Corporate Governance and Its Theories

The report provides explanation on corporate governance, its theories and weaknesses. It discusses the characteristics of good corporate governance and explains the theories that support the same. Furthermore, the report analyses a case study and provide recommendations on its structure of corporate governance. It identifies its weaknesses and explains the steps to improve the same in its later part.

The system of rules, practices, policies and procedures that guides, directs and controlled a firm and its operations is known as corporate governance. Company directs its managers to control and monitor the functioning of a firm in such a way that protects the interest of the shareholders. It helps in balancing the interest of many stakeholders that includes management, customers, suppliers, government, investors and community. The concept of corporate governance offers a framework with the help of which a company can easily attain its objectives and establish appropriate internal control measures for making the performance effective and efficient (Bajpai, 2016). 

In general, it lay down some rules and regulations which direct the corporate behaviour of board of directors. The board is the key element of corporate governance as it is responsible for making important and suitable decisions for the firm such as deciding the dividend policies, executive compensations and many more (Fernando, 2012). There are some principles of Corporate Governance Council which are been recommended to be followed by every company listed on Australian Stock Exchange. It includes the process through which the objectives of the entity are set and pursued in context of social regulatory and market environment. The mechanisms include monitoring the actions, plans, practices and the decisions of stakeholders and their agents. The activities of corporate governance are much affected by the conflict of interests between the stakeholders and management of the corporation. Therefore, it is very much necessary for a company to have a good corporate governance so to facilitate smooth functioning and become successful in future (Calder, 2008). 

Corporate governance is considered as good when the process of transparency and disclosure is followed within the organizations with a motive of providing accurate and true information to the regulators and shareholders as well as to the general public. The company should represent true and fair data about its financial, operational and other aspects of the business. The main aim of pursuing a good CG is to earn profits and present them in a transparent and accountable manner. Following are the characteristics the good corporate governance holds for itself.

Corporate Governance Weaknesses Evident from the Overheard Conversation

Clear strategy

The procedure of creating good CG starts with developing a clear strategy for the corporation. The board of directors and the management should be clearly aware about the organization’s goals and the practices required achieving the same. The managers and employees should know about the strategy at each stage of the process so as to keep themselves focused towards company’s objectives and goals (Yocam, 2010). 

Efficient and effective management of risk

Generally, companies operate in an environment where cut throat competition prevails and despite having smart policies and procedures; an organization can face problems from the end of its competitor. Such unexpected risks might affect the operations and fluctuations in the economy can influence the competency of the company’s target market. Therefore, it is vital to have an effective risk management system in order to deal with such uncertainties.

Discipline

The effectiveness of corporate strategies relies on their implementation. If the firm’s management can’t mobilize its employees to implement the strategy in a proper manner, the planning and initiative taken will fail. Hence, good corporate governance requires the discipline and commitment factor from the employees as well as from the senior managers (Aras, 2016). 

Transparency

This is the most important characteristic required for creating good CG. It deals with disclosing all the important and material information to the shareholders and public so as to provide them the fair view of company’s performance and position. Transparency is created at the level when the employees understand the management’s strategies and work accordingly. Furthermore, when they are allowed to control the financial performance of the company, a high level of transparency exists.

Social responsibility

Creating a sense of being socially responsible at corporate level helps the directors to create good corporate governance. It helps in identifying the ways by which the members of the organization can be responsible towards their customers. The good CG assists in improving the practices and procedures as well as it promotes the social good by reinvesting in the local community.

Apart from the above characteristics, there are various theories of corporate governance which states the features of creating good CG for the organization. They are as follows:

Agency Theory

The theory was developed by Alchian and Demsetz (1972) and further explained by Jensen and Meckling (1976). It basically explains the relationship between the principal and its agent. At corporate level, shareholders are treated as principal and the executives and managers of the organizations are considered as agents. The theory suggests that the agents have to work in interest of principal and take decisions in their interest only (Farrar, 2008). However, the same may not necessarily take place and agency problems may arise in future. Overall, it focuses on the fact that employees and managers are held responsible and accountable for their tasks and responsibilities. Therefore, they should focus on creating good governance structure rather than just emphasizing on the need of shareholders (Abdullah & Valentine, 2009).

Recommendations for Improving Corporate Governance

Stewardship Theory

It was defined by Davis, Schoorman & Donaldson (1997) as the steward’s main objective is to maximize and protect the shareholder’s wealth by improving performance of the firm. As per this perspective, stewards are company’s employees, managers and executives who are working for the shareholders and in their interest (Clarke, 2004). The theory does not focus on the concept of individualism like agency theory; instead it promotes the role of top management and suggests that the stewards are motivated and satisfied when the objectives of the firm are met. Furthermore, the theory focuses on unifying the role of chairman and CEO with the motive of reducing the agency cost and to increase the role of managers and employees. Thus, it is evident that stewardship leads to better safeguarding of shareholders’ interest and creation of good corporate governance (Tricker & Tricker, 2015). 

Stakeholder Theory

It was developed by Freeman (1984) and it explains that managers are not only required to serve the owners of the company but should also focus on meeting the requirements of other stakeholders such as customers, employees, suppliers and many others. Creation of such network can affect the process of decision making as the theory totally depends upon the nature of the relationships. By working in context of all the stakeholders, the company can establish a good corporate governance structure in the business (Jensen, 2017).

Joshua is an employee of a medium sized company listed on Australian Securities Exchange. One fine day he was working late he overheard the conversation going on between the company’s chief executive officer and its non-executive director. After hearing the conversation, he found out that both the senior executives are planning to manipulate the profit figures by showing them slightly higher as compare to the previous year. For doing this, they decided to showcase the sale proceeds of their toothbrush division which has not taken place. The numbers will appear only on the books and as per them; it is just the manipulation of timing.

From the above case, it is analysed that the corporate governance structure of Joshua’s company is weak as it does not follow the concept of transparency and fair disclosure. However, the executives used the concept of earnings management in order to show high profits on their books of accounts. This will eventually help them to retain their best and potential investors and attract the new ones also. The term earnings reflect the net income of the business earned during a particular period of time. It is the most important component that reflects the overall financial position and performance of the entity. The managers and executives can go to any extent to keep their earnings high and mange them properly. Given such importance, it can be said that the management has great interest in knowing how their earnings are been reported on the books. The concept of earnings management deals with taking legal and meaningful decisions in respect to financial reporting. However, the notion is always mixed with illegal activities where the executives are manipulating their earnings to show high and increased profits for their company (Francis & Schipper, 2011).

Conclusion

In the case study, the CEO and non-executive director tried to manage their earnings and show high profits so that they can keep their large investors and shareholders in the business. For this purpose, they reported the sales of their toothbrush division on the books but it did not take place in real till October. However, such action is against the characteristic of good corporate governance and once noticed may affect the performance of the organization and its employees. Their actions reflected some sort of discrepancies in the company’s corporate governance structure. Moreover, the conversation was overhead by the employee Joshua which can have a negative impact on its performance as well as may stimulate the change in his behaviour towards the company.

There are some weaknesses identified in the corporate governance of Australian company. One of them is the appointment of non-executive director, Alan who is the cousin of company’s chief executive officer Paul. Both the members have close family connection and therefore the director cannot be considered as independent on his appointment. Another limitation was noticed in the role of CEO. The officer is held responsible for all executive management matters affecting the company. He is accountable to the chairman and is required to perform his duties and responsibilities with honesty and due diligence. However, the same is not reflected in the case study as the CEO Paul was involved in manipulation of financial statements along with the director Alan. They both decided to increase the profit figures by showing the false sales of their toothbrush segment. This is considered as the weakness in the role of CEO as he did not ensure the true and fair disclosure of all the information.

Furthermore, the corporate governance of the company also lacks transparency in its system. The modification of accounts and presentation of faulty image reflects that there was no transparency in company’s practices and procedures. The annual report of the company did not provide all the material information to its users and potential investors. It misguided them and presented a false image of entity’s financial performance and position. Overall, the governance focused only on the interest of investors and did not consider the needs and goals of other people of the organization. The main and prominent weakness was that it did not comply with the corporate governance disclosure requirements and other ASX CGC principles. The structure failed to follow the concept of transparency and objectives of financial reporting. Thus, it can be concluded that there is a need to improve the CG of the company otherwise it can have negative impact on its employees and other related people.

Conclusion 

The above case study concludes that there are certain measures which are required to be taken in order to improve the governance structure of the company. Firstly, the enterprise is required to comply with all the disclosure requirements of CG and should present the necessary information in its annual report. Apart from this, the CEO must understand its responsibility of creating transparency in the books of accounts by not manipulating the figures. Moreover, apart from the legal requirement, the company should also provide additional information in its reports which are of use for the users.  This includes disclosure of internal control mechanisms, policies and procedures related to risk management and others. Further, the periodic reviews of board’s and organization’s performance can also contribute in making the governance effective. Additional improvements require prioritizing risk management, providing timely information, increasing diversity and appointing competent and skilled directors on the board. Overall, it can be concluded that it is very important to have a good corporate governance so to ensure smooth functioning as well as improved performance.  

References 

Abdullah, H., & Valentine, B. (2009). Fundamental and ethics theories of corporate governance. Middle Eastern Finance and Economics, 4(4), 88-96.

Aras, G. (2016). Global perspectives on corporate governance and CSR. England: CRC Press.

Bajpai, G. N. (2016). The essential book of corporate governance. India: SAGE Publications

Calder, A. (2008). Corporate governance: A practical guide to the legal frameworks and international codes of practice. United States: Kogan Page Publishers.

Clarke, T. (2004). Theories of corporate governance. The Philosophical Foundations of Corporate Governance, Oxon.

Farrar, J. (2008). Corporate governance: theories, principles and practice. USA: Oxford University Press.

Fernando, A. C. (2012). Corporate Governance: Principles, Polices and Practices. India: Pearson Education India.

Francis, J., & Schipper, K. (2011). Earnings Management: Emerging Insights in Theory, Practice, and Research. USA: Springer.

Jensen, M. C. (2017). Value maximisation, stakeholder theory and the corporate objective function. In Unfolding stakeholder thinking (pp. 65-84). Routledge.

Tricker, R. B., & Tricker, R. I. (2015). Corporate governance: Principles, policies, and practices. USA: Oxford University Press.

Yocam, E. (2010). Corporate Governance: a Board Director’S Pocket Guide: Leadership, Diligence, and Wisdom. New York: iUniverse.