What are the ingredients of corporate governance?

The article talks about the essential elements of corporate governance and the theories that govern corporate governance dynamics.
Estimated Reading Time: 8 minutes

Introduction

Corporate governance is commonly referred to as the organizational practice to direct, organize, and control the company. The organization practice is strongly influenced by the participants involved in the company’s management system, which includes the investors, shareholders, employees, creditors, government, and corporate governance. They seek to balance the interests of all of the mentioned stakeholders involved. Corporate governance means institutional decision-making in its broadest sense. The Cadbury committee report defines corporate governance as “a system in which companies are directed and controlled.”[1] Corporate governance is a system integrated with sound corporate governance principles to direct the company professionally. But who is responsible for the implementation of ingredients of corporate governance in the company?

The board of directors is primarily responsible for the proper execution of governance principles at a place. Further, the shareholders have a role in appointing the directors on board and appointing auditors and ensuring that both the appointed directors and auditors run the organization’s appropriate governance structure.

Six essential elements of corporate governance

There are various elements of corporate governance, but few of them are of essential importance. Following outlined is the seven basic yet crucial elements of corporate governance that make the whole structured system perform better:

  1. Streamlined Structure: When aligned with the company’s strategic priorities, an efficient structure helps the board and staff applies their organizational skills in concert to fulfil the main objective.
  2. Strategic Planning: The strategic planning procedure charts a future course for operational purpose and then drives the actions that move the company forward. It characterizes the board’s structures, aligning the concerned committees and task forces with strategic objectives. It also shapes the personnel work, timetables, and checkpoints and guides the thought leadership prospecting process.
  3. Board Meetings: The boardroom is the professional place where the board of directors acts on its authority. They conduct formal meetings with a particular agenda and well-planning that leads to constructive execution of the meeting. A productive board meeting is the crux of decision making.
  4. The Composition of the board and staff: The board needs to be comprised of the right people with right attitude in the right positions, who work on the right mission. This leads to successful corporate governance.
  5. The leadership of the board and the corporation: Good governance is participatory. Behind the productivity of any high-performing corporation, one would find that it is led by a dedicated board of directors and the CEO. The reputation and value of a corporation are gauged through its leaders. The leaders committed to a constructive partnership built on a shared understanding of the ultimate goal and vision, mutual respect, trust, reciprocal communications, and support for each other and their partnership.
  6. Stakeholder rights: Investors should consider shareholder rights as a key ingredient of corporate governance. As mentioned, corporate governance is based on the idea that all stakeholders’ interests should be protected, so from shareholders to the management everyone’s rights and interests need to be aligned.
  7. Board diversity and auditor independence: The boards and auditors should be independent, having no company’s financial interests. The majority of the auditor’s revenue should be derived from the audit activities and not their consultation services. The accounting must also be handled thoroughly, providing all details and reporting to the board on time to avoid any questionable findings. Further, there should be a focus on the board’s diversity so that the varied composition works committed to improving corporate performance.[2]
  8. The objective: Finally, a clear, concise, and compelling objective unifies and motivates the board and staff to achieve the desired goal with meaningful results.

Institutional ingredients of corporate governance

The institutional ingredients of corporate governance mechanisms include institutional ownership in the company, characteristics of the board of directors, stock ownership by directors and executive officers, age and tenure of the CEO, and the CEO’s pay-for-performance sensitivity.[3] Let’s see how this mechanism will help in the company’s functioning.

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Many institutional investors in the company will have the opportunity, ability, and resources to monitor and influence the manager. Shares and/or options ownerships by directors and executive officers will encourage the management system’s behaviour to increase its value. It will also enable managers to use discretionary accruals during sale shares or options, which will again improve the company’s performance. The appointed directors will play a crucial role in managing and controlling the business and acting agent to the company and its shareholders; they must protect the interests of the company owners, i.e. shareholders.

Moreover, the board of directors’ characteristics can be measured in terms of the ratio of independent directors, CEO duality, and the board’s size limit. The CEO’s age and tenure influence the company’s effectiveness because it is seen that the older is the CEO’s tenure; he/she has a deeper understanding of management functioning and improving corporate performance.

Basic Model of Corporate governance

The basic model of corporate governance constitutes of the following elements:

  1. Shareholders elect the board of directors who become the legal representative and responsible for shareholders interests.
  2. The board votes on the key issues and makes responsible and ethical decision considering majority interest.
  3. Transparent decisions are made and regarding the well-being of corporative and society.
  4. The corporative should comply with national laws and professional regulations and standards.
  5. The corporative should assure reliable and timely financial and administrative statements, which reflect effectiveness and efficiency in its operation to shareholders.
  6. The corporative should ensure an effective internal system for decision making, where if any issue arises, decision-makers are held accountable.

Internal corporate governance variables

Good corporate governance is needed to have institutions and established work mechanisms to ensure that the corporation achieves the desired goal and needs with the ideal use of available resources like sustainable use of natural resources and environment protection. The internal corporate governance mechanism comprises a balanced organization culture with ownership concentration, internal control procedures and internal auditors, monitoring by the board, management compensation, and disclosure and transparency. The additional management control system includes strategic planning and budgeting, organizational structure, and balance of power.

Ownership concentration

Ownership concentration represents the relative amounts of stock owned by each shareholder and institutional investors. The structure refers to the types and composition of ownership with a shareholder in a corporation.

Internal control procedures and internal audit

Internal control procedures represent the board’s policies, audit committee, management, and others to guarantee reasonable assurance that the company achieves its objective in terms of operating efficiency, financial reporting, and compliance with laws and regulations. Internal control and audit provide safeguarding of the company’s assets.

Monitoring by the board of directors

The board of directors represents the company and is in such a position that they have primary responsibility and obligation to monitor its overall functioning and strategic decisions. They have a crucial role in the corporate governance framework. The board has a legal authority to hire, fire, and even compensate top management and safeguard the capital invested in the company.  

Management compensation

Management remuneration involves the salary, bonus, and long-term incentives for the managerial personnel to align their and shareholder’s interests. The remuneration may be in the form of cash or non-cash payments like shares and share options, superannuation, and other specific benefits.

Disclosure and Transparency

The company should clarify publicly and make board and management roles and responsibilities clear to provide the owners with accountability. It is required to implement timely procedures for independent verification of the company’s financial reporting and other material matters so that investors have a clear idea of factual information before making a decision. Disclosure and transparency play a pivotal role in maintaining the company’s integrity and values.

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Theories governing Corporate Governance

Several schools of thought govern corporate governance dynamics, including agency theory, stewardship theory, stakeholder theory, dependency theory, transaction cost theory, political theory, and ethical theory. This article will study the four essential theories as one of the ingredients of corporate governance.

Agency Theory

Agency theory undertakes to resolve the core friction issue: the conflict of interests between the various parties involved in the company’s management. The theory is based on the assumption that the managers and the company’s shareholders are expected to have potentially conflicting interests from each other. So, an agency problem exists in a company when the shareholder (principal) employs or appoints the CEO (agent) and the executive team to lead the company’s management on behalf of the principal.[4]

The agency theory is further expanded into stewardship theory to align principal and agents’ interests through rule setting, monitoring, and incentive and sanctioning mechanisms.

Stewardship Theory

Stewardship theory works on the principles that the management should put the long term collective best interests of a group ahead of the individual’s self-interest.[5] Unlike agents in the agency theory, Stewards seek to align their interests with the interests of the company and its shareholders. Additionally, managers as stewards of the company are in the perfect position to maximize the stakeholder’s interests, including the shareholders. It is because managers are most familiar with the dynamics of corporate strengths, weaknesses, threats, and opportunities,[6] and are competent to commit the involved participants to work towards a common goal without taking each other’s advantage.

Following stewardship theory, corporate governance is needed to ensure that all stakeholders’ voice is heard, and the material information about the company is equally distributed to stakeholders.

Stakeholder Theory

Stakeholder theory assumes that a company’s good performance depends on the various contributions from different parties of the corporation. The stakeholders and the shareholders are one such party, along with others who have a stake in the company and can choose how to prioritize their stakes based on the material information they receive about the company. It becomes the responsibility of the management to align all these interests. The stakeholders can try to influence the management to meet their best interests, goals, and expectations.

Shareholder Theory

The shareholder theory views the corporation as the property of its owners, i.e. shareholders who may dispose of it as they deem fit. Shareholders are oriented towards self-interest, so the present theory takes a self-centered approach to expect the maximum return on investment from its managers and employees. They should integrate controls and procedures that cannel the company’s operation and its members in the direction of shareholder’s interests. Shareholders exercise suitable business judgment and avoid conflict of interests and violations of confidence and focus on compliance strategies.

Conclusion

The formula for effective corporate governance boils down to its essential ingredients. The ingredients of corporate governance provide for a company’s significant achievement. The ingredients mentioned above are neither complex nor profound, but few successful corporations consistently and thoroughly apply it to their company’s operation. While the ingredients of corporate governance take its time, flexibility, attention, and intention to enable an organization to advance its objective, it makes an exemplary difference in the world and the community it serves.


[1] Cadbury Report, (London: London Stock Exchange, 1992).

[2] Aimee B. Forsythe, Six Essential elements of effective Corporate Governance, (2018), last assessed Jan 9th 2021, at https://www.cambridgetrust.com/insights/investing-economy/six-essential-elements-of-effective-corporate-gove.

[3] M.M. Cornett, A.J. Marcus, H. Tehranian, Journal of Financial Economics, 87, 357- 373 (2008).

[4] Jensen, M.C. and W.H. Meckling (1976). The Theory of the Firm: Managerial Behavior, Agency Cost, and Ownership Structure, Journal of Financial Economics, 3, no. 4 (October), p. 305-60.

[5] Hernandez, M. (2012). Toward an understanding of the psychology of stewardship. Academy of Management Review, 37(2), p. 172-193.

[6] Davis, J.H., F.D. Schoorman, L. Donaldson (1997), Towards a stewardship theory of management, Academy of Management Review, Vol. 22, No.1, p. 20-47.

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