Alternative Information Sources and Information Asymmetry Reduction: Evidence from Small Business Debt

Abstract

We examine whether more sophisticated accounting methods (in the form of accrual accounting) interact with other information sources to reduce information asymmetries between small business borrowers and lenders, thereby lowering borrowers‫׳‬ probability of loan denial and cost of debt. We find that higher third party credit scores, but not the use of accrual accounting, decrease the likelihood of loan denial. However, firms using accrual accounting exhibit statistically lower interest rates after controlling for many factors associated with the cost of debt. Further, the interest rate benefits from accrual accounting are greatest when the borrower‫׳‬s credit score is low and/or the length of its banking relationship with the lender is short. This evidence indicates that accrual accounting can benefit small business borrowers, but that the information contained in third-party credit scores and obtained through ongoing banking relationships can substitute for the incremental information provided by accrual accounting.

The Value of Financial Statement Verification in Debt Financing: Evidence from Private U.S. Firms

“…First, there are several variables, such as the terms of the loan, collateral, and the length of the banking relationship, that have been identified as significant factors in previous studies but have not been included here as a result of data availability. For example, Cassar et al [2010] find that credit scores and banking relationships attenuate the benefits of accrual accounting in the small firm setting. This interaction effect with other information sources may possibly carry over to the setting of larger private firms considering a financial statement audit.…”

“…4 However, not all studies in the private firm setting find a negative relation between the presence of an audit and the cost of debt. Two studies using survey data from the Federal Reserve's Survey of Small Business Finances (Allee and Yohn [2009], table 8; Cassar et al [2010]) do not find that an audit is significantly associated with a lower interest rate in small privately held firms.…”

“…The choice of these variables is based on prior studies that have examined private firm interest rates (e.g., Blackwell et al [1998], Allee and Yohn [2009]), while I also acknowledge that I do not have access to certain variables used in prior studies (such as the presence of collateral and the length of the banking relationship, e.g., Cassar et al [2010]), which I discuss further below. Table 3 presents the statistics both unconditionally (panel A) and conditionally on audit level (panel B).…”

“…First, it enhances our understanding of the role of audits in the debt pricing process. While theory strongly suggests a negative relation between the cost of debt and the presence of an audit, the extant archival literature has mixed findings (e.g., Blackwell et al [1998], Allee and Yohn [2009], Cassar et al [2010], Kim et al [2011]). I contribute to the literature by explicitly addressing the endogeneity of the audit choice and by utilizing a significantly larger and broader U.S. private firm sample compared to prior studies.…”

“…Innovative recent studies (e.g., Ball and Shivakumar [2005], Burgstahler et al [2006], Allee and Yohn [2009], Cassar [2009], Cassar et al [2010], Kim et al [2011]) have begun to shed light on the economic importance of privately held firms and the uniqueness of their financial reporting environment. However, a considerable gap in our understanding of the lending technologies used in this setting remains (Berger and Udell [2006]).…”