Judgment in accounting:The case of credit losses in banks

Abstract

Principles-based accounting standards require the application of profes- sional judgment in the production of nancial statements. In recent years, the bene ts of such judgment has been debated, for example in relation to fair value measurement. An accounting area where estimates are of partic- ular sign cance is that of credit losses in the banking sector. In this paper, we evaluate the `incurred loss model' under IFRS - an accounting area char- acterized by relatively few estimates compared to the `expected loss model'. We nd that only recognizing incurred losses decreases the validity of loan loss provisions and thus has a negative e ect on the quality of accounting for credit losses in banks. This indicates that the expected loss model would work better to prevent or reduce negative e ects of nancial crises. There are consequently important implications for the IASB as it deliberates whether to adopt the more principles-based `expected loss model'.