What is Corporate Governance?
Corporate Governance is a set of systems or rules or practices through which an entity is directed and controlled to achieve the objective of increasing the wealth of shareholder by way of increasing the economic value for the entity and which is concerned about its relations with various stakeholders of the entity.
Corporate Governance is concerned with the relationship among various stakeholders such as the Board of Directors, shareholdersShareholdersA shareholder is an individual or an institution that owns one or more shares of stock in a public or a private corporation and, therefore, are the legal owners of the company. The ownership percentage depends on the number of shares they hold against the company's total shares., management of the entity, customers, suppliers, employees, bankers, and the government. It covers certain critical issues such as the role of the Board of Directors, composition of the Board of Directors, roles of the Chairman and the CEO, risk management for the entity, assurances over control mechanism, etc.
The primary of corporate governance is to increase the value of shareholders’ wealth and to protect the interest of various related persons of the business entity (i.e. its stakeholders). Good corporate governance ensures compliance of laws, regulations & self-accepted practices. This makes the firm to acquire high-quality resources such as human capital, which, in effect, enables the entity to perform efficiently.
The other objectives include constituting the board of directors which will take independent decisions for various affairs of the entity and to arrive at procedures & practices which are transparent to the stakeholders.
Corporate Governance Examples
Amazon has one of the highest market capitalizations in the world. The website of the giant company states that it started with “1997 letter to Shareholders”. The said letter states that “the fundamental value of the company will be the shareholder value that the company creates in the long-run”. It’s corporate governance objectives as follows:
- Customer-centric approach
- The objective of increasing the cash flows
- Maintaining a lean culture over the entity & spending the cash resources wisely.
- Continuous hiring of a talented workforce.
- Long term considerations have more value than short term profits.
As depicted by the clear message from Amazon, the company is a well-settled image of its corporate governance. The satisfied employees over the globe are clear proof of good corporate governance. Since their employees worked hard in the middle of pandemic (COVID-19), Amazon provided huge performance bonuses over the globe for delivering values to the potential customers.
Structure of Corporate Governance
It is structured as follows:
#1 – Board of Directors (BOD)
- Board of Directors is the apex body in the structure of corporate governance. Hence, BOD is also called as “Those Charged With Governance” (TCWG).
- The Board of Directors has control over the management of the entity. All its decisions are made for fulfilling the long-term objectives of the entity.
- The BOD is responsible for monitoring the performance of the CEO of the entity. It must ensure that conflict of interest does not arise due to any of its decisions.
- It is further responsible for taking care of the interest of various stakeholders. BOD defined the visions & mission statement of the entity, which guides the team.
#2 – Management
- The management of the company is different from the BOD. It is a subset of the BOD led by CEO of the company. CEO means Chief Executing Officer, i.e. the most important employee of the company who looks for everything within the company
- The CEO is responsible for preparing the strategies of the entity and the evaluation of various associated risks.
- CEO is further held responsible for commenting on the performance of the entity & its financial reportingFinancial ReportingFinancial Reporting is the process of disclosing all the relevant financial information of a business for a particular accounting period. These reports are used by the stakeholders (investors, creditors/ bankers, public, regulatory agencies, and government) to make investing and other relevant decisions. .
- The management is held responsible for the business operationsBusiness OperationsBusiness operations refer to all those activities that the employees undertake within an organizational setup daily to produce goods and services for accomplishing the company's goals like profit generation. of the company.
#1 – Shareholders
- These are the investors who had put their hard-earned money into the company, with the confidence that the BOD will manage the funds for the business of the company.
- Shareholders cannot invest their daily time in managing the affairs of the entity & hence they elect the directors who will report them.
- To ensure compliance and to enrich the corporate governance, shareholders appoint the auditors who will thoroughly audit the affairs of the entity & will provide the audit reportAudit ReportAn audit report is a document prepared by an external auditor at the end of the auditing process that consolidates all of his findings and observations about a company's financial statements..
Principles of Corporate Governance
- Communication of important information to the stakeholders other than shareholders, i.e. vendors, customers, financers, employees or members of an affiliated association.
- The Board of Directors will define an ethical code of conduct for the business of the entity.
- Appointment of new directors is made transparently & ethically with all due procedures.
- There should be crystal clear transparency in the policies adopted by the entity.
- Fair treatment to be given to all stakeholders.
- The management is accountable, transparent and fair in its operations for the business of the entity.
- Periodic review of management decisions is done & auditor can report directly to the Board of Directors (i.e. those charged with governance).
- In the recent past, it has been observed that the corporate officers of the entity have abused power granted by the shareholders. Hence, strict laws & regulations are imposed on the entity to take corporate governance on a serious note.
- Sarbanes-Oxley ActSarbanes-Oxley ActThe Sarbanes-Oxley Act (Sox) of 2002 was enacted by the US Federal Law for increased corporate governance, strengthening the financial and capital markets at its core and boost the confidence of general users of financial reporting information and protect investors from scandals like that of Enron, WorldCom, and Tyco. came into force after financial scandals emerged in the early 2000s involving companies such as Enron Corporation, Tyco International Plc and WorldCom. This was the first form of government regulation to restore losing the interest of the public at large in corporate entities.
- Gramm-Leach-Bliley Act caused changes in the perception of the public with respect to financial institutionsFinancial InstitutionsFinancial institutions refer to those organizations which provide business services and products related to financial or monetary transactions to their clients. Some of these are banks, NBFCs, investment companies, brokerage firms, insurance companies and trust corporations. . This act provided edge support to the faith of the public, in the financial systems.
- There should be a ready plan for the management of various risks.
- The auditors should be independent.
- Majority of directors should be independent.
- The secured mechanism for whistle-blowers.
- Strong internal controls with a requirement for internal auditInternal AuditInternal audit refers to the inspection conducted to assess and enhance the company's risk management efficacy, evaluate the different internal controls, and ensure that the company adheres to all the regulations. It helps the management and board of directors to identify and rectify the loopholes before the external audit..
- Review of entity’s process of preparation of financial reports.
- The transparent mechanism for appointment of key individuals.
- Optimum business strategy to be in place.
Corporate Governance Benefits
- Good governance is reflected in the positive outlook of the share price of the entity.
- It reduces the cost of capital for the entity.
- It reduces corruption within & around the entity.
- It provides proper management of the entity.
- Interests o various stakeholders are secured.
- No issue with the Company to raise capital effectively.
- Company will always be flourished with investors.
Consequences of Weak Corporate Governance
- An easy way for accounting scandalsAccounting ScandalsAccounting Scandals refer to situations which demonstrate intentional falsification or misrepresentation of financial documents. Some of the most famous ones are by Enron, Freddie Mac, HealthSouth, & American Insurance Group etc. such as Enron Corporation.
- Independence of auditors will be at risk & auditor may resign from the entity.
- Weak control over financial reporting.
- Lower assurance over the honesty of the management of the entity in dealing with the affairs of the entity.
- Management may act as the owner of the entity.
- Deficiencies in compliances with the management.
- Weak internal controls.
- Erroneous reporting of figures in the financial reports.
This has been a guide to What is Corporate Governance & its definition. Here we discuss the objectives of corporate governance, example and structure along with principles, rules & regulation, benefits and consequences. You can learn more about from the following articles –