The SFO's investigation was triggered by allegations made by the Guardian newspaper and the BBC's Money Programme about the existence of a Â£60m slush fund at BAE Systems designed to facilitate defence contracts.
BAE has consistently denied the allegations.
The SFO said its investigators, assisted by Ministry of Defence Police officers, had arrested two men - aged 73 and 66 - in connection with their enquiries.
"The Serious Fraud Office has commenced an investigation into suspected false accounting in relation to contracts for services between Robert Lee International, Travellers World and BAE in connection with defence equipment contracts with the government of Saudi Arabia," the SFO said in a statement.
BAE's shares fell following the announcement and were down 7.5p or, 3%, at 238p by mid-afternoon,
The SFO's decision to launch a formal investigation comes less than a month after the BBC's Money Programme conducted an investigation into BAE's use of cash, gifts and personal services to "sweeten" Saudi officials overseeing major arms deals.
Employees from travel firms Travellers World and Robert Lee International - which are at the centre of the investigation - told the programme that they had been asked by BAE to lavish luxury on Saudi officials.
Beneficiaries included Prince Turki bin Nasser, a leading member of the Saudi royal family who was responsible for overseeing the massive al-Yamamah arms deal between Saudi Arabia and the United Kingdom, which made billions of pounds for BAE.
Peter Gardiner, founder of Travellers World, told the Money Programme he provided chartered aircraft, luxury limousines and exotic holidays for Prince Turki and his entourage.
Other gifts paid for by BAE included a Â£170,000 Rolls-Royce, given to Prince Turki's wife as a birthday present, and a wedding video for the Prince's daughter worth Â£200,000.
Edward Cunningham, a former employee of Robert Lee International, told the programme that he had procured prostitutes for young Saudi pilots and settled gambling bills.
Neither Mr Gardiner nor Mr Cunningham have been arrested.
However, Mr Gardiner is voluntarily assisting the SFO with its investigation.
The programme also described how BAE disguised where the slush fund money was going by replacing detailed records of the expenditure with single page invoices giving no idea what the money was spent on.
In response to the programme, BAE published a statement categorically denying the existence of a slush fund.
"Neither has BAE Systems or any of its officers or employees been involved in false accounting," the firm added.
The Guardian reported last year that Rosalind Wright, former head of the SFO, had written to the Ministry of Defence in March 2001 highlighting concerns about the amount of money claimed by BAE in invoices for expenses and hospitality.
The paper said that Ms Wright had told the MoD that it was "conceivable that government money has been misused" but that there was not enough evidence to justify an inquiry