Researchers have found a link between short selling and a faster time-to-discovery of when companies misreport their financial results.

The research examined whether short sellers are better able to detect firms that misrepresent their financial statements before the companies publicly announce the restatements. The researchers, Jonathan M. Karpoff of the University of Washington’s Foster School of Business, and Xiaoxia Lou of the University of Delaware’s Lerner School of Business and Economics, found that abnormal short interest increases steadily in the 19 months before the misrepresentation is publicly revealed, particularly when the misconduct is severe.

“Short selling is associated with a faster time-to-discovery, and it dampens the share price inflation that occurs when firms misstate their earnings,” they wrote in a forthcoming paper in the Journal of Finance, a publication of the American Finance Association. “These results indicate that short sellers anticipate the eventual discovery and severity of financial misconduct. They also convey external benefits, helping to uncover misconduct and keeping prices closer to fundamental values when firms provide incorrect financial information.”

The researchers found that the amount of short selling was positively related to measures of misconduct severity, indicating that short sellers take larger positions when the misrepresentation is particularly egregious. 

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