The Enron Scandal and the Sarbanes-Oxley Act

The Sarbanes-Oxley Act, also known as the SOX Act, is a 2002 federal law that enacted a comprehensive reform of business financial practices. It put in place new standards for public accounting firms, corporate management, and corporate boards of directors at publicly held companies.

The act was passed in response to a number of corporate accounting scandals that occurred between 2000 and 2002, most notably the fraud that occurred at Enron.

What Was the Enron Scandal?

A scandal involving public energy company Enron exposed weaknesses in compliance standards for public accounting and auditing. In the 1990s, Enron was one of the largest—and thought to be one of the most financially sound—companies in the U.S. during one of the longest bull markets the country had ever seen.

Enron, located in Houston, Texas, made its name by creating markets to buy and sell futures of gas, oil, coal, paper, steel, and more. Through a number of complex accounting maneuvers, Enron overvalued its futures contracts in energy commodities, utilized special-purpose entities to hide bad investments, and diluted earnings by issuing stock to pay for investment losses.

The damaging misrepresentations produced inflated earnings reports for shareholders, who eventually suffered devastating losses when the company failed.

The company filed for bankruptcy in 2001 after revised Securities Exchange Commission filings and a failed merger brought most of the company’s fraud to light. The company’s former CEO was charged with conspiracy and securities fraud among other charges.

The Sarbanes-Oxley Act

The SOX Act was created to restore public trust in corporations following the corporate accounting scandals that made names such as Enron synonymous with corporate malfeasance.

U.S. Senator Paul Sarbanes and U.S. Representative Michael Oxley drafted the legislation, which became known as the Sarbanes-Oxley Act (SOX). The intent of SOX was to protect investors by improving the accuracy and reliability of corporate disclosures in financial statements and other documents by:

• Closing loopholes in accounting practices
• Strengthening corporate governance rules
• Increasing accountability and disclosure requirements of corporations, especially corporate executives, and corporations’ public accountants and auditors
• Increasing requirements for corporate transparency in reporting to shareholders and descriptions of financial transactions
• Strengthening whistleblower protections and compliance monitoring
• Increasing penalties for corporate and executive malfeasance
• Authorizing the creation of the Public Company Accounting Oversight Board (PCAOB) to monitor corporate behavior, especially in the area of accounting

Sarbanes-Oxley Today

Although the Sarbanes-Oxley Act of 2002 is generally credited with having reduced corporate fraud and increasing investor protections, it also has its critics. Proponents of the act argue that it provides key benefits:

• Improved financial reporting: A 10-year retrospective study published in 2014 suggested that the SOX Act may have improved the quality of financial reporting.
• Lower risk of fraud and financial scandals: Research in 2017 revealed that the SOX Act acts as an "early-warning system" for corporations that can help reveal fraud because weak internal controls are linked with hidden fraud. The strict financial reporting requirements of the Sarbanes-Oxley Act can improve internal controls and thereby help companies identify fraud or similar corrupt activities and stop them before they lead to an Enron-like scandal that can be financially ruinous to the company and its investors.

Conversely, some analysts have criticized the legislation for the high costs that firms must incur to comply with the rules. Costs have been found to disproportionately fall on small firms, although studies indicate that costs have leveled out since the law was first introduced.

Critics argue that these costs discourage the formation of new firms, particularly smaller companies, and that the requirements of the act make it more difficult for these firms to go public. Research from 2017, however, found little evidence that the act has had little effect on either.

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