Introduction

Laurent Birade, Masha Muzyka, Yashan Wang and Jing Zhang

Reserving for credit loss is one of the most critical aspects of a financial institution’s accounting practice. Its objective is to provide financial statement users with decision-useful information about the potential credit losses on financial instruments. Reserve measurement affects both the balance sheet and income statement. It impacts earnings, capital, dividends and bonuses, and attracts the attention of stakeholders — from the board of directors and regulators to equity investors. Following the 2007–09 global financial crisis, it was obvious that the accounting standard methodology for setting aside reserves — the “incurred loss model” (ILM) — failed to properly address timely adjustment of reserve levels, known as allowance for loan and lease losses (ALLL). The ILM relies on current and historical conditions to determine the level of ALLL, and as such, during the crisis, ALLL did not account for the economy’s negative outlook, which was apparent. As a result, reserves were not adequately representing the management’s expectation of credit losses, creating situations where institutions were building reserves at the same time they were booking actual charge-offs in excess