An agreement wherein a parent company promises that it will provide a subsidiary with all the financing requirements for a specific time period
Over 1.8 million professionals use CFI to learn accounting, financial analysis, modeling and more. Start with a free account to explore 20+ always-free courses and hundreds of finance templates and cheat sheets.
A keepwell agreement is an arrangement initiated between a parent company and one of its subordinate businesses. The parent company promises that it will provide the subsidiary with all the financing requirements for a specific time period. A keepwell agreement can be referred to as a comfort letter.
A keepwell agreement enables the subsidiary to look more creditworthy to the lenders. It implies that the subsidiary is more likely to get loans approved if there is a keepwell agreement in place. The guarantee period is predetermined by both parties and set at the time of outlining the contract.
However, a keepwell agreement is a product of negotiation preceding its creation, and it is usually more unclear and less specific than traditional legal commitments. There is no guarantee that such an agreement will be enforced since it cannot be invoked legally.
With the keepwell agreement, the parent company commits to offer the subsidiary help with all its financing requirements for a specific time period.
The agreement enables the subsidiary to enhance its credit rating and look more favorable to lenders and bondholders.
A keepwell agreement acts as a loss contingent and should be reported as a guarantee under the Statement of Financial Accounting Standard.
Significance of a Keepwell Agreement
When a subsidiary finds it difficult to access financing for continuing its business operations, a keepwell agreement proves to be helpful. Its parent company will support it financially and help it in maintaining solvency for the time period specified in the agreement. When a company puts a keepwell agreement in place, the creditworthiness of corporate borrowing and debt instruments increases.
A keepwell agreement assures the bondholders and lenders that the subsidiary can meet its financial commitments and continue to operate smoothly. A cash-strapped subsidiary can be seen favorably by suppliers in the presence of the agreement.
The parent company guarantees interest payments and other payment obligations of the subsidiary until the contract is active. The lenders and bondholders can resort to the parent company in case the subsidiary faces financial distress.
Moreover, a keepwell agreement helps to enhance the credit of the subsidiary through the credit support of the parent company. It attracts investors and reduces the risk of default, increasing the credit rating of the subsidiary and decreasing interest rates.
A keepwell agreement can also be drafted to enhance the credit of a bond. If a subsidiary fails to make bond payments, the trustees of the bond can enforce the agreement in the interest of the bondholders. The parent company accepts the responsibility of keeping the subsidiary in sound financial health.
Suppose ABC Co. is a parent company, and XYZ Inc. is one of its subsidiaries. XYZ Inc., a mobile phone manufacturer, is facing financial distress, and there is a shortage of supply. To continue the manufacturing of its new model of mobile phones, XYZ Inc. needs to secure a loan of $5 million. However, due to its low credit rating, it’s been difficult for XYZ Inc. to secure a loan.
Thus, to continue with the production and also keep interest rates low, XYZ Inc. can enter into a keepwell agreement with its parent, ABC Co., for a period equal to the term of the loan. ABC Co. will guarantee that XYZ Inc. remains financially stable during the loan term. It will increase the credit rating of XYZ Inc., and it can secure the loan with lower interest rates.
Financial Reporting of a Keepwell Agreement
Keepwell agreements act as loss contingents and should be reported as guarantees under the Statement of Financial Accounting Standard. Courts hold such agreements as a legally enforceable obligation if they agreement meet certain standard language criteria.
Hence, auditors must review the language of the keepwell agreement and attempt to find out the contingent liabilities that are not disclosed in the financial statements in cases when a keepwell agreement exists. The information regarding contingent liabilities related to the agreement can be obtained from management and third parties.
CFI offers the Commercial Banking & Credit Analyst (CBCA)™ certification program for those looking to take their careers to the next level. To keep learning and developing your knowledge base, please explore the additional relevant resources below:
Learn accounting fundamentals and how to read financial statements with CFI’s free online accounting classes.
These courses will give the confidence you need to perform world-class financial analyst work. Start now!
Building confidence in your accounting skills is easy with CFI courses! Enroll now for FREE to start advancing your career!
Take your learning and productivity to the next level with our Premium Templates.
Upgrading to a paid membership gives you access to our extensive collection of plug-and-play Templates designed to power your performance—as well as CFI's full course catalog and accredited Certification Programs.
Already have a Self-Study or Full-Immersion membership? Log in
Access Exclusive Templates
Gain unlimited access to more than 250 productivity Templates, CFI's full course catalog and accredited Certification Programs, hundreds of resources, expert reviews and support, the chance to work with real-world finance and research tools, and more.