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Abstract
Financial accounting has emphasized the historical cost approach because of its objectivity. Yet in the event of bankruptcy and liquidation, assets will be liquidated at their market values. In this paper, we compare the probability of insolvency computed using market values to the probability of insolvency computed using historical costs. We find that the historical value based computation has the potential to both understand and overstate the true probability of insolvency. The disparity between the historical value based computation and the market value based computations depends on the degree of leverage and the age of the assets.