Auditing as a Signal in Small Business Lending

This paper models the borrowing decision of a small firm seeking a bank loan when it can optionally hire, at a cost, an independent external auditor to convey its risk characteristics to lenders. The analysis shows that a necessary condition for a potential borrower to prefer having an audit to not having an audit is that the borrower’s debt to equity ratio must be above a certain minimum cut-off value. For observed audit cost functions, this cut-off debt-equity ratio is higher for smaller initial size firms. Such firms will forego an audit even if they are of low risk, and potentially face loan denial and higher interest rate. Additionally, the cutoff debt-equity ratio is an increasing function of audit cost. Hence smaller audit costs may allow more high quality small firms to reveal their types to the banks, thus leading to a more partially separating equilibrium. The model suggests a number of interesting empirical questions for further study.