Abstract: In recent years, some scholars have begun to pay attention to the impact of removing short selling constraints on earnings management. The ways that managers manipulate earnings mainly include accrual earnings management and real earnings management. Most of the existing studies on the impact of removing short selling constraints on earnings management start from accrual earnings management and suggest that short sellers focus on the essence of things. This type of short seller can accurately identify and short firms with distorted accounting information, we call them essence-oriented short sellers. Their trading behavior can cause stock prices to fall, and firms react to this exogenous shock by reducing accrual earnings management. Unfortunately, although some scholars have pointed out that in addition to essence-oriented short sellers, there are also superficies-oriented short sellers in the financial market. However, there is no literature on the impact of superficies-oriented short sellers on real earnings management. Superficies-oriented short sellers often short the firm whose profit does not meet the market expectation, which forces managers to improve earnings management. On the one hand, because short sellers have the ability to identify accrual earnings management, the room for manipulation in accrual earnings management has been greatly reduced. On the other hand, according to accounting standards implemented in China, "the relevant expenditures in the research phase must be fully expensed in the same period that they are incurred", thus, managers can inflate short-term earnings by cutting R&D expenditures, and this manipulation is difficult to detect due to the uncertainty of R&D activities. Therefore, as an alternative to accrual earnings management, under the pressure of short selling, managers may choose a more covert approach to manipulate earnings, that is, R&D expenditures manipulation. Furthermore, we study the moderate effects of market environment and equity incentives in this process. As a financial innovation tool, short selling is more complex than general financial products, and its acceptance by investors is closely related to the external market environment. In regions with a high degree of marketization, there are more financial intermediaries to help investors familiarize themselves with the business process, thus reducing the cost for investors to participate. This makes short-selling more active in developed markets. In recent years, economic and geographical literatures show that both institutional investors and individual investors have local preference, that is, they tend to choose the stocks of local firms as their investment objects. Therefore, short selling is more active in regions with a higher degree of marketization, and the local preference of superficies-oriented short sellers will bring more obvious pressure to listed firms in developed markets and force them to carry out R&D expenditures manipulation. The core purpose of equity incentives is to promote the interests of incentive objects and corporate shareholders to be consistent and alleviate the principal-agent problem. However, in reality, whether the negative effect of short selling pressure can be effectively suppressed through equity incentives depends on the type of equity incentives. Equity incentives can be divided into long-term equity incentives and short-term equity incentives. For managers with long-term equity incentives, the main goal is to wait for the expiration of the vesting period and to meet the vesting conditions of equity incentives. Even under short-selling pressure, managers with long-term equity incentives are less likely to manipulate R&D expenditures. This is because the reduction of R&D expenditures will have a profound impact on the performance of the listed firms, resulting in the cancellation of the long-term equity incentive held by managers due to the fact that the vesting conditions are not met. On the contrary, for managers who hold short-term equity incentives, the main goal is to increase short-term stock prices as much as possible, thus, they are more motivated to cut R&D expenditures to avoid stock prices decline caused by superficies-oriented short sellers. Therefore, the influence of the removal of short selling constraints on the manipulation of R&D expenditures is effectively inhibited among managers who hold long-term equity incentives, while short-term equity incentives do not have such effect. To test the above theoretical mechanism, we focus on China′s short-selling and margin-trading pilot scheme launched on March 31, 2010, which gradually relaxed short-selling constraints for a designated sample of Chinese stocks over a period of time. Initially, only 90 stocks were eligible for short selling. Then Shanghai Stock Exchange and Shenzhen Stock Exchange substantially expanded the list according to a number of observable criteria, such as stock turnover, number of years from listed date to current date and circulation market value. The most meaningful feature of this pilot scheme is that the ban on short-selling was lifted only for a subset of stocks and the list of stocks eligible for short selling changes over time, thus creating both cross-sectional and time-series variations for us to investigate the impact of short selling on R&D expenditures manipulation. Through empirical research, we find that the removal of short selling constraints promotes listed firms to cut R&D expenditures; and the reason behind it is that short selling reinforces the incentives of managers to cut R&D expenditures for earnings management. This phenomenon is more obvious for firms in developed markets but effectively inhibited in firms whose managers hold long-term equity incentives, and the governance effect of long-term equity incentives still exists in firms located in developed markets. Furthermore, we exclude the alternative explanations such as changes in investment opportunities and prove that managers′ reduction in R&D expenditures after removing short selling constraints is indeed caused by the enhancement of earnings management motivation. The contributions of this paper are as follows: First, unlike previous studies which only discuss the governance effect of removing short selling constraints on earnings management from the perspective of essence-oriented short sellers, this paper analyzes the possible negative effect of removing short selling constraints from the perspective of superficies-oriented short sellers. Second, most existing literatures believe that the developed external market environment can promote stakeholders to supervise the listed firms and make up for the lack of internal governance. On the contrary, we find that the negative effect brought by financial innovation is more obvious in the developed markets, while the long-term equity incentives have an inhibitory effect on it.

Key words: removing short selling constraints, R&D expenditures, earnings management, market environment, equity incentives