The Sarbanes-Oxley Act is legislation passed in July of 2002 which addressed flaws in the governance of U.S. publicly traded corporations.
The legislation is named after the bill’s key sponsors, former Democratic Senator Paul Sarbanes and former Republican Congressman Michael Oxley.
The legislation was passed in response to a wave of corporate scandals that occurred in the late 1990’s and early 2000’s. The two most notable scandals occurred at Enron and WorldCom.
WorldCom was a telecommunications company whose top executives engaged in fraud involving recording billions of dollars of expenses as capital expenditures. This accounting fraud had the effect of vastly overstating the company’s assets and profits.
Enron was a large energy firm whose top executives engaged in widespread accounting fraud. The most notable of these frauds was the use of “special purposes entities”. Special purposes entities are subsidiaries which companies form to isolate certain financial risks from the parent company. Enron used these vehicles extensively to keep debt off its balance sheet and to keep losses away from its income statement. Enron failed to provide adequate disclosure on these vehicles in its corporate filings.
One of the most troubling aspects of the WorldCom and Enron scandals was that their respective accounting practices were approved by their auditor, accounting firm Arthur Andersen. Among the primary reasons for Andersen’s complacency was that the firm was also doing lucrative consulting work for their clients. This arrangement created a massive conflict of interest for Andersen.
Both Enron and WorldCom declared bankruptcy after their frauds were revealed, leading to investor losses in the tens of billions of dollars.
Among the major impacts of the Sarbanes-Oxley Act were enhanced financial disclosures, reduced conflicts within the auditing profession, and greater responsibility for corporate executives over financial reporting.
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