Credit Cycles and Financial Statement Verification

We use the US construction industry during the years 2002 to 2011 as a setting to examine whether credit cycles affect the use of financial statement verification in debt financing. Our estimates reveal that banks reduced their collection of unqualified audited 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 significant construction loan growth. These trends reversed during the subsequent housing crisis in 2008 to 2011 when the credit cycle reversed. Moreover, using bank and firm level data we find a strong negative (positive) relation between audited financial statements and subsequent loan losses (construction firm survival). Collectively, our results reveal that macroeconomic credit fluctuations produce temporal shifts in the overall level of financial statement verification in the economy and that temporal shifts in verification are related to bank loan portfolio quality and borrower performance.