Financial Information Credibility, Legal Environment, and SMEs’ Access to Finance

Abstract

There remains academic debate on the association between credible financial information and small firms’ access to diversified sources of finance. This study investigates the role of credible financial information and its interaction with a country’s legal and regulatory environment on the access of small- and medium-sized enterprises (SMEs) to diversified sources of finance in 129 developing countries. The findings indicate positive impacts of financial information quality and a country’s legal and regulatory environment on small firms’ access to diversified sources of finance. SMEs operating in a weak legal and regulatory environment benefit more from providing credible financial information. The findings are robust after controlling for the endogeneity of firms audit decision using a two-stage instrumental variable method. Our evidence suggests that firms’ credible signaling of the quality of their financial information helps reduce the adverse selection problem for finance suppliers, increasing small firms’ access to diversified sources of finance.