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) interacts with other information sources and the pledging of collateral 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, third-party credit scores and information obtained through ongoing banking relationships appear to substitute for the incremental information from accrual accounting, with the benefits from accruals decreasing in the firm’s credit score and relationship length. We find little evidence that any of the alternative information sources influence loan decisions when collateral is pledged, consistent with theories that collateral provides an alternative means for addressing information asymmetry problems. Finally, our results indicate that borrower characteristics such as the firm's age and legal liability further moderate the relations between the various information sources and interest rates.

Keywords: accounting sophistication; accrual accounting; credit denial; credit scores; cost of capital; interest rates; relationship lending; small business; soft information; collateral

JEL Classification: G12, G21, G33, M41, M44