Short-Selling Pressure, Reporting Transparency, and the Use of Real and Accruals Earnings Management to Meet Benchmarks

Abstract

Prior literature finds that short selling is beneficial to the market because it increases liquidity and helps to discipline optimistic market prices. In this paper we use two controlled experiments to examine the potential for an unintended consequence of allowing short selling or easing short selling restrictions. Because prior research identifies short sellers as sophisticated market participants who have the ability to see through accrual earnings management choices, we predict and find that, when reporting is transparent, managers are more likely to use real earnings management (REM) relative to accrual earnings management (AEM) when short selling restrictions are relaxed. This is consistent with the idea that REM activities are more defensible as the result of legitimate operating decisions, and are therefore more likely to hold up to scrutiny from short sellers. Overall, our results suggest that regulations that are unrelated to financial reporting can affect how managers respond to the transparency that arises from financial reporting regulations.

Keywords: short selling, transparency, real earnings management, accruals, earnings benchmarks, managerial incentives

JEL Classification: M40, M41