Two tales of earnings management with short sales deregulation

Abstract

We study the impact of short sales on accrual-based and real earnings management (EM). Based on the costs and benefits of using EM to hide negative information, we derive an analytical model showing that there are two possibilities: (1) a firm engages in less accrual-based and real EM when facing short-seller scrutiny (the informational efficiency hypothesis), or (2) a firm switches from accrual-based EM (a less sophisticated method) to real EM (a more sophisticated method), which we call the sophisticated information-hiding hypothesis. That is, there is a tradeoff between accrual-based and real EM in the presence of short sales. Using a natural experiment of the recent short sales deregulation in China, we show findings consistent with the latter reaction. Additional analysis suggests that the decrease in accrual-based EM and increase in real EM are driven primarily by firms with non-Big 10 auditors or firms not under shareholder or regulatory scrutiny. We interpret the findings as being consistent with the model prediction that for firms with weak inside and outside monitoring, the probability of detecting real EM is low, and thus the tradeoff between accrual-based and real EM prevails in the presence of short sales.