How does audit quality affect firm innovation? Evidence from China

Existing research based on the US setting suggests that high‐quality audits impede firm innovation by inducing managerial myopia that leads managers to sacrifice innovative activities. We extend this literature by examining the impact of audit quality on firm innovation in a major emerging market, China. Given the weak institutional environments in China, we posit that increases in audit quality enhance firm innovation by facilitating firms’ external financing abilities and promoting managers’ innovation efforts. Consistent with our predictions, we find that increased audit quality due to “switching” to BigN auditors after auditor mergers significantly improves firms’ innovation quantity and quality. We further find that increases in audit quality impact firm innovation by increasing external financing and motivating both internal and external investment in innovation. Overall, our results indicate that audit quality has a positive governance effect on firms’ real decisions in a major economy with weak legal environments.