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Line is when you have an external preamp such as a mixer that's sending signal into the camera and so the camera's own preamp is not used. Mic uses the camera's preamp and should be used when the mic is going straight into the camera.
So if it is set incorrectly to mic, could this could lead to clipping the audio?
If there is a mixer feeding you a line signal, it needs to be set to line. If it is set to mic the camera's preamp will boost the gain of the incoming signal and cause further noise and/or clipping.