Economic Growth and Financial Statement Verification

• Published date: 01 September 2017
• DOI: http://doi.org/10.1111/1475-679X.12165
• Date: 01 September 2017

DOI: 10.1111/1475-679X.12165

Journal of Accounting Research

Vol. 55 No. 4 September 2017

Printed in U.S.A.

Economic Growth and Financial

Statement Verification

PETRO LISOWSKY,

∗MICHAEL MINNIS,

†

AND ANDREW SUTHERLAND

‡

Received 22 September 2015; accepted 17 November 2016

ABSTRACT

We use a proprietary data set of financial statements collected by banks to ex-

amine whether economic growth is related to the use of financial statement

verification in debt financing. Exploiting the distinct economic growth and

∗University of Illinois at Urbana-Champaign and Norwegian Center for Taxation;

†University of Chicago Booth School of Business; ‡Massachusetts Institute of TechnologySloan

School of Management.

Accepted by Stephen Ryan. This paper was previously titled, “Credit Cycles and Financial

Statement Verification.” We thank two anonymous referees, Ray Ball, Itzhak Ben-David (dis-

cussant), Phil Berger, Robert Bushman, Hans Christensen, Christian Leuz, Canice Prender-

gast, Nayana Reiter (discussant), Amit Seru, Douglas Skinner, Luigi Zingales, and participants

at the PCAOB-JAR Conference on Auditing and Capital Markets, FARS Midyear conference,

and Chicago Booth, Iowa, National University of Singapore, Singapore Management Univer-

sity, and Wharton workshops for helpful comments. We are extremely grateful to the Risk

Management Association, Sageworks Inc., and the Internal Revenue Service (IRS) for pro-

viding data for this project. Confidential tax return information was provided to Lisowsky by

the IRS Large Business & International (LB&I) Planning, Analysis, Inventory, and Research

Division (PAIR). Because tax data are confidential and protected by data nondisclosure agree-

ments under the Internal Revenue Code, all statistics are presented in the aggregate so that

no specific taxpayer can be identified from this manuscript. Any opinions are those of the au-

thors and do not necessarily reflect the views of the IRS. Lisowsky acknowledges support from

the MIT Sloan School of Management, as well as the PricewaterhouseCoopers Faculty Fellow-

ship and the Professor Ken Perry Faculty Fellowship at the University of Illinois at Urbana-

Champaign. Minnis acknowledges support from the ARAMARK Faculty Research Fund and

the Chicago Booth School of Business. Sutherland acknowledges support from the Ernie Wish

Fellowship at the Chicago Booth School of Business and MIT Sloan School of Management.

Any errors or omissions are our own. An online appendix to this paper can be downloaded at

http://research.chicagobooth.edu/arc/journal-of-accounting-research/online-supplements.

745

Copyright C, University of Chicago on behalf of the Accounting Research Center,2017

746 P.LISOWSKY,M.MINNIS,AND A.SUTHERLAND

contraction patterns of the construction industry over the years 2002–2011,

our estimates reveal that banks reduced their collection of unqualified au-

dited financial statements from construction firms at nearly twice the rate

of firms in other industries during the housing boom period before 2008.

This reduction was most severe in the regions that experienced the most sig-

nificant construction growth. These trends reversed during the subsequent

housing crisis in 2008–2011 when construction activity contracted. Moreover,

using bank- and firm-level data, we find a strong negative (positive) relation

between audited financial statements during the growth period, and subse-

quent loan losses (construction firm survival) during the contraction period.

Collectively, our results reveal that macroeconomic fluctuations produce tem-

poral shifts in the overall level of financial statement verification and tempo-

ral shifts in verification are related to bank loan portfolio quality and bor-

rower performance.

JEL codes: D82; E32; E44; G21; M40

Keywords: economic growth; commercial lending; banks; financial crisis;

audit; verification; financial statements; lending standards

1. Introduction

A substantial literature in accounting highlights that audited financial state-

ments are a key input into lenders’ underwriting and monitoring prac-

tices. Banks can request financial statements audited by an independent

accountant as part of a formal contract or as part of an implicit contract-

ing process to learn more about the borrower (e.g., Armstrong, Guay, and

Weber [2010], Christensen, Nikolaev, and Wittenberg-Moerman [2016]).

Studies examining the use of accounting in debt financing typically con-

sider borrower, bank, or contract-specific characteristics. However, recent

theories argue that broader economic conditions affect banks’ lending

standards (e.g., Ruckes [2004], Dell’Ariccia and Marquez [2006]). In par-

ticular, favorable economic shocks within a sector create a surge in credit

demand, which in turn compels competition among banks to reduce the

actual or perceived benefit of firm-specific credit analysis. As a result,

these theories broadly suggest that economic growth and underwriting

standards—of which financial statement verification via auditing is an im-

portant input—are negatively related. Motivated by this theoretical frame-

work, we investigate two research questions: Does financial statement ver-

ification in debt contracting change with the rate of economic growth

within a sector? If so, does this variation have implications for loan portfolio

performance?

We use the U.S. construction industry from 2002 to 2011 to examine

these questions. This setting has several useful features. First, the vast ma-

jority of the construction activity is conducted by privately held firms that

ECONOMIC GROWTH AND FINANCIAL STATEMENT VERIFICATION 747

FIG. 1.—Acquisition, development, and construction (ADC) loans at FDIC-supervised institu-

tions, 1991–2010. This figure reports the amount (in billion dollars) of ADC loans outstanding

each year (source: U.S. Office of Inspector General [2012, p. 4]).

do not face an audit mandate.1Thus, for the vast majority of firms in the

construction industry, independent verification of financial performance is

a market-driven equilibrium with the potential to vary with economic con-

ditions. Second, the industry experienced significant variation in economic

growth over this period. Commercial construction and development loans

outstanding increased from $200 billion in 2001 to nearly $700 billion by

2008 (see figure 1 and OIG [2012]). Employment (number of construction

establishments) increased by 900,000 (74,716), or 13% (11%), during this

same period (U.S. Bureau of Economic Analysis [2015], U.S. Census Bu-

reau [2016]). After the onset of the housing crisis, construction loan losses

exceeded $100 billion (FDIC Call Reports); the construction industry ac-

counted for over one-third of net private sector job losses from 2007 to

2011, or 2.1 million jobs (Bureau of Economic Analysis); and the number

of construction establishments decreased from a peak of 773,614 to 657,738

in 2011 (U.S. Census Bureau [2016]). Moreover, the economic growth ex-

perienced by this industry over this time varied greatly across geographic re-

gion. Therefore, this setting provides the necessary economic significance

and temporal and spatial variation in auditing and economic performance

to examine our research questions.

We use a proprietary data set of borrower financial reports compiled by

the Risk Management Association (RMA) and a difference-in-differences

research design to examine how intensively banks verified the financial

1Construction firms with fewer than 500 employees represent over 84% (98%) of total

employment (establishments) in the industry, versus 48% (84%) for all U.S. industries (U.S.

Bureau of Economic Analysis [2015]).