A loan agreement may require specification of whether original financial statements are prepared under IFRS or a local (national) GAAP and may establishes whether the financial statements are to be prepared using flexible or frozen GAAP.  Using flexible GAAP, a company prepares its financial statements for lenders according to the current GAAP as they change, whereas under frozen GAAP the borrower prepares its financial statements for lenders in accordance with the GAAP that apply at the time a loan agreement is executed.

Flexible GAAP, rather than frozen GAAP, is prescribed in the American Banking Association (ABA) model indenture agreement as well in Loan Market Association (LMA) facility agreements.  The purpose of frozen GAAP provisions is to apply contractual covenants formulated on the basis of accounting standards in existence at the date of the signing of the financing agreement, prior to an accounting change.  Frozen GAAP allows for the comparison of the borrower’s financial performance and compliance with financial covenants after any change in the applicable GAAP.

Changes of New Lease Accounting Standards on Financials
Ratio Operating Lease Finance Lease
Current Ratio Higher Lower
Working Capital Higher Lower
Asset Turnover Higher Lower
Return on Assets (ROA) Higher Lower
Return on Equity (ROE) Higher Lower
Debt/Equity Ratio (D/E) Lower Higher

Where financing facilities include financial covenants, lenders generally insist on the frozen GAAP provision for the convenience and certainty it provides in enabling the covenants to be measured on a consistent basis.  Borrowers, however, will be concerned about the cost and effort of applying frozen GAAP, especially the need to involve auditors to validate calculations and presentation based on prior period accounting standards as well as the added administrative burden.

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