Equity incentives, internal control, and earnings management: the moderating role of internal control quality

1. Introduction

The integrity of financial reporting is a cornerstone of efficient capital markets, yet it is persistently threatened by earnings management [1]. Equity incentives are a widely adopted governance tool intended to mitigate agency conflicts by aligning the interests of managers with those of shareholders. However, a significant body of research suggests that these incentives often act as a "double-edged sword" [2]. Though designed to spur value creation, such incentives can exert intense pressure on managers to massage earnings—whether to hit performance benchmarks or to bolster stock prices for personal gain [3]. This duality raises a critical question for corporate governance: what mechanisms can effectively constrain the opportunistic behaviors potentially induced by equity incentives?

The academic literature and regulatory frameworks increasingly point to internal control as a key mitigating mechanism. A robust internal control system functions as a corporate "firewall" by establishing a structured environment that limits the opportunities and increases the costs of managerial misbehavior [4, 5]. While prior studies have extensively documented the separate effects of equity incentives on earnings management and internal control on earnings quality, there remains a significant gap in understanding their interactive effect. Few studies, particularly in emerging markets like China, have placed these core governance pillars within a unified framework to examine if the strength of an internal monitoring system moderates the consequences of an incentive system.

This paper fills the void by examining how the quality of internal control (ICQ) moderates the link between equity incentives and earnings management. The central research question is whether high-quality internal control can effectively weaken the positive association between equity incentives and earnings management. This study will employ a multiple regression analysis on a large panel of Chinese A-share listed firms from 2012 to 2022. The significance of this research lies in its potential to provide a more nuanced understanding of how incentive and monitoring systems interact. For corporate boards and policymakers, the findings will offer crucial insights into the importance of co-designing governance mechanisms to ensure that incentives drive sustainable value rather than short-term opportunism.

2. Literature review and hypothesis development

2.1. The "double-edged sword" of equity

Incentives and Earnings Management Agency theory posits that equity incentives align the interests of managers and shareholders by making managerial wealth sensitive to firm performance. However, this very sensitivity can also create powerful motives for opportunistic behavior. On one hand, managers may be pressured to meet or beat performance benchmarks stipulated in their incentive contracts to ensure their options vest or restricted stocks are unlocked. This creates an incentive to artificially inflate reported earnings. On the other hand, managers may manage earnings upwards to boost the stock price, maximizing their gains when selling shares or exercising options [3]. This potential for gains from insider trading further amplifies the dark side of equity incentives [2]. Empirical studies by Duellman et al. provide evidence consistent with this opportunistic view, especially in environments with weak oversight [6]. Based on this line of reasoning, the first hypothesis is proposed:

H1: The intensity of equity incentives is positively associated with the level of corporate earnings management.

2.2. The "firewall" function of internal control

Internal control is a process effected by an entity's board of directors, management, and other personnel, designed to provide reasonable assurance regarding the achievement of objectives in the reliability of financial reporting. A high-quality internal control system constrains managers’ ability to manipulate accounting figures by establishing clear lines of authority, robust approval procedures, and effective oversight mechanisms. Research in the Chinese context confirms this effect. For instance, Zheng and Han find that supervisory boards curb earnings management primarily through the mediating path of improving internal control quality [4]. Similarly, Li et al. show that strong internal control mitigates both accrual and real earnings management, even in firms under financial distress [5]. Further supporting this view, recent evidence from Xia et al. [7] demonstrates that the implementation of mandatory internal control audits in China significantly improves the accuracy of management earnings forecasts, a key dimension of financial reporting quality. This finding underscores the role of a robust and externally verified internal control system in enhancing the credibility of corporate disclosures. Thus, the second hypothesis is

H2: Higher internal control quality is negatively associated with the level of corporate earnings management.

2.3. The moderating effect of internal control

The Interplay of Incentive and Monitoring. When the "spear" of incentives threatens financial reporting integrity, can the "shield" of supervision offer an effective defense? It is argued that internal control quality plays a crucial moderating role. The core of this logic lies in how ICQ affects the cost and feasibility for managers to translate opportunistic motives into actual behaviors. In firms with high-quality internal control, the institutional environment is characterized by transparency, rigorous procedures, and effective oversight. Any attempt at earnings manipulation faces a heightened risk of detection and prohibitive costs (e.g., reputational damage, termination, legal liability). The "firewall" of internal control thus weakens the positive link between equity incentives and earnings management. Conversely, in firms with weak internal control, the governance structure is riddled with loopholes, providing fertile ground for manipulation where the opportunistic motives created by equity incentives can be easily and cheaply translated into practice.

This moderating logic is directly supported by the findings of Duellman et al. [6] and Hao [1], who both find that stronger monitoring mechanisms dampen the positive relationship between incentives and earnings management. Internal control is expected to act as a counter-edge, dulling the opportunistic blade of equity incentives. Therefore, the primary hypothesis is proposed:

H3: Internal control quality negatively moderates the relationship between equity incentives and earnings management. That is, the positive association between equity incentives and earnings management is weaker for firms with higher internal control quality.

3. Methodology

3.1. Sample selection and data sources

The sample for this study consists of Chinese A-share listed companies for the period 2012–2022. The initial sample was screened by: (1) excluding firms in the financial industry; (2) excluding firms designated as ST, *ST, or those newly listed or delisted during the sample year; and (3) excluding firms with missing data for key variables. Data on internal control quality are sourced from the DIB Internal Control Index Database. All other financial and corporate governance data are obtained from the China Stock Market & Accounting Research (CSMAR) database. To curb outlier effects, all continuous variables were winsorized at the 1st and 99th percentiles. The final unbalanced panel consists of 29,818 firm-year observations.

3.2. Variable definitions

The variables used in this study are defined in Table 1.

3.3. Model specification

To empirically test the hypotheses developed in the previous section, this study constructs the following multiple regression models. Panel data analysis is employed to control for unobserved firm-specific heterogeneity and time-specific effects.

First, to examine the main effects of equity incentives (H1) and internal control quality (H2) on earnings management, Model (1) is specified as follows:

$$ {\mathrm{E}\mathrm{M}}_{\mathrm{i},\mathrm{t}}={\mathrm{\alpha }}_0+{\mathrm{\alpha }}_1\mathrm{E}{\mathrm{I}}_{\mathrm{i},\mathrm{t}}+{\mathrm{\alpha }}_2{\mathrm{I}\mathrm{C}\mathrm{Q}}_{\mathrm{i},\mathrm{t}}+\sum {\mathrm{\alpha }}_{\mathrm{k}}{\mathrm{C}\mathrm{o}\mathrm{n}\mathrm{t}\mathrm{r}\mathrm{o}\mathrm{l}\mathrm{s}}_{\mathrm{i},\mathrm{t}}+\sum \mathrm{Y}\mathrm{e}\mathrm{a}\mathrm{r}+\sum \mathrm{I}\mathrm{n}\mathrm{d}\mathrm{u}\mathrm{s}\mathrm{t}\mathrm{r}\mathrm{y}+{\mathrm{ϵ}}_{\mathrm{i},\mathrm{t}}$$(1)

In this model, the subscript  $$ \mathrm{i}$$  denotes the firm and  $$ \mathrm{t}$$  denotes the year. The dependent variable  $$ {\mathrm{E}\mathrm{M}}_{\mathrm{i},\mathrm{t}}$$  represents the level of earnings management.  $$ \mathrm{E}{\mathrm{I}}_{\mathrm{i},\mathrm{t}}$$  and  $$ {\mathrm{I}\mathrm{C}\mathrm{Q}}_{\mathrm{i},\mathrm{t}}$$  are the primary independent variables for equity incentive intensity and internal control quality, respectively. Based on H1, the coefficient  $$ {\mathrm{\alpha }}_1$$  is expected to be significantly positive. Based on H2, the coefficient  $$ {\mathrm{\alpha }}_2$$  is expected to be significantly negative.  $$ \sum \mathrm{C}\mathrm{o}\mathrm{n}\mathrm{t}\mathrm{r}\mathrm{o}\mathrm{l}\mathrm{s}$$  represents a vector of control variables as defined in Table 1 to mitigate potential omitted variable bias. Year and Industry fixed effects are included to control for macroeconomic shocks and time-invariant industry characteristics.

Next, to test the core hypothesis of this study regarding the moderating role of internal control(H3), an interaction term between equity incentives and internal control quality is introduced into the baseline model. The moderating effect model is specified as Model (2):

$$ {\mathrm{E}\mathrm{M}}_{\mathrm{i},\mathrm{t}}={\mathrm{\beta }}_0+{\mathrm{\beta }}_1{\mathrm{E}\mathrm{I}}_{\mathrm{i},\mathrm{t}}+{\mathrm{\beta }}_2{\mathrm{I}\mathrm{C}\mathrm{Q}}_{\mathrm{i},\mathrm{t}}+{\mathrm{\beta }}_3({\mathrm{E}\mathrm{I}}_{\mathrm{i},\mathrm{t}}\times {\mathrm{I}\mathrm{C}\mathrm{Q}}_{\mathrm{i},\mathrm{t}})+\sum {\mathrm{\beta }}_{\mathrm{k}}{\mathrm{C}\mathrm{o}\mathrm{n}\mathrm{t}\mathrm{r}\mathrm{o}\mathrm{l}\mathrm{s}}_{\mathrm{i},\mathrm{t}}+\sum \mathrm{Y}\mathrm{e}\mathrm{a}\mathrm{r}+\sum \mathrm{I}\mathrm{n}\mathrm{d}\mathrm{u}\mathrm{s}\mathrm{t}\mathrm{r}\mathrm{y}+{\mathrm{ϵ}}_{\mathrm{i},\mathrm{t}}$$(2)

The key variable of interest in Model (2) is the interaction term  $$ {\mathrm{E}\mathrm{I}}_{\mathrm{i},\mathrm{t}}\times {\mathrm{I}\mathrm{C}\mathrm{Q}}_{\mathrm{i},\mathrm{t}}$$ . The coefficient  $$ {\mathrm{\beta }}_3$$  captures the moderating effect of internal control quality on the relationship between equity incentives and earnings management. According to H3, a negative moderating effect is predicted. Therefore, the coefficient  $$ {\mathrm{\beta }}_3$$  is expected to be statistically significant and negative. A negative  $$ {\mathrm{\beta }}_3$$  would indicate that as internal control quality improves, the positive association between equity incentives and earnings management is weakened, providing strong support for the hypothesis that robust internal control can effectively constrain the opportunistic behaviors induced by incentive schemes.

4. Empirical results and analysis

4.1. Descriptive statistics and correlation analysis

Table 2 presents the descriptive statistics for the main variables used in the analysis. The mean of earnings management (da) is close to zero, with a standard deviation of 0.093, indicating considerable variation in accounting practices across the sample. The average executive shareholding (ei) is 7.3%, while the average internal control quality index (icq) is 634.54, suggesting a moderate level of both incentive alignment and control quality on average. The control variables are consistent with characteristics of Chinese listed firms.

Table 3 provides the Pearson correlation matrix for the key variables. Earnings management (da) shows a weak positive correlation with equity incentives (ei) (0.031) and a more noticeable positive correlation with internal control quality (icq) (0.148), which is counterintuitive and highlights the need for multivariate analysis. As expected, internal control quality (icq) is positively correlated with firm size (size) (0.128) and profitability (roa) (0.381). The low to moderate correlations among the independent variables suggest that multicollinearity is not a significant concern in the subsequent regression analysis.

4.2. Regression analysis

To test the hypotheses, a series of multiple regression models were estimated. All models include year and industry fixed effects, and robust standard errors are clustered at the firm level to address potential heteroskedasticity and serial correlation.

First, to establish a baseline, Model 1 in Table 4 tests the direct effect of internal control quality on earnings management, in line with H2. The coefficient for internal control quality (icq_100) is -0.001 and statistically significant (z=-2.21), supporting H2. This result indicates that firms with higher-quality internal control systems exhibit significantly lower levels of earnings management, confirming the "firewall" function of internal control as discussed in the literature [4, 5].

Note: Robust z-statistics in parentheses. p<0.01, p<0.05, *p<0.1*

Model 2 in Table 4 examines the main effect of equity incentives on earnings management, testing H1. The coefficient for equity incentives (ei) is 0.005 but is not statistically significant (z = 1.01). This result does not support H1, suggesting that, in isolation, the level of executive shareholding does not have a direct, discernible impact on earnings management practices in the sample. This finding contrasts with some prior studies [3, 6] and indicates that the "double-edged sword" effect may be neutralized by other governance factors, necessitating an investigation of interaction effects.

The core hypothesis of this study, H3, is tested in Table 5, which introduces the interaction term between equity incentives and internal control quality. The coefficient on the interaction term (ei_X_icq100) is 0.007, but it is not statistically significant (z=1.51); thus, the result does not support H3. It fails to provide evidence that internal control quality moderates the relationship between equity incentives and earnings management. The coefficient for equity incentives (ei) remains insignificant, while the coefficient for internal control quality (icq_100) remains negative and significant (-0.001, z = -2.63), reinforcing the strong, direct deterrent effect of internal control.

Note: Robust z-statistics in parentheses. p<0.01, p<0.05, *p<0.1*

5. Conclusion

This study empirically investigates the complex tripartite relationship among equity incentives, internal control, and earnings management using a large panel of Chinese A-share listed firms from 2012 to 2022. The empirical findings yield several key insights.

First, consistent with a large body of literature, this study confirms that high-quality internal control serves as a powerful governance mechanism, significantly curbing corporate earnings management. This supports the "firewall" theory of internal control, underscoring its critical role in ensuring financial reporting integrity [4, 5]. Second, contrary to the "double-edged sword" hypothesis, this study does not find a significant direct relationship between the level of equity incentives and earnings management. This suggests that the opportunistic and alignment effects of incentives may either offset each other or be overshadowed by other, more dominant governance factors in the Chinese context.

Most importantly, the analysis of the moderating effect did not yield statistically significant results. The evidence does not support the hypothesis that internal control quality alters the relationship between equity incentives and earnings management. Instead, the results consistently point to the strong, independent, and direct effect of internal control in reducing earnings management, regardless of the level of equity incentives.

The practical implications of these findings are direct and crucial: the foundational role of internal control cannot be overstated. For corporate boards and regulators, the results suggest that focusing on building and maintaining a high-quality internal control system is a more direct and effective strategy for combating earnings management than simply adjusting incentive structures. While equity incentives are vital for motivating managers, their effectiveness in aligning interests without creating adverse effects appears to be contingent on a pre-existing strong control environment. Therefore, firms should prioritize the strengthening of their internal control frameworks as the primary mechanism for ensuring high-quality financial reporting.