The effect of internal control quality on real and accrual-based earnings management: evidence from France

Abstract

This paper examines the effect of internal control (IC) quality, measured by IC weakness disclosures, on the quality of financial statements’ information, measured by real and accrual-based earnings management. The sample consists of 686 firm-year observations of French non-financial companies listed in the SBF 120 index during the period between 2012 and 2018. Using ordinary least squares (OLS) and generalized method of moments (GMM) regression, our empirical results indicate that IC weakness disclosures are positively and significantly related to real activities manipulation and negatively associated with discretionary accruals. This provides empirical evidence that a good system of IC reduces accrual-based earnings management activities and improves the reliability of financial statements; however, it cannot control real earnings management (REM). The research findings are of practical interest not only to financial analysts, auditors, and investors—guiding them to pay attention to REM activities in case of disclosures of IC weaknesses—but also to regulators, who may consider additional disclosure requirements when reporting material IC weaknesses and designing policies that could help in reducing REM practices.

Foreign ownership, subjective willing, and internal control level

“…Regarding the relationship between foreign ownership and internal control, Li et al (2021) [ 5 ] discovered that companies with qualified overseas institutional investors generally exhibit higher internal control quality and fewer internal control deficiencies. Effective internal control has increasingly proven its crucial role in mitigating operational risks [ 26 , 27 ], enhancing profitability [ 6 , 28 ], curbing earnings management [ 29 , 30 ], promoting green innovation [ 31 ], and creating sustainability performance [ 32 ]. Additionally, factors influencing internal control can be categorized into internal and external aspects.…”