1 s2.0 S1815566920300242 Main

Journal of Contemporary Accounting and Economics 16 (2020) 100210
Contents lists available at ScienceDirect
Journal of Contemporary
Accounting and Economics
journal homepage: www.elsevier.com/locate/jcae
Financial distress, internal control, and earnings management:

Evidence from China
Yuanhui Li a, Xiao Li a, Erwei Xiang b,⇑, Hadrian Geri Djajadikerta b
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
a r t i c l e i n f o a b s t r a c t
Article history: Using a sample of listed firms in China during the period of 2007–2015, this paper inves-
Received 3 September 2018 tigates how financial distress influences the choice of earnings management methods and
Revised 17 March 2020 how internal control quality moderates the above relation. This paper finds that financially
Accepted 20 May 2020
distressed firms tend to undertake more accrual earnings management and less real earn-
Available online 29 May 2020
ings management. Internal control exerts a moderation effect on the relation between
financial distress and earnings management by restraining both accrual and real earnings
JEL classification:
management. This study provides additional insights into earnings management and inter-
G33
G34
nal control in financially distressed firms, particularly from the perspective of an emerging
M41 economy.
Ó 2020 Elsevier Ltd. All rights reserved.
Keywords:
Financial distress
Internal control
Accrual earnings management
Real earnings management
1. Introduction
The existing literature finds that certain situations (e.g., initial public offering, violation of debt covenant) might put man-
agers 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., 2013a,b). 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 manip-
ulate 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
⇑ Corresponding author at: School of Business and Law, Edith Cowan University, 270 Joondalup Drive, Joondalup, WA 6027, Australia.
E-mail address: e.xiang@ecu.edu.au (E. Xiang).
https://doi.org/10.1016/j.jcae.2020.100210
1815-5669/Ó 2020 Elsevier Ltd. All rights reserved.
2 Y. Li et al. / Journal of Contemporary Accounting and Economics 16 (2020) 100210
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. Fur-
ther, 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 dur-
ing 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.1 Although firms now 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). Fol-
lowing the US, China issued the Basic Internal Control Norms for Enterprises (BICNE) in June 2008, which is viewed as ‘Chi-
na’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 coun-
tries. 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 circum-
stance (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 mod-
eration 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 man-
agement. 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
compared with their peers that voluntarily disclose internal control information. Financially distressed companies with sev-
ere internal control deficiencies undertake more accrual and real earnings management compared with companies with gen-
eral 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 vari-
ations 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.
The remainder of the paper is organized as follows. Section 2 introduces the institutional background of the capital mar-
ket 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.
1
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.
Y. Li et al. / Journal of Contemporary Accounting and Economics 16 (2020) 100210 3
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 termi-
nated. 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. According to the BICNE, companies should conduct self-assessment on the effectiveness of their inter-
nal 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 Enter-
prise 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, 2012.2 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 con-
clusion 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 disclo-
sure 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.”3
Although the internal control norms and related guidelines in China generally follow the Internal Control – Integrated
Framework of the Committee of Sponsoring 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 – Inte-
grated Framework is set by the COSO, which is a joint initiative of five private sector organizations. Therefore, the setup pro-
cess 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.4 The regulations on internal
2
See more details at https://home.kpmg/cn/en/home/services/advisory/risk-consulting/internal- audit-risk/the-basic-standard-for-enterprise-internal-con
trol.html.
3
See more details at http://www.csrc.gov.cn/pub/csrc_en/newsfacts/release/201402/t20140219_244019.html.
4
See 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.
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 con-
trol system 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 financ-
ing 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 dis-
tress 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 activ-
ities 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 earn-
ings management to real earnings management. Liu et al. (2011) also show that the 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 surpris-
ing 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 dis-
torted. 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 per-
formed activities, the risk of real earnings management being detected by auditors or regulators is relatively lower. In con-
trast, 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 man-
agement 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 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 reg-
ulators, we expect that the greater the financial distress firms face, the more likely they are to choose accrual earnings man-
agement. 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 stud-
ied 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 earn-
ings 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 compa-
nies with internal control weaknesses are associated with poor inventory management (Feng et al., 2015) and increased insi-
der 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 al. (2016) argue that a weak internal control environment pro-
vides 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.5
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 nec-
essary resources to conduct adequate tests of internal controls, making them less likely to detect and disclose existing inter-
nal 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 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 reg-
ulations 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.6 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 con-
trol 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 pro-
cesses; 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
5
The authors, however, acknowledge the following: ‘‘whether this decline is caused by the passage of SOX . . . cannot be inferred from this analysis.”
6
Some 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.
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 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. (2013a,b) 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 abovemen-
tioned 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 specif-
ically investigate the effect of internal control on earnings management in financially distressed firms and propose the fol-
lowing 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:

Accrualsi;t =Ai;t1 ¼ a0 þ a1 1=Ai;t1 þ a2 DSi;t =Ai;t1 þ a3 PPEi;t =Ai;t1 þ ei;t ð1Þ
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; DSi,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 resid-
uals (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 expen-
ditures, 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;t1 ¼ a0 þ a1 1=Ai;t1 þ a2 Si;t =Ai;t1 þ a3 DSi;t =Ai;t1 þ ei;t ð2Þ
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 t1; Si,t is the
net sales of firm i in year t; and DSi,t is the change in net sales between year t1 and t. Abnormal CFO (AbCFO) is the actual
CFO minus the normal level of CFO calculated using the estimated coefficient from Eq. (2). Following Zang (2012), we mul-
tiply 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 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., 2013a,b).
The normal level of production costs is estimated following Roychowdhury (2006), as follows:

PRODi;t =Ai;t1 ¼ a0 þ a1 1=Ai;t1 þ a2 Si;t =Ai;t1 þ a3 DSi;t =Ai;t1 þ a4 DSi;t1 =Ai;t1 þ ei;t ð3Þ
where PRODi,t is the sum of the cost of goods sold in year t and the change in inventory from t1 to t; Ai,t-1 is the total assets
of firm i in year t1; Si,t is the net sales of firm i in year t; and DSi,t1 is the change in net sales from year t1 to t. Then, the
abnormal level of production costs (AbPROD) is measured as the estimated residual from Eq. (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 profitabil-
ity 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:

DISX i;t =Ai;t1 ¼ a0 þ a1 1=Ai;t1 þ a2 Si;t1 =Ai;t1 þ ei;t ð4Þ
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,t1 is the total assets of firm i in year
t1 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 ¼ AbPRODi;t þ AbDISX i;t þ AbCFOi;t ð5Þ
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. (2018) (forthcoming), we use RM by
taking its absolute value. The greater the index value, the higher is the degree of real earnings management.7
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 lia-
bilities 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 mod-
ified Z-score (ZSCORE) to measure financial distress:
ZSCOREi;t ¼ 0:3X 1 þ 1:0X 2 þ 1:4X 3 þ 1:2X 4 þ 0:6X 5 ð6Þ
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 neg-
ative 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 control deficiency disclo-
sures 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 inter-
nal 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 devel-
opments of COSO.8 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 annu-
7
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.
8
This is translated based on the Chinese description of DIB’s products (http://www.dibdata.cn/#/product/1/ic).
ally 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 ¼ a0 þ a1 DISTRESSi;t þ a2 SIZEi;t þ a3 OCF i;t þ a4 OWNCONi;t þ a5 MtoBi;t þ a6 BIG4i;t þ a7 ROEi;t þ a8 GROWTHi;t
þ a9 INV i;t þ ei;t ð7Þ
RMi;t ¼ b0 þ b1 DISTRESSi;t þ b2 SIZEi;t þ b3 OCF i;t þ b4 OWNCONi;t þ b5 MtoBi;t þ b6 BIG4i;t þ b7 ROEi;t þ b8 GROWTHi;t
þ b9 INV i;t þ ei;t ð8Þ
AMi;t ¼ a0 þ a1 DISTRESSi;t þ a2 ICDi;t þ a3 DISTRESSi;t ICDi;t þ a4 SIZEi;t þ a5 OCF i;t þ a6 OWNCONi;t þ a7 MtoBi;t
þ a8 BIG4i;t þ a9 ROEi;t þ a10 GROWTHi;t þ a11 INV i;t þ ei;t ð9Þ
RMi;t ¼ b0 þ b1 DISTRESSi;t þ b2 ICDi;t þ b3 DISTRESSi;t ICDi;t þ b4 SIZEi;t þ b5 OCF i;t þ b6 OWNCONi;t þ b7 MtoBi;t
þ b8 BIG4i;t þ b9 ROEi;t þ b10 GROWTHi;t þ b11 INV i;t þ ei;t ð10Þ
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, a1 in Model (7) and b1 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, a1 in Model (7) is expected to be positive, while b1 in Model (8) is expected to be negative.
To test H2a and H2b, a3 in Model (9) and b3 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, respec-
tively. According to H2a and H2b, a3 and b3 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 manip-
ulate 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 concen-
tration 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 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 gen-
eral 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.9 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 indus-
try, 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
1227 listed firms in 2007 were included in our sample, while in 2015, this number increased to 2250.
9
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.
Table 1
Sample distribution.
Industry code 2007 2008 2009 2010 2011 2012 2013 2014 2015 Total Percentage
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 15,769
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 manu-
facturing 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.
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 win-
sorized 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 con-
sistent with our hypotheses.
5.2. Analysis of regression results
5.2.1. Financial distress and earnings management

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 coef-
ficients 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 manage-
ment 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.
Table 2
Descriptive statistics.
Panel A. Descriptive statistics of the whole sample

Variables N Mean Median Maximum Minimum Std
AM 15,769 0.0698 0.0482 0.2543 0.0040 0.0662
RM 15,769 0.1880 0.1307 0.6899 0.0112 0.1783
DISTRESS1 15,769 3.8717 2.5670 0.5399 14.6060 3.6387
DISTRESS2 15,769 0.2709 0.0000 1.0000 0.0000 0.4444
ICD 15,769 0.3750 0.0000 1.0000 0.0000 0.4841
SIZE 15,769 21.9236 21.7866 24.3215 20.1517 1.1415
OCF 15,769 0.0513 0.0483 0.2092 0.1000 0.0780
OWNCON 15,769 0.1987 0.0000 1.0000 0.0000 0.3991
MtoB 15,769 3.8516 3.0054 11.2352 1.0205 2.6881
Big4 15,769 0.0594 0.0000 1.0000 0.0000 0.2365
ROE 15,769 0.0701 0.0678 0.2312 0.1325 0.0830
GROWTH 15,769 0.1497 0.1077 0.9089 0.3119 0.2937
INV 15,769 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 15,769 0.1880 0.1307 0.6899 0.0112 0.1783
AbPROD 15,769 0.1045 0.0705 0.4017 0.0063 0.1036
AbDISX 15,769 0.0592 0.0396 0.2276 0.0034 0.0591
AbCFO 15,769 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.
Table 3
Financial distress and earnings management.
AM (1) RM (2) AM (3) RM (4)

DISTRESS1 0.0016*** (9.54) 0.0059*** (13.39)
DISTRESS2 0.0201*** (4.50) 0.0366*** (2.63)
SIZE 0.0056*** (10.00) 0.0028* (1.91) 0.0156*** (9.61) 0.0215*** (4.23)
OCF 0.0402*** (5.54) 0.0379** (1.98) 0.0987*** (3.84) 0.4122*** (5.14)
OWNCON 0.0026** (2.00) 0.0095*** (2.73) 0.0180*** (3.64) 0.0485*** (3.15)
MtoB 0.0029*** (13.27) 0.0070*** (12.06) 0.0004*** (11.43) 0.0003*** (2.90)
Big4 0.0006 (0.28) 0.0005 (0.07) 0.0133 (1.52) 0.0191 (0.70)
ROE 0.0252*** (3.60) 0.2897*** (15.68) 0.0232*** (28.81) 0.0043* (1.73)
GROWTH 0.0183*** (9.96) 0.0688*** (14.23) 0.0670*** (10.19) 0.3190*** (15.58)
INV 0.0864*** (22.49) 0.2215*** (21.86) 0.2005*** (15.84) 0.4183*** (10.60)
CONS 0.1693*** (13.62) 0.0063 (0.19) 0.3795*** (10.88) 0.5617*** (5.17)
Industry Yes Yes Yes Yes
Year Yes Yes Yes Yes
Adj R2 0.0744 0.1112 0.0760 0.0289
Observations 15,769 15,769 15,769 15,769
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.
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 manage-
ment. 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 (DIS-
TRESS1 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.
Table 4 first shows a positive relation between financial distress (DISTRESS1 and DISTRESS2) and accrual earnings man-
agement (AM), which again supports H1. A positive relation between accrual earnings management (AM) and internal con-
trol deficiency (ICD) is shown in Table 4. The coefficients are 0.0120 and 0.0050, respectively, which are statistically
Table 4
Financial distress, internal control and earnings management.
AM (1) RM (2) AM (3) RM (4)

ICD 0.0120*** (6.69) 0.0305*** (6.45) 0.0050*** (3.58) 0.0095*** (2.72)
DISTRESS1 0.0011*** (5.89) 0.0072*** (14.04)
DISTRESS1 ICD 0.0014*** (3.17) 0.0049*** (4.31)
DISTRESS2 0.0027* (1.70) 0.0302*** (7.13)
DISTRESS2 ICD 0.0107*** (4.59) 0.0130** (2.10)
SIZE 0.0049*** (8.75) 0.0040*** (2.67) 0.0042*** (7.58) 0.0004 (0.29)
OCF 0.0388*** (5.36) 0.0394** (2.06) 0.0402*** (5.55) 0.0646*** (3.36)
OWNCON 0.0026** (1.97) 0.0095*** (2.74) 0.0022* (1.69) 0.0097*** (2.78)
MtoB 0.0028*** (12.78) 0.0067*** (11.60) 0.0021*** (10.16) 0.0095*** (17.13)
Big4 0.0010 (0.45) 0.0007 (0.11) 0.0013 (0.58) 0.0005 (0.09)
ROE 0.0380*** (5.27) 0.3162*** (16.58) 0.0351*** (4.83) 0.3227*** (16.76)
GROWTH 0.0192*** (10.45) 0 0.0707*** (14.61) 0.0202*** (11.06) 0.0649*** (13.38)
INV 0.0871*** (22.72) 0.2232*** (22.05) 0.0897*** (26.56) 0.1824*** (17.58)
CONS 0.1502*** (11.81) 0.0321 (0.96) 0.1230*** (10.65) 0.0777** (2.40)
Adj R2 0.0775 0.1135 0.0805 0.1052
Observations 15,769 15,769 15,769 15,769
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.
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 demon-
strating 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 a1 and a3 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, respec-
tively. The negative estimated coefficient for b1, but positive coefficient for b3 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

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.
Table 5
Financial distress, internal control and earnings management (alternative measures of real earnings management).
AbDISX (1) AbPROD (2) AbCFO (3) RM_Zang (4)

DISTRESS1 0.0002*** (4.32) 0.0041*** (14.13) 0.0005*** (2.75) 0.0029*** (12.09)
ICD 0.0034*** (3.34) 0.0225*** (8.30) 0.0106*** (6.62) 0.0124** (5.76)
DISTRESS1 ICD 0.0002** (4.06) 0.0042*** (6.48) 0.0017*** (4.36) 0.0024*** (4.49)
SIZE 0.0040*** (9.27) 0.0014* (1.82) 0.0015*** (3.06) 0.0005 (0.83)
OCF 0.0002** (2.49) 0.0002 (1.42) 0.0183*** (2.81) 0.0001*** (1.32)
OWNCON 0.0009 (0.75) 0.0071*** (3.60) 0.0056*** (4.77) 0.0103*** (6.42)
MtoB 0.0009*** (4.72) 0.0040*** (12.20) 0.0026*** (13.34) 0.0027*** (10.02)
Big4 0.0045** (2.09) 0.0066* (1.87) 0.0008 (0.38) 0.0081 (2.86)
ROE 0.0006*** (3.48) 0.1799*** (17.26) 0.0632*** (7.12) 0.0007*** (2.95)
GROWTH 0.0141*** (8.70) 0.0344*** (12.45) 0.0248*** (15.09) 0.0427*** (19.81)
INV 0.0200*** (6.91) 0.1744*** (26.34) 0.0813*** (23.63) 0.1540*** (39.66)
Intercept 0.1459*** (14.82) 0.0097 (0.58) 0.0613*** (5.37) 0.0265* (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 15,769 15,769 15,769 15,769
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.
Table 6
Financial distress, internal control and earnings management (alternative measures of accrual earnings management).
AM_Jones (1) AM_Jones (2) AM_Jones (3) AM_Jones (4)

ICD 0.0096*** (5.75) 0.0048*** (3.87)
DISTRESS1 0.0016*** (10.61) 0.0013*** (7.45)
DISTRESS1*ICD 0.0010** (2.37)
DISTRESS2 0.0070*** (6.14) 0.0025* (1.69)
DISTRESS2*ICD 0.0084*** (3.85)
SIZE 0.0051*** (11.36) 0.0047** (10.27) 0.0042*** (7.58) 0.0035** (7.84)
OCF 0.0283*** (4.18) 0.0001 (1.06) 0.0043*** (9.76) 0.0346** (5.12)
OWNCON 0.0021* (1.69) 0.0018 (1.48) 0.0020 (1.61) 0.0022* (1.80)
MtoB 0.0027*** (13.35) 0.0026*** (12.91) 0.0020*** (10.23) 0.0020*** (10.00)
Big4 0.0010 (0.45) 0.0008 (0.37) 0.0009 (0.43) 0.0005 (0.22)
ROE 0.0205*** (3.15) 0.0236*** (3.66) 0.0180*** (2.74) 0.0307*** (4.53)
GROWTH 0.0148*** (8.65) 0 0.0153*** (8.94) 0.0162*** (9.48) 0.0168*** (9.82)
INV 0.0686*** (22.14) 0.0725*** (24.45) 0.0778*** (24.63) 0.0851*** (23.28)
CONS 0.1600*** (15.76) 0.1451 (13.91) 0.1357*** (13.84) 0.1151** (11.45)
Adj R2 0.0727 0.0741 0.0683 0.0683
Observations 15,769 15,769 15,769 15,769
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.
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 and
practice regarding internal control deficiencies, a firm is seen to have internal control deficiencies when either of the follow-
ing criteria is incurred:
1) The firm is punished by the regulating bodies, like the CSRC, because of its violation of the requirements of the reg-
ulating 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.
Table 7
Financial distress, internal control and earnings management (alternative measures of internal control deficiency).
AM (1) RM (2)
DISTRESS1 0.0014*** (7.97) 0.0061*** (13.28)
ICD1 0.0112*** (4.81) 0.0146** (2.35)
DISTRESS1 ICD1 0.0032*** (4.25) 0.0025* (1.82)
SIZE 0.0061*** (12.54) 0.0026* (1.80)
OCF 0.0342*** (4.73) 0.0395** (2.06)
OWNCON 0.0030** (2.25) 0.0098*** (2.82)
MtoB 0.0027*** (12.51) 0.0069*** (11.94)
Big4 0.0043* (1.87) 0.0003 (0.05)
ROE 0.0268*** (3.84) 0.2943*** (15.86)
GROWTH 0.0186*** (10.19) 0.0691*** (14.29)
INV 0.0817*** (24.66) 0.2219*** (21.90)
CONS 0.1797*** (16.53) 0.0066 (0.20)
Industry Yes Yes
Year Yes Yes
Adj R2 0.0831 0.1115
Observations 15,769 15,769
This table presents the robustness test results on the relation between financial distress, internal control and earnings man-
agement 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.
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 con-
ducted 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 regula-
tions has been subject to both voluntary and mandatory regimes over the past decade, it is imperative to examine the effec-
tiveness of each regime in terms of restriction on earnings management. To address this issue, we perform a robustness test
on the relations between financial distress, internal control, and earnings management by comparing mandatory and volun-
tary 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 deficien-
cies. 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 deficien-
cies. 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
Table 8
Financial distress, internal control and earnings management (mandatory vs. voluntary disclosure).
AM (1) RM (2)
DISTRESS1 0.0011*** (8.93) 0.0083*** (15.81)
ICD 0.0100*** (5.62) 0.0130*** (2.77)
TIME 0.0093*** (5.81) 0.0022* (1.76)
DISTRESS1 ICD 0.0011*** (2.64) 0.0043*** (3.70)
DISTRESS1 TIME 0.0002* (1.93) 0.00004*** (2.62)
SIZE 0.0039*** (6.77) 0.0072*** (4.72)
OCF 0.0353** (4.87) 0.0003 (1.54)
OWNCON 0.0017 (1.26) 0.0124*** (3.55)
MtoB 0.0029*** (13.55) 0.0073*** (12.61)
Big4 0.0010 (0.42) 0.0055 (0.90)
ROE 0.0466*** (6.59) 0.0019*** (3.77)
GROWTH 0.00001 (1.05) 0.0934*** (19.71)
INV 0.0809*** (24.35) 0.2021*** (23.86)
CONS 0.1353*** (10.49) 0.0799** (2.34)
Industry Yes Yes
Year Yes Yes
Adj R2 0.0795 0.0989
Observations 15,769 15,769
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.
Table 9
Financial distress, type of internal control deficiency, and earnings management.
AM (1) RM (2)
DISTRESS1 0.0006** (2.00) 0.0113*** (2.64)
ICDtype 0.0085** (2.30) 0.0160*** (3.10)
DISTRESS1 ICDtype 0.0002** (1.98) 0.0047** (2.06)
SIZE 0.0045*** (3.89) 0.0027*** (0.89)
OCF 0.0333** (2.01) 0.0183 (0.41)
OWNCON 0.0025 (0.92) 0.0079*** (1.08)
MtoB 0.0023*** (4.49) 0.0053*** (3.90)
Big4 0.0096** (2.26) 0.0172 (1.50)
ROE 0.0009*** (0.88) 0.0013 (0.49)
GROWTH 0.0132*** (3.03) 0.0024*** (4.44)
INV 0.0457*** (6.15) 0.1388*** (7.85)
CONS 0.1390*** (5.11) 0.1506** (2.04)
Industry Yes Yes
Year Yes Yes
Adj R2 0.0482 0.0682
Observations 2380 2380
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.
deficiency 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 earn-
ings 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 defi-
ciencies of internal control and improve the effects of internal control. Therefore, exploring whether firms that rectify their
Table 10
Financial distress, internal control deficiency rectification, and earnings management.
AM (1) RM (2)
DISTRESS1 0.0014*** (2.83) 0.0026* (1.81)
ICDtype(t1) 0.0070**(2.41) 0.0164* (1.87)
ICDRe 0.0066* (1.79) 0.0313* (1.86)
DISTRESS1 ICDRe 0.0002* (1.86) 0.0010* (1.80)
SIZE 0.0021 (1.64) 0.0026 (0.62)
OCF 0.0231*** (4.28) 0.0341 (0.55)
OWNCON 0.0001 (0.04) 0.0077 (0.78)
MtoB 0.0027*** (4.75) 0.0083*** (4.78)
Big4 0.0036 (0.68) 0.0053* (0.33)
ROE 0.0017 (0.96) 0.2411*** (5.21)
GROWTH 0.0006*** (3.00) 0.0745*** (5.01)
INV 0.0407*** (5.29) 0.0855*** (3.57)
CONS 0.0887*** (2.97) 0.1489 (1.51)
Industry Yes Yes
Year Yes Yes
Adj R2 0.0572 0.0844
Observations 1599 1599
This table presents the robustness test results on the relation between financial distress, internal control deficiency rectifi-
cation, 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.
internal control deficiencies behave differently is of interest. To address this issue, we perform a robustness test on the rela-
tions 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
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 ten-
dency 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 dis-
close 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 con-
trol 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 manip-
ulation 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 inter-
nal 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 manage-
ment 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 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.
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).
Appendix A. Definition of variables
Variables Definition
Dependent AM Absolute value of accrual earnings management
variables RM Absolute value of real earnings management
Independent DISTRESS1 Multiply Z-score by 1

variables DISTRESS2 Dummy variable that equals one if the net working capital is negative and zero otherwise
ICD Internal control deficiency, which is a proxy for internal control 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
Control SIZE Natural logarithm of total assets

variables OCF Cash flow from operations scaled by the total assets
OWNCON Dummy variable taking the value one if the ownership of the Top 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
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Journal of Contemporary Accounting and Economics 16 (2020) 100210

Contents lists available at ScienceDirect

Financial distress, internal control, and earnings management:

2.1. Rules and guidance on delisting

2.2. Internal control regulations

3. Literature review and development of hypotheses

3.1. Financial distress and earnings management

3.2. Financial distress, internal control, and earnings management

4.1. Measurement of the main variables

4.1.1. Accrual earnings management

4.1.2. Real earnings management

4.1.3. Financial distress

4.1.4. Internal control

4.2. Estimation models

The models below are used to test our hypotheses:

4.3. Data and sample

5.1. Descriptive statistics

5.2. Analysis of regression results

5.2.1. Financial distress and earnings management

Panel A. Descriptive statistics of the whole sample

Panel B. Descriptive statistics of real earnings management

AM (1) RM (2) AM (3) RM (4)

5.2.2. Financial distress, internal control, and earnings management

AM (1) RM (2) AM (3) RM (4)

5.3. Robustness tests

5.3.1. Alternative measurement of real earnings management

5.3.2. Alternative measurement of accrual earnings management

AbDISX (1) AbPROD (2) AbCFO (3) RM_Zang (4)

AM_Jones (1) AM_Jones (2) AM_Jones (3) AM_Jones (4)

5.3.3. Alternative measurement of internal control deficiency

5.3.4. Mandatory versus voluntary disclosure

5.3.5. The impact of internal control deficiency type

5.3.6. The impact of internal control deficiency rectification

Appendix A. Definition of variables

Independent DISTRESS1 Multiply Z-score by 1

Control SIZE Natural logarithm of total assets

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