Do Speculative Short Sellers Detect Earnings Management?

This paper examines empirically whether sophisticated speculative short sellers can detect earnings management by targeting stocks with large income-increasing discretionary accruals and high total accruals. Prior research indicates that total accruals are overpriced and this overpricing is largely attributable to the mispricing of discretionary accruals. Recent studies show that neither auditors nor financial analysts utilize information in accruals. Using samples of 11,537 firm-quarter observations and 5,118 firm-year observations for 1,146 12/31 non-financial NYSE firms from 1992 to 1999, I find supporting evidence those speculative short sellers can detect earnings management using financial accounting information disclosed in 10-Q and 10-K report. Specifically, I identify a significant and positive association between relative short interest and quarterly accruals. When I decompose accruals into its discretionary and non-discretionary components, I find that quarterly discretionary accruals are positively and significantly related to relative short interest. I further divide quarterly data into four sub-samples of separate fiscal quarters and find that speculative short sellers detect earnings management especially in the third and fourth quarters of a fiscal year and trade consistent with the information provided in quarterly accruals. In addition, the empirical results indicate that speculative short sellers establish short positions in firms with high accruals and large income-increasing discretionary accruals estimated using annual financial accounting information.