How Do Forward‐Looking Estimates of Credit Losses Affect the Judgments of Financial Statement Users?

ABSTRACT

Financial accounting standard setters recently changed the accounting for estimates involving credit risk. The change shifted the accounting from an incurred‐loss model (ILM), which is based on credit‐risk conditions that exist at the time of the estimate, to a model based on expected credit losses over the life of the asset in question (ELM), which considers expectations of future conditions. Our paper is based on the theoretical premise that ELM will reduce surprise via its Day 1 forewarning, which, in turn, should lessen the potential for hindsight bias (i.e., Monday‐morning quarterbacking) and judging management as having made a poor quality lending decision if an actual credit loss later occurs. Three experiments support this premise, revealing when ELM accounting should have a differential impact relative to the prior accounting.