In this lesson, you will learn about the impact of recent guidelines and regulatory changes on corporate governance. Specifically, this lesson will cover the following:
Corporate governance is the system by which companies are directed and controlled. It involves the following:
Regulatory and market mechanisms
Roles and relationships between a company’s management, its board, its shareholders, and other stakeholders
Goals for which the corporation is governed
In contemporary business corporations, the main external stakeholder groups are shareholders, debtholders, trade creditors, suppliers, customers, and communities affected by the corporation’s activities. Internal stakeholders are the board of directors, executives, and other employees.
Much of the contemporary interest in corporate governance is concerned with the mitigation of the conflicts of interest between stakeholders. Ways of mitigating or preventing these conflicts of interest include the processes, customs, policies, laws, and institutions that have an impact on the way a company is controlled. An important theme of corporate governance is the nature and extent of accountability of the people in the business.
The four pillars of corporate governance
A related but separate thread of discussion focuses on the impact of a corporate governance system on economic efficiency, with a strong emphasis on shareholders’ welfare. In large firms where there is a separation of ownership and management and no controlling shareholder, the principal-agent issue arises between upper management (the “agent”) and shareholders (the “principals”); the upper management may have very different interests and, by definition, considerably more information than the shareholders. Rather than overseeing management on behalf of shareholders, the board of directors may become insulated from shareholders and beholden to management. This aspect is particularly present in contemporary public debates and developments in regulatory policy.
terms to know
Corporate Governance
The roles of and relationships between a company’s management, board, shareholders, and other stakeholders as well as the goals for which the corporation is governed. Much of the contemporary interest in corporate governance is concerned with the mitigation of conflicts of interest and the nature and extent of accountability of the people in the business.
Stakeholders
A person or organization with a legitimate interest in a given situation, action, or enterprise.
Conflicts of Interest
Occur when an individual or organization is involved in multiple interests, one of which could possibly corrupt the motivation for an act in the other.
2. Principles
Contemporary discussions of corporate governance tend to refer to the principles raised in three documents released since 1990:
The Cadbury Report (United Kingdom, 1992)
The Principles of Corporate Governance (OECD, 1998 and 2004)
The Sarbanes-Oxley Act of 2002 (United States, 2002)
The important principles that are addressed in the concept of corporate governance are described in the list below.
Treatment of shareholders: Companies must respect the rights of shareholders and, beyond that, help them exercise those rights. This is largely done through effective communication and encouraging participation at annual shareholder meetings.
Treatment of other stakeholders: Companies should act in a way that respects the social, legal, and market-driven relationships that they have with employees, debtors, creditors, and local communities, among others.
Role of the board: Board members must have relevant skills and knowledge to review management performance. It needs enough members to provide appropriate levels of independence and commitment.
Integrity and ethical behavior: Integrity is a fundamental requirement for corporate officers and board members. Organizations must develop a code of conduct for their directors and executives that promotes ethical and responsible decision-making.
Disclosure and transparency: Organizations should make publicly known the roles and responsibilities of the board and management to provide stakeholders with some accountability. They should also have procedures to verify and safeguard the integrity of their financial reporting. Disclosure of material matters should be timely and balanced so that all investors have clear, factual information.
The principles of corporate governance
think about it
PepsiCo is a global leader in the food and beverage industry. It has also been noted for its excellence in corporate governance. Take a look at the PepsiCo website. Why do you think the company has won numerous awards and was featured in Fortune’s annual Blue Ribbon Companies list?
3. Sarbanes-Oxley Act of 2002
The Sarbanes-Oxley Act of 2002 is a federal law that sets standards for all domestic company boards of directors and management and accounting firms. It’s more commonly called Sarbanes-Oxley or SOX.
IN CONTEXT
The Sarbanes-Oxley Act, named after its sponsors U.S. Senator Paul Sarbanes (D-MD) and U.S. Representative Michael G. Oxley (R-OH), was enacted to restore public trust in financial markets and to protect investors from fraudulent financial reporting by corporations. SOX was a response to a series of high-profile financial scandals that exposed significant weaknesses in corporate governance and financial reporting. The most notable of these scandals involved major corporations such as Enron, WorldCom, and Tyco, where fraudulent accounting practices led to massive financial losses for investors and employees.
A line graph of Enron’s closing stock price from August 23, 2000, to January 11, 2001
Enron’s case was particularly influential in spurring the creation of SOX. The energy company used complex accounting loopholes to hide debt and inflate profits, misleading investors and analysts about its true financial health. When these deceptions came to light, Enron declared bankruptcy, devastating shareholders and employees and shaking trust in U.S. financial markets.
The changes enacted by Sarbanes-Oxley included the following:
Establishing the Public Company Accounting Oversight Board in order to provide independent oversight of accounting firms and audits
Establishing standards for the independence of external auditors, including new auditor approval and reporting requirements
Mandating that senior executives take personal responsibility for the accuracy of financial reports, including the definition of the relationship between external auditors and corporate audit committees
Setting reporting requirements for financial transactions, including off-balance-sheet transactions, pro forma figures, and stock transactions of corporate officers
Restoring investor confidence in securities analysts by requiring disclosure of conflicts of interest
Requiring the comptroller general and the SEC to study and report on the effects of consolidation of accounting firms and the role that credit rating agencies play in the markets
Defining specific criminal penalties for manipulation of financial records while also providing certain protections for whistleblowers
Setting criminal penalties associated with white-collar crimes and recommending stronger sentencing guidelines making failure to certify corporate financial reports a criminal offense
Requiring that the chief executive officer sign the company tax return
terms to know
Audits
The verification of the financial statements of a legal entity intended to enhance the degree of confidence of intended users in the financial statements by providing reasonable assurance that the financial statements are presented fairly.
External Auditor
An audit professional who performs an audit of the financial statements of a company, government entity, or other legal entity or organization in accordance with specific laws or rules and who is independent of the entity being audited.
summary
In this lesson, you learned that corporate governance is defined as the system by which companies are directed and controlled and concerns the handling of conflicts of interest between and among a company’s management, board, shareholders, and other external stakeholders. Principles of corporate governance regarding ethical behavior, public disclosure, and transparency have emerged from three main sources since 1990, including the Sarbanes-Oxley Act of 2002. The Sarbanes-Oxley Act required managers to certify published financial statements, stiffened penalties for fraud, and increased the oversight role of boards of directors and the independence of auditors, among other changes.
The verification of the financial statements of a legal entity intended to enhance the degree of confidence of intended users in the financial statements by providing reasonable assurance that the financial statements are presented fairly.
Conflicts of Interest
Occur when an individual or organization is involved in multiple interests, one of which could possibly corrupt the motivation for an act in the other.
Corporate Governance
The roles of and relationships between a company’s management, board, shareholders, and other stakeholders as well as the goals for which the corporation is governed. Much of the contemporary interest in corporate governance is concerned with the mitigation of conflicts of interest and the nature and extent of accountability of the people in the business.
External Auditor
An audit professional who performs an audit of the financial statements of a company, government entity, or other legal entity or organization in accordance with specific laws or rules and who is independent of the entity being audited.
Stakeholders
A person or organization with a legitimate interest in a given situation, action, or enterprise.
