Accounting for Asset Pricing Factors

Abstract

This paper is a treatise on handling accounting numbers in building factor models. Those numbers include book value, investment, return on equity (ROE), and other profitability measures that appear in standard models, but often from data mining without a clear explanation of why they indicate investment risk. The numbers are generated by accounting principles that deal with risk, providing an explanation but also a critique of how the numbers enter extant models. Those principles also point to additional accounting numbers for factor construction. Empirical tests confirm. Accounting numbers are codetermined in a double-entry system, a feature that is exploited for packaging them into a factor model. Rather than entering as the separate, additive factors in extant models, adding to the “factor zoo,” the numbers are combined parsimoniously into factors that capture the information that they jointly convey about risk and return in the double-entry system. Again, empirical tests against extant models confirm.