The Undesirable Effect of Audit Quality: Evidence from Firm Innovation

Abstract

This study examines whether and how audit quality affects a firm’s technological innovation. Using a sample of 7,482 U.S. firms between 2000 and 2009, we demonstrate that high audit quality is associated with lower innovation output, measured by patent counts and patent citations. The effect remains valid after a series of tests for endogeneity issues, alternative measures of audit quality, and different subsamples. We also find that firms with high audit quality attract more non-dedicated institutional investors and financial analysts, who often exert excessive pressure on managers for short-term performance. These pressures, in turn, exacerbate managerial myopia and lead them to forgo investments in innovation. Our findings provide new insights into audit quality by showing its undesirable, most likely unintended, consequences.

Keywords: audit quality, innovation, financial reporting, managerial myopia

JEL Classification: G34, M42, O31