Do short sellers arbitrage pricing anomalies related to earnings management?

KoEun Park, Purdue University


I study whether short sellers' trading behavior is related to firms' earnings management. Prior literature shows that stock prices do not rationally reflect the future earnings implications of the current earnings associated with earnings management activities and that there are pricing anomalies related to those earnings. I posit that sophisticated investors like short sellers have incentives to exploit the anomalies. Using a large sample for the period of 1989-2009, I provide evidence that earnings management activities are positively associated with subsequent short interest. More specifically, I find that short sellers' activities are associated with firms' real earnings management activities but not with accrual earnings management activities. This finding is consistent with recent studies that show the increasing importance of understanding real earnings management. Moreover, I show that the positive relation between earnings management activities and short interest is more pronounced for firms with high institutional ownership, small positive earnings surprises, and analyst following. These findings are consistent with the following view: short sellers attempt to refine their trading strategies to minimize transaction costs.




Watts, Purdue University.

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