Financial Accounting: An Integrated Statements Approach, 2nd Edition

SARBANES-OXLEY ACT OF 2002

During the Enron,WorldCom,Tyco,Adelphia, and other financial scandals of the

early 2000s, stockholders, creditors, and other investors lost millions and in some cases

billions of dollars.^1 The resulting public outcry led Congress to pass the Sarbanes-

Oxley Act of 2002. This act, referred to simply as Sarbanes-Oxley, is considered one of

the most important and significant laws affecting publicly held companies in recent

history. Although Sarbanes-Oxley applies only to companies whose stock is traded on

public exchanges, referred to as publicly held companies, it has become the standard for

assessing the financial controls and reporting of all companies.

Sarbanes-Oxley’s purpose is to restore public confidence and trust in the financial

statements of companies. In doing so, Sarbanes-Oxley emphasizes the importance of

effective internal control.^2 Internal controlis broadly defined as the procedures and

processes used by a company to safeguard its assets, process information accurately,

and ensure compliance with laws and regulations.

Sarbanes-Oxley requires companies to maintain strong and effective internal con-

trols over the recording of transactions and the preparing of financial statements. Such

controls are important because they deter fraud and prevent misleading financial state-

ments as shown in the following illustration:

1 Exhibit 9 in Chapter 1 briefly summarizes these scandals.

2 Sarbanes-Oxley also has important implications for corporate governance and the regulation of

the public accounting profession. In this chapter, we focus on the internal control implications of

Sarbanes-Oxley.

306 Chapter 7 Sarbanes-Oxley, Internal Control, and Cash

Describe the Sarbanes-

Oxley Act of 2002 and its

impact on internal controls

and financial reporting.

1

Prior to Passage of

Sarbanes-Oxley

Enactment of

Sarbanes-Oxley

After Passage of

Sarbanes-Oxley

Effective Internal

Controls

Fraud

and Theft

Fraud

and Theft

Threats

Enron

Tyco

WorldCom

Businesses

Businesses

Sarbanes-Oxley

Act of 2002

Investors

Stockholders

Creditors

Investors

Stockholders

Creditors

Sarbanes-Oxley not only requires companies to maintain strong and effective

internal controls, but it also requires companies and their independent accountants to