We hypothesize that short selling has a disciplining role vis-à-vis firm managers that forces them to reduce earnings management. Using firm-level short-selling data for thirty-three countries collected over a sample period from 2002 to 2009, we document a significantly negative relationship between the threat of short selling and earnings management. Tests based on instrumental variable and exogenous regulatory experiments offer evidence of a causal link between short selling and earnings management. Our findings suggest that short selling functions as an external governance mechanism to discipline managers.

We hypothesize that short selling has a disciplining role vis-à-vis firm managers that forces them to reduce earnings management. Using firm-level short-selling data for thirty-three countries collected over a sample period from 2002 to 2009, we document a significantly negative relationship between the threat of short selling and earnings management. Tests based on instrumental variable and exogenous regulatory experiments offer evidence of a causal link between short selling and earnings management. Our findings suggest that short selling functions as an external governance mechanism to discipline managers.

Leveraging the China Securities Regulatory Commission’s annual random inspection exercise as a quasi-natural experiment, we document that the risk scrutiny of preventive regulatory enforcement creates regulatory uncertainty about inspected firms to business partners, leading them to reduce the provision of trade credit. Reduced access to trade credit is more pronounced for firms with weak bargaining power, high opacity, or low financial resilience. Reduced access is also evident in both ‘compliant’ and non-compliant firms, though the reduction gradually subsides as uncertainty dissipates in different ways for the two types of inspected firms. Our findings uncover an important unintended effect of preventive regulation and have implications for policy making.