Frozen GAAP: How a Covenant Survives a New Standard

A covenant level is a number agreed against a particular set of accounts. When the facility was priced, the lender looked at the borrower's EBITDA and debt as its accountants then built them, and set leverage and cover tests with headroom over those figures. If the standard changes underneath the agreement, the same business produces different numbers, and the headroom the parties negotiated can vanish or widen overnight.

Leases are the change that made the clause familiar. IFRS 16, adopted as NZ IFRS 16 and AASB 16, applied to periods beginning on or after 1 January 2019 and brought most leases onto lessees' balance sheets. In the UK, the revised FRS 102 does much the same for periods beginning on or after 1 January 2026, so a UK mid-market group meets now the question that groups in New Zealand and Australia met in 2019. Not every borrower is affected: UK micro-entities reporting under FRS 105 keep the old lease treatment, and New Zealand and Australian businesses that prepare special-purpose accounts may not apply the lease standard at all.

Facility agreements usually define the accounting principles the borrower reports under and then say what happens when those principles change. Three approaches are common. Under a frozen clause, covenant calculations stay on the original basis automatically. Under a floating clause, the covenants follow the accounts as they change, and the parties live with the result. A third version floats unless either side asks for a freeze when a change arrives. Which approach a facility takes is negotiated, so the clause's presence and wording vary deal by deal.

Where a freeze applies, the statutory accounts still follow the new standard. The agreement typically requires a reconciliation, from the auditors or certified in the compliance certificate, showing the adjustments that return the figures to the old basis. Many agreements add an obligation to negotiate in good faith, often for a set period, amendments that move the covenants onto the new basis with the same commercial effect. If nothing is agreed, the old basis usually continues.

A freeze reaches only the parts of the agreement it is written to reach. Lenders working through 2019 found that a clause covering the financial covenants did not necessarily cover the definition of borrowings used in debt baskets and the negative pledge, where a lease that had been an operating lease could start to count as debt. Later agreements often deal with leases expressly, keeping any lease that would have been an operating lease under the old rules outside debt.

A garden-centre group in England, constructed for this page like every figure in it, signed a facility in 2024 with a net leverage covenant of 3.25 times and an interest cover covenant of 4.00 times. The levels are the example's, not a market norm. It reports under FRS 102, and its financial year beginning 1 January 2026 is its first under the revised standard. Its centres are leased: rent of US$4.0m a year, and lease liabilities of US$32m once the leases are on the balance sheet. In US$m:

Nothing at the garden centres changed on 1 January. Floated onto the new basis with the lease liabilities counted as debt, the group breaches both covenants; frozen, it passes both with the headroom it borrowed on. The last line is the quieter error: if the agreement floats EBITDA while its debt definition still leaves leases out, leverage reads 2.00 times, and the borrower gains headroom nobody negotiated. The reconciliation in each certificate is the bridge back: take reported EBITDA of 15.0, deduct the 4.0 of rent the old standard charged, and leave the 32.0 of lease liabilities out of net debt.

A frozen GAAP clause and a lender's own lease-adjusted leverage answer different questions. The clause is contractual: it fixes how the borrower reports against the covenant, and it keeps the leases out of the test if they were out at signing. The lease adjustment is analytical: the lender puts the leases into both debt and earnings in its own credit work, whatever the covenant says, because rent is a fixed charge either way. A file can carry both, a frozen covenant that ignores the leases and a credit paper that reads them in full. The clause protects the test; it does not make the leases harmless.

DEFINED IN ONE PARAGRAPH → · LEASE-ADJUSTED LEVERAGE → · RIGHT-OF-USE ASSET AND LEASE LIABILITY →

At signing, the questions are whether there is a freeze, whether it is automatic or on request, and what it reaches: the covenants only, or the debt definition and baskets as well. A borrower that expects its accounting framework to change, such as a UK group moving to the revised FRS 102 or a growing New Zealand company becoming large enough to prepare general-purpose accounts, has reason to raise it before the first certificate rather than after.

Over the life of the facility the freeze has a running cost. The borrower keeps the old numbers alive for covenant purposes, and they drift further from the accounts each year as leases are renewed and new ones signed, so the reconciliation grows longer. In the year of change it also stops a twelve-month test period from mixing quarters on the old basis with quarters on the new, which would produce a ratio that is neither. Most freezes end at a refinancing, when the new agreement sets its levels on the current standard and says plainly what the leases count as.

COMPLIANCE CERTIFICATE → · LTM EBITDA → · LOAN COVENANTS, EXPLAINED →