Smaller and newer public companies have long been exempt from Section 404(b) of the Sarbanes-Oxley Act, which requires an outside auditor to attest to the effectiveness of a company’s internal control over financial reporting. In May 2026, the SEC proposed extending this exemption. According to the SEC, lower compliance expenses “may allow registrants to redeploy freed up resources toward productive investment and growth opportunities.” The SEC also acknowledged a downside: Without the auditor’s attestation, financial statements may become less reliable, and the cost of capital could rise.

In a new paper, we study the optimal audit standard for firms that struggle to raise capital. The SEC’s argument seems strongest when capital is scarce. If a firm cannot raise more outside financing, every dollar it spends on audit fees is a dollar it cannot invest. Our analysis points the other way. Stricter standards do increase audit fees, but they can also expand a firm’s capacity to raise outside financing by more than the higher fees. The welfare-maximizing audit standard becomes stricter, not more lenient, as financing constraints tighten.

How Stricter Audits Can Expand Financing

We introduce audit regulation into the workhorse financing model of Holmström and Tirole. An entrepreneur with limited wealth seeks outside financing for a project whose scale she can choose. Once the project is funded, she decides how hard to work. Hard work makes it more likely that the business develops favorably, which in turn makes eventual success more likely. Shirking gives her private benefits, such as leisure or time for other ventures. Investors cannot observe her effort, so she must keep a large enough stake in the project to stay motivated. This stake limits the share of the project’s income that can be promised to investors (its “pledgeable income”) and therefore the amount she is able to raise.

The regulator sets the audit standard, which determines how diligent the audit must be. A stricter standard makes it more likely that the auditor catches a misstatement that hides a deterioration in the business. Once the problem comes to light, investors stop the project and redeploy its assets. Auditing thus improves efficiency by stopping projects that are no longer worth continuing. A stricter standard also raises the audit fee, which the firm must finance along with the investment itself.

For a financially unconstrained firm, whose founder—an entrepreneur—has enough wealth to raise all the financing she needs, the optimal standard balances better decisions about whether to continue the project against higher audit costs. That standard maximizes both investment and welfare, and it depends neither on the entrepreneur’s wealth nor on the severity of the incentive problem.

For a financially constrained firm, stricter auditing matters for a second reason: It strengthens the entrepreneur’s incentive to work, which expands financing. If the business deteriorates and the auditor misses the problem, the project continues, and the entrepreneur still has a chance at a payoff. A stricter audit makes it more likely that the deterioration is caught and the project stopped. The financing contract gives investors the liquidation proceeds, so stopping the project leaves the entrepreneur with nothing. Since deterioration is more likely when the entrepreneur shirks, stricter auditing reduces her expected payoff from shirking more than her payoff from working. She therefore stays motivated with a smaller stake, which increases the project’s pledgeable income and lets the firm raise more capital. Because of this incentive effect, a constrained firm’s investment peaks at a standard stricter than the one that is optimal for an unconstrained firm.

Why Tighter Constraints Call for Stricter Standards

For a financially constrained firm, the welfare-maximizing standard is stricter than the standard that is optimal without financing constraints, but less stringent than the standard that maximizes investment. The reason is that a higher fee applies to the entire project, not only to the additional investment it makes possible. As the standard approaches the investment-maximizing level, the value of the additional investment shrinks, and the higher audit costs come to outweigh the benefits of more investment and of stopping projects that have deteriorated. Between the welfare-maximizing and investment-maximizing standards, a stricter standard increases investment but reduces welfare. Stricter is not always better: Beyond a certain point, additional audit requirements reduce welfare.

Our main result is that the welfare-maximizing standard becomes stricter as financing constraints tighten, whether because the firm has less internal capital or because the incentive problem is more severe. This result builds on the previous one. Because the welfare-maximizing standard is less strict than the one that maximizes investment, a slightly stricter standard at the welfare optimum still generates enough additional financing to cover the higher fees and expand investment. This additional investment is worth more to a more constrained firm, which invests less, because with decreasing returns to scale the marginal return on investment rises as investment declines. The standard that is optimal for a less constrained firm is therefore too lenient for a more constrained one.

Implications for SOX 404(b)

Companies exempt from Section 404(b) still undergo a financial-statement audit, so an exemption reduces the scope of required audit work rather than eliminating auditing. We capture this as a lower required audit intensity. In our model, a lower standard reduces audit fees but can reduce external financing by even more, leaving less money for investment. If smaller firms are more financially constrained than otherwise comparable larger firms, the model implies stricter, not more lenient, optimal standards for them. Giving smaller firms relief because capital is scarce can then weaken the audit discipline that helps them obtain that capital.

The same reasoning applies to new standards of the Public Company Accounting Oversight Board (PCAOB). Under the JOBS Act, PCAOB rules adopted after April 5, 2012, do not apply to audits of emerging growth companies unless the SEC determines that applying them is “necessary or appropriate in the public interest,” after considering investor protection and whether the action will promote efficiency, competition, and capital formation. When the SEC made this determination for AS 1000, the PCAOB’s 2024 standard on auditors’ general responsibilities, it acknowledged that these audits could become more costly but noted that better audits can lower the cost of capital and enhance capital formation. If emerging growth companies face tighter financing constraints than comparable issuers, our analysis supports this reasoning. The capital-formation consideration can favor rules that increase audit diligence despite higher fees.

To the extent that economic downturns or less developed financial markets tighten financing constraints, our analysis likewise points to stricter optimal standards, holding other determinants of audit costs and benefits fixed.

What Empirical Studies Should Measure

For a financially constrained firm, welfare, investment, and outside financing do not peak at the same standard. As the standard becomes stricter, welfare peaks first, investment later, and outside financing can peak later still. Between the first two peaks, a stricter standard raises investment but lowers welfare. Beyond the investment peak, it can still raise outside financing even as investment falls, because more of the money raised goes to audit fees. An increase in investment or outside financing after a stricter standard is therefore not, by itself, evidence that welfare has improved. Studies that draw welfare conclusions should measure audit fees alongside outside financing and productive investment and, where possible, other benefits of auditing.

The case for audit relief usually rests on the fees that firms save. For financially constrained firms, our analysis suggests that this case is incomplete. The same audit work that generates the fees also determines how much outside capital the firm can raise.

Negin Attar-Niggemann is a post-doctoral researcher at WU Vienna University of Economics and Business, Volker Laux is a professor at the University of Texas at Austin, and Felix P. Niggemann is an assistant professor at the University of Vienna. This post is based on their recent paper, “Audit Regulation for Financially Constrained Firms,” available here.