Judgments about the Quality of Loans and Loan Originators under Expected versus Incurred Loss Accounting

By recognizing expected credit losses at loan origination, the FASB’s new accounting for credit losses (CECL) changes the “Day 1” information as compared to the prior accounting (SFAS 5). Two experiments test whether CECL differentially affects financial statement users’ views about both the quality of the loan (i.e., default likelihood) and the loan originator as compared to SFAS 5. Results reveal the perceived default likelihood is higher at loan origination under CECL versus SFAS 5. Moreover, once users learn that a realized loss occurred, CECL (but not SFAS 5) attenuates biased thoughts of “knowing all along” that a loss was imminent, but only for those with low business knowledge. High business knowledge users are immune to falsely believing they “knew all along” under both accounting methods. Views about the quality of the lender’s decision-making process are determined solely by whether or not users learn that the loan is in default.