Accounting and auditing of credit loss estimates: The hard and the soft

Abstract

A key goal of financial reporting is to address information asymmetries, which are amplified in the case of banks given their credit, maturity and liquidity transformation and complex, judgmental accounting standards dealing with expected credit losses (ECL).The paper explores the role of bank management in estimating and recognizing ECL, and how external auditors challenge the resulting figures. Based on analysis of G-SIB disclosures, it concludes that management and auditors tend to prioritize observable and verifiable, hard information to reduce challenge to their reported estimates and protect against the threat of legal liability. Emphasis on such information facilitates loss deferral, damaging the reliability of banks’ financial reporting, obscuring their safety and soundness picture and jeopardizing financial stability.Based on these conclusions, the paper seeks to open a new path to the research and policy analysis of credit loss recognition, introducing proposals to address the procyclicality of credit loss accounting by tackling inappropriate incentives that decouple risk taking from its translation onto banks’ financial statements.

Keywords

• Expected Credit Losses
• Information asymmetries
• Disclosures
• Externalities
• Financial stability
• Procyclicality