A borrower can report positive income and still violate its borrowing agreement because contractual definitions exclude particular earnings adjustments. To perform debt covenant calculations, the preparer translates each provision into specified inputs, a measurement date, and an exact comparison.
A debt covenant is a contractual requirement governing the borrower during the lending relationship, including required actions, prohibited actions, and financial limits.
The triggering event follows the particular provision: a declaration restriction applies when a dividend is declared, while a payment restriction applies when cash leaves. A restriction covering both events requires both tests, using any contractually required adjustment for the proposed distribution.
- Identify whether calculations cover the parent, a named subsidiary, or the consolidated group.
- Separate balance-sheet inputs measured on one date from income and cash-flow inputs measured over a stated period.
- Distinguish quarter-end testing from continuous compliance and testing immediately before or after a proposed transaction.
- Apply specified accounting policies, including any agreement that freezes definitions despite later accounting changes.
Common mistakes
- Wrong debt definition. Including Briar's $400,000 operating lease liability overstates contract debt; subtracting cash from debt-to-equity applies a deduction permitted only for net leverage.
- Double-counted adjustment. Adding the $240,000 depreciation twice produces adjusted EBITDA of $1,240,000 instead of $1,000,000 in Example 1.
- Wrong payment period. Replacing $340,000 historical scheduled principal with a future maturity figure changes the specimen's trailing-twelve-month debt-service test.
Bottom line
- Covenant definitions, measurement dates, entity scope, permitted adjustments, and triggering events control every compliance calculation.
- Each financial test stands independently, and equality passes only when the contractual inequality includes it.
- Permitted earnings add-backs must be supported, capped when required, and counted without duplication.
- A breach's classification effect depends on repayment rights, scheduled maturities, and any applicable exception.
Exam shortcut
Start by marking the measurement date, comparison sign, and defined numerator and denominator. Build a separate reconciliation for each adjustment before entering ratios. For a near-threshold maximum, multiply the permitted ratio by the positive denominator and compare that dollar ceiling with the numerator. This exposes a breach hidden by rounded ratios. When classification is requested, mark each instrument's current portion first.
The full lesson (about 4,624 words, 31 min read) adds 2 worked examples, all 6 common mistakes, a self-check, free in the app.
Learning objectives
- II.H2
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