The Invisible Hand of Short Selling: Does Short Selling Discipline Earnings Management?

http://rfs.oxfordjournals.org.libproxy.smu.edu.sg/content/28/6/1701.full.pdf+html

Rev. Financ. Stud. (2015) 28 (6):1701-1736.

The Invisible Hand of Short Selling: Does Short Selling Discipline Earnings Management?

Massimo MassaBohui ZhangHong Zhang

Abstract

We hypothesize that short selling has a disciplining role vis-à-vis firm managers that forces them to reduce earnings management. Using firm-level short-selling data for thirty-three countries collected over a sample period from 2002 to 2009, we document a significantly negative relationship between the threat of short selling and earnings management. Tests based on instrumental variable and exogenous regulatory experiments offer evidence of a causal link between short selling and earnings management. Our findings suggest that short selling functions as an external governance mechanism to discipline managers.

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