Final answer:
The Sarbanes-Oxley Act was enacted in response to significant corporate scandals, aiming to improve corporate governance and auditor independence to protect investors. It mandates rigorous internal controls, empowers boards of directors, and strengthens the role of independent auditors.
Step-by-step explanation:
The Sarbanes-Oxley Act of 2002 was a transformative piece of legislation in reaction to major corporate and accounting scandals including those related to Enron, Tyco International, and WorldCom. These scandals shook investor confidence and highlighted profound deficiencies in corporate governance and auditor independence. The Act introduced major changes aimed at improving corporate accountability, enhancing the accuracy and reliability of financial disclosures, and preventing corporate and accounting fraud to protect investors.
At its core, the Sarbanes-Oxley Act strengthened the role of the board of directors and imposed strict obligations on corporate executives to attest to the accuracy of financial statements. It introduced stringent measures for auditors to ensure their independence from the firms they audit, preventing conflicts of interest and encouraging impartial scrutiny of corporate accounts. A significant provision under Sarbanes-Oxley is the establishment of the Public Company Accounting Oversight Board (PCAOB), which oversees the audits of public companies to protect the interests of investors and further the public interest in the preparation of informative, fair, and independent audit reports.
The legislation enhanced corporate governance by reinforcing the responsibilities of various entities. The first line of defense in corporate governance—the board of directors—is underscored as the guardians of shareholder interests, along with the requirement for a majority of independent directors and the institution of more effective internal controls.
The role of external auditors, as a second institution, is to review the company's financial records critically and verify the integrity of the information provided. Lastly, outside investors, particularly institutional investors with significant holdings, represent a third institution, exerting influence and demanding transparency and accountability from companies they invest in. In the broader context of corporate failures such as Lehman Brothers, where corporate governance did not fulfill its role, the importance of Sarbanes-Oxley in establishing a more robust framework for corporate governance and accountability becomes evident.