Can Short Selling Improve Financial Reporting?

FANG, Vivian W. | HUANG, Allen | KARPOFF, Jonathan M.

Short selling is undoubtedly a controversial activity; it is motivated by the belief that the price of the stock will decline, so it can be bought back at a profit. Previous research has shown that short sellers can identify earnings manipulation and fraud before they are publicly revealed. But this is for earnings manipulation that has already taken place; might short selling also constrain firms’ incentives to manipulate or misrepresent earnings in the first place? That is, does the prospect of short selling help improve the quality of firms’ financial reporting?

Vivian W. Fang, Allen H. Huang, and Jonathan M. Karpoff exploited a randomized experiment to shed light on an important effect of short selling on firms’ financial reporting practices. In 2005, the Securities and Exchange Commission adopted a new regulation governing short-selling activities in the US equity markets that included a pilot program in which every third stock in the Russell 3000 index ranked by trading volume was designated as a pilot stock. This created an ideal setting to examine the effect of short selling on corporate financial reporting decisions; for example, there was no evidence that the firms themselves lobbied to be included in the program, or that any firm knew it would be in the pilot group until the program was announced; and the program had specific beginning and ending dates, facilitating difference-in-differences analysis.

From May 2, 2005 to August 6, 2007, the pilot stocks were exempted from short-sale price tests, thus decreasing the cost of short selling and increasing the prospect of short selling among these stocks.

The researchers found that pilot firms’ discretionary accruals (a measure of earnings management) and likelihood of marginally beating earnings targets decreased during this period, and revert to pre-experiment levels when the program ended. After the program started, pilot firms were more likely to be caught for fraud initiated before the program, and their stock returns better incorporated earnings information. These results indicated that short selling, or its prospect, curbed earnings management, helped detect fraud, and improved price efficiency.

Furthermore, as the researchers sequentially included cases of fraud initiated after the pilot program began, the unconditional likelihood that pilot firms would be caught for financial misconduct converged toward that for non-pilot firms. Previous research had shown that short selling both anticipates and accelerates the public discovery of financial misconduct. Their result was, however, the first to reveal that an increase in the prospect of short selling increases the detection of misconduct. Overall, the results indicated that the pilot program lowered the cost of short selling sufficiently to increase potential short sellers’ incentives to scrutinize pilot firms’ earnings reports and uncover misconduct, and that managers responded to the prospect of increased scrutiny by decreasing earnings management.

Finally, the results indicated that pilot firms’ reduction in earnings management during the pilot program corresponds to an increase in the efficiency of their stock prices with respect to earnings information.

Although short selling remains a controversial activity, this study uncovers important external benefits from short-selling activity. The results uncover important external benefits from short-selling activity. In particular, a decrease in the cost of short selling curbs managers’ willingness to manipulate earnings, increases the likelihood of fraud detection, and increases the informativeness of stock prices with respect to earnings. The research thus demonstrated one channel through which trading in secondary markets has an impact on firms’ business decisions.

HUANG, Allen

Associate Dean (UG Programs), Associate Professor