Does audit quality affect firm innovation?

This paper investigates the impact of audit quality on firm innovation. We develop a theoretical intertemporal framework to model an entrepreneur's optimal behavior and find that entrepreneurs increase R&D with an increase in audit quality. Using a sample of Chinese firms listed on Shanghai Security Exchange and Shenzhen Security Exchange over the period 2011–2020, we employ "Going Concern Opinions," an indicator gauging a firm's ability to continue operation or to avoid bankruptcy, as a proxy of audit quality. To address endogeneity concerns, we construct a Bartik shift-share instrument based on the differential impact of common shocks on firms with pre-determined exposures. Our empirical results are consistent with the proposition drawn from the theoretical model. Through a decomposition analysis with Rotermberg weights, we also identified the top ten industries and the years demonstrating the most significant impact of audit quality on firm innovation.