Short Selling and Earnings Management : A Controlled Experiment

During 2005 to 2007, the SEC ordered a pilot program in which one-third of the Russell 3000 index were arbitrarily chosen as pilot stocks and exempted from short-sale price tests. Pilot firms' discretionary accruals and likelihood of marginally beating earnings targets decrease during this period, and revert to pre-experiment levels when the program ends. After the program starts, pilot firms are more likely to be caught for fraud initiated before the program, and their stock returns better incorporate earnings information. These results indicate that short selling, or its prospect, curbs earnings management, helps detect fraud, and improves price efficiency