Testing debt covenant compliance means obtaining every financial covenant in every active borrowing agreement, recomputing each covenant ratio using the agreement's own defined terms rather than the statutory financial statement line items, and tracing any breach — waived or not — through to two separate consequences: whether the loan should be classified as current under Ind AS 1, and whether the breach is a factor relevant to the going-concern assessment under SA 570.
Why the agreement's definitions, not the financial statements, govern
Loan agreements define EBITDA, net debt, tangible net worth and fixed charge coverage in their own terms, and those definitions routinely diverge from the financial statement captions with the same name — add-backs for one-off items, exclusion of lease liabilities, different treatment of minority interest. Recomputing a covenant using the statutory figures instead of the contractual definitions is a common source of a false pass.
The testing sequence
- 01Obtain every active loan agreement and list every financial covenant in itNot just the facility the entity flags as having covenants — read each agreement, including smaller working capital lines, which sometimes carry covenants the entity has stopped monitoring.
- 02Extract the exact definition of each ratio term from the agreementEBITDA, net worth, total debt and coverage definitions as the lender defined them, including any specified add-backs, carve-outs or testing frequency.
- 03Recompute each covenant ratio independently as at the relevant testing dateUsing the entity's trial balance and the agreement's own definitions, not the entity's self-prepared covenant compliance certificate.
- 04Compare the recomputed ratio to the required threshold and to the entity's own certificateAny difference between your recomputation and the entity's certificate should be investigated and explained before concluding either way.
- 05For any breach found, obtain the lender's response in writingA waiver letter, an amendment, or a demand notice. An oral assurance that the lender 'won't call the loan' is not sufficient evidence on its own.
- 06Test the classification consequence of an unwaived breach as at the reporting dateUnder Ind AS 1, a loan is classified as current where the entity breaches a covenant on or before the reporting date giving the lender the right to demand repayment, unless the lender has agreed, on or before the reporting date, not to demand repayment for at least twelve months after that date — a waiver obtained after the reporting date does not change the classification as at that date.
- 07Feed the breach into the going-concern assessment, independent of the classification outcomeEven a waived breach is relevant evidence about the entity's financial trajectory and the lender relationship, and should be considered alongside the entity's cash flow forecasts and its ability to meet the next covenant test date, not dismissed because the balance sheet classification issue has been resolved.
- 08Test subsequent covenant test dates falling within the going-concern assessment periodWhere the next test date falls within twelve months of the audit report, recompute a forecast covenant position using the entity's own cash flow forecast and assess whether a further breach is likely.
| Question | Evidence |
|---|---|
| What does the loan agreement actually require | Covenant clauses, defined terms schedule, testing frequency |
| Was the covenant met | Independent recomputation from the trial balance using the agreement's definitions |
| Was there a breach, and was it waived | Lender correspondence dated on or before the reporting date |
| Does the loan classify as current | Ind AS 1 twelve-month waiver test applied to the actual waiver date |
| Does this affect going concern | Forecast covenant position at the next test date against the cash flow forecast |
A covenant waiver that arrives after the reporting date, however routinely the lender grants it each year, does not change the current-versus-non-current classification as at that reporting date under Ind AS 1. The date on the waiver letter matters more than the fact of the waiver.
How we think about this
Recomputing a covenant ratio from a defined formula is deterministic and should be reperformed exactly, not sampled or accepted from a management certificate. Deciding what a breach, a waiver, or a forecast covenant shortfall means for going concern is a judgement about the entity's future, and that judgement is the auditor's, informed by the recomputation but not replaced by it.
This is practical guidance written for audit teams, not an authoritative statement of any standard or statute. Standards, forms and timelines change. Check the current text issued by the ICAI and the relevant authority before relying on anything here in an audit file.
Related resources
- Audit workflow & automationSA 570: going concern, and when it actually changes the audit reportMost going-concern evaluations end exactly where they should: no material uncertainty, no change to the report. The standard is about the minority of cases where that's not true.
- Bank, cash & treasuryLoans and borrowings audit checklistSanction letter checks, charge verification against ROC filings, covenant compliance, interest testing, and current/non-current classification.
- Bank, cash & treasuryBank confirmation letters: what to request and verifyWhat a bank confirmation covers beyond the balance, how to keep the request genuinely independent, and what to do when the bank is late.
- Audit workflow & automationSA 540: auditing accounting estimates, where judgment replaces a verifiable numberAn estimate can't be vouched to a source document the way an invoice can. SA 540 is about what replaces vouching when there's no single right answer to check against.
Free tools, no signup
Each one reads a file entirely in your browser — or, for two of them, just answers a few questions — and nothing is ever uploaded.
- Purchase register checkDuplicate payments, round-sum amounts, weekend-dated invoices, incomplete records.
- GSTR-2B reconcilerMatches your purchase register against GSTR-2B — missing invoices either side, amount mismatches.
- Bank reconciliation checkerMatches your cash book against a bank statement — what's outstanding on each side.
- Fixed asset register checkDuplicate asset codes, missing location or useful life, negative net book value.
- Payroll red-flag scannerBank accounts shared across employees, and records missing an ID, PAN or salary.
- CARO applicability checkerAnswer a few questions about the company and see which CARO 2020 clauses likely apply.
- MSME payment delay checkerMSME-flagged invoices paid — or still unpaid — beyond the 45-day Section 22 limit.
- Related-party transaction screenerTransactions above a threshold you set with no approval reference, grouped by counterparty.
- Depreciation useful life checkerCompares a useful life in use against the Schedule II, Part C indicative figure.
- Materiality calculatorOverall and performance materiality against PBT, revenue, assets or equity, with reasoning shown.
- Sample size calculatorStatistical sample size for a test of controls or a substantive test of detail.