IFRIC Interpretation 2 - Members’ Shares in Co-operative Entities and Similar Instruments (detailed review)

Objective

The objective of this interpretation is to prescribe the accounting principles for the classification of ‘members’ interest in ‘Co-operative and other similar entities’ and financial instruments having attributes as such, as liability or equity.

Background

It is a common attribute of the social communities that groups of individuals living in such communities establish ‘Co-operative and other similar entities’ to meet their common social or economic needs. A co-operative entity is typically defined by National Laws as ‘a society formed by group of individuals, who pool up their resources in order to meet their common social and economic needs by mean of joint business arrangements i.e. (so called the principle of self-support). The members’ interest in such co-operative entities is normally denominated as units, members’ shares or the similar; therefore it is termed as ‘members’ shares’ for the purpose of this interpretation.

The accounting requirements to classify the financial instruments as financial liability or equity are laid out in IAS 32 Financial Instruments: Presentation. The principles of IAS 32 are also applicable to classify the puttable instruments which gives holder the right to put such instruments back to the issuer of the instrument for a cash payment or an-other financial instrument.

However, the application of these accounting requirements in IAS 32 for the classification of ‘members’ shares in co-operative and similar entities’ is quite a complex area. In addition few of the constituents at International Accounting Standards Board have also asked for assistance in understanding that how the accounting requirements in IAS 32 are applicable to the members’ shares in co-operative and similar entities for the purpose of their classification as liability or equity.

Standard References

a) IFRS 9 Financial Instruments (issued October 2010)

b) IFRS 13 Fair Value Measurement

c) IAS 32 Financial Instruments: Disclosure and Presentation (as revised in 2003)

Scope

The requirements of this Interpretation are applicable to the financial instruments which are covered under the scope of IAS 32 Financial Instruments: Presentation, together with the financial instruments that are issued to the members of co-operative societies which reflect the members’ ownership stake in the related entity. However, the requirements placed in this Interpretation are not applicable to financial instruments which will or may be settled in own equity instruments of the entity.

Issue

Several financial instruments, as well as members’ shares, have the attributes of equity which includes right to participate in dividend distributions and exercise of voting power. Some of these also give holder the right to redeem the instrument for a cash payment or an-other financial instrument however it may be involving or subject to certain limits or restrictions relating to the redemption of financial instruments. How should the financial instruments including the members’ shares with those redemption terms be assessed in determining the classification of financial instruments as equity or liability.

Consensus

1. Only the redemption right held by the holder relating to financial instruments as well as members’ shares in co-operative entities do not, innately, reflects that financial instrument is a financial liability. The entity should take into account all the terms and conditions relating to financial instrument in determination of its classification as a equity or financial liability. Such terms and conditions entails relevant regulations, local laws or the governing charter of the entity in force at the classification date, except any expected changes to those regulations, laws or governing charter of the entity in future.

2. Members’ interest in Co-operatives and other similar entities will be classified as equity, if either, it satisfy the conditions stated in the following paragraphs (a) and (b) below or the members’ shares have the characteristics and meet all the conditions laid out in the paragraphs 16A to 16D in IAS 32 Financial Instruments: Presentation. Demand deposits, current accounts, including deposit accounts and the like contracts which are established, when members act in the capacity of customers therefore, these are treated as the financial liability of the related entity.

a) Members’ shares or other similar financial instrument will be classified as equity when the entity holds an unconditional right to reject or refuse the redemption of the financial instrument

b) Relevant regulations, local laws or the governing charter of the entity places various sort of restrictions or prohibitions relating to the redemption of members’ shares, these prohibitions may be ‘unconditional’ or prohibitions based on the funds sufficiency or liquidity criteria. These are considered as follows:

i) If relevant regulations, local laws or the governing charter of the entity unconditionally (not subject to certain conditions) prohibit the redemption of members’ share, then members’ shares will be classified as equity.

ii) However, if the requirements of relevant regulations, local laws or the governing charter of the entity prohibit the redemption of members’ share only if certain conditions such as availability of funds or liquidity covenants are satisfied (or are not satisfied) will not result in members’ shares being classified as equity.

3. The unconditional prohibition can be absolute or partial. If the unconditional prohibition is absolute in such case all the redemptions will be prohibited.

4. However, if the unconditional prohibition is partial, in such a case it prohibits the redemption of members’ shares if redemption would result in fall in the number of members’ shares or the value of paid-in capital from members’ shares below a certain specified level. In this case, the entity will classify the members’ shares over and above the prohibition level against redemption as liability, until unless the entity holds an unconditional right to reject or refuse the redemption as defined in paragraph (a) above or the members’ shares have the characteristics and meet all the conditions laid out in the paragraphs 16A to 16D of IAS 32 Financial Instruments: Presentation.

5. In certain cases, there may be a change in the value of paid-in capital or the number of members’ shares subject to a redemption prohibition over the passage of time, in such a situation the variation in the redemption prohibition will result in a transfer among the financial liability and equity.

6. The entity should measure the financial liability for redemption on initial recognition, at fair value. Therefore, for members’ shares with redemption attribute, the entity will measure the fair value of its financial liability for redemption at the highest amount payable in accordance with the redemption requirements of its governing charter or related applicable regulations and laws.

7. Distributions to the equity instruments holders are directly recognized in equity. However, Interest and other returns linked to the financial instruments which are classified as financial liability will be treated as expenses and reported to statement of profit or loss.

Disclosure

If the variation in the value of paid-in capital or the number of members’ shares subject to a redemption prohibition result in a transfer among equity and financial liability, the entity is required to disclose this fact, timing, amount and reason for transfer

Effective date

a) This interpretation is effective from the same date as for IAS 32 (as revised in 2003) and have the same transition requirements. The requirements of this Interpretation are applicable for the annual accounting periods commencing on or after 1 January 2005.

b) If an entity applies this Interpretation for a accounting period commencing before 1 January 2005, it is required to disclose that fact.

c) The requirements of this Interpretation are applicable retrospectively.

Application Examples

Example 1

The governing charter of the entity includes a provision that the redemption of members’ share depend upon the sole decision of the entity. The governing charter does not include any further details or limitation on this discretion. Although the governing board has the right to refuse the redemption but the entity has never refused to redeem members’ shares, in past years.

Classification

The members’ shares in the example above will be classified as equity as the entity holds the unconditional right to reject or refuse the redemption of members’ shares. IAS 32 prescribes the principles for the classification of financial instruments which are based on the terms of the financial instrument. It should be noted that the history of, or intention to make, discretionary payments does not, in itself give rise to liability.

Example 2

The governing charter of the entity includes a provision that redemption of members’ share depend upon the sole decision of the entity. However, the governing charter further elaborates that approval of a redemption request is automatic, until unless the entity is not able to make redemption payments because of requirements of local laws and regulations regarding reserves or liquidity.

Classification

The members’ shares in the example above will be classified as financial liability as the entity does not hold the unconditional right to reject or refuse the redemption of members’ shares. The restrictions mentioned above are subject to entity’s ability to settle its obligation, i.e. these only restrict the redemptions when the reserves or liquidity requirements of local laws and regulations are not satisfied and then only until such time. Hence, the financial instruments are not equity in the example above.

Example 3

The terms of the governing charter of the entity and local laws governing the operations of co-operatives prohibit an entity from the redemption of the members’ shares if, the redemption would result in reduction in paid-in capital of the entity from members’ shares, falling below 75% of the highest amount of paid-in capital from members’ shares. The highest amount stated for a co-operative is $2,000,000. The entity has a paid-in capital of $1,800,000 at the end of the reporting period.

Classification

In this case, $1,500,000 will be classified as equity while $300,000 will be classified as financial liability.