Accounting Quality, Factor Loading Uncertainty and Expected Stock Return

Abstract

We hypothesize and document that firms with worse accounting quality have higher factor loading uncertainty. Such a finding is robust across pooled sample analysis, firm fixed effects analysis, Fama-Macbeth estimation, and quasi-experiments utilizing financial restatements and firms? disclosures of their internal control weakness. The effect appears to be more pronounced in firms with worse information environment. In addition, innate accounting quality has a larger explanatory power compared with discretionary accounting quality. Employing path analysis methodology, we find that worse accounting quality is associated with lower stock returns through the channel of factor loading uncertainty. Such an effect dominates the positive stock return effect through beta. Collectively, our study suggests a new channel through which accounting quality can affect expected stock returns. Such a link has not been incorporated in prior studies, and helps explain the mixed evidence on the association between accounting quality and expected stock returns.