Financial Statements as Monitoring Mechanisms: Evidence from Small Commercial Loans

• Author: ANDREW SUTHERLAND,MICHAEL MINNIS
• Published date: 01 March 2017
• Date: 01 March 2017
• DOI: http://doi.org/10.1111/1475-679X.12127

DOI: 10.1111/1475-679X.12127

Journal of Accounting Research

Vol. 55 No. 1 March 2017

Printed in U.S.A.

Financial Statements as Monitoring

Mechanisms: Evidence from Small

Commercial Loans

MICHAEL MINNIS

∗AND ANDREW SUTHERLAND

†

Received 22 February 2014; accepted 1 April 2016

ABSTRACT

Using a data set that records banks’ ongoing requests of information from

small commercial borrowers, we examine when banks use financial state-

ments to monitor borrowers after loan origination. We find that banks request

financial statements for half the loans and this variation is related to borrower

credit risk, relationship length, collateral, and the provision of business tax re-

turns, but in complex ways. The relation between borrower risk and financial

statement requests has an inverted U-shape; and tax returns can be both sub-

stitutes and complements to financial statements, conditional on borrower

∗University of Chicago Booth School of Business; †MIT Sloan School of Management.

Accepted by Christian Leuz. We thank Brad Badertscher, Douglas Baird, Ray Ball, Phil

Berger, Hans Christensen, Douglas Diamond, Joao Granja, Bjørn Jørgensen, Anil Kashyap,

Russell Lundholm, Edward Morrison, Valeri Nikolaev, Stephen Ryan (discussant), Nemit

Shroff, Stephanie Sikes, Douglas Skinner,Abbie Smith, Ross Watts, Joseph Weber (discussant),

Regina Wittenberg-Moerman, two anonymous referees, and the participants at the Colorado

Summer Accounting Research Conference, FARS Midyear Meeting, Goethe University, Lon-

don Business School, and London School of Economics for helpful comments. We are ex-

tremely grateful to Sageworks Inc. for providing the data for this project, and particularly to

Tim Keogh for providing assistance. Any errors or omissions are our own. Both authors grate-

fully acknowledge financial support from the University of Chicago Booth School of Business

and the Initiative on Global Markets. Minnis also acknowledges support from the ARAMARK

Faculty Research Fund. Sutherland acknowledges support from the Ernie Wish Fellowship.

The data used for this project are proprietary, but the authors are willing to provide code to

researchers with access to this data. An online appendix to this paper can be downloaded at

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

197

Copyright C, University of Chicago on behalf of the Accounting Research Center,2016

198 M.MINNIS AND A.SUTHERLAND

characteristics and the degree of bank–borrower information asymmetry. Fre-

quent financial reporting is used to monitor collateral, but only for non–real

estate loans and only when the collateral is easily accessible to lenders. Col-

lectively, our results provide novel evidence of a fundamental information

demand for financial reporting in monitoring small commercial borrowers

and a specific channel through which banks fulfill their role as delegated

monitors.

JEL codes: G21; G24; G32; G28; H25; H32; M40; M41

Keywords: loan monitoring; financial contracting; collateral; debt con-

tracts; relationship lending; tax returns; credit risk; banks

1. Introduction

When do banks use financial statements to monitor small commercial bor-

rowers? In serving as delegated monitors, banks privately collect informa-

tion from firms in order to discipline borrowers’ investment decisions and

protect any proceeds in case of default. While banks may prefer firms pro-

vide financial statements throughout the term of the loan, financial report-

ing is costly and substitute monitoring mechanisms are available (Cassar,

Cavalluzzo, and Ittner [2015]). In this paper, we empirically examine when

banks use financial statements to monitor borrowers using a proprietary

data set of small commercial loans. The data set includes not only loan con-

tract terms (e.g., maturity, interest rate, amount, presence of collateral), but

also the documents that banks request from the borrowers after the loan

has been originated (e.g., financial reports, tax returns and other nonfinan-

cial information). We find that, although financial statements are the most

requested document type in the data set, banks use them to monitor small

commercial borrowers for only half the loans in the sample. We model this

variation in ongoing financial statement requests as a function of the bank–

borrower relationship, borrower risk, use of collateral, business tax return

collection, nonfinancial information, and other loan terms to better under-

stand what factors are associated with the use of financial statements in the

monitoring of borrowers.

We motivate our analyses using theoretical frameworks that offer compet-

ing predictions for when banks and borrowers would agree to use financial

statements. For instance, the relation between a borrower’s risk and finan-

cial statement provision is not straightforward. On the one hand, ongoing

financial reporting may be more beneficial for high-risk borrowers because

commitments to higher levels of monitoring allow them to access credit

(e.g., Jensen and Meckling [1976], Watts [1977]). On the other hand, low-

risk firms could be more likely to produce financial statements and provide

them to lenders on an ongoing basis to portray themselves as high-quality

borrowers. Still other theories indicate the relation between a borrower’s

risk profile and the use of financial reporting is more complex and, in fact,

nonmonotonic (e.g., Diamond [1991]).

FINANCIAL STATEMENTS AS MONITORING MECHANISMS 199

Alternative financial information sources and monitoring mechanisms

are also prevalent, but the extent to which these alternatives serve as substi-

tutes for financial reporting is unclear. For example, tax returns are an im-

portant source of financial information that firms are required to produce

annually for the Internal Revenue Service (IRS). However, prior research

has been unable to directly examine how or when tax returns mediate the

usefulness of financial statements. Although tax returns are natural substi-

tutes for financial statements because of overlapping information, recent

findings suggest that tax reports can complement financial statements be-

cause of the implicit monitoring role of the IRS (e.g., Hanlon, Hoopes,

and Shroff [2014]). How financial reporting interacts with collateral is also

unclear, a priori. The evidence in Bester [1987] suggests that collateral re-

duces the need for financial statement monitoring, but the analysis in Rajan

and Winton [1995] suggests that the use of collateral enhances the demand

for financial statements to monitor the existence and condition of pledged

assets.

Collectively, theoretical arguments produce a variety of predictions for

when financial statements will be used as monitoring mechanisms in debt

contracting. We divide the theoretical framework into three specific re-

search questions to structure our empirical analyses: (1) How is borrower

credit risk related to the propensity for banks to use borrower financial

statements? (2) Are financial statements and collateral substitute or com-

plement mechanisms? (3) How do tax returns relate to the use of financial

statements?

We investigate these research questions in the setting of small commer-

cial loans. In this setting, banks and borrowers address information asym-

metry problems exclusively through private reporting channels, rather than

public disclosures (Diamond [1984, 1991], Fama [1985], Rajan and Win-

ton [1995]). Examining private information channels isolates the reporting

motives related to the credit relationship compared to public voluntary dis-

closure decisions that also take into consideration the reactions of competi-

tors, suppliers, employees, and others.1Moreover, the lack of a regulatory

mandate in this setting allows us to better isolate a market-driven equilib-

rium of financial reporting. We present three main empirical results.

First, we find that banks collect financial statements more frequently

from borrowers with middle-tier credit risk relative to borrowers with ei-

ther high or low credit risk. This finding is consistent with the intuition of

Diamond [1991]. Diamond [1991] suggests that low-risk borrowers require

little monitoring because their positive reputation allows them to “have a

lower cost of capital, and such a rating needs to be maintained to retain this

source of higher present value of future profits.” As such, “these high-rated

1Privately held firms are not the only setting where private monitoring can be studied,

however. Recent research also uses the setting of public firms by examining the extent and

type of private communications agreed upon between borrower and lender in the publicly

available contractual agreements (e.g., Frankel et al. [2011], Carrizosa and Ryan [2016]).