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

In capital markets, financial reporting reliability remains under relentless assault from earnings management. Equity incentives, designed to align managerial and shareholder interests, often have the unintended consequence of motivating opportunistic earnings manipulation. This creates a need for effective internal governance mechanisms to constrain such behavior. This study investigates the interplay between equity incentives, internal control, and earnings management within Chinese listed firms. It specifically examines the critical question of whether internal control quality (ICQ) moderates the relationship between equity incentives and the propensity for earnings management. The research is grounded in agency theory and proposes an empirical test using a panel dataset of Chinese A-share listed companies from 2012 to 2022. The primary analytical tool is a multiple regression model designed to test the main effects and the interaction effect between equity incentives and ICQ. Data for internal control are sourced from the DIB database, with other financial and governance data from CSMAR. The study predicts that although equity incentives fuel earnings management, this association is markedly dampened when firms maintain high-quality internal controls. More importantly, the findings reveal that internal control quality negatively moderates the relationship between equity incentives and earnings management, suggesting that the benefits of incentives are conditional upon a robust control environment. These findings highlight that robust monitoring is essential and that incentive and control systems must be designed synergistically.