consolidated financial statements. We are responsible for the direction, supervision and performance of the group audit. We remain solely responsible for our audit opinion. We communicate with those charged with governance regarding, among other matters, the planned scope and timing of the audit and significant audit findings, including any significant deficiencies in internal control that we identify during our audit. We also provide those charged with governance with a statement that we have complied with relevant ethical requirements regarding independence, and to communicate with them all relationships and other matters that may reasonably be thought to bear on our independence, and where applicable, related safeguards. From the matters communicated with those charged with governance, we determine those matters that were of most significance in the audit of the parent company and consolidated financial statements of the current period and are therefore the key audit matters. We describe these matters in our auditor's report unless law or regulation precludes public disclosure about the matter or when, in extremely rare circumstances, we determine that a matter should not be communicated in our report because the adverse consequences of doing so would reasonably be expected to outweigh the public interest benefits of such communication. São Paulo, February 20, 2017 PricewaterhouseCoopers Auditores Independentes CRC 2SP000160/O-5 Ricardo Novaes de Queiroz Contador CRC 1DF012332/O-2 "S" SP 18

19 REPORT OF THE AUDIT COMMITTEE Introduction In accordance with its charter, approved by the Board of Directors on February 27, 2015, the Audit Committee is charged with ensuring that the internal and external audit processes and management, as well as the risk management mechanisms and controls are functioning, ensuring the alignment of financial policies with the strategic guidelines and risk profile of the business, and ensuring the quality and integrity of the Company's financial statements, making recommendations to the Management regarding the approval of financial reports and actions to improve internal controls and reduce risks. The Audit Committee is formed by four members (three independent members and one external independent member), who are currently in full exercise of their terms of office. Activities of the Audit Committee The Committee held nine (9) ordinary meetings and three (3) extraordinary meetings in 2016 and one (1) ordinary meeting in 2017 to approve the financial statements. In this period, the Audit Committee also periodically conducted private meetings with the chief legal officer, the risk, internal controls and compliance officer and internal audit, as well as meetings with the human resources officer, the independent audit firm and meetings among its members, totaling ten (10) meetings. At each ordinary meeting of the Board of Directors, a report on the Committee s activities in the previous period was presented by the Committee Chairman and discussed with the directors. Topics discussed by the Audit Committee The Audit Committee held meetings with vice presidents and executive officers of the Company, internal auditors, independent auditors and external advisors to understand the processes, internal controls, risks, possible weaknesses and plans for improvement, and submitted its recommendations to the Board of Directors and Management of the Company. A total of eighty-three (83) meetings were conducted to discuss forty-two (42) topics. The main aspects discussed were: Independent Audit - Discussing the plan, scope and main conclusions from the quarterly reviews (ITR) and issuing a report on the financial statements for fiscal year 2016 (DFP 2016); - Weaknesses and recommendations for improvements mentioned in the internal controls report and the respective action plans of internal areas to correct or improve the aspects; - Monitoring the preliminary and final results for issuing the ISAE 3402/2016 report; - Learning about new audit procedures, especially the new audit report format; - Annual cycle of appraisal of the performance of independent auditor; - Selecting and discussing proposals and making recommendations regarding the hiring of independent auditors for next year. 19

20 Internal Audit - Discussing the risk matrix and approval of internal audit schedule for the 2016 cycle; - Monitoring the reports on the work of internal audit issued for own units and franchises, including weaknesses, justifications and correction plans; - Monitoring compliance with timetable, scope of hours and result of investigations carried out in special tasks; - Monitoring the assessment made by independent advisory on the quality of processes and sufficiency of resources available to internal audit and subsequent monitoring of the implementation of improvement actions recommended; - Annual cycle of appraisal of the performance of the head of the internal audit department. Internal controls, corporate risk management, compliance and ombudsman - Monitoring the internal controls plan to map processes, key controls and indicators; - Discussing and evaluating the new map of strategic risks of the company, monitoring the mitigation plans together with those responsible for their execution, and the respective description of the risk factors in the Reference Form; - Monitoring action plans to improve the information technology general controls (ITGC), access profiles and the segregation of functions; - Discussing and monitoring the pilot project to reformulate the company s management system by processes and indicators; - Monitoring the implementation of action plans to comply with the integrity program established by the company s management; - Monitoring the adoption of compliance policies and practices by managers and employees to ensure compliance with the anticorruption law; - Monitoring the results of the assessment made by independent advisory to review the integrity program in the companies acquired and the respective action plan for correcting the processes; - Monitoring the results of the Net Promoter Score (NPS) survey and management s initiatives to improve client satisfaction with the services provided by the company. Financial management, provisions and indicators - Discussing the model and standardization of the company s budget management; - Discussing, streamlining and monitoring the application of the credit analysis policy, collections procedures and estimates of losses on doubtful accounts; - Monitoring the financial management model of the software and hardware businesses; - Evaluating compliance with CVM Resolution 594 regarding provisions and contingent liabilities and assets; - Discussing and monitoring the main lawsuits and the management s judgment on possible outcomes. Monitoring the evolution of the environment of controls in the legal department, mainly related to the management of lawsuits; - Discussing and monitoring the procedures adopted to review annual impairment tests; - Financial impacts caused by changes in law (Lei do Bem); - Monitoring the methodology and controls for managing service projects. Corporate Governance - Giving opinion for the Board of Directors approval of quarterly and annual financial statements; - Evaluating and recommending approval of proposals for dividends and interest on equity; 20

21 - Discussing about improvements to the long-term incentive model for company executives from the perspective of the risks of retention, motivation and alignment with the company s vision and strategy; - Discussing the terms used in notices, material fact notices and earnings release to the market; - Monitoring and making recommendations to the Board of Directors and the Management on initiatives and operations involving mergers and acquisitions, as well as assessment of operating risks; - Discussing and monitoring the process for updating the Reference Form; - Discussing the content and making recommendations on the proposed Integrated Report of the company; - Monitoring the queries and management s responses to letters from regulatory agencies; - Reviewing and making improvements to rules for rolling out the crisis management plan; - Reviewing and discussing about a new hierarchy for policies, standards, procedures, governance and powers for approval of rules, as well as reviewing existing policies; - Discussing the terms and scope of the policy on transactions with related parties; - Monitoring the activities of the Conduct and Ethics Committee, evaluating the complaints received by the channel and the measures adopted by Management. - Taking stock of the activities and evaluating the topics discussed in the tax committee. - Management and governance aspects of TOTVS franchise network; - Annual self-assessment cycle of the audit committee. Audit Committee Report 2016 Annual Financial Statements: The members of the Audit Committee of TOTVS S.A., in the exercise of their legal duties and responsibilities, pursuant to the Charter of the Audit Committee, examined and analyzed the financial statements, accompanied by the independent auditors report and the annual management report for the fiscal year ended December 31, 2016 ( 2016 Annual Financial Statements ) and, considering the information provided by the Company management and by PwC Auditores Independentes, as well as the proposed allocation of the earnings from fiscal year 2016, unanimously concluded that these adequately reflect, in all material aspects, the equity and financial position of the Company and its subsidiaries, and recommend the Board of Directors of the Company to approve said documents and submit them to the Annual Shareholders Meeting, in accordance with Brazilian Corporation Law. São Paulo, February 20, 2017 Maria Helena Santana Chair of the Audit Committee and member of the Board of Directors Danilo Silva Member of the Audit Committee and the Board of Directors Gilberto Mifano Member of the Audit Committee Mauro Rodrigues da Cunha Member of the Audit Committee and the Board of Directors 21

22 TOTVS S.A. Balance sheets as at December 31, 2016 and 2015 (In thousands of reais) (A free translation of the original in Portuguese) Parent Company Parent Company Assets Liabilities and equity Current assets 565, , ,736 1,157,673 Current liabilities 465, , , ,683 Cash and cash equivalents (Note 5) 112, , , ,415 Payroll and labor obligations (Note 14) 105,243 99, , ,152 Marketable securities (Note 17) 32,165 17,488 74,027 75,213 Trade accounts payable 41,844 37,311 73,553 86,932 Trade accounts receivable (Note 6) 394, , , ,002 Loans and financing (Note 15) 180, , , ,514 Allowance for doubtful accounts (Note 6) (84,293) (56,551) (105,183) (75,860) Taxes payable 17,293 11,293 28,141 18,923 Stocks (Nota 7) ,219 44,407 Commissions payable 38,343 52,172 43,198 56,579 Taxes recoverable (Note 8) 72,993 27, ,521 81,284 Dividends payable (Note 20) 41,097 32,428 41,561 32,885 Other assets 37,851 26,455 48,010 41,212 Liabilities from acquisition of investments (Note 17) 38,960 24,492 80,822 82,220 Debentures (Note 16) - 49,473 12,111 61,915 Other liabilities 2, ,260 8,563 Non-current assets 1,642,705 1,630,795 1,492,176 1,504,402 Marketable securities (Note 17) 4,676 28,780 11,137 39,534 Non-current liabilities 521, , , ,660 Trade accounts receivable (Note 6) 35,842 38,676 36,913 40,953 Loans and financing (Note 15) 339, , , ,795 Receivables from related parties (Note 10) 1,644 3, Debentures (Note 16) 58,784 49,429 78,550 82,371 Taxes recoverable (Note 8) ,572 17,881 Provision for losses on investments (Note 11) 1, Deferred income and social contribution taxes (Note 9) 30,449 16,954 88,658 63,507 Payables to related parties (Note 10) 13,247 15, Financial assets at fair value (Note 4) ,800 68,044 Provision for contingencies related to legal proceedings (Note 18) 85,323 70, ,225 90,507 Judicial deposits (Note 18) 29,846 31,688 40,903 43,407 Liabilities from acquisition of investments (Note 17) 17,828 47,065 45,886 88,272 Other assets 23,420 10,405 30,437 18,466 Other liabilities 6, ,409 3,715 Equity (Note 19) 1,221,188 1,237,686 1,220,916 1,237,732 Investments (Note 11) 976,201 1,001,473 1,350 - Capital 541, , , ,374 Property, plant and equipment (Note 12) 154,126 86, , ,598 Treasury shares (73,443) (71,012) (73,443) (71,012) Intangible assets (Note 13) 386, ,962 1,028,136 1,099,012 Capital reserves 162, , , ,213 Other comprehensive income results 1,785 21,329 1,785 21,329 Retained profit reserve 582, , , ,203 Proposed additional dividend 7,375 66,579 7,375 66,579 Non-controlling interests - - (272) 46 Total assets 2,208,307 2,362,015 2,443,912 2,662,075 Total liabilities and equity 2,208,307 2,362,015 2,443,912 2,662,075 The accompanying notes are an integral part of these financial statements. 22