Real Earnings

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Financial Distress, Internal Control, and Earnings Management: Evidence

from China
Yuanhui Li, Xiao Li, Erwei Xiang, Hadrian Geri Djajadikerta
PII: S1815-5669(20)30024-2
DOI: https://doi.org/10.1016/j.jcae.2020.100210
Reference: JCAE 100210
To appear in: Journal of Contemporary Accounting & Econom‐

ics
Received Date: 3 September 2018

Revised Date: 17 March 2020
Accepted Date: 20 May 2020
Please cite this article as: Li, Y., Li, X., Xiang, E., Geri Djajadikerta, H., Financial Distress, Internal Control, and
Earnings Management: Evidence from China, Journal of Contemporary Accounting & Economics (2020), doi:
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Financial Distress, Internal Control, and Earnings Management:
Evidence from China
Yuanhui Lia, Xiao Lia, Erwei Xiangb,*, Hadrian Geri Djajadikertab
a School of Economics and Management, Beijing Jiaotong University, Beijing, 100044, PR

China
b School of Business and Law, Edith Cowan University, Joondalup, WA, 6027, Australia
Acknowledgements
We acknowledge the valuable comments and suggestions received from the editor
(Professor Bin Srinidhi), anonymous reviewers, and George Shan. We would also like
to thank participants and discussants at the 2017 Business Doctoral and Emerging
Scholars Conference in Perth, Australia; the 2018 Accounting & Finance Association
of Australia & New Zealand (AFAANZ) annual conference in Auckland, New
Zealand; the 2018 International Conference on Accounting and Finance in Emerging
Markets (ICAFEM) in Nanjing, China; and the 2019 Journal of Contemporary
Accounting & Economics (JCAE) annual symposium in Putrajaya, Malaysia. Dr.
Yuanhui Li acknowledges the financial support of the National Natural Science
Foundation of China (grant number: NNSFC 71872010 and 71572009), Beijing
Municipal Social Science Foundation (grant number: 16YJB014), and the
Fundamental Research Funds for the Central Universities of China (grant number:
2019JBWB003). Xiao Li acknowledges the support of the Fundamental Research
Funds for the Central Universities of China (grant number: 2016YJS049).
* Corresponding author. Tel.: +61 8 63044990; E-mail address: e.xiang@ecu.edu.au (E. Xiang);
Address: School of Business and Law, Edith Cowan University, 270 Joondalup Drive, Joondalup WA
6027 Australia.
1
Financial Distress, Internal Control, and Earnings Management:
Evidence from China
Abstract: Using a sample of listed firms in China during the period of 2007 to 2015,
this paper investigates how financial distress influences the choice of earnings
management methods and how internal control quality moderates the above relation.
This paper finds that financially distressed firms tend to undertake more accrual
earnings management and less real earnings management. Internal control exerts a
moderation effect on the relation between financial distress and earnings management
by restraining both accrual and real earnings management. This study provides
additional insights into earnings management and internal control in financially
distressed firms, particularly from the perspective of an emerging economy.
Keywords: Financial distress; Internal control; Accrual earnings management; Real

earnings management
JEL classification: G33; G34; M41
2
1. Introduction
The existing literature finds that certain situations (e.g., initial public offering,
violation of debt covenant) might put managers under extreme pressure. Especially
when firms are financially distressed, managers’ decision-making processes and
behaviors might be affected by the pressure of distress (Iatridis and Kadorinis, 2009).
Conceptually, financial distress occurs when a firm’s liquidation of total assets is less
than the total value of creditor claims (Chen et al., 1995). This situation can arise at
any stage of the firm’s lifecycle, with direct implications for the firm’s future
performance (Avramov et al., 2013). If such a situation is prolonged, it can lead to
bankruptcy (Fan et al., 2013). Firms should be responsive to financial distress by
taking corrective action or restructuring to recover from the situation (Sudarsanam
and Lai, 2001). However, prior studies have found that firms in financial trouble have
strong incentives to manipulate their earnings to achieve a certain target and
consequently mislead stakeholders regarding their underlying financial performance
(Campa and Camacho-Miñano, 2015; Graham et al., 2005; Zang, 2012).
Accrual earnings management and real earnings management are the two main
tools available for managers to manipulate earnings (Cohen et al., 2008; Gunny, 2010;
Mao and Renneboog, 2015; Roychowdhury, 2006; Dinh et al., 2016; Zang, 2012).
Regarding the choice between these two tools, since room for manipulating accrual
earnings has become increasingly small because of the oversight by regulators such as
the Securities and Exchange Commission (SEC) and by auditors (The Economist,
2016; Carangelo and Ferrillo, 2016), managers have gradually been switching to real
earnings management. Further, Graham et al. (2005) argue that accrual-based
manipulation activities, which usually occur at the end of a fiscal year, have become
more easily detectable by regulators and auditors. Accordingly, real earnings
management, which occurs during the course of a fiscal year, is preferred since it is
less vulnerable to the scrutiny of regulators and auditors. However, it is not clear
whether this claim holds during a period of financial distress.2 Although firms now
2 Enomoto et al. (2015) examines the differences in accrual-based and real earnings management from
the perspective of investor protection. While some studies have examined the choice of earnings
management behaviors among financial distressed companies (e.g., Campa & Camacho-Miñano, 2015;
Rosner, 2003; Zang, 2012), their findings are not conclusive.
3
have more reason to lean toward real earnings management, financially distressed
firms are an exception and are potentially more desperate to take the risks associated
with accrual earnings management, depending on the extent of the firms’ distress.
In the US, the Sarbanes–Oxley Act (SOX) was promulgated in 2002 after the
Enron financial scandal, and attention has since been on internal control. The extant
literature has investigated the effect of internal control on earnings management, with
mixed results (Ashbaugh-Skaife et al., 2008; Cohen et al., 2008; Doyle et al., 2007a;
Järvinen and Myllymäki, 2016). Following the US, China issued the Basic Internal
Control Norms for Enterprises (BICNE) in June 2008, which is viewed as ‘China’s
SOX’. Although China’s internal control norms generally follow US practices, there
are some key differences regarding internal control standard setters, level of
marketization, mandatory or voluntary internal control disclosure, and content of
disclosure. These differences are likely to affect the incentives of firms conducting
earnings management in both countries. Accordingly, China provides a sound setting
for reexamining the impact of internal control on earnings management in an
emerging market, especially for financially distressed firms.
This paper investigates the relation between financial distress, internal control,
and earnings management in the context of China. In our study, we specifically
investigate which method (accrual vis-à-vis real) a firm chooses under a given
circumstance (distressed vis-à-vis non-distressed) and the role internal control quality
plays in those methods.
Our sample consists of all listed firms between 2007 and 2015, inclusive, with
15,769 firm-year observations conducted. We empirically investigate the impact of
financial distress on the selection of earnings management methods and the
moderation effect of internal control on the relation between financial distress and
earnings management. Our empirical ﬁndings indicate that financially distressed firms
tend to undertake more accrual earnings management and less real earnings
management. Internal control exerts a moderation effect on the relation between
financial distress and earnings management by suppressing both accrual and real
earnings management behaviors in financially distressed firms. Our results are robust
to alternative measures of earnings management and internal control deficiency.
Moreover, we find that financially distressed companies that mandatorily disclose
internal control information undertake less accrual and real earnings management
4
compared with their peers that voluntarily disclose internal control information.
Financially distressed companies with severe internal control deficiencies undertake
more accrual and real earnings management compared with companies with general
internal control deficiencies. In addition, financially distressed companies that have
completed deficiency rectification undertake less accrual and real earnings
management compared with companies that have not undergone deficiency
rectification.
Our paper contributes to the literature in three ways. First, our paper responds to
the call for studies on how distressed firms manage earnings (real vis-à-vis accrual)
(Campa and Camacho-Miñano, 2015; Rosner, 2003; Tinoco and Wilson, 2013). The
existing literature on the influence of financial distress on earnings management is
limited (Saleh and Ahmed, 2005). Moreover, this literature focuses mostly on listed
firms in the US (e.g., Zang, 2012). Therefore, a study on the relation between
financial distress and earnings management in other contexts, including emerging
markets, can contribute to our understanding of the incentives and constraints
regarding earnings management. The delisting rules in China provide a strong
incentive of earnings management to financially distressed firms, which makes China
a good context to examine the relation between financial distress and earnings
management.
Second, the prior literature has shown that good internal control can inhibit
accrual earnings management (e.g., Chen et al., 2017), but the effect of better internal
control on real earnings management is not yet clear, especially for financially
distressed firms. Our paper aims to fill this gap.
Third, a large body of literature has examined the relation between internal
control and earnings management in the US (Ashbaugh-Skaife et al., 2008; Cohen et
al., 2008; Doyle et al., 2007a; Järvinen and Myllymäki, 2016). However, little is
known about their relation in the context of financial distress, especially in emerging
markets, which might exhibit different capital market environments, internal control
standards, and management behaviors compared with the US because of variations in
history, politics, judiciary, culture, and social norms (Chan and Hameed, 2006; Xiang
et al., 2014). This paper fills this gap by investigating the relation between earnings
management and financial distress in China, and once that relation is established, the
potential moderating role of internal control quality within the same setting.
5
The remainder of the paper is organized as follows. Section 2 introduces the
institutional background of the capital market in China. Section 3 reviews the existing
studies on the relation between financial distress, internal control, and earnings
management, and describes the development of our hypotheses. Section 4 discusses
our sample collection process and empirical design. We present the empirical ﬁndings
in Section 5 and conclude our paper in Section 6.
2. Institutional background
2.1. Rules and guidance on delisting
Owing to the unique design of capital market systems in China, firms’ listing
qualification is an extremely scarce resource. According to the current rules and
guidance on delisting in China, which are specified in China’s Company Law and
Securities Law, a listed firm that experiences two consecutive annual losses will be
labeled “special treatment” (ST). It is considered that such firms are “facing imminent
danger of delisting unless they return to profitability after reporting two consecutive
annual losses” (Chu et al., 2011, p. 135). If the firm continues to experience a loss in
the third year, it will receive a delisting risk warning from the stock exchange, and an
“*ST” label will be inserted before the firm’s stock name to distinguish it from other
stocks. If, subsequently, the firm continues to generate losses, its listing qualification
can be suspended or even terminated. The delisting criteria under the current rules are
mainly based on earnings. Consequently, ST firms that cannot improve their
operations and performance in a timely fashion but wish to retain their listing
qualification would have strong incentives to manipulate their earnings. Therefore,
Chinese data provide good material to examine the relation between financial distress
and earnings management.
2.2. Internal control regulations
A recent milestone in China’s capital market development was the

implementation of a series of internal control norms for enterprises. In June 2008,
China issued the BICNE, which is known as “China’s SOX.” The BICNE was
implemented first in listed companies starting from July 1, 2009. Meanwhile, other
unlisted large and medium companies were encouraged to implement the BICNE.
6
According to the BICNE, companies should conduct self-assessment on the
effectiveness of their internal control and issue internal control self-assessment reports.
However, this requirement was not formally implemented until April 26, 2010 when
the relevant government regulatory agencies further issued the Guidelines for
Application of Enterprise Internal Controls, the Guidelines for Assessment of
Enterprise Internal Controls, and the Guidelines for Audit of Enterprise Internal
Controls (collectively, the Implementation Guidelines). The Implementation
Guidelines were effective for companies listed, both domestically and abroad, from
January 1, 2011, and companies listed on the main board of the Shanghai Stock
Exchange (SHSE) and Shenzhen Stock Exchange (SZSE) from January 1, 2012.3
According to the Guidelines for Assessment of Enterprise Internal Controls, an
internal control assessment report should disclose, for example, information on the
process of internal control assessment, the recognition and classification of internal
control deficiency and its rectification, and the conclusion on the effectiveness of
internal control.
Further, on January 3, 2014, the China Securities Regulatory Commission

(CSRC) and the Ministry of Finance jointly released the No. 21 Rules regarding the
Preparation of Reports for Information Disclosure Purpose of Companies Which
Publicly Offer Securities – General Provisions on the Annual Report of Internal
Control Evaluation (hereinafter referred to as the General Provisions on the Annual
Report of Internal Control Evaluation). These rules aim to improve the quality of
information disclosure regarding internal control evaluation of listed companies. The
General Provisions on the Annual Report of Internal Control Evaluation “clearly
stipulates the major components of the internal control evaluation report and offers
specific explanations on the main contents to be disclosed and relevant requirements
regarding key components including significant statements, conclusion of internal
control evaluation, specific issues of the evaluation and statements on other major
issues related to internal control.”4
Although the internal control norms and related guidelines in China generally
follow the Internal Control – Integrated Framework of the Committee of Sponsoring
3 See more details at https://home.kpmg/cn/en/home/services/advisory/risk-consulting/internal-
audit-risk/the-basic-standard-for-enterprise-internal-control.html.
4 See more details at http://www.csrc.gov.cn/pub/csrc_en/newsfacts/release/201402/t20140219
_244019.html.
7
Organizations of the Treadway Commission (COSO) in the US, there are some key
differences between the two frameworks, described as follows.
The first difference relates to the institutions in charge of the internal control
standards. The US Internal Control – Integrated Framework is set by the COSO,
which is a joint initiative of five private sector organizations. Therefore, the setup
process is bottom-up. Internal control standards in China, however, are set by the
government, and thus the setup process is top-down. Owing to the authority and
influence that governments exert, especially in China, government-led internal control
regulations are expected to have a real and strong effect on firms’ earnings
management behaviors.
The second difference concerns market conditions. While the US market is

widely regarded as a highly developed market with an elevated level of marketization,
China is a developing and emerging market with poor institutional regulations (Allen
et al., 2005). Under these different market conditions, both the regulations and
practices of internal control might exhibit distinct characteristics (Liu et al., 2014).
The third difference pertains to the level of internal control mandatory disclosure.
In the US, it is mandatory for listed firms to disclose internal control information,
while in China, only large listed firms are required to disclose internal control
information, and the remaining firms may voluntarily report their internal control
information.5 The regulations on internal control in China render it a unique setting to
examine whether firms that voluntarily disclose their internal control information
behave differently from the mandatory disclosers.
The fourth difference relates to the content of internal control disclosure. In the
US, listed firms are mainly required to report internal control information relating to
financial reports. Therefore, it can be seen that internal control regulations within the
US context focus more on the auditing perspective. However, listed firms in China are
required to report internal control information relating to both financial reports and
non-financial reports. This indicates that the Chinese internal control system
5See more details on the classification of large, medium, and small enterprises in China at
http://www.stats.gov.cn/english/ClassificationsMethods/Classifications/200210/t20021016_72367.html
.
8
emphasizes both auditing and management perspectives, which enables us to examine
the influence of internal control on corporate earnings management, especially the
choice between alternative earnings management methods.
3. Literature review and development of hypotheses
3.1. Financial distress and earnings management
When a listed firm is in financial trouble, its earnings might not meet its
investors’ expectations, which would result in a decline in its stock price and firm
value. Financial distress would also raise firms’ costs to issue debts and render debt
financing more difficult. As discussed in Section 2.1, under the current rules and
guidance on delisting in China, firms who wish to retain their listing qualification but
are in financial trouble might have strong incentives to manipulate their earnings (Chu
et al., 2011; Ding et al., 2007; Du and Lai, 2018; Jiang and Wang, 2008). Several
studies have provided evidence that Chinese listed firms tend to take the approach of
earnings management to avoid a loss, and a three-year consecutive loss in China’s
particular context (e.g., Chen et al., 2001; Haw et al., 2005).
However, empirical evidence on earnings management implemented by

financially distressed firms is extremely limited (Saleh and Ahmed, 2005). Moreover,
this considerably limited literature has focused on the relation between financial
distress and accrual earnings management. For example, Jaggi and Lee (2002) relate
the choice of income-increasing or income-decreasing discretionary accruals to
financial distress and find that the choice between income-increasing or
income-decreasing discretionary accruals is influenced by the severity of financial
distress. Saleh and Ahmed (2005) also find that managers of distressed firms tend to
adopt income-decreasing accruals.
When firms manipulate their earnings, they can utilize not only accrual earnings
management, which is done through applying different accounting methods, but also
real earnings management, which is achieved through real operation activities or
transactions (Cohen et al., 2008; Gunny, 2010; Mao and Renneboog, 2015;
Roychowdhury, 2006; Dinh et al., 2016; Zang, 2012). Among the existing studies,
Cohen et al. (2008) find that US firms recently switched from accrual-based earnings
management to real earnings management. Liu et al. (2011) also show that the
9
methods for manipulating earnings in Chinese listed firms have changed gradually
from accrual earnings management, which is normally undertaken easily but is more
likely to be detected, to real earnings management, which is less likely to be detected.
Neither study examines the influence of financial distress on the choice between
accrual and real earnings management. This lack of research is surprising since
financial distress could alter the trend discussed above of shifting from accrual to real
earnings management, given that it is an extreme financial situation where corporate
behaviors, including earnings management practices, can be distorted. This view is
supported by the evidence from a survey documented by Graham et al. (2005), who
find that CFOs admit that if a company is in a “negative tailspin,” its managers’
endeavors to survive will dominate their reporting concerns.
In one recent study, Zang (2012) examines the impact of poor financial health on
the trade-off between real activities manipulation and accrual-based earnings
management and documents that firms with poor financial health implement a higher
level of accrual earnings management. However, this study does not specifically study
the impact of financial distress on the choice between accrual and real earnings
management, especially in an emerging market context where institutional
regulations, market conditions, and corporate behaviors are different from those in
developed markets.
Since firms conducting real earnings management usually do not need to disclose
relevant information related to the performed activities, the risk of real earnings
management being detected by auditors or regulators is relatively lower. In contrast,
accrual earnings management involves the adjustment of the accounting numbers,
which needs to be disclosed in the financial report, and hence it is relatively more
likely to be identified by auditors or regulators. However, unlike managers of
financially healthy firms, who may undertake earnings management for various
objectives, such as smoothing corporate earnings and meeting analysts’ forecasts
(Degeorge et al., 1999), managers of distressed firms may resort to earnings
management to survive (Graham et al., 2005) or to avoid delisting, particularly in
China’s context (Chen et al., 2001; Haw et al., 2005). In the instance that a firm faces
survival or delisting issues, its managers would not have many resources to undertake
real earnings management, which usually requires an adjustment to business strategies
or operations. Moreover, since real earnings management adjusts earnings through
10
altering firms’ economic activities, such as abnormal promotion at the end of the
accounting period, the provision of slack credit policies, or cutting research and
development expenditures, it usually involves many aspects or processes and incurs a
higher cost. For instance, Zang (2012) argues that since the marginal cost of deviating
from optimal business strategies is likely to be high for a firm in financial distress,
managers may perceive real activities manipulation as relatively costly. In contrast,
since accrual earnings management manipulates earnings through changing
accounting policies, accounting estimates, and/or methods of asset impairment, and it
does not alter corporate cash flows and economic activities, it is relatively easy to
implement and incurs a lower cost. Zang (2012) finds that firms with poor financial
health have a higher level of accrual earnings management. Haga et al. (2018) also
show that accrual earnings management is still utilized by riskier firms.
Based on the discussion above, although firms have been facing greater scrutiny
from auditors and regulators in China, weighing the relative costliness of earnings
management methods and the risk of them being detected by auditors and regulators,
we expect that the greater the financial distress firms face, the more likely they are to
choose accrual earnings management. Thus, we propose our first hypothesis:
H1: All else being equal, firms with greater financial distress have a higher level
of accrual earnings management and a lower level of real earnings management.
3.2. Financial distress, internal control, and earnings management
Since the promulgation of SOX in the US, the relation between internal control
and earnings management has been studied extensively. However, mixed results are
found. For example, Ashbaugh-Skaife et al. (2008) show that although some
companies may initially have internal control deficiencies, once their internal control
is subsequently improved, their earnings management is lower than that of companies
whose internal control has not been improved. Doyle et al. (2007a) find that weak
internal control is positively associated with accrual earnings management. Other
prior studies find that companies with internal control weaknesses are associated with
poor inventory management (Feng et al., 2015) and increased insider trading (Skaife
et al., 2013), which suggests that internal control does have an “economically
significant effect on firm operations” (Feng et al., 2015, p.529). Meanwhile, Lenard et
11
al. (2016) argue that a weak internal control environment provides firms with
opportunities to manipulate real activities, and that firms may abnormally increase
revenues or generate excess cash flows through an increase of production or a
decrease of discretionary expenditures. Järvinen and Myllymäki (2016) also find that,
compared with companies with effective internal controls, companies with internal
control weaknesses engage in more manipulation of real activities, which is difficult
for outsiders to detect or constrain. However, Cohen et al. (2008) find real earnings
management has increased following SOX, although they find an overall decline in
accruals-based earnings management.6
Another stream of literature examines the relationship between internal control

quality and financial distress in the US market. For example, Doyle et al. (2007b)
show that firms in financial distress have a higher likelihood of material weakness
disclosure, which proxies for internal control quality. The argument is that good
internal control requires both financial resources and management time. Since firms in
poor financial health are concerned about simply surviving and staying in business,
developing proper internal control should not be their priority. What is more,
managers of distressed firms may not have sufficient time and/or money to invest in
good controls. In a more recent study, Hoitash et al. (2009) further support Doyle et
al.’s (2007b) finding. In addition, Rice and Weber (2012) argue that firms in poor
financial health may lack the necessary resources to conduct adequate tests of internal
controls, making them less likely to detect and disclose existing internal control
weaknesses. However, although Ashbaugh-Skaife et al. (2007) agree that firms in
financial distress are more likely to underinvest in internal control systems and
experience staffing problems that lead to internal control weaknesses, the authors tend
to believe that those firms are more likely to disclose internal control weaknesses.
While prior research investigates the impact of internal control on earnings

management and the relationship between financial distress and internal control in the
US market, it fails to incorporate financial distress, internal control, and earnings
management in one setting and investigate the moderating effect of internal control
quality on firms experiencing financial distress who use earnings management. This
research is interesting and important because little is known about whether common
6The authors, however, acknowledge the following: “whether this decline is caused by the passage of
SOX … cannot be inferred from this analysis.”
12
corporate earnings management and internal control behaviors revealed by prior
studies are distorted within an extreme situation of financial distress, particularly in an
emerging market like China. Compared with the US market, China, as an emerging
market and developing country, still has a relatively weak capital market, even after
the issuance of the BICNE and the subsequent supporting guidelines. Moreover, there
are a few key differences among the internal control regulations in China and the US,
such as the institutions in charge of the internal control standards, the level of internal
control mandatory disclosure, and the content of internal control disclosure. These
differences then raise the question of whether internal control regulations in China
have played their roles in the capital market effectively.
Since the issuance of the internal control regulations in China, a large body of
literature has investigated the effect of internal control on accrual earnings
management. However, the findings are inconclusive.7 For example, some studies
argue that high-quality internal control is expected to restrict firms’ accrual earnings
management (e.g., Ye et al., 2012). However, using A-share listed firms in SHSE as a
sample, Zhang (2008) finds that high-quality internal control is not accompanied by
high-quality earnings. The study also finds that accrued earnings quality is not
improved with the improvement of internal control quality.
According to the requirements of the BICNE and the subsequent supporting

guidelines, internal control can help to meet reporting, compliance and operational
objectives. For example, internal control can help to monitor the operational processes;
safeguard assets, which cover human resources, information systems, and other
resources; and influence various aspects of a firm, such as production, sales,
expenditure, and others. Fang and Jin (2011) and Li and Li (2018) argue that weak
internal controls provide opportunities for real earnings management by increasing
production, alternating sales, cutting R&D and advertising expenditures, and reducing
operational costs. Therefore, high-quality internal control is expected to restrict firms’
real earnings management. Some studies, for example, Ye et al. (2012), document the
evidence showing the positive effect of internal control on real earnings management.
Xu et al. (2015) investigate the mutual influence of relationship-based transactions and
7Some studies also examine the relationship between internal control and other attributes of earnings.
For example, Ji et al. (2015) investigate the effect of voluntary disclosure of internal control
weaknesses on earnings response coefficients in Chinese listed firms.
13
internal control as two different governance mechanisms on earnings management.
They find that high-quality internal control constrains real earnings management
induced by the supplier relationship-based transactions. However, Fan et al. (2013)
find that high-quality internal control does not help restrict firms’ real earnings
management.
The inconclusive findings on the correlations between internal control and

accrual/real earnings management motivate us to investigate the role of internal
control in restricting firms’ earnings management behaviors. Based on the
abovementioned theoretical analysis and the analysis of the characteristics of the
internal control regulations in China, we posit that good internal controls would
restrain management from engaging in earnings management in China. Further, given
that firms with a higher level of financial distress might have greater motivation to
manipulate their earnings because of the higher pressures they encounter, we
conjecture that the role of internal control in restricting firms’ earnings management
behaviors would be greater in these firms. Therefore, to effectively examine the role of
internal control in China, we specifically investigate the effect of internal control on
earnings management in financially distressed firms and propose the following
hypotheses:
H2a: All else being equal, high-quality internal control can restrict accrual
earnings management in firms with higher financial distress.
H2b: All else being equal, high-quality internal control can restrict real earnings
management in firms with higher financial distress.
4. Research design
4.1. Measurement of the main variables
4.1.1. Accrual earnings management
Following Cohen et al. (2008), we use discretionary accruals to proxy for accrual
earnings management. Discretionary accruals are the difference between firms’ actual
accruals and the normal level of accruals. The latter is estimated using the following
modified Jones (1991) model:
14
Accrualsi,t /Ai,t-1 = α0+α1(1/Ai,t-1)+α2(ΔSi,t/Ai,t-1)+α3(PPEi,t/Ai,t-1)+εi,t
(1)
where Accrualsi,t is the earnings before extraordinary items and discontinued

operations minus the operating cash flows reported in the statement of cash flows of
firm i in year t; Ai,t-1 is the total assets at year t−1; ΔSi,t is net receivables in year t less
net receivables in year t-1; and PPEi,t is the gross property, plant, and equipment of
firm i in year t. The estimated residuals (AM), which capture discretionary accruals,
are our proxy for accrual earnings management. Because discretionary accruals could
be positive or negative, following prior studies (e.g., Cohen et al., 2008; Yung and
Root, 2019), this paper uses the absolute value to measure the level of accrual
earnings management so that we can avoid the offset effect of the positive and
negative numbers of earnings management. Therefore, the degree of earnings
management can be reflected more precisely.
4.1.2. Real earnings management
Following Cohen et al. (2008) and Roychowdhury (2006), this paper uses the sum
of abnormal cash flows from operating activities (AbCFO), abnormal discretionary
expenditures (AbDISX) and abnormal production costs (AbPROD) to measure real
earnings management. First, we calculate the normal cash flows from operating
activities, the normal discretionary expenditures, and the normal production costs.
Then, we obtain residuals by running regressions to estimate the abnormal cash flows
from operating activities (AbCFO), the abnormal discretionary expenditures
(AbDISX), and the abnormal production costs (AbPROD), respectively.
Following Cohen et al. (2008), normal CFO can be expressed as a linear function
of sales and change in sales as follows:
CFOi,t/Ai,t-1=α0+α1/Ai,t-1+α2Si,t/Ai,t-1+α3ΔSi,t/Ai,t-1+εi,t (2)
where CFOi,t is the normal cash flow from operations of firm i in year t; Ai,t-1 is the
total assets of firm i in year t-1; Si,t is the net sales of firm i in year t; and ΔSi,t is the
change in net sales between year t-1 and t. Abnormal CFO (AbCFO) is the actual
CFO minus the normal level of CFO calculated using the estimated coefficient from
Equation (2). Following Zang (2012), we multiply the residuals by −1 such that
higher values indicate greater amounts of CFO decreased by firms to increase
reported earnings. Through discounts and sales on credit, a firm can increase its sales
15
revenue and profits, but at the same time, this reduces the firm’s operating cash flow.
In other words, the increase in the firm’s profit reflects the abnormal reduction of cash
flow from operations such as discounts and other promotional activities (Fan et al.,
2013).
The normal level of production costs is estimated following Roychowdhury

(2006), as follows:
PRODi,t/Ai,t-1=α0+α1/Ai,t-1+α2Si,t/Ai,t-1+α3ΔSi,t/Ai,t-1+α4ΔSi,t-1/Ai,t-1+εi,t (3)
where PRODi,t is the sum of the cost of goods sold in year t and the change in
inventory from t-1 to t; Ai,t-1 is the total assets of firm i in year t-1; Si,t is the net sales
of firm i in year t; and ΔSi,t-1 is the change in net sales from year t-1 to t. Then, the
abnormal level of production costs (AbPROD) is measured as the estimated residual
from Equation (3). Although the increase in product yield is the main reason for the
increase in production costs, the increase in product yield can lead to a decrease in the
unit product fixed cost. Therefore, the increase in abnormal production costs may lead
to an increase in the profitability per unit of product and increase firms’ reported
earnings.
Following Roychowdhury (2006) and Zang (2012), we estimate the normal level
of discretionary expenditures using the following equation:
DISXi,t/Ai,t-1=α0+α1/Ai,t-1+α2Si,t-1/Ai,t-1+εi,t (4)
where DISXi,t is the discretionary expenditures (i.e., the sum of research and
development, advertising, and selling, general and administrative expenditures) of
firm i in year t. The abnormal level of discretionary expenditures (AbDISX) is
measured as the estimated residual from the regression. We multiply the residuals by
−1 such that higher values indicate greater amounts of discretionary expenditures cut
by firms to increase reported earnings. Ai,t-1 is the total assets of firm i in year t-1 and
Si,t is the net sales of firm i in year t. The higher are abnormal discretionary
expenditures, the lower are firm profits.
We then aggregate the three real activities manipulation measures into one proxy,
RM, by taking their sum as follows:
RMi,t=AbPRODi,t+AbDISXi,t+AbCFOi,t (5)
16
where RMi,t is the proxy for real earnings management of firm i in year t; AbPRODi,t is
the abnormal production costs from operating activities of firm i in year t; AbDISXi,t is
the abnormal discretionary expenditures of firm i in year t; and AbCFOi,t is the
abnormal cash flow of firm i in year t. Following Sohn (2016) and Al-Shattarat et al.
(forthcoming), we use RM by taking its absolute value. The greater the index value,
the higher is the degree of real earnings management.8
4.1.3. Financial distress
When a firm’s cash flow is insufficient to pay back its existing debt, or when the
existing current assets and current liabilities do not match, the firm will face the threat
of financial distress. While there are many measures of financial distress, there is no
single measure that is universally accepted (Bugeja, 2015). Many studies use the
Z-score defined by Altman (1968), which is normally seen as “the most widely used
financial distress measure” (Bugeja, 2015, p. 367). Zang (2012) uses a modified
version of the Z-score to proxy for a firm’s financial health. Following Zang (2012),
this study also uses the modified Z-score (ZSCORE) to measure financial distress:
ZSCOREi,t=0.3X1+1.0X2+1.4X3+1.2X4+0.6X5 (6)
where ZSCOREi,t measures financial distress; X1 is the ratio of net profits to total
assets; X2 is the ratio of sales to total assets; X3 is the ratio of retained earnings to total
assets; X4 is the ratio of working capital to total assets; and X5 is the ratio of market
value of equity to total liabilities. The larger the ZSCORE, the better is the financial
condition of the firm. For the purpose of illustration, we multiply ZSCORE by −1 to
proxy for financial distress and label it DISTRESS1. Following Ahsan et al. (2013),
we also use a dummy variable, DISTRESS2, to proxy for financial distress.
DISTRESS2 equals one if the net working capital is negative and zero otherwise.
4.1.4. Internal control
Among the empirical studies on internal control deficiencies, Doyle et al. (2007a)
measure internal control deficiencies based on the information of material weaknesses
disclosed in firms’ internal control over financial reporting, which can be found in the
SEC filing. Ashbaugh-Skaife et al. (2008) further use both SOX-mandated internal
8 We also use each component of the integrated real activities manipulation measure to proxy for real
earnings management to test the robustness of our results.
17
control deficiency disclosures and external auditor opinions on internal control to
measure internal control deficiencies.
Chinese listed firms have been gradually required by regulations to disclose their
annual self-assessment reports on internal control. In addition, the Guidelines for
Audit of Enterprise Internal Controls also demand that certified public accountants
disclose significant deficiencies found during their audit on firms’ internal control.
This paper uses the internal control index constructed by Shenzhen DIB
Enterprise Risk Management Technology to proxy for internal control deficiencies.
The DIB internal control index was developed based on the BICNE and its
Implementation Guidelines as a framework. The DIB internal control index also refers
to the regulations on information disclosure of listed companies in China, such as the
No.21 General Provisions on the Annual Report of Internal Control Evaluation and
the developments of COSO.9 DIB’s internal control index is a composite index that
reflects the internal control quality based on the listed firm’s internal control
disclosure, internal control assessment, and auditing/assurance reports. This index is
consistent with the ideas of Doyle et al. (2007a) and Ashbaugh-Skaife et al. (2008)
but has more advantages since it was constructed by a third-party professional rating
agency with great independence, high data reliability, and strong objectivity. This
index is published annually and has been widely used by studies on internal control in
China (e.g., Li, 2015). Following Zhang et al. (2018), we construct a dummy variable,
internal control deficiencies (ICD), based on DIB’s internal control index.
Specifically, ICD equals one if DIB’s internal control index of a firm is below the
industry average and zero otherwise.
4.2. Estimation models
The models below are used to test our hypotheses:
AMi,t=α0+α1DISTRESSi,t+α2SIZEi,t+α3OCFi,t+α4OWNCONi,t+α5MtoBi,t+α6Big4i,t
+α7ROEi,t+α8GROWTHi,t+α9INVi,t+εi,t (7)
9 This is translated based on the Chinese description of DIB’s products

(http://www.dibdata.cn/#/product/1/ic).
18
RMi,t=0+1DISTRESSi,t+2SIZEi,t+3OCFi,t+4OWNCONi,t+5MtoBi,t+6Big4i,t
+7ROEi,t+8GROWTHi,t+9INVi,t+εi,t (8)
AMi,t=α0+α1DISTRESSi,t+α2ICDi,t+α3DISTRESSi,t×ICDi,t+α4SIZEi,t+α5OCFi,t+α6
OWNCONi,t+α7MtoBi,t+α8Big4i,t+α9ROEi,t+α10GROWTHi,t+α11INVi,t+εi,t (9)
RMi,t=0+1DISTRESSi,t+2ICDi,t+3DISTRESSi,t×ICDi,t+4SIZEi,t+5OCFi,t+6
OWNCONi,t+7MtoBi,t+8Big4i,t+9ROEi,t+10GROWTHi,t+11INVi,t+εi,t (10)
The definitions of each variable are provided in Appendix A. Financial distress

(DISTRESS) and internal control deficiencies (ICD) are the main independent
variables. The dependent variables are accrual earnings management (AM) and real
activity earnings management (RM). To test H1, α1 in Model (7) and 1 in Model (8)
are used to explain the relation between financial distress and accrual earnings
management and the relation between financial distress and real earnings
management, respectively. According to H1, α1 in Model (7) is expected to be
positive, while 1 in Model (8) is expected to be negative. To test H2a and H2b, α3 in
Model (9) and 3 in Model (10) are used to illustrate the moderation effect of internal
control on the relation between financial distress and accrual earnings management as
well as real earnings management, respectively. According to H2a and H2b, α3 and 3
are expected to be positive.
We also include a set of control variables to control for the possible effect of
other factors on our dependent variables. Gong et al. (2013) argue that larger firms
have more resources to improve their internal control and are less likely to manipulate
their earnings. Hence, we include firm size as a control variable, which is measured
by the natural logarithm of total assets. Doyle et al. (2006) find that both OCF and
ROE are negatively associated with earnings management. Hence OCF and ROE are
included as control variables. OCF is the cash flow from operations scaled by the total
assets, and ROE is the ratio of profits to net assets in the current year. Leuz et al.
(2003) find that higher ownership concentration is associated with a higher likelihood
of earnings manipulation. Following Gul et al. (2010), we use the largest-shareholder
ownership concentration to proxy for ownership concentration (OWNCON), which is
a dummy variable taking the value one if the ownership of the Top 1 shareholder
exceeds 50% and zero otherwise. Becker et al. (1998) find high-quality auditors are
helpful to restrict firms’ earnings management and also affect the construction of
19
firms’ internal control. We include Big4, which is a dummy variable that equals one if
the financial reports are audited by one of the four biggest accounting firms and zero
otherwise. Following Zang (2012), we include the market-to-book (MtoB) ratio to
control for firm growth. INV measures the level of inventory in a firm. If a firm grows
rapidly, then it will have more inventories and a higher internal control risk, which
calls for the governance of internal control (Gong et al., 2013).
All models are estimated using panel regression. Year and industry dummies are
included to control for variations in general economic conditions each year and each
industry.
4.3. Data and sample
Our sample consists of all publicly traded firms in China and covers the period of
2007–2015, inclusive.10 Data used in this study are all sourced from CSMAR. Owing
to the specialty of the finance industry, firms in the finance industry are eliminated.
We also eliminate firms whose financial data or internal control data are missing.
Applying the abovementioned filters yields our final sample, consisting of 15,769
firm-year observations. Table 1 presents the sample distribution by year and industry.
As shown in Table 1, 58.72% of our sample firms are from the manufacturing
sector, which is consistent with the status of China as the manufacturing powerhouse
around the world. The second largest sector is the wholesale and retail trade industry,
which contributes 7.23% of our sample firms. The comprehensive industry is the
smallest sector, which only contributes 1.23% of our sample firms. Table 1 also
shows the trend of the development of Chinese listed firms. More specifically, only
1,227 listed firms in 2007 were included in our sample, while in 2015, this number
increased to 2,250.
[Insert Table 1 about here]
10 Since China’s current accounting standards (i.e., “the new accounting standards”) were effective
from January 1, 2007, to avoid the inconsistencies in some accounting terms between pre- and
post-new accounting standards, the sample period for this study starts from 2007.
20
5. Empirical results
5.1. Descriptive statistics
Panel A in Table 2 provides the descriptive statistics of the variables. After

obtaining the absolute value, the mean and median of the accrual earnings
management (AM) are 0.0698 and 0.0482, respectively. The real earnings
management (RM), on average, is 0.1880, and its median is 0.1307. The financial
distress (DISRESS1) measured by Z-score (ZSCORE) is −3.8717 on average. The
financial distress (DISRESS2) measured by net working capital is 0.2709 on average.
The mean of internal control deficiencies (ICD) is 0.3750. To eliminate the possible
effects of outliers, all continuous variables are winsorized at the first and ninety-ninth
percentile.
Panel B in Table 2 presents the descriptive statistics of each component of the

integrated real activities manipulation measure, including the abnormal production
costs (AbPROD), the abnormal discretionary expenditures (AbDISX), and the
abnormal cash flow from operating activities (AbCFO). The mean values of AbPROD,
AbDISX, and AbCFO are 0.1045, 0.0592, and 0.0670, respectively, which show that
abnormal production costs (AbPROD) contributes the most to real earnings
management.
Panel C in Table 2 presents the Pearson correlation coefficient between the main
variables. There is a positive correlation between accrual earnings management (AM)
and financial distress (DISRESS1). There is also a positive correlation between
accrual earnings management (AM) and internal control deficiency (ICD), which is
statistically significant at the 1% level. The real earnings management (RM) is
negatively correlated with financial distress, while the internal control deficiency
(ICD) is positively correlated with financial distress. The abovementioned correlation
coefficients provide preliminary evidence consistent with our hypotheses.
5.2. Analysis of regression results
5.2.1. Financial distress and earnings management
21
Table 3 presents the regression results on the relation between financial distress
and earnings management. As shown in Columns (1) and (3), DISTRESS1 and
DISTRESS2 are positively associated with the accrual earnings management measure
(AM). The coefficients are 0.0016 and 0.0201, respectively, which are both
statistically significant at the 1% level. Meanwhile, Columns (2) and (4) show a
negative relation between DISTRESS1, DISTRESS2, and real earnings management
(RM). The coefficients are −0.0059 and −0.0366, respectively, which are both
statistically significant at the 1% level. This result suggests that the worse the
financial condition of a firm, the more accrual earnings management and the less real
earnings management behaviors are conducted by the firm. In other words, firms with
greater financial distress have a higher level of accrual earnings management and a
lower level of real earnings management, which supports H1. This result is consistent
with the studies of Graham et al. (2005) and Zang (2012).
Regarding the control variables, our regression results show that firm size is
negatively associated with accrual earnings management, which is consistent with the
study of Gong et al. (2013). There is a positive relation between OWNCON and
earnings management, which is consistent with the studies of Leuz et al. (2003). Big4
is negatively but insignificantly related to earnings management, which indicates that
auditing in China does not significantly restrict firms’ earnings management. INV is
positively related to earnings management, which is consistent with Gong et al.
(2013), suggesting that firms with faster growth and more inventories tend to engage
in more earnings management behaviors.
5.2.2. Financial distress, internal control, and earnings management
Table 4 presents the regression results on the relation between financial distress,
internal control, and earnings management. In Columns (1) and (3), the dependent
variable is accrual earnings management (AM), while in Columns (2) and (4) the
dependent variable is real earnings management (RM). In this section, an interaction
item between financial distress (DISTRESS1 and DISTRESS2) and internal control
deficiency (ICD) is created to investigate the moderation effect of internal control
deficiency on the relation between financial distress and earnings management.
22
Table 4 first shows a positive relation between financial distress (DISTRESS1
and DISTRESS2) and accrual earnings management (AM), which again supports H1.
A positive relation between accrual earnings management (AM) and internal control
deficiency (ICD) is shown in Table 4. The coefficients are 0.0120 and 0.0050,
respectively, which are statistically significant at the 1% level. Basically, referring to
higher internal control deficiency is the same as referring to lower internal control
quality, and vice versa. This result, therefore, indicates that the lower the internal
control quality of a firm, the more accrual earnings management behaviors are
conducted by the firm, which provides preliminary empirical evidence demonstrating
the restriction effect of internal control quality on accrual earnings management.
Further, the coefficients of the interaction term DISTRESS1×ICD and
DISTRESS2×ICD are 0.0014 and 0.0107, respectively, which are both significant at
the 1% level. The positive estimated coefficients for both α1 and α3 in Model (9)
indicate that financially distressed firms with higher internal control deficiency tend to
conduct more accrual earnings management behaviors. In other words, high-quality
internal control can restrict accrual earnings management in financially distressed
firms, which supports H2a.
Regarding the relation between financial distresses, internal control, and real
earnings management, Table 4 first exhibits a negative relation between financial
distress (DISTRESS1 and DISTRESS2) and real earnings management (RM), which
again supports H1. The coefficients of the interaction term DISTRESS1×ICD and
DISTRESS2×ICD are 0.0049 and 0.0130, respectively. The negative estimated
coefficient for 1, but positive coefficient for 3 in Model (10), suggest that the
moderation effect of internal control deficiency drives financially distressed firms to
conduct more real earnings management behaviors. In other words, high-quality
internal control can restrict real earnings management in firms with higher financial
distress, which supports H2b.
5.3. Robustness tests
5.3.1. Alternative measurement of real earnings management
23
In the baseline regressions, we follow Roychowdhury (2006) and Cohen et al.
(2008) and use the sum of the abnormal cash flow from operating activities (AbCFO),
the abnormal discretionary expenditures (AbDISX), and the abnormal production costs
(AbPROD) to measure real earnings management. To ensure that our results are
robust to alternative measurement of the real earnings management variable, we use
each component of the integrated real activities manipulation measure as well as the
sum of the abnormal discretionary expenditures (AbDISX) and the abnormal
production costs (AbPROD), which follows Zang (2012), to proxy for real earnings
management. The results are presented in Table 5. The results from using each
component of the integrated real activities manipulation measure are shown in
Column (1) to Column (3), respectively, and Column (4) presents the results from
using Zang (2012)’s measure.
As shown in Column (1) of Table 5, when real earnings management is measured

by the alternative measures, financial distress (DISTRESS1) always exhibits a
negative association with real earnings management, while the interaction term
DISTRESS1×ICD is positively associated with real earnings management, which is
consistent with the baseline regression results of Table 4.
5.3.2. Alternative measurement of accrual earnings management
To ensure that our baseline results are not altered by the alternative measurement
of accrual earnings management, we conduct a robustness check using the Jones
model, proposed by Jones (1991), to estimate the accrual earnings management
(AM_Jones). As shown in Table 6, when accrual earnings management is estimated
by the Jones model, the result is similar.
5.3.3. Alternative measurement of internal control deficiency
To ensure that our baseline results are robust, we further use an alternative
measure (ICD1) to proxy for internal control deficiency. Following Doyle et al.
(2007a) and Ashbaugh-Skaife et al. (2008), and also considering China’s regulation
24
and practice regarding internal control deficiencies, a firm is seen to have internal
control deficiencies when either of the following criteria is incurred:
1) The firm is punished by the regulating bodies, like the CSRC, because of its
violation of the requirements of the regulating bodies in the current year.
2) There is a non-standard audit opinion issued by the auditor.
3) The internal control assessment report issued by the auditor discloses internal
control deficiency.
ICD1 is set as a binary variable that equals one if a firm has internal control
deficiencies and zero otherwise. The results shown in Table 7 suggest that
high-quality internal control can restrict both accrual and real earnings management in
firms with higher financial distress. Therefore, our baseline results hold.
5.3.4. Mandatory versus voluntary disclosure
As mentioned in Section 2.2, the implementation of the BICNE and its

Implementation Guidelines in China has been conducted gradually, starting with
target groups of companies to all companies listed on the main board of the SHSE and
SZSE, where our sample firms come from. What is more, these regulations did not
become mandatory until January 1, 2012, since listed firms could elect to comply with
these rules voluntarily prior to this date (Ji et al., 2015). Some studies (e.g., Deumes
and Knechel, 2008) find that managers voluntarily report on internal control to reduce
the efficiency loss of information and agency problems, whereas Brown et al. (2014)
provide evidence for the positive effect of mandatory internal control and risk
management regulation on earnings quality.
Given that some listed companies chose to voluntarily disclose internal control
information before it was mandatory to do so in China, it would be interesting to
know whether firms that voluntarily disclose their internal control information behave
differently from the mandatory disclosers. More importantly, since implementation of
the internal control regulations has been subject to both voluntary and mandatory
regimes over the past decade, it is imperative to examine the effectiveness of each
regime in terms of restriction on earnings management. To address this issue, we
25
perform a robustness test on the relations between financial distress, internal control,
and earnings management by comparing mandatory and voluntary disclosures of
internal control information. We include a dummy variable, Time, that equals one if
the sample firms fall in the period of 2012 to 2015, which is the mandatory disclosure
period, and zero otherwise. We anticipate that the role of mandatory disclosure of
internal control information in restricting earnings management is more profound in
China mainly because internal control information disclosed by firms needs to be
audited from January 1, 2012 following the Guidelines for Audit of Enterprise
Internal Controls.
The results in Table 8 reveal that mandatory disclosure of internal control

information is negatively associated with both accrual and real earnings management.
This indicates that mandatory disclosure plays a more significant role in restricting
earnings management.
5.3.5. The impact of internal control deficiency type
According to the Guidelines for Assessment of Enterprise Internal Controls,

internal control deficiencies can be classified into major deficiencies, important
deficiencies, and general deficiencies, depending on the severity of internal control
deficiencies. A major deficiency, also known as a material weakness, refers to a
combination of one or more control deficiencies that can seriously influence the
effectiveness of the overall internal control. In turn, this can lead to the inability of a
company to prevent or detect significant deviations from the overall control
objectives. The severity of important deficiencies is lower than that of major
deficiencies, but it will also have a huge adverse impact on the company. Therefore, it
also needs to attract the attention of management. General deficiencies refer to
deficiencies other than important deficiencies and major deficiencies. General
deficiencies are also worthy of attention by management, since major and important
deficiencies usually start from general deficiencies.
It is interesting to explore whether firms that disclose different types of internal

control deficiency information behave differently. To address this issue, we conduct a
robustness test on the relations between financial distress, internal control deficiency
26
type, and earnings management. We construct a variable, ICDtype, that equals one,
two, or three if the deficiency identified for a company is either general deficiency,
important deficiency, or major deficiency, respectively.
The results provided in Table 9 demonstrate that the severity of internal control
deficiency is positively associated with both accrual and real earnings management.
This indicates that, compared with companies with general internal control
deficiencies, financially distressed companies with severe internal control deficiencies
undertake more accrual and real earnings management.
5.3.6. The impact of internal control deficiency rectification
In the case of problems that exist in the internal environment, companies can take
certain measures to rectify the deficiencies of internal control and improve the effects
of internal control. Therefore, exploring whether firms that rectify their internal
control deficiencies behave differently is of interest. To address this issue, we perform
a robustness test on the relations between financial distress, internal control deficiency
rectification, and earnings management. We include a dummy variable, ICDRe, that
equals one if the internal control deficiency of last year is rectified and zero otherwise.
The results provided in Table 10 reveal that rectification of internal control

deficiency is negatively associated with both accrual and real earnings management.
This indicates that, compared with companies that have not undergone deficiency
rectification, financially distressed companies that have completed rectification
implement less accrual and real earnings management.
6. Conclusion
This paper employs a sample comprising all Chinese listed firms between 2007
and 2015, inclusive, incorporating 15,769 firm-year observations, to empirically
investigate the impact of financial distress on the selection of earnings management
27
methods and the moderation effect of internal control on the relation between
financial distress and earnings management.
We find that firms with a higher level of financial distress tend to engage in more
accrual earnings management and less real earnings management. After trading off
the relative cost and risk, financially distressed firms collectively reveal a tendency to
conduct more accrual earnings manipulation and less real earnings manipulation. We
also find that internal control exerts a moderation effect on the relation between
financial distress and earnings management by suppressing both accrual and real
earnings management behaviors in financially distressed firms. Our results are robust
to alternative measures of earnings management and internal control deficiency. We
further find that, compared with companies that voluntarily disclose internal control
information, financially distressed companies that mandatorily disclose internal
control information undertake less accrual and real earnings management. Moreover,
financially distressed companies with severer internal control deficiencies undertake
more accrual and real earnings management compared with companies with general
internal control deficiencies. In addition, financially distressed companies that have
completed deficiency rectification undertake less accrual and real earnings
management compared with companies that have not undergone deficiency
rectification.
Our finding that financially distressed firms conduct more accrual earnings
manipulation and less real earnings manipulation has implications for both researchers
and regulators. For researchers, this finding suggests that factors, including costliness
and risk, should be incorporated altogether to fully explain earnings management
activities. For regulators, it implies that increasing scrutiny or constraints over
accounting discretion does not necessarily eliminate accrual earnings management
activities. In addition, our finding regarding the moderation effect of internal control
on the relation between financial distress and earnings management would have some
implications for the assessment of the effectiveness of internal control regulations and
practices in China as well as other emerging markets.
Having drawn these conclusions, it must also be acknowledged that this study
does not explore real earnings management activities by industries. Given that certain
industries have unique characteristics and thus may focus on diverse kinds of real
earnings management activities, future studies might need to investigate real earnings
28
management activities based on the industry variation. Also, this paper does not break
the “black box” of internal control and examine the impact of each component of it on
earnings management. Future studies might need to investigate specifically how good
internal control would influence earnings management and precisely what internal
control mechanisms would deter earnings management.
29
Appendix A. Definition of variables
Variables Definition
Dependent AM Absolute value of accrual earnings management
variables RM Absolute value of real earnings management
DISTRESS1 Multiply Z-score by -1
DISTRESS2 Dummy variable that equals one if the net working capital is
negative and zero otherwise
Independent ICD Internal control deficiency, which is a proxy for internal control
variables quality. ICD is a dummy variable that equals one if DIB’s
internal control index of a firm is below the industry average and
zero otherwise
ICD1 Dummy variable taking the value one if firm is punished by the
regulating bodies or issued with a non-standard audit opinion or
internal control deficiency and zero otherwise
ICDtype A variable that equals one, two, or three if the deficiency
identified for a company is general deficiency, important
deficiency, or major deficiency, respectively
ICDRe Dummy variable taking the value one if the internal control
deficiency of last year is rectified and zero otherwise
TIME Dummy variable taking the value one if the sample firms fall the
period from 2012 to 2015 and zero otherwise
SIZE Natural logarithm of total assets
OCF Cash flow from operations scaled by the total assets
Control OWNCON Dummy variable taking the value one if the ownership of the Top
variables 1 shareholder exceeds 50% and zero otherwise
MtoB Market-to-book ratio
Big4 Dummy variable that equals one if the financial reports are
audited by one of the 4 biggest accounting firms and zero
otherwise
ROE Ratio of profits to the net assets in the current year
GROWTH The growth rate of business revenue of a firm
INV Ratio of inventories to total assets
30
Acknowledgements
We acknowledge the valuable comments and suggestions received from the editor
(Professor Bin Srinidhi), anonymous reviewers, and George Shan. We would also like to
thank participants and discussants at the 2017 Business Doctoral and Emerging Scholars
Conference in Perth, Australia; the 2018 Accounting & Finance Association of Australia
& New Zealand (AFAANZ) annual conference in Auckland, New Zealand; the 2018
International Conference on Accounting and Finance in Emerging Markets (ICAFEM) in
Nanjing, China; and the 2019 Journal of Contemporary Accounting & Economics
(JCAE) annual symposium in Putrajaya, Malaysia. Dr. Yuanhui Li acknowledges the
financial support of the National Natural Science Foundation of China (grant number:
NNSFC 71872010 and 71572009), Beijing Municipal Social Science Foundation (grant
number: 16YJB014), and the Fundamental Research Funds for the Central Universities of
China (grant number: 2019JBWB003). Xiao Li acknowledges the support of the
Fundamental Research Funds for the Central Universities of China (grant number:
2016YJS049).
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37
Table 1.
Sample distribution.
Industry 2007 2008 2009 2010 2011 2012 2013 2014 2015 Total Percentage
code
A 19 22 23 24 23 34 35 37 38 255 1.62%
B 40 43 54 57 49 63 66 67 66 505 3.20%
C 674 746 819 850 852 1159 1364 1413 1383 9260 58.72%
D 70 72 74 72 65 75 77 77 75 657 4.17%
E 26 31 36 35 40 49 60 60 61 398 2.52%
F 57 62 64 65 67 71 76 77 75 614 3.89%
G 54 60 66 70 93 133 157 170 169 972 6.16%
H 113 118 122 122 119 133 139 138 136 1140 7.23%
J 100 116 122 124 115 126 129 124 126 1082 6.86%
K 39 43 48 48 47 65 69 68 69 496 3.15%
L 11 14 16 15 17 25 32 33 33 196 1.24%
M 24 24 23 22 19 20 22 21 19 194 1.23%
Total 1227 1351 1467 1504 1506 1953 2226 2285 2250 15769
Percentage 7.78% 8.57% 9.30% 9.54% 9.55% 12.39% 14.12% 14.49% 14.27% 100%
This table presents the sample distribution by year and industry. The classification of the industry is based on the Guidelines for the Industry Classification of
Listed Companies 2001. A represents agriculture, forestry, livestock farming and fishery industry; B represents mining industry; C represents manufacturing
industry; D represents industry of electric power, gas and water production and supply; E represents construction industry; F represents transport and storage
industry; G represents information technology industry; H represents wholesale and retail trade industry; J represents real estate industry; K represents social
services; L represents communication and cultural industry; M represents comprehensive industries.
38
Table 2.
Descriptive statistics.
Panel A. Descriptive statistics of the whole sample
Variables N Mean Median Maximum Minimum Std
AM 15769 0.0698 0.0482 0.2543 0.0040 0.0662
RM 15769 0.1880 0.1307 0.6899 0.0112 0.1783
DISTRESS1 15769 -3.8717 -2.5670 -0.5399 -14.6060 3.6387
DISTRESS2 15769 0.2709 0.0000 1.0000 0.0000 0.4444
ICD 15769 0.3750 0.0000 1.0000 0.0000 0.4841
SIZE 15769 21.9236 21.7866 24.3215 20.1517 1.1415
OCF 15769 0.0513 0.0483 0.2092 -0.1000 0.0780
OWNCON 15769 0.1987 0.0000 1.0000 0.0000 0.3991
MtoB 15769 3.8516 3.0054 11.2352 1.0205 2.6881
Big4 15769 0.0594 0.0000 1.0000 0.0000 0.2365
ROE 15769 0.0701 0.0678 0.2312 -0.1325 0.0830
GROWTH 15769 0.1497 0.1077 0.9089 -0.3119 0.2937
INV 15769 0.1645 0.1287 0.5509 0.0057 0.1410
Panel B. Descriptive statistics of real earnings management

Variables N Mean Median Maximum Minimum Std
RM 15769 0.1880 0.1307 0.6899 0.0112 0.1783
AbPROD 15769 0.1045 0.0705 0.4017 0.0063 0.1036
AbDISX 15769 0.0592 0.0396 0.2276 0.0034 0.0591
AbCFO 15769 0.0670 0.0487 0.2296 0.0043 0.0601
Panel C. Pearson correlation coefficient

AM RM ZSCORE
RM 0.2928***
DISTRESS1 0.0361*** -0.1412***
ICD 0.0556*** -0.0424*** -0.0424***
This table reports the summary statistics for the variables used in the analyses (Panel A and B) and the
Pearson correlation coefficients among the main variables (Panel C). All variables are defined in Section
4.1. and 4.2. and summarized in Appendix A. The Spearman correlation coefficients are presented in Panel
C. *, **, *** indicate significance at the 10%, 5%, and 1% levels, respectively.
39
Table 3.
Financial distress and earnings management.
AM RM AM RM
(1) (2) (3) (4)
DISTRESS1 0.0016*** -0.0059***
(9.54) (-13.39)
DISTRESS2 0.0201*** -0.0366***
(4.50) (-2.63)
SIZE -0.0056*** 0.0028* -0.0156*** -0.0215***
(-10.00) (1.91) (-9.61) (-4.23)
OCF -0.0402*** 0.0379** -0.0987*** 0.4122***
(-5.54) (1.98) (-3.84) (5.14)
OWNCON 0.0026** 0.0095*** 0.0180*** 0.0485***
(2.00) (2.73) (3.64) (3.15)
MtoB 0.0029*** 0.0070*** -0.0004*** 0.0003***
(13.27) (12.06) (-11.43) (2.90)
Big4 0.0006 -0.0005 0.0133 0.0191
(0.28) (-0.07) (1.52) (0.70)
ROE 0.0252*** 0.2897*** 0.0232*** 0.0043*
(3.60) (15.68) (28.81) (1.73)
GROWTH 0.0183*** 0 .0688*** 0.0670*** 0.3190***
(9.96) (14.23) (10.19) (15.58)
INV 0.0864*** 0.2215*** 0.2005*** 0.4183***
(22.49) (21.86) (15.84) (10.60)
CONS 0.1693*** 0.0063 0.3795*** 0.5617***
(13.62) (0.19) (10.88) (5.17)
Industry Yes Yes Yes Yes
Year Yes Yes Yes Yes
Adj R2 0.0744 0.1112 0.0760 0.0289
Observations 15769 15769 15769 15769
This table presents the regression results on the relation between financial distress and earnings
management. All variables are defined in Section 4.1. and 4.2. and summarized in Appendix A. Year and
industry dummies are included to control for variations in general economy conditions each year and each
industry. T statistics are reported in parentheses. ***, **, and * denote statistical significance at 1%, 5%,
and 10%, respectively.
40
Table 4.
Financial distress, internal control and earnings management.
AM RM AM RM
(1) (2) (3) (4)
ICD 0.0120*** 0.0305*** 0.0050*** 0.0095***
(6.69) (6.45) (3.58) (2.72)
DISTRESS1 0.0011*** -0.0072***
(5.89) (-14.04)
DISTRESS1×ICD 0.0014*** 0.0049***
(3.17) (4.31)
DISTRESS2 0.0027* -0.0302***
(1.70) (-7.13)
DISTRESS2×ICD 0.0107*** 0.0130**
(4.59) (2.10)
SIZE -0.0049*** 0.0040*** -0.0042*** 0.0004
(-8.75) (2.67) (-7.58) (0.29)
OCF -0.0388*** 0.0394** -0.0402*** 0.0646***
(-5.36) (2.06) (-5.55) (3.36)
OWNCON 0.0026** 0.0095*** 0.0022* 0.0097***
(1.97) (2.74) (1.69) (2.78)
MtoB 0.0028*** 0.0067*** 0.0021*** 0.0095***
(12.78) (11.60) (10.16) (17.13)
Big4 0.0010 0.0007 0.0013 -0.0005
(0.45) (0.11) (0.58) (-0.09)
ROE 0.0380*** 0.3162*** 0.0351*** 0.3227***
(5.27) (16.58) (4.83) (16.76)
GROWTH 0.0192*** 0 .0707*** 0.0202*** 0.0649***
(10.45) (14.61) (11.06) (13.38)
INV 0.0871*** 0.2232*** 0.0897*** 0.1824***
(22.72) (22.05) (26.56) (17.58)
CONS 0.1502*** -0.0321 0.1230*** 0.0777**
(11.81) (-0.96) (10.65) (2.40)
Adj R2 0.0775 0.1135 0.0805 0.1052
Observations 15769 15769 15769 15769
This table presents the regression results on the relation between financial distress, internal control and
earnings management. All variables are defined in Section 4.1. and 4.2. and summarized in Appendix A.
Year and industry indicators are included to control for variations in general economy conditions each year
and each industry. T statistics are reported in parentheses. ***, **, and * denote statistical significance at
1%, 5%, and 10%, respectively.
41
Table 5.
Financial distress, internal control and earnings management (alternative measures of real earnings
management).
AbDISX AbPROD AbCFO RM_Zang

(1) (2) (3) (4)
DISTRESS1 -0.0002*** -0.0041*** -0.0005*** -0.0029***
(-4.32) (-14.13) (-2.75) (-12.09)
ICD -0.0034*** 0.0225*** 0.0106*** 0.0124**
(-3.34) (8.30) (6.62) (5.76)
DISTRESS1×ICD 0.0002** 0.0042*** 0.0017*** 0.0024***
(4.06) (6.48) (4.36) (4.49)
SIZE -0.0040*** 0.0014* -0.0015*** -0.0005
(-9.27) (1.82) (-3.06) (-0.83)
OCF -0.0002** 0.0002 0.0183*** -0.0001***
(-2.49) (1.42) (2.81) (-1.32)
OWNCON 0.0009 0.0071*** 0.0056*** 0.0103***
(0.75) (3.60) (4.77) (6.42)
MtoB 0.0009*** 0.0040*** 0.0026*** 0.0027***
(4.72) (12.20) (13.34) (10.02)
Big4 0.0045** 0.0066* 0.0008 0.0081
(2.09) (1.87) (0.38) (2.86)
ROE 0.0006*** 0.1799*** 0.0632*** 0.0007***
(3.48) (17.26) (7.12) (2.95)
GROWTH 0.0141*** 0.0344*** 0.0248*** 0.0427***
(8.70) (12.45) (15.09) (19.81)
INV -0.0200*** 0.1744*** 0.0813*** 0.1540***
(-6.91) (26.34) (23.63) (39.66)
Intercept 0.1459*** -0.0097 0.0613*** 0.0265*
(14.82) (-0.58) (5.37) (1.95)
Industry dummies Yes Yes Yes Yes
Year dummies Yes Yes Yes Yes
Adj R2 0.0250 0.1453 0.0990 0.1341
Observations 15769 15769 15769 15769
This table reports the robustness test results where we use each component of the integrated real activities
manipulation measure as well as the sum of the abnormal discretionary expenditures (AbDISX) and the
abnormal production costs (AbPROD), which follows Zang (2012), to proxy for real earnings management.
The results from using each component of the integrated real activities manipulation measure are shown in
Column (1) to Column (3), respectively, and Column (4) presents the result from using Zang (2012)’s
measure. All other variables are defined in Section 4.1. and 4.2. and summarized in Appendix A. Year and
industry dummies are included to control for variations in general economy conditions each year and each
industry. T statistics are reported in parentheses. ***, **, and * denote statistical significance at 1%, 5%,
and 10%, respectively.
42
Table 6.
Financial distress, internal control and earnings management (alternative measures of accrual earnings
management).
AM_Jones AM_Jones AM_Jones AM_Jones

(1) (2) (3) (4)
ICD 0.0096*** 0.0048***
(5.75) (3.87)
DISTRESS1 0.0016*** 0.0013***
(10.61) (7.45)
DISTRESS1*ICD 0.0010**
(2.37)
DISTRESS2 0.0070*** 0.0025*
(6.14) (1.69)
DISTRESS2*ICD 0.0084***
(3.85)
SIZE -0.0051*** -0.0047** -0.0042*** -0.0035***
(-11.36) (-10.27) (-7.58) (-7.84)
OCF -0.0283*** 0.0001 -0.0043*** -0.0346***
(-4.18) (1.06) (-9.76) (-5.12)
OWNCON 0.0021* 0.0018 0.0020 0.0022*
(1.69) (1.48) (1.61) (1.80)
MtoB 0.0027*** 0.0026*** 0.0020*** 0.0020***
(13.35) (12.91) (10.23) (10.00)
Big4 0.0010 0.0008 0.0009 0.0005
(0.45) (0.37) (0.43) (0.22)
ROE 0.0205*** 0.0236*** 0.0180*** 0.0307***
(3.15) (3.66) (2.74) (4.53)
GROWTH 0.0148*** 0 .0153*** 0.0162*** 0.0168***
(8.65) (8.94) (9.48) (9.82)
INV 0.0686*** 0.0725*** 0.0778*** 0.0851***
(22.14) (24.45) (24.63) (23.28)
CONS 0.1600*** 0.1451 0.1357*** 0.1151**
(15.76) (13.91) (13.84) (11.45)
Adj R2 0.0727 0.0741 0.0683 0.0683
Observations 15769 15769 15769 15769
This table reports the robustness test results where we use the Jones model proposed by Jones (1991) to
estimate the accrual earnings management (AM_Jones). All other variables are defined in Section 4.1. and
4.2. and summarized in Appendix A. Year and industry dummies are included to control for variations in
general economy conditions each year and each industry. T statistics are reported in parentheses. ***, **,
and * denote statistical significance at 1%, 5%, and 10%, respectively.
43
Table 7.
Financial distress, internal control and earnings management (alternative measures of internal control
deficiency).
AM RM
(1) (2)
DISTRESS1 0.0014*** -0.0061***
(7.97) (-13.28)
ICD1 0.0112*** 0.0146**
(4.81) (2.35)
DISTRESS1×ICD1 0.0032*** 0.0025*
(4.25) (1.82)
SIZE -0.0061*** 0.0026*
(-12.54) (1.80)
OCF -0.0342*** 0.0395**
(-4.73) (2.06)
OWNCON 0.0030** 0.0098***
(2.25) (2.82)
MtoB 0.0027*** 0.0069***
(12.51) (11.94)
Big4 0.0043* 0.0003
(1.87) (0.05)
ROE 0.0268*** 0.2943***
(3.84) (15.86)
GROWTH 0.0186*** 0.0691***
(10.19) (14.29)
INV 0.0817*** 0.2219***
(24.66) (21.90)
CONS 0.1797*** 0.0066
(16.53) (0.20)
Industry Yes Yes
Year Yes Yes
Adj R2 0.0831 0.1115
Observations 15769 15769
This table presents the robustness test results on the relation between financial distress, internal control and
earnings management by using the alternative measure of internal control deficiency. ICD1 is a binary
variable that equals one if a firm has internal control deficiencies and zero otherwise. All other variables
are defined in Section 4.1. and 4.2. and summarized in Appendix A. Year and industry indicators are
included to control for variations in general economy conditions each year and each industry. T statistics
are reported in parentheses. ***, **, and * denote statistical significance at 1%, 5%, and 10%, respectively.
44
Table 8.
Financial distress, internal control and earnings management (mandatory vs. voluntary disclosure).
AM RM
(1) (2)
DISTRESS1 0.0011*** -0.0083***
(8.93) (-15.81)
ICD 0.0100*** 0.0130***
(5.62) (2.77)
TIME -0.0093*** -0.0022*
(-5.81) (1.76)
DISTRESS1×ICD 0.0011*** 0.0043***
(2.64) (3.70)
DISTRESS1×TIME -0.0002* -0.00004***
(-1.93) (-2.62)
SIZE -0.0039*** 0.0072***
(-6.77) (4.72)
OCF -0.0353** -0.0003
(-4.87) (-1.54)
OWNCON 0.0017 0.0124***
(1.26) (3.55)
MtoB 0.0029*** 0.0073***
(13.55) (12.61)
Big4 -0.0010 0.0055
(-0.42) (0.90)
ROE 0.0466*** 0.0019***
(6.59) (3.77)
GROWTH 0.00001 0.0934***
(-1.05) (19.71)
INV 0.0809*** 0.2021***
(24.35) (23.86)
CONS 0.1353*** -0.0799**
(10.49) (-2.34)
Industry Yes Yes
Year Yes Yes
Adj R2 0.0795 0.0989
This table presents the robustness test results on the relation between financial distress, internal control and
earnings management by comparing between mandatory and voluntary internal control disclosure. Time is
a dummy variable that equals one if the sample firms fall the period from 2012 to 2015, which is the
mandatory disclosure period, and zero otherwise. All other variables are defined in Section 4.1. and 4.2.
and summarized in Appendix A. Year and industry indicators are included to control for variations in
general economy conditions each year and each industry. T statistics are reported in parentheses. ***, **,
and * denote statistical significance at 1%, 5%, and 10%, respectively.
45
Table 9.
Financial distress, type of internal control deficiency, and earnings management.
AM RM
(1) (2)
DISTRESS1 0.0006** -0.0113***
(2.00) (-2.64)
ICDtype 0.0085** 0.0160***
(2.30) (3.10)
DISTRESS1×ICDtype 0.0002** 0.0047**
(1.98) (2.06)
SIZE -0.0045*** -0.0027***
(-3.89) (-0.89)
OCF -0.0333** -0.0183
(-2.01) (-0.41)
OWNCON -0.0025 -0.0079***
(-0.92) (-1.08)
MtoB 0.0023*** 0.0053***
(4.49) (3.90)
Big4 0.0096** 0.0172
(2.26) (1.50)
ROE 0.0009*** 0.0013
(0.88) (0.49)
GROWTH 0.0132*** 0.0024***
(3.03) (4.44)
INV 0.0457*** 0.1388***
(6.15) (7.85)
CONS 0.1390*** 0.1506**
(5.11) (2.04)
Industry Yes Yes
Year Yes Yes
Adj R2 0.0482 0.0682
This table presents the robustness test results on the relation between financial distress, type of internal
control deficiency and earnings management. ICDtype equals one, two, or three if the deficiency identified
for a company is general deficiency, important deficiency, or major deficiency, respectively. All other
variables are defined in Section 4.1. and 4.2. and summarized in Appendix A. Year and industry indicators
are included to control for variations in general economy conditions each year and each industry. T
statistics are reported in parentheses. ***, **, and * denote statistical significance at 1%, 5%, and 10%,
respectively.
46
Table 10.
Financial distress, internal control deficiency rectification, and earnings management.
AM RM
(1) (2)
DISTRESS1 0.0014*** -0.0026*
(2.83) (-1.81)
ICDtype(t-1) 0.0070** 0.0164*
(2.41) （1.87）
ICDRe -0.0066* -0.0313*
(-1.79) (-1.86)
DISTRESS1×ICDRe -0.0002* -0.0010*
(1.86) (-1.80)
SIZE -0.0021 -0.0026
(-1.64) (-0.62)
OCF -0.0231*** -0.0341
(-4.28) (-0.55)
OWNCON -0.0001 0.0077
(-0.04) (0.78)
MtoB 0.0027*** 0.0083***
(4.75) (4.78)
Big4 0.0036 -0.0053*
(0.68) (-0.33)
ROE -0.0017 0.2411***
(-0.96) (5.21)
GROWTH 0.0006*** 0.0745***
(3.00) (5.01)
INV 0.0407*** 0.0855***
(5.29) (3.57)
CONS 0.0887*** 0.1489
(2.97) (1.51)
Industry Yes Yes
Year Yes Yes
Adj R2 0.0572 0.0844
This table presents the robustness test results on the relation between financial distress, internal control
deficiency rectification, and earnings management. ICDRe is a dummy variable that equals one if the
internal control deficiency of last year is rectified and zero otherwise. All other variables are defined in
Section 4.1. and 4.2. and summarized in Appendix A. Year and industry indicators are included to
control for variations in general economy conditions each year and each industry. T statistics are
reported in parentheses. ***, **, and * denote statistical significance at 1%, 5%, and 10%, respectively.
47
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Journal Pre-proofs

Financial Distress, Internal Control, and Earnings Management: Evidence

Yuanhui Li, Xiao Li, Erwei Xiang, Hadrian Geri Djajadikerta

To appear in: Journal of Contemporary Accounting & Econom‐

Received Date: 3 September 2018

© 2020 Elsevier Ltd. All rights reserved.

Evidence from China

Yuanhui Lia, Xiao Lia, Erwei Xiangb,*, Hadrian Geri Djajadikertab

a School of Economics and Management, Beijing Jiaotong University, Beijing, 100044, PR

Evidence from China

Keywords: Financial distress; Internal control; Accrual earnings management; Real

JEL classification: G33; G34; M41

2.1. Rules and guidance on delisting

2.2. Internal control regulations

A recent milestone in China’s capital market development was the

Further, on January 3, 2014, the China Securities Regulatory Commission

The second difference concerns market conditions. While the US market is

3. Literature review and development of hypotheses

3.1. Financial distress and earnings management

However, empirical evidence on earnings management implemented by

3.2. Financial distress, internal control, and earnings management

Another stream of literature examines the relationship between internal control

While prior research investigates the impact of internal control on earnings

According to the requirements of the BICNE and the subsequent supporting

The inconclusive findings on the correlations between internal control and

4.1. Measurement of the main variables

4.1.1. Accrual earnings management

where Accrualsi,t is the earnings before extraordinary items and discontinued

4.1.2. Real earnings management

The normal level of production costs is estimated following Roychowdhury

4.1.3. Financial distress

4.1.4. Internal control

4.2. Estimation models

The models below are used to test our hypotheses:

9 This is translated based on the Chinese description of DIB’s products

The definitions of each variable are provided in Appendix A. Financial distress

4.3. Data and sample

[Insert Table 1 about here]

5.1. Descriptive statistics

Panel A in Table 2 provides the descriptive statistics of the variables. After

Panel B in Table 2 presents the descriptive statistics of each component of the

[Insert Table 2 about here]

5.2. Analysis of regression results

5.2.1. Financial distress and earnings management

[Insert Table 3 about here]

5.2.2. Financial distress, internal control, and earnings management

[Insert Table 4 about here]

5.3. Robustness tests

5.3.1. Alternative measurement of real earnings management

As shown in Column (1) of Table 5, when real earnings management is measured

[Insert Table 5 about here]

5.3.2. Alternative measurement of accrual earnings management

[Insert Table 6 about here]

5.3.3. Alternative measurement of internal control deficiency

2) There is a non-standard audit opinion issued by the auditor.

[Insert Table 7 about here]

5.3.4. Mandatory versus voluntary disclosure

As mentioned in Section 2.2, the implementation of the BICNE and its

The results in Table 8 reveal that mandatory disclosure of internal control

[Insert Table 8 about here]

5.3.5. The impact of internal control deficiency type

According to the Guidelines for Assessment of Enterprise Internal Controls,

It is interesting to explore whether firms that disclose different types of internal