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To apply the embedded derivative model, it is necessary to understand the economic characteristics and risks of the host contract. Certain instruments, such as preferred stock, have characteristics of both debt and equity, and the determination of the host contract will have a direct impact on the conclusion of whether an embedded component should be separated. For example, a conversion feature in preferred stock that is deemed an equity host would not be separated by the investor because the conversion option is clearly and closely related to an equity host contract. In contrast, a conversion feature in preferred stock deemed to be a debt host would not be clearly and closely related; therefore, it would be separated by the investor if the remaining criteria in ASC 815-15-25-1 are met.

4.5.1 Determining if an equity contract is a debt or equity host

To determine its nature, the reporting entity needs to consider the host contract’s underlying economic characteristics and risks. Whether a host instrument is an equity or debt host is not determined by its balance sheet classification. An instrument, such as a preferred stock instrument, may be classified as equity, but may be considered a debt host contract for purposes of evaluating embedded components. For further analysis and examples on determining whether a host instrument is an equity or debt host, refer to FG 5.4.1. The guidance used in the analysis of whether an equity contract is a debt or equity host for purposes of evaluating embedded derivatives would be the same for both an investor in the instrument or an issuer of the instrument.
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