Lecture Corporate governance and ethics: Chapter 2 - Rezaee

Chapter 2 - Corporate governance. After completing this chapter, students will be able to: Identify the corporate governance developments in the post-SOX era, understand how corporate governance is designed; define corporate governance structure and its components of principles, functions, and mechanisms;...

Corporate Governance

Chapter II 

Chapter Objectives:

•  Identify the corporate governance developments in the post-SOX era.

• Understand how corporate governance is designed

• Define corporate governance structure and its components of principles, functions, and mechanisms.

• Illustrate how corporate governance has evolved from compliance function to a strategic Imperative.

• Provide an overview of corporate governance aspects and principles.

• List and define the seven essential corporate governance functions.

• Identify significant improvements resulting from corporate governance reforms in the United States.

• Become familiar with best practices of corporate governance.

• Become familiar with corporate governance reporting and its components as well

as corporate governance ratings.

Definition of Corporate

Governance

The process affected by a set of legislative, regulatory, legal, market mechanisms, listing standards, best practices, and efforts of all corporate governance participants, including the company’s directors, officers, auditors, legal counsel, and financial advisors, which creates a system of checks and balances with the goal of creating and enhancing enduring and sustainable shareholder value, while protecting the interests of other stakeholders.

Aspects of Corporate

Governance

In the post-SOX era, Corporate Governance further evolved to the integrated aspects of meeting both compliance requirements and promoting a strategic business imperative There are three aspects: shareholder aspect, stakeholder aspect, and an integrated aspect

Integrated Aspect

Modern corporate governance emphasizes BOTH financial aspects of increasing shareholders value AND an integrated approach that considers the rights and interests of all stakeholders

Corporate Governance Structure

 Corporate governance is based on three interrelated components: corporate governance principles, functions and mechanisms

Corporate Governance Principles

HONESTY Corporate communications with both internal and external

audiences, including public financial reports, should be accurate, fair, transparent, and trustworthy

RESIELNCE A resilient corporate governance structure is sustainable

and enduring in the sense that it will easily recuperate from setbacks and abuses

RESPONSIVENESS. Effective corporate governance responsive to the interests and desires of all stakeholders, as well as responsive to emerging initiatives, and changes in political, regulatory, social, and environmental issues

TRANSPARENCY Transparency means that the company is not hiding relevant information, and disclosures are fair, accurate, and reliable

What are the other principles corporate governance

structure should be developed on?

They are the following:

- Value-adding philosophy

- Ethical conduct

- Accountability

- Shareholder democracy and fairness

- Integrity of the financial reporting

- Transparency

- Independence

Corporate Governance

Functions

Corporate Governance

Functions

 OVERSIGHT FUNCTION The board of directors should provide strategic advice to

management and oversee managerial performance, yet avoid micromanaging.

 MANAGERIAL FUNCTION The effectiveness of this function depends on the alignment of

management’s interests with those of shareholders.

 COMPLIANCE FUNCTION The set of laws, regulations, rules, standards, and best practices

developed by state and federal legislators, regulators, standard-setting bodies, and professional organizations to create a compliance framework for public companies in which to operate and achieve their goals

 INTERNAL AUDIT FUNCTION Assurance and consulting services to the company in the areas

of operational efficiency, risk management, internal controls, financial reporting, and governance processes.

 LEGAL AND FINANCIAL ADVISORY FUNDTIONS Legal advice and assists the company, its

directors, officers, and employees in complying with applicable laws and other legal obligations and fiduciary duties.

 EXTERNAL AUDIT FUNCTION External auditors lend credibility to the company’s financial

reports and thus add value to its corporate governance through their integrated audit of both internal control over financial reporting and financial statements.

 MONITORING FUNCTION Shareholders, particularly institutional shareholders, empowered to

elect and, if warranted, remove directors

.   

 Corporate Governance

Mechanisms

The corporate governance structure is shaped by internal and external governance mechanisms, as well as policy interventions through regulations Both internal and external corporate governance mechanisms of the company have evolved over time to monitor, bond and control management

Examples of internal governance mechanisms:

- board of directors, particularly

Examples of external mechanisms:

- market for corporate control

Corporate Governance

Reports

To restore investor’s confidence after the collapse of the dotcom market, the economic downturn, reported financial scandals, and numerous earnings restatements of high-profile companies several corporate governance reforms in the United States have been established, including SOX, SEC-related implementation rules, listing standards of national stock exchanges, auditing standards of the PCAOB, guiding principles of professional organizations (The Conference Board, Council

of Institutional Investors, and National Association of Corporate Directors), and best practices

Sources of Corporate

Governance

Corporate Laws May vary from state to state But most adopted Model

Business Corporation Act as their corporate law

The Federal Securities Laws Fundamental are: the Securities Act of 1933 and

Securities Exchange Act of 1934 SOX expanded the role of federal statutes by providing

measures to improve corporate governance, financial

reports, and audit activities.

Listing Standards Adopted by national stock exchanges, these standards are

applicable to all public companies listing their equity

shares with some exceptions

Best Practices Recommended by professional organizations (e.g The

Conference Board, the Business Roundtable Institute) and investor activists (e.g Council of Institutional Investors)

Sarbanes-Oxley Act of 2002

SOX was signed into law on July 30, 2002, to reinforce corporate

accountability and rebuild investor confidence in public financial reports It

was designed to:

(1) establish an independent regulatory structure for the accounting

profession,

(2) set high standards and new guiding principles for corporate governance,

(3) improve the quality and transparency of financial reporting,

(4) improve the objectivity and credibility of audit functions and empower the

instances, significantly enhanced

 Certain aspects of state corporate law were preempted and federalized (For example, Section 402 of SOX prohibits loans to directors and officers, whereas state law permits such loans)

Cost Benefit Of Sarbanes-

A 2007 survey of 2000 corporate executives reveals that:

(1) The compliance costs of SOX for the second consecutive year declined substantially;

(2) The cost dropped 23 percent in 2006;

(3) Total compliance costs decreased to an average $2.9 million per company in 2006, which is down 35 percent from the $4.51 million average costs in 2006;

(4) There was no significant change in audit fees;

(5) The majority of surveyed executives (78 percent) reported that the costs to comply with section 404 still outweigh any benefits

More manageable and cost-effective Section 404 compliance is currently being addressed by the SEC and the PCAOB

Corporate Governance Rating

National and international organizations, including Institutional Shareholder Services (ISS), the Corporate Library, Standard & Poor’s, Moody’s Investment Service, Core Ratings, Governance Metrics International (GMI), and Glass Lewis & Co., have developed and published variations of corporate governance ratings that are often used by shareholders in assessing their stock returns and bondholders

in determining the costs of lending

Example: GMI established its scoring algorithm with hundreds of metrics relevant to the governance quality and risk assessment of each rated company into six categories of board accountability, financial disclosure, shareholder rights, executive compensation, takeover defenses, and reputation/regulatory problems

Corporate Governance Reporting

Corporate Governance Reporting (CGR) entails assessing the quality and effectiveness of the organization’s corporate governance and reporting findings to interested stakeholders, including the board of directors, executives, auditors, regulatory agencies, and shareholders.Corporate Governance Reporting:

(1) Disclose all relevant information about the effectiveness of the company’s corporate governance

(2) Focus on the company’s sustainability performance

(3) Provide transparent information about the company’s performance and its impacts on all stakeholders

(4) Assess the company’s responsiveness to the needs of its stakeholders

Global Convergence in Corporate

Governance

globally accepted corporate

Conclusion  

• Corporate governance participants must structure the process to ensure the goals of both shareholder value creation and stakeholder value protection for public companies.

• The corporate governance structure is shaped by internal and external governance mechanisms, as well as policy interventions through regulations.

• Corporate governance mechanisms are viewed as a nexus of contracts that

is designed to align the interests of management with those of the shareholders.

• The effectiveness of both internal and external corporate governance mechanisms depends on the cost–benefit trade-offs among these mechanisms and is related to their availability, the extent to which they are being used, whether their marginal benefits exceed their marginal costs, and

the company’s corporate governance structure.

• There are three aspects of corporate governance: the shareholder aspect, the stakeholder aspect, and the integrated aspect.

• Corporate governance structure should be based on the principles of adding philosophy, ethical conduct, accountability, shareholder democracy and fairness, integrity of financial reporting, transparency, and independence.

value-• A well-balanced operation of the seven corporate governance functions— oversight, managerial, compliance, internal audit, legal and financial advisory, external audit, and monitoring— can contribute toward effective corporate governance

• Corporate governance effectiveness is defined as the extent to which the company’s corporate governance is achieving its objectives in three categories: (1) promoting efficient and effective operational, financial, and social performance; (2) creating shareholder value while protecting the interests of other stakeholders (employees, suppliers, customers, and creditors); and (3) ensuring the integrity, quality, reliability, and transparency of financial reporting.