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Corporate Governance

A system of direction and control that dictates how a board of directors governs and oversees a company

What is Corporate Governance?

Corporate governance is something altogether different from the daily operational management activities enacted by a company’s executives. It is a system of direction and control that dictates how a board of directors governs and oversees a company.

 

Corporate Governance

Summary: 

  • Corporate governance is a system of rules, policies, and practices that dictate how a company’s board of directors manages and oversees the operations of a company;
  • Corporate governance includes principles of transparency, accountability, and security.
  • Poor corporate governance, at best, leads to a company failing to achieve its stated goals, and, at worst, can lead to the collapse of the company and significant financial losses for shareholders.

 

A Key Principle of Corporate Governance – Shareholder Primacy

Perhaps one of the most important principles of corporate governance is the recognition of shareholders. The recognition is two-fold. First, there is the basic recognition of the importance of shareholders to any company – people who buy the company’s stock fund its operations. Equity is one of the major sources of funding for businesses. Second, from the basic recognition of shareholder importance follows the principle of responsibility to shareholders.

The policy of allowing shareholders to elect a board of directors is critical. The board’s “prime directive” is to be always seeking the best interests of shareholders. The board of directors hires and oversees the executives who comprise the team that manages the day-to-day operations of a company. This means that shareholders, effectively, have a direct say in how a company is run.

 

Transparency

Shareholder interest is a major part of corporate governance. Shareholders may reach out to the members of the community who don’t necessarily hold an interest in the company but who can nonetheless benefit from its goods or services.

Reaching out to the members of the community encourages lines of communication that promote company transparency. It means that all members of the community – those who are directly or indirectly affected by the company – and members of the press get a clear sense of the company’s goals, tactics, and how it is doing in general. Transparency means that anyone, whether inside or outside the company, can choose to review and verify the company’s actions. This fosters trust and is likely to encourage more individuals to patronize the company and possibly become shareholders as well.

 

Security

An increasingly important aspect of corporate governance is security. Shareholders and customers/clients need to feel confident that their personal information is not being leaked or accessed by unauthorized users. It’s equally important to ensure that the company’s proprietary processes and trade secrets are secure. A data breach is not just very expensive. It also weakens public trust in the company, which can have a drastically negative effect on its stock price. Losing investor trust means losing access to capital that is necessary for corporate growth.

Everyone in a company, from entry-level staffers to members of the board, needs to be well-versed in corporate security procedures such as passwords and authentication methods.

 

Consequences of Poor Corporate Governance

One of the biggest purposes of corporate governance is to set up a system of rules, policies, and practices for a company – in other words, to account for accountability. Each major piece of the “government” – the shareholders, the board of directors, the executive management team, and the company’s employees – is responsible to the others, therefore keeping them all accountable. Part of this accountability is the fact that the board regularly reports financial information to the shareholders, which reflects the corporate governance principle of transparency.

Poor corporate governance is best explained with an example, and there is no better example than Enron Corp. Many of the executives used shady tactics and covert accounting methods to cover up the fact that they were essentially stealing from the company. Erroneous figures were passed along to the board of directors, who failed to report the information to shareholders.

With responsible accounting methods gone out the window, shareholders were unaware that the company’s debts and liabilities totaled much more than the company could ever repay. The executives were eventually charged with a number of felonies, and the company went bankrupt. It killed employee pensions and hurt shareholders immeasurably.

When good corporate governance is abandoned, a company runs the risk of collapse, and shareholders stand to suffer substantially.

 

More Resources

CFI is the official provider of the global Financial Modeling & Valuation Analyst (FMVA)™ certification program, designed to help anyone become a world-class financial analyst.

Through financial modeling courses, training, and exercises, anyone in the world can become a great analyst. To keep advancing your career, the additional CFI resources below will be useful:

  • Business Ethics
  • Fiduciary Duty
  • Top Accounting Scandals
  • Types of Due Diligence

Financial Analyst Certification

Become a certified Financial Modeling and Valuation Analyst (FMVA)® by completing CFI’s online financial modeling classes and training program!