We study the impact of short selling on accrual-based and real earnings management (EM). Using the recent short sales deregulations in China, we examine how less short sales restriction affects the extent of both types of EM. A firm can be honest and engage in less accrual-based and real EM when facing short seller monitoring and scrutiny. That is, it chooses to disclose negative information (the information efficiency hypothesis). Alternatively, a firm switches to sophisticated methods, such as real EM, to cover up negative information to counter the efforts of short sellers (the sophisticated information hiding hypothesis). Our findings suggest that firms engage in less accrual-based EM after short sales deregulations but engage in more real EM. In addition, the extent of real EM is more severe among non-SOEs and firms with non-Big 4 auditors, suggesting that when incentives to cover up information are strong (e.g., non-SOEs) or outside monitoring is weak (e.g., firms with non-Big 4 auditors), a firm engages in more real EM. Furthermore, after short sales deregulation, the crash risk of shortable stocks increases, in particular when their real EM is high. Our findings are consistent with the sophisticated hiding information hypothesis.

Huili Zhang graduated from Guanghua School of Management in 2011, and now is an associate professor in Beijing Normal University. Her research focuses on accounting information and capital market, and corporate finance.

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