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Stock returns
Information risk, stock returns, and asset
and asset pricing: Evidence pricing

from China
Raheel Safdar and Chen Yan 379
School of Accounting, Dongbei University of Finance and Economics,
Dalian, China Received 24 April 2015
Revised 4 October 2015
Accepted 23 December 2015

Abstract
Purpose – This study aims to investigate information risk in relation to stock returns of a firm and whether
information risk is priced in China.
Design/methodology/approach – The authors used accruals quality (AQ) as their measure of
information risk and performed Fama-Macbeth regressions to investigate association of AQ with future
realized stock returns. Moreover, two-stage cross-sectional regression analysis was performed, both at firm
level and at portfolio level, to test if the AQ factor is priced in China in addition to existing factors in the Fama
French three-factor model.
Findings – The authors found poor AQ being associated with higher future realized stock returns.
Moreover, they found evidence of market pricing of AQ in addition to existing factors in the Fama French
three-factor model. Further, subsample analysis revealed that investors value AQ more in non-state owned
enterprises than in state owned enterprises.
Research limitations/implications – The study sample comprises A-shares only and the
generalization of the findings is limited by the peculiar institutional and economic setup in China.
Originality/value – This study contributes to market-based accounting literature by providing further
insight into how and if investors value information risk, and it seeks to fill gap in empirical literature by
providing evidence from the Chinese capital market.
Keywords Cost of capital, Accruals quality, Information risk, Asset pricing tests
Paper type Research paper

1. Introduction
The questions concerning the role of information risk in determination of a firm’s cost of
capital and whether information risk is diversifiable are among the most contentious issues
in market-based accounting literature. A number of recent studies, both theoretical and
empirical, attempt to address these issues but they fall far from agreement. The traditional
asset pricing models, e.g. capital asset pricing model and the Fama and French (1993) three-
factor model, do not incorporate any factor concerning information risk of a firm and thus
maintain that information risk is diversifiable and, therefore, should not command a risk
premium. Opposing this view, a theoretical model by Easley and O’Hara (2004) proposes
that stocks with more private information risk pose greater risk to unaware investors who
are unable to diversify it and would, therefore, demand a risk premium for it. However,
Hughes et al. (2007) argued that information asymmetry does not affect cost of capital in a
cross-section of firms after controlling for factor betas and is not priced in a large market.
However, they maintain that higher information asymmetry about systematic factors leads Accounting Research Journal
Vol. 30 No. 4, 2017
pp. 379-394
© Emerald Publishing Limited
1030-9616
The authors are thankful to the anonymous referee for providing insight. DOI 10.1108/ARJ-04-2015-0057
ARJ to overall higher cost of capital in the economy through increased factor risk premiums.
30,4 More recently, Lambert et al. (2012) showed that in markets with perfect competition,
information asymmetry does not affect the cost of capital but information precision does.
Moreover, in imperfect markets, information asymmetry, as well as information precision
plays a role in determination of cost of capital of a firm.
Francis et al. (2005), using US data, documented that poor accruals quality (AQ), their
380 proxy of information risk, is associated with higher cost of capital and an AQ factor is a
priced risk factor in addition to existing factors in the Fama and French (1993) three-factor
model. However, Core et al. (2008) criticized their methodology and showed that AQ is not a
priced risk factor in USA. Later, Kim and Qi (2010) showed that AQ is a priced risk factor
after controlling for low-priced stocks and the market price AQ only in periods of economic
expansion. Outside USA, Gray et al. (2009) reported AQ to be priced risk factor in Australia,
but Mouselli et al. (2013) reported AQ not being priced risk factor in the UK. Moreover, using
probability of information-based trading (PIN), Easley et al. (2002) showed information risk
being relevant in assets’ returns, but Duarte and Young (2009) showed PIN being priced
because of its illiquidity component and not because of information asymmetry component.
This lack of consensus in recent studies, both theoretical and empirical, and the fact that
almost all of these studies are conducted in developed economies motivate us to investigate
these questions in China, which is a huge but developing economy and has its unique
economic and institutional setup. Moreover, the notoriously opaque information
environment in China prompts us to explore the role of information risk in Chinese capital
market. So, this study aims at investigating information risk in relation to cost of capital of a
firm and, also, whether information risk is a priced risk in China.
We used AQ, as measured by Francis et al. (2005), to proxy information risk, and to test
the relationship between information risk and cost of capital, we performed Fama and
Macbeth (1973) regressions of monthly stock returns over AQ and other firm-specific
characteristics. Our results show that poor AQ is significantly associated with higher future
realized stock returns and suggest a role for information risk. But this relation is somewhat
attenuated if we control for firm beta. Further, we performed asset pricing tests using two-
stage cross-sectional regressions (2SCSR) to test whether an AQ factor is a priced risk factor
in China in addition to existing factors in the Fama and French (1993) three-factor model.
Our results provide evidence of an AQ_factor being priced in firm-level analysis, and results
are similar when using alternative measures of information risk, i.e. discretionary accruals,
earnings volatility and earnings smoothing.
This study contributes to market-based accounting literature by providing further
insight into investors’ valuing of information risk. Our results have theoretical implications
by supporting theories suggesting a role for information risk in investors’ decision-making.
Moreover, this study further highlights the differences between state-owned enterprises
(SOEs) and non-state-owned enterprises (NSOEs) in China, particularly from information
risk and cost of capital perspectives. The rest of the paper is arranged as follows. Section 2
develops hypotheses for testing; Section 3 delineates our research design; Section 4 presents
results and analysis; and Section 5 concludes this paper.

2. Review of literature and hypothesis development

We define information risk as the likelihood that firm-specific information relevant to
investor’s decisions is of poor quality (Francis et al., 2005). The existing asset pricing
models, e.g. Fama French three-factor model, though consider that factors other than market
risk can influence the expected return, they do not incorporate information risk and
maintain that information risk is diversifiable in an efficient portfolio and, therefore, should
not command a risk premium. Contrary to this view, Easley and O’Hara (2004) noted that Stock returns
the information structure surrounding a company’s stock can influence its cost of capital. In and asset
their theoretical model, they showed that stocks with relatively greater amount of private
information pose greater risk to the unaware investors who are unable to readjust their
pricing
portfolios according to total information existing in the market. Thus, a sort of systematic
risk arises which uninformed investors cannot diversify away. So they require greater
returns to compensate this information risk. Hughes et al. (2007) showed that, given a fixed
level of total information in the market, greater information asymmetry leads to market- 381
wide higher cost of capital but is not relevant in cross-section of firms. However, Lambert
et al. (2012) argued that perfect competition information precision, rather than information
asymmetry, affects a firm’s cost of capital and firms can reduce their cost of capital by better
disclosure.
Francis et al. (2005) tested the hypothesis that AQ, their proxy of information risk, is a
priced risk factor. They created an AQ factor and documented that market price AQ as non-
diversifiable risk in addition to existing factors in the Fama French three-factor model in the
USA. However, Core et al. (2008) criticized their methodology and retested the said
hypothesis using 2SCSR methodology. They concluded that AQ is not a priced risk factor in
the USA. They further showed that AQ, even as firm characteristics, is not significant in
explaining the future stock returns. Mouselli et al. (2013) used absolute discretionary
accruals to calculate AQ in the UK and showed that AQ is not a priced risk factor. However,
they showed that AQ, as a characteristic, has a significantly positive relationship with
future stock returns. A major deficiency in this later mentioned finding of Mouselli et al.
(2013) is that they skipped firm beta from other explanatory variables used by Core et al.
(2008) when testing the relationship between AQ and future stock returns. Here it is
pertinent to mention that Lambert et al. (2007) argued that the cost of capital effect of
information risk is “fully captured by an appropriately specified, forward-looking beta” and
market expected returns so there is no need to put an additional factor of information risk in
the asset pricing models. In Australia, Gray et al. (2009) provide evidence for AQ being a
priced risk factor.
The conflict in literature regarding market pricing of AQ, specifically in the USA, is
conciliated to some extend by Kim and Qi (2010) who documented that AQ is not a priced
risk factor if we consider all firms over the sample period. However, they found evidence of
market pricing of AQ after controlling for low-priced stocks from their sample. In this
regard, they argued that low-priced stock constitutes only 2 per cent of total market size, and
their returns are noisy because of various factors, and it is difficult to detect AQ and returns
relationship in this case. Further, they showed that AQ is priced in periods of economic
expansion but not in recessionary periods. Ogneva (2012) reported that AQ is negatively
associated with future realized returns after controlling for cash flow shocks. She also found
evidence of market pricing of the AQ factor. The aforementioned conflicting evidences in
literature and the unique institutional and economic environment of China provide us with
the motivation to investigate market pricing of AQ in China. Thus, we develop the following
hypotheses in this regard to test the relationship between AQ and the future stock returns
and market pricing of AQ. Stated in null form:
H1. There is no relationship between accruals quality and future stock returns of a firm.

H2. Accruals quality is not a priced risk factor in China.

One potential pitfall in using AQ as measure of information risk is that it focuses primarily
on information asymmetry between the insider management and the outsider stockholders
ARJ while ignoring the risk arising from information asymmetry among the shareholders
30,4 themselves. So, there is possibility that a firm with relatively poor AQ but lower information
asymmetry among shareholders and effective checks on insider trading may pose lesser
information risk than a firm with better AQ but higher information asymmetry among
shareholders and greater insider trading. However, in our sample, we believe it to be highly
improbable that firms with poorer AQ, experiencing lower information asymmetry among
382 shareholders and having effective control over insider trading are given the high ownership
concentration in Chinese firms and poor corporate governance setup in China. Moreover, we
use alternative measures of information risk to strengthen our research design. The next
section explains in details the research design to test the hypotheses developed in this
section.

3. Research design
In early 1990s, when Shanghai Stock Exchange and Shenzhen Stock Exchange were
established, the Chinese stock market comprised mainly SOEs, with only a small proportion
of their outstanding stock being tradable in the market. This dual class structure was very
peculiar to China and was introduced initially considering the economic realities of the
country. Over time, as the economy was transformed and increasingly Westernized, the
equity dual class structure proved a hindrance in the growth and efficiency of the capital
market. So in year 2006, non-tradable shares reforms were initiated at a wide scale and,
resultantly, holders of non-tradable shares were granted trading rights by reaching some
settlement with holders of existing tradable shares in individual firms. Since non-tradable
shares reforms the market activity is more vigorous as the number of tradable shares has
increased manifold. Trading is more and more reflective of firm-specific information as the
block-holders who have potential information advantage but earlier possessed non-tradable
shares are now able to trade their holdings. Because of non-tradable shares phenomenon and
given that we aim at investigating information risk, which we believe is more relevant after
non-tradable shares reforms, we limit our final analysis of market pricing of information
risk to the period 2006-2013. However, because of computational requirements of certain
variables, which in some cases require prior six yearly observations, our initial sample
comprises all non-financial firms having A-shares issued and listed on Shanghai Stock
Exchange or Shenzhen Stock Exchange from year 2000 to 2013. The relevant monthly and
annual data are obtained from RESSET Financial Research Database (www.resset.cn).
Chinese equity market has several other unique characteristics which set it apart
from other major equity markets in the world. A huge chunk of market capitalization
comprises SOEs, with a fractional part privatized, and state holds the direct control of
these enterprises through government appointed officials. These SOEs are huge in size
and hold many characteristics different from other firms and enjoy preferential
treatments from government and debt market (Chen et al., 2011). Further, there are
different categories of shares traded in the market of which the most noteworthy are the
A-shares and B-shares. A-shares are the Chinese Yuan-denominated shares issued by
domestic firms and can only be held by the Chinese nationals. However, in recent years
the Chinese government has allowed some foreign investment bodies under qualified
foreign institutional investors scheme to invest a limited amount in A-shares. A-shares
constitute the predominant part of the equity market. B-shares are foreign currency
denominated shares and were entitled originally for foreign investment, but since 2001
they are open for investment by Chinese nationals too.
3.1 Measuring accruals quality Stock returns
Following the stream of research that investigates the role of information risk in explaining and asset
stock returns and cost of capital (Francis et al., 2005; Core et al., 2008; Cohen, 2008; Kim and
Qi, 2010; Mashruwala and Mashruwala, 2011; Mouselli et al., 2013, etc.), we use AQ as proxy
pricing
of information risk. In this regard Francis et al. (2005) argued, as mentioned earlier, that
accruals component of earnings is the main source of uncertainty in cash flows and is a more
valid measure for information risk than other attributes of earnings. To measure AQ we use
Dechow and Dichev (2002) model as modified by Francis et al. (2005), hereinafter modified-
383
DD model. The modified-DD model is as follows:

TCAi;t ¼ f o; i þ f 1; i CFOi;t1 þ f 2; i CFOi;t þ f 3; i CFOi;tþ1 þ f 4; i DRevi;t

þ f 5; i PPEi;t þ y i;t (1)

TCAi,t is the total current accruals of a firm i in year t calculated as net income plus
depreciation minus cash flow from operations (TCAi,t = NetIncomei,t – CFOi,t þ
Depriciationi,t). CFOi,t is the cash flows from operations of a firm in year t obtained from
cash flow statement. CFOi,t1 and CFOi,tþ1 are cash flows from operations of the previous
and next year, respectively. DRevi,t is the change in revenues of a firm from year t1 to t.
PPEi,t is the level of property plant and equipment of a firm in year t. All variables are scaled
to average total assets.
The original Dechow and Dichev (2002) model, hereafter DD model, considers only cash
flows from operations of current, previous and the next period to estimate current accruals,
and is based on the notion that the convertibility of the accruals into cash flows determines
the quality of accruals. It implies that the level of discretionary accruals per se does not
manifest the poor quality of accruals. If discretionary accruals are mapped into cash flows of
the adjacent periods, they still are of good quality and pose lesser information risk than if
they are not mapped into cash flows of adjacent periods. McNichols (2002) criticized the DD
model by documenting the tendency of DD model to provide accruals estimates which are
“significantly associated with cash flows” and may not be an outcome of managerial
discretion. McNichols also criticized the DD model for not considering the performance
factor. Thus, modified-DD model includes change in revenue and the level of PPE as
additional explanatory variables to the DD model.
We estimate the Equation (1) for each industry-year based on second level industry
classification of China Security Regulatory Commission. We removed industry-years with
less than 10 observations from analysis and calculated the AQ score for each firm-year on
the basis of residuals from Equation (1). AQ for a given firm-year is calculated as the five-
year moving standard deviation of the residuals, that is, to have AQ value for a given year a
firm is required to have residual value from Equation (1) for the current and previous four
years. So a firm must have at least seven yearly observations to be included in our analysis,
as AQ calculation requires five residuals, and the Equation (1) includes one lag and one next
period value of CFO. This can introduce sample bias by removing the younger firms from
analysis. But, as noted by Francis et al. (2005), it will, if anything at all, reduce the volatility
of AQ and will make it more difficult to detect its effects.

3.2 Accruals quality and future stock returns

To address the question whether AQ as a characteristic is relevant in explaining future
stock returns, we regress monthly firm-specific stock returns over firm characteristics using
ARJ the Fama and Macbeth (1973) method. In this regard, for every month, we regress monthly
30,4 stock returns cross-sectionally over AQ and other factors believed to explain stock returns,
namely, size, book-to-market (BM) ratio and firm beta. So we estimate following Fama-
Macbeth regression:

Ri;m ¼ l 0 þ l SIZE Sizei;m þ l BM BMi;t1 þ l AQ AQi;t1 þ l BETA Betai;t

384 þ l SOE SOE þ « it (2)

Ri,m is the holding-period return on A-share of a firm during month m. Sizei,m is the natural
log of the market capitalization of a firm in month m. BMi,t-1 is the natural log of the BM
ratio of a firm at the end of preceding year. AQi,t-1 is the accrual quality score of a firm for
the previous ended year. Betai,m is the 36-month CAPM (capital asset pricing model) beta for
a firm in month m. SOE is dummy variable assuming Value 1 for SOEs. We estimate the
Equation (2) for every month for an eight-year period, from 2006 to 2013, which results into
96 cross-sectional estimates for every parameter in the equation. We then used Fama-
Macbeth standard errors to test whether the mean estimate of a given characteristic is
significantly different from zero, i.e. whether a given characteristic is relevant in explaining
future stock returns. So if l AQ is significantly different from zero, it provides us evidence
that AQ is relevant in explaining firm-specific future stock returns. We expect l AQ to be
significantly positive.

3.3 Market pricing of accruals quality

To test whether AQ is a priced risk factor in China, we first created and loaded an AQ factor
(AQ_factor) in addition to existing factors in the Fama French (FF) three-factor model. We
then performed 2SCSR testing to see if AQ_factor is a priced risk factor. 2SCSR is an
established method in literature to test the market pricing of a candidate risk factor
(Brennan et al., 2004; Campbell and Vuolteenaho, 2004; Petkova, 2006; etc.). Following
various studies concerning market pricing of AQ (Francis et al., 2005; Core et al., 2008; Kim
and Qi, 2010; Mouselli et al., 2013, etc.), we calculate AQ_factor as follows: for every month
we categorize all firms in our analysis into five quintiles based on their AQ score of the
previous ended year, and the AQ_factor value for a given month is the difference between
the equal-weighted returns of the top two AQ quintiles and the bottom two AQ quintiles.
This provides a time series of AQ_factor having values for each of the 96 months in our
sample period from January 2006 to December 2013. We then perform 2SCSR testing to test
if the AQ_factor is a priced risk factor in addition to the existing factor in the Fama French
three-factor model. In the first stage of 2SCSR, we perform time-series regressions of
monthly excess returns of every firm or portfolio over contemporaneous market excess
returns and factor returns of SMB, HML and AQ_factor. Equation (3) below represents the
first stage equation of 2SCSR:


Ri;t  Rf ;t ¼ ai þ b RmRf;i Rm;t  Rf ;t þ b SMB;i SMBt þ b HML;i HMLt
þ b AQ;i AQ factort þ « I;t (3)

where Ri,t  Rf,t is firm or portfolio specific excess return in a given month t. SMBt and
HMLt are returns on Fama French size factor-mimicking portfolios and book-to-market
(BM) factor-mimicking portfolios, respectively, for the month t. AQ_factort is the return on
AQ_factor -mimicking portfolio calculated as explained above. b RmRf,i, b SMB,i, b HML,i Stock returns
and b AQ,i are firm or portfolio specific factor betas. and asset
We then, in the second stage, use factors’ betas from Equation (3) as explanatory
variables to regress monthly excess returns of a firm or portfolio cross-sectionally for every
pricing
month in our sample period using the Fama and Macbeth (1973) method. The second stage
regression equation is as follows:

Ri;t  Rf ;t ¼ ai þ l 1 b RmRf ;i þ l 2 b SMB;i þ l 3 b HML;i þ l 4 b AQ;i þ « I;t (4) 385

Estimating Equation (4) cross-sectionally for every month will provide a time series of 96
estimates associated with every factor beta. We then compute the Fama-Macbeth t-statistic
to test whether time-series of estimates associated with each factor beta produced in second
stage is significantly different from zero or not. If AQ_factor is a priced risk factor, then l 4
is expected to be positive and significantly different from zero.
An important issue in this regard is whether to perform 2SCSR testing on the individual
firm level or to create portfolios based on factor characteristics. In this regard, existing
literature suggests a trade-off between using individual stocks or creating portfolios (Kim
and Qi, 2010).Using individual stocks has stronger testing power, but it could potentially
lead to errors-in-variables bias because the factor betas used in testing are estimates and not
the real betas. However, this bias can be reduced by using relatively longer time series in
estimating betas in first stage. On the other hand, using portfolios reduces errors-in-
variables bias, but it reduces the power of the test to detect the explanatory power of the
factor betas in cross-sectional regressions. Further, as Kim and Qi (2010) noted, an even
more serious concern is that the test results are very sensitive to the way portfolios are
constructed. So following Kim and Qi (2010), we perform stock level testing to decide if
AQ_factor is a priced risk factor. However, we also constructed different portfolios and their
test results are produced along with stock level results.

4. Empirical results and analysis

4.1 Summary statistics
Table I, Panel A, presents descriptive statistics of sample and major variables used in our
analysis. One major variable in our analysis is AQ, our proxy of information risk. AQ’s
median value of 0.03 is much smaller than its mean value of 0.06, suggesting that more firms
have an AQ score less than the mean value of overall sample. However, the distribution of
our AQ variable is very similar to that of Francis et al. (2005), who reported AQ’s mean,
median, 10th and 90th values as 0.044, 0.031, 0.01 and 0.094, respectively. AQ has
observations lower than any other variables because AQ calculation for a firm in a given
year requires at least six annual observations prior to that year. The earnings to price ratio
has a positive mean value. Mean beta is close to one, suggesting that overall risk level of the
firms in our sample is closer to that of market. An overall look on the variables’ distribution
suggests sufficient variability in values.
Panel B of Table I contains difference-of-means analysis of SOEs and NSOEs on the
basis of various variables. The frequency of NSOEs is greater than that of SOEs, however,
SOEs tend to be much larger in size than NSOEs, and the difference between their size’s
means is highly significant. The SOEs and NSOEs differ significantly from each other in all
variables except leverage and beta. The AQ score of NSOEs is greater and suggests that
they have, on average, poorer quality accruals than that of SOEs. Poorer AQ in NSOEs is
tenable given that NSOEs have more volatile earnings (as suggested by unreported higher
standard deviation of earnings in NSOEs than that in SOEs), and managers in NSOEs have
ARJ Variables Mean SD 10% 50% 90% N
30,4
Panel A: full sample
AQ 0.0612 0.0826 0.015 0.0367 0.122 9,721
Total assets (million ¥) 4,618.6 10,649 322.2 1,592.5 9,204.4 19,416
B/M ratio 0.3949 0.2705 0.1397 0.3461 0.7362 17,388
ROA 0.0403 0.0889 0.0173 0.0402 0.1235 19,505
386 Leverage 0.5176 0.4144 0.1734 0.485 0.7521 19,413
Beta 1.0311 0.2889 0.6687 1.0255 1.3853 13,067
E/P ratio 0.0149 0.0612 0.0104 0.0215 0.0591 17,407
Panel B: difference of means between SOEs and NSOEs
NSOE SOE Diff (NSOE-SOE)
Mean N Mean N t-statistic
AQ 0.0698 5,539 0.0498 4,182 11.93
Total assets (million ¥) 3,832.39 12,515 6,044.39 6,901 13.92
B/M ratio 0.3633 10,626 0.4445 6,762 19.5
ROA 0.0438 12,591 0.0339 6,914 7.4
Leverage 0.5146 12,513 0.523 6,900 1.35
Beta 1.0314 7,289 1.0308 5,778 0.13
E/P ratio 0.0129 10,636 0.0182 6,771 5.58
Panel C: descriptive statistics of factor returns (N = 96, January 2006 December 2013)
Mean SD Minimum Median Maximum t
Rm-Rf 0.012 0.0946 0.2541 0.0217 0.2375 1.24
SMB 0.0122 0.0497 0.1369 0.0142 0.1281 2.41***
HML 0.0001 0.0315 0.0766 0.0015 0.0842 0.02
AQ_factor 0.0054 0.0228 0.0772 0.0036 0.1032 2.33***
Panel D: correlation matrix of factor returns
Rm-Rf SMB HML AQ_factor
Rm-Rf 1
SMB 0.02 1
HML 0.19 0.06 1
AQ_factor 0.15 0.44 0.19 1

Notes: Panel A presents the descriptive statistics of key variables and Panel B presents the difference of
means analysis between SOEs and NSOEs. AQ is the five year moving standard deviation of the residuals
from modified Dechow and Dichev (2002) model. Higher AQ values represent poor accruals quality. B/M
ratio is the ratio of book-to-market value of equity. ROA is the return on assets of a firm. Leverage is total
liabilities divided by total assets. Beta is the 36-month CAPM beta of a firm. E/P ratio is the earnings to
price ratio. N represents number of observations. Panel C and D respectively present descriptive statistics
Table I. and correlation matrix of factor returns calculated monthly from January 2006 to December 2013. Rm-Rf is
monthly excess market return. SMB and HML are monthly returns to size and BM factor-mimicking
Descriptive statistics portfolios respectively calculated following Fama and French (1993) and obtained from RESSET financial
(sample period research database. AQ_factor is return to accruals quality factor-mimicking portfolio calculated as
2000-2013) explained in the methodology section of this study; ***represents two-tail significance at 1%

greater incentives to manipulate earnings because of a myriad of reasons documented in the

literature. NSOEs appear to be more profitable, on average, than SOEs, as suggested by
return on asset (ROA). Furthermore, B/M ratio suggests that market values NSOEs’ book
equity more than SOEs’.
Panel C of Table I presents the descriptive statistics of the AQ_factor along with
other factors. The mean AQ_factor is positive and its t-statistics is significant at
1 per cent. This is contrary to Core et al. (2008), who reported insignificant t-statistics
for AQ_factor over their sample period in the USA. The t-statistic for SMB is significant Stock returns
at 1 per cent, whereas that of HML is insignificant. This again is contrary to Core et al. and asset
(2008), who reported insignificant SMB and significant HML. Overall, the factor returns
in China generally differ from those in the USA and, therefore, may be associated with
pricing
stock returns differently.
Panel D of Table I reports correlation matrix of factor returns. The AQ_factor is
positively correlated with SMB suggesting that size premium and AQ premium move in
tandem. In our sample period in China, HML is positively correlated with Rm-Rf. This is 387
contrary to what is reported by Core et al. (2008) and Mouselli et al. (2013), who reported
negative correlation between the said two factor returns in the USA and the UK,
respectively. It suggests that, in China, when market performs relatively well, the firms with
lower BM ratio, i.e. growth stocks, perform better than firms with higher BM value, i.e. value
stock. This argument holds well if we keep in mind the rapid growth of the Chinese economy
over our sample period.

4.2 Accruals quality and stock returns

Table II presents results from Fama and Macbeth (1973) regressions of monthly stock
returns over various firm characteristics where AQ is treated as a firm characteristic. In
Model 1, Table II, where AQ is only an explanatory variable, AQ bears a significant
positive coefficient that further strengthens in Model 3, where size and BM ratio are
added as explanatory variables. This is in consonance with Mouselli et al. (2013), who
found AQ to bear a significantly positive coefficient in addition to size and BM in
explanation of monthly stock returns. However, Mouselli et al. (2013) did not consider
beta as explanatory of monthly stock returns. In Model 4, where we consider 36-month
beta as an additional explanatory variable, the AQ estimate becomes insignificant in
two-tail testing but significant at 10 per cent in one-tail testing. This, somewhat,
supports the argument of Lambert et al., (2007), who suggested that information risk is

Dependent variable: monthly stock return

Model Intercept Size BM AQ Beta SOE Avg.R2 N

1 Estimates 0.0240 0.0776 0.007 1,10,333

FM-t (2.02)** (2.01)**
2 Estimates 0.0508 0.0008 0.0046 0.030 1,51,450
FM-t (0.97) (0.36) (2.14)**
3 Estimates 0.0394 0.0005 0.0056 0.1198 0.036 1,07,316
FM-t (0.68) (0.20) (2.13)** (2.21)**
4 Estimates 0.0182 0.0001 0.0028 0.0513 0.0432 0.093 1,06,352
FM-t (0.32) (0.06) (1.70)* (1.41) (2.60)***
5 Estimates 0.0184 0.0002 0.0031 0.0504 0.0433 0.0025 0.095 1,06,352
FM-t (0.32) (0.09) (1.87)* (1.39) (2.60)*** (2.0)**

Notes: This table presents the results from Fama and Macbeth (1973) regressions of monthly stock returns
over AQ and other firm characteristics. Size is the natural log of the market capitalization of a firm in a
given month. BM is the natural log of the book-to-market ratio of a firm at the end of preceding year. AQ is
the accrual quality score of a firm for the previous ended year. Beta is the 36-month CAPM beta for a firm in
a given month, so firms with less than 36 monthly observations of stock returns are excluded from analysis.
Table II.
SOE is dummy variable assuming Value 1 for SOEs. Fama-Macbeth-t is the t-statistic calculated using
Fama-Macbeth standard errors. Avg.R2 is the average of adjusted-R2 from monthly cross-sectional Accruals quality and
regressions. N is the number of observations; ***, **, and *represents two-tail significance at 1, 5 and 10%, future stock returns
respectively (2006-2013)
ARJ captured by beta. In Model 5, the significantly negative estimate of SOE dummy
30,4 suggests that SOEs realize lower monthly stock returns (recall from descriptive
statistics that SOEs have relatively better AQ). The insignificant (and positive in Model
4 and 5) coefficient on size is contrary to theory and much of the empirical research,
where big firms are considered to have lower risk and thus lower stock returns. It can
be ascribed to the unique economic setup in China (e.g. SOEs and NSOEs) and the
388 tendency of our analysis to exclude younger firms from sample. The overall results in
Table II lead us to infer that greater information risk, as measured by AQ, is associated
with higher monthly stock returns but this relationship is, somewhat, absorbed by the
firm beta.

4.3 Asset pricing tests of AQ_factor

To test whether AQ is a priced risk factor in addition to existing factors in the Fama French
(FF) three-factor model, we first calculated an AQ_factor and then performed 2SCSR testing.
Table III presents results from firm-level 2SCSR testing of AQ factor in addition to
existing factors in the Fama French three-factor model. Panel A shows that in time
series regressions AQ_factor has, on average, negative coefficient in Model 2 and
positive coefficient in Model 3, and the respective t-statistics suggest that it is
significantly different from zero. This negative mean coefficient in Model 2 is contrary
to positive coefficient of AQ_factor in firm-level time series regressions reported by
Francis et al. (2005), Core et al. (2008) and Kim and Qi (2010). However, when we remove
SMB factor in Model 3 the AQ_factor is positive and highly significant. This is because
of highly positive correlation between SMB and AQ_factor, as shown in Panel D of
Table I. As noted by Core et al. (2008), a significant coefficient in time series regressions
does not imply that the given factor is a priced factor. Rather, the average coefficient of
a given factor in time series regressions conveys the degree and nature of exposure of
the sample firms to the said factor. To see whether AQ_factor is a priced risk factor we
estimate Fama-Macbeth regressions of excess returns on factor betas from the first
stage. The firm-level results are presented in the Panel B of Table III.
In firm-level second stage cross-sectional regressions, as presented in Panel B of
Table III, the mean estimate of AQ_factor is consistently positive across various model
specifications, i.e. in Model 2, 3 and 4. In all of these specifications, the Fama-Macbeth
t-statistic is significant at 5 per cent, in one-tail testing, and provides us evidence that,
in firm-level analysis, AQ_factor is a priced risk factor in China. Further, adding an AQ
factor in the Fama French three-factor model increases its power to explain cross-
sectional variability of firm-level returns from 10 to 12 per cent on average. This is
contrary to the findings of Core et al. (2008), who reported that AQ is not a priced risk
factor in the USA. However, Kim and Qi (2010) found evidence of market pricing of AQ
in the USA after removing for low priced stock. Other relevant studies, e.g. Gray et al.
(2009) and Mouselli et al. (2013), performed testing of the AQ factor only at the portfolio
level and did not analyze on firm level. Further, our firm-level results do not provide
support for market pricing of SMB and HML factors in China during our sample period.
Considering the characteristic differences between SOEs and NSOEs, as suggested
by difference of means analysis in Panel B of Table I, we further extend our analysis of
market pricing of AQ by dividing our sample into subsamples of SOEs and NSOEs.
Panel C of Table III presents the results from second stage of 2SCSR testing for
subsamples of SOEs and NSOEs. The results with respect to AQ_factor are different in
the subsamples. Though the average coefficient of AQ_factor is positive in both SOEs
and NSOEs, it is insignificant in case of SOEs. So the subsample analysis provides
Model Intercept Rm-Rf SMB HML AQ_factor Avg.R2
Stock returns
and asset
Panel A: First stage time-series regressions of monthly stock returns over factor returns. (full sample of 1991 pricing
firms)
1 Estimate 0.0001 1.0343 0.8870 0.1654 0.51
t-stat (0.22) (128)*** (43)*** (7.6)***
2 Estimate 0.0006 1.0422 0.9092 0.1845 0.1015 0.53
t-stat (1.49)* (135.9)*** (38.41)*** (8.98)*** (2.07)** 389
3 Estimate 0.0069 1.0449 0.2125 0.7428 0.45
t-stat (21.5)*** (153)*** (10.4)*** (16.1)***
4 Estimate 0.0004 1.0355 0.9926 0.0131 0.50
t-stat (0.11) (140)*** (47)*** (0.26)
Panel B: Second stage cross-sectional regressions of monthly stock returns over factor betas. (full sample of
1991 firms)
1 Estimate 0.0066 0.0275 0.0020 0.0043 0.10
FM t-stat (0.59) (1.90)** (0.31) (1.03)
2 Estimate 0.0003 0.0241 0.0004 0.0049 0.0059 0.12
FM t-stat (0.04) (2.01)*** (0.06) (1.18) (1.78)**
3 Estimate 0.0051 0.0242 0.0049 0.0060 0.09
FM t-stat (0.42) (1.82)** (1.18) (1.73)**
4 Estimate 0.0038 0.023 0.0023 0.0058 0.09
FM t-stat (0.43) (1.83)** (0.36) (1.73)**
Panel C: Subsample analysis of SOEs and NSOEs. 739 SOEs and 1252 NSOEs. Second stage cross-sectional
regressions of monthly stock returns over factor betas
SOEs Estimate 0.0001 0.0231 0.0006 0.0039 0.0043 0.13
FM t-stat (0.01) (1.86)** (0.09) (0.87) (1.24)
NSOEs Estimate 0.0019 0.0197 0.0023 0.0043 0.0053 0.13
FM t-stat (0.31) (1.72)** (0.40) (1.05) (1.60)*

Notes: This table presents the results from 2SCSR for 1991 individual firms for 96 months period from
January 2006 to December 2013. Firms with less than 36 monthly observations are removed from analysis.
Panel A contains results from the first stage of 2SCSR and presents average of factor betas from firm-
specific time-series regressions of monthly excess stock returns over factor returns from January 2006 to
December 2013. Panel B presents results from Fama-Macbeth monthly cross-sectional regressions of excess
stock returns over firm-specific factors’ betas from the first stage. Panel C presents the second stage of
2SCSR results for subsamples of SOEs and NSOEs. Rm-Rf is monthly excess market return. SMB and HML
are monthly returns to size and BM factor-mimicking portfolios, respectively, calculated following Fama Table III.
and French (1993). AQ_factor is return to accruals quality factor-mimicking portfolio; ***, **, and Firm-level asset
*represent one-tail significance at 1, 5, and 10 %, respectively pricing test

evidence of market pricing of AQ in NSOEs but not in SOEs. It somewhat suggests that
investors perceive information risk differently for SOEs than they do for NSOEs, and
information risk is more relevant in NSOEs than in SOEs. We conjecture that investors
care less for information risk in case of SOEs because of perceived stability of SOEs and
their backing by government, which is always there to bailout in case of trouble. And
because of these reasons institutional and other investors with diversified portfolios
favor SOEs and consider them as a tool to reduce the overall risk of their portfolios. We
decide about the market pricing of AQ on the basis of firm-level testing because of
reasons noted by Kim and Qi (2010), as described in methodology section of this study.
However, we also performed asset pricing test on various portfolio formations, and the
results from second stage cross-sectional regressions of value-weighted portfolio
returns over factor betas are presented in Table IV. In unreported results from
ARJ Intercept Rm-Rf SMB HML AQ_factor Adj.R2
30,4
Panel A: 37-Industry portfolios
Estimate 0.0006 0.0210 0.0021 0.0114
FM t-stat (0.05) (1.33) (0.37) (2.48)*** 0.28
Estimate 0.0003 0.0203 0.0022 0.0109 0.0019
FM t-stat (0.02) (1.31) (0.37) (2.43)** (0.58) 0.30
390
Panel B: 25 Size-BM portfolios
Estimate 0.0004 0.0189 0.0048 0.0002
FM t-stat (0.02) (0.96) (0.92) (0.06) 0.49
Estimate 0.0004 0.0169 0.0054 0.0014 0.0018
FM t-stat (0.02) (0.86) (1.05) (0.36) (0.56) 0.56
Panel C: 64 Size- BM-AQ portfolios
Estimate 0.0067 0.0274 0.0026 0.0012
FM t-stat (0.53) (1.86)* (0.47) (0.30) 0.26
Estimate 0.0020 0.0238 0.0019 0.0011 0.0027
FM t-stat (0.18) (1.67)* (0.35) (0.29) (1.01) 0.28
Panel D: 100-AQ portfolios
Estimate 0.0004 0.0211 0.0029 0.0064
FM t-stat (0.03) (1.30) (0.45) (1.22) 0.06
Estimate 0.0076 0.0153 0.0017 0.0042 0.0032
FM t-stat (0.60) (1.08) (0.25) (1.02) (0.96) 0.08

Notes: This table presents the second stage cross-sectional regressions of value-weighted monthly
portfolio returns of various portfolio formations over factor betas. The reported ‘Estimates’ are the average
of betas from 96 monthly cross-sectional regressions over the period 2006-2013. Fama-Macbeth t-statistics
is calculated using Fama-Macbeth standard errors from time-series of 96 second stage monthly betas for
each factor. Rm-Rf is monthly excess market return. SMB and HML are monthly returns to size and BM
factor-mimicking portfolios, respectively, calculated following Fama and French (1993). AQ_factor is return
to accruals quality factor-mimicking portfolio. 37-Industry portfolios are formulated for only those 37
second-stage industry codes which were used to calculate AQ as explained in the estimation of Equation (1).
To formulate 25 Size-BM portfolios, firms in each month were divided into five quintiles independently on
Table IV. the basis of monthly market capitalization and BM ratio of previous ended year. Thus, 25 portfolios are
Fama-Macbeth created based on each combination of Size and B/M quintiles (5  5). Similarly, to formulate 64 Size-BM-AQ
portfolios, firms in each month were divided into four quartiles independently on the basis of monthly
regressions of value-
market capitalization, BM ratio of previous ended year and AQ score of previous ended year. So 64
weighted portfolio portfolios are formulated on the basis of all possible combinations of Size-BM-AQ quartiles (4  4  4). To
returns over factor create 100-AQ portfolios, in every month, firms were classified into 100 groups based on their AQ scores;
betas ***, **, and *represents two-tail significance at 1, 5 and 10 %, respectively

first-stage time series regressions of portfolio returns over factor returns, AQ_factor
bears negative coefficient, significant at 1 per cent, in all four portfolio formations. This
suggests that our portfolio formations have on average negative exposure to AQ_factor
during our sample period in China.
The portfolio level results from second stage cross-sectional regressions show that
average estimate of AQ_factor is negative only in case of 25 Size-BM portfolios and
positive in 37-industry, 100-AQ and 64 Size-BM-AQ portfolios. However, AQ_factor is
not significant in any of the portfolio formations and, thus, does not provide evidence of
market pricing of AQ in China. The Fama-Macbeth t-statistic of AQ_factor is greater
than that of SMB in all portfolio formations other than 25 Size-BM portfolios.
It suggests the relative importance of AQ_factor in explaining cross-sectional Stock returns
variability of portfolio returns as compared to that of SMB. Moreover, adding and asset
AQ_factor increases average adjusted R2 from 2 to 7 percentage points in every pricing
portfolio formation. HML factor is significant in 37-industry portfolios only and market
factor is significant in 64 Size-BM-AQ portfolios only. It hints at the limited power of
Fama-French factors to explain variability of portfolio returns in China.
Overall, our asset pricing tests provide evidence of market pricing of AQ on firm- 391
level analysis, and we reject our null hypothesis of AQ not being a priced risk factor in
China. However, in portfolio-level asset pricing test, our results do not provide
sufficient evidence to conclude that AQ is a priced risk factor in China. We ascribe this
lack of sufficient evidence, in case of portfolio-level analysis, to reduced power of
portfolios to detect cross-sectional variability of returns as argued by Kim and Qi
(2010). Further, our results suggest that including AQ factor to existing factors in the
Fama French three-factor model enhance the explanatory power of the model, both at
firm and portfolio level.

4.4 Robustness analysis

For robustness of our findings, we re-performed the analysis using alternate measures
of information risk, namely, discretionary accruals, earnings volatility and earnings
smoothness. Table V, Panel A, presents results for Fama-Macbeth regressions of stock
returns over firm characteristics using alternate measures of information risk. The
reported results support the positive association of information risk with stock returns
and further strengthen our earlier finding. Panel B of Table V presents results from
second stage of 2SCSR testing where we use alternate measures of information risk to
test the market pricing of information risk. The reported results show the significant
average beta on information risk factor in all of three alternate measures of information
risk. It strengthens our finding that information risk is a priced risk factor while
controlling for existing factors in the Fama and French (1993) three-factor model.

5. Conclusion
We investigated information risk in relation to future realized stock returns and also
whether information risk is a priced risk factor in China. Using Fama and Macbeth
(1973) regressions of monthly stock returns over various firm characteristics, where
AQ is treated as a firm characteristic, we provide evidence of significant association
of poorer AQ with higher future realized stock returns. However, this association is
somewhat attenuated if we control for firm-specific CAPM beta. Further, in asset
pricing tests, our calculated AQ_factor shows a mean positive risk premium
significantly different from zero during our sample period, and our results from
2SCSR provide evidence, in firm-level analysis, of AQ_factor being a priced risk
factor in addition to existing factors in the Fama-French three-factor model.
Moreover, subsample analysis revealed that investors care less about information
risk in case of SOEs and information risk factor is significant in NSOEs only. Overall,
our results provide sufficient evidence in support of theories, suggesting a role of
information risk in investors’ pricing decisions and that information risk is a priced
risk factor despite, or maybe because of, the notoriously opaque information
environment in China.
 30,4
ARJ

392

Table V.

measures of
using alternate

information risk
Robustness analysis
Panel A: accruals quality and future stock returns
Dependent Discretionary accruals Earnings volatility Earnings smoothing
variable = stock (1) (2) (3) (4) (5) (6)
returns
Info risk 0.0265 (3.85)*** 0.0180 (2.61)*** 0.0899 (2.37)** 0.0384 (1.54) 0.0014 (2.28)** 0.0001 (0.27)
Beta 0.0399 (2.45)** 0.0388 (2.52)*** 0.0442 (2.74)***
SOE 0.0027 (1.74)* 0.0040 (3.05)*** 0.0029 (1.85)* 0.0039 (3.05)*** 0.0029 (1.89)* 0.0038 (2.93)***
Size 0.0000 (0.01) 0.0002 (0.08) 0.0001 (0.04) 0.0002 (0.08) 0.0006 (0.29) 0.0004 (0.18)
BM 0.0058 (2.43)** 0.0035 (1.93)* 0.0070 (2.73)*** 0.0041 (2.45)** 0.0055 (2.48)*** 0.0034 (1.97)**
Intercept 0.0336 (0.63) 0.0034 (0.06) 0.0347 (0.69) 0.0024 (0.05) 0.0481 (0.92) 0.0018 (0.03)
Avg. R2 0.039 0.093 0.039 0.090 0.036 0.090
N 1,39,077 1,17,364 1,49,728 1,26,546 1,51,279 1,27,890
Panel B: second stage Fama-Macbeth regression of factor betas over excess return
Dependent (1) (2) (3)
variable = excess Discretionary accruals Earnings volatility Earning smoothing
returns Estimate t-stat Estimate t-stat Estimate t-stat
Rm-Rf 0.0224 (1.92) * 0.0248 (2.12)** 0.0255 (2.09)**
SMB 0.0023 (0.38) 0.0018 (0.28) 0.0002 (0.04)
HML 0.0046 (1.1) 0.0048 (1.14) 0.0047 (1.15)
*
IR_factor 0.0046 (1.67) 0.0044 (1.64)* 0.0050 (1.92)*
Intercept 0.0007 (0.1) 0.0028 (0.37) 0.0016 (0.22)
N 1,58,388 1,58,388 1,58,388
Avg. R2 0.128 0.1244 0.1288

Notes: This table presents results from robustness analysis using alternate measures of information risk. Panel A presents results from Fama and Macbeth
(1973) regressions of monthly stock returns over our measure of information risk and other firm characteristics where information risk is proxied by discretionary
accruals, earnings volatility and earnings smoothing. Alternatively, Panel B presents results from the second stage of 2SCSR testing where, using Fama and
Macbeth (1973) regressions, monthly excess stock returns are regressed over firm-specific factor betas from the first stage of 2SCSR. IR_factor is return to
information risk factor-mimicking portfolio using discretionary accruals, earnings volatility and earnings smoothing as alternative measures of information risk.
Discretionary accruals are the absolute residuals from modified Jones (1991) model. Earnings volatility is the five-year standard deviation of earnings where
earnings are the income before extraordinary items scaled to average total assets. Earnings smoothing is the five-year standard deviation of the earnings divided
by the same period standard deviation of cash flows from operations. Fama-Macbeth t is the t-statistic calculated using Fama-Macbeth standard errors. Avg.R2 is
the average of adjusted-R2 from monthly cross-sectional regressions. N is the number of observations; ***, **, and *represents two-tail significance at 1, 5, and 10
%, respectively
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Further reading
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cost of equity capital”, Asia-Pacific Journal of Financial Studies, Vol. 41 No. 4, pp. 458-490.

Corresponding author
Raheel Safdar can be contacted at: raheelchattha@hotmail.com

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