Sarbanes-Oxley Act and the Enron Scandal - Why Are They Important?

The Sarbanes-Oxley Act and Corporate Fraud

Enron On The Verge Of Collapse
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Sarbanes-Oxley, or SOX, is a federal law that is a comprehensive reform of business practices. The  2002 Sarbanes-Oxley Act aims particularly at public accounting firms that participate in audits of corporations and was passed in response to a number of corporate accounting scandals that occurred between 2000-2002. This act set new standards for public accounting firms, corporate management, and corporate boards of directors.

 

What Prompted the Sarbanes-Oxley Act?

The Enron scandal was certainly enough to show the American public and its representatives in Congress that new compliance standards for public accounting and auditing were needed. Enron was one of the biggest and, it was thought, one of the most financially sound companies in the U.S.

Enron, located in Houston, TX, was considered one of a new breed of American companies that participated in a variety of ventures related to energy. It bought and sold gas and oil futures. It built oil refineries and power plants. It became one of the world's largest pulp and paper, gas, electricity, and communications companies before it bankrupted in 2001. Several years before the Enron bankruptcy, the government had deregulated the oil and gas industry to allow more competition, but this also made it easier to cheat. Enron, among other companies, took advantage of this deregulation.

The various misdeeds and crimes committed by Enron were extensive and ongoing. Particularly damaging misrepresentations pumped up earnings reports to shareholders, many of whom eventually suffered devastating losses when the company failed. But there were many other instances of dishonesty and fraud, including actual embezzlement of corporate funds by Enron executives and illegal manipulations of the energy market.

 

What Is the Sarbanes-Oxley Act?

In order to cut down on the incidence of corporate fraud, Senator Paul Sarbanes and Representative Michael Oxley drafted the Sarbanes-Oxley Act. The intent of the SOX Act was to protect investors by improving the accuracy and reliability of corporate disclosures by

  • closing loopholes in recent accounting practices
  • strengthening corporate governance rules
  • increasing accountability and disclosure requirements of corporations, especially corporate executives, and corporation's public accountants
  • increasing requirements for corporate transparency in reporting to shareholders and descriptions of financial transactions
  • strengthening whistle-blower protections and compliance monitoring
  • increasing penalties for corporate and executive malfeasance
  • authorizes the creation of the Public Company Accounting Oversight board to further monitor corporate behavior, especially in the area of accounting

In response to what was widely seen as collusion by Enron's accountants, The Arthur Andersen firm, in Enron's fraudulent behavior, SOX also changes the way corporate boards deal with their financial auditors. All companies, according to SOX, must provide a year-end, report about the internal controls they have in place and the effectiveness of those internal controls.

Although the Sarbanes-Oxley Act of 2002 is generally credited with having reduced corporate fraud and increasing investor protections, it also has its critics, some of whom note the degree to which Congress has weakened the act by withholding funding necessary to put these reforms into motion and by passing bills that effectively counter the intent of the act. Other critics, on the contrary, oppose the act because it increases corporate costs and reduces corporate competitiveness.