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Market Transparency and the Accounting Regime


  • We are grateful to Hyun Song Shin and Thomas Hemmer for their guidance and continued support, the editor Ray Ball and one anonymous referee for detailed comments, and David Webb, Dimitri Vayanos, and seminar participants at LSE for helpful discussions. Both authors are PhD students in finance at LSE. Communications to: Department of Accounting and Finance, LSE, London WC2A 2AE, UK;,


We model the interaction of financial market transparency and different accounting regimes. This paper provides a theoretical rationale for the recently proposed shift in accounting standards from historic cost accounting to marking to market. The paper shows that marking to market can provide investors with an early warning mechanism while historical cost gives management a “veil” under which they can potentially mask a firm's true economic performance. The model provides new explanations for several empirical findings and has some novel implications. We show that greater opacity in financial markets leads to more frequent and more severe crashes in asset prices (under a historic-cost-accounting regime). Moreover, our model indicates that historic cost accounting can make the financial market more rather than less volatile, which runs counter to conventional wisdom. The mechanism shown in the model also sheds light on the cause of many financial scandals in recent years.

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