Concepts of Corporate Governance
Concepts of Corporate Governance
Corporate governance practiced through standard reporting and auditing practices that develop a positive outlook of the firm among investors and raise the value of company shares has become an important business principle - Concepts of Corporate Governance introduction. Corporate governance is the process of authoritatively directing an organization (Colley et al., 2005) through the application of the basic principles of accountability, responsibility, integrity, honesty and trust (Tirole, 2001). Corporate governance is also the management of relationships within the organization involving members of the board, management team, employee pool as well as suppliers, creditors and customers (Monks & Minow, 2003). Corporate governance encompasses leadership and relationship building that determines corporate management strategies and policies as well as influences the implementation of policies and decisions. Key concepts of corporate governance reflected in accounting and management scandals are organizational architecture, operational architecture, and maximization of shareholder wealth.
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Accounting scandals and management failures express these corporate management concepts. Enron Corporation is one example of poor corporate governance because its board of directors worked without independence and oversight resulting to earnings manipulations in order to ensure greater compensation for the Chairman and some members of the board. Enron’s organizational architecture was not heeded when the company engaged in massive external debt and guaranteeing these through share offerings. (Wearing, 2005) Organizational architecture or the framework guiding the realization of core qualities expressed in the vision and mission of the company (Monks & Minow, 2003; Colley et al., 2005) constitute the principles that guide corporate management and the maximization of the shareholder wealth. Lack of oversight and massive borrowing lessened the credit rating of Enron (Wearing, 2005). There was also weak operational architecture. Operational architecture pertains to the system of information management linked to the various business processes that this supports as well as the manner that the system handles information from these business processes (Monks & Minow, 2003). Since there was no independent auditor or auditing team and financial reports to investors were manipulated to show growth even if the company is already in debt. Enron failed at leading and directing the company towards the fulfillment of its organizational architecture because of poor information management and non-consideration of the maximization of shareholder wealth. (Wearing, 2005)
WorldCom, Inc. is another example of the failure of these concepts. WorldCom engaged in a series of aggressive mergers and acquisitions, which is reflective of the organizational architecture of the company. However, the mergers and acquisitions went overboard resulting to the failure of corporate governance and poor operational architecture since headquarters found it difficult to control and link all its subsidiaries because of the diversity of billing and technical structures as well as sales plans resulting to the mounting of customer complaints and lawsuits. There was also no standard information management since internal audit failed to act on problems of cash overstatement. WorldCom failed to make effective financial policies and implement other management policies that consider the maximization of profit of shareholders. (Wearing, 2005)
Scandals and management failures could also be due to the impact of institutional stock ownership on corporate governance. Institutions such as large accounts and mutual funds likely own significant shares in well-known firms. The move of institutional shareholders affects corporate governance by constituting a signal to individual shareholders and the public about expected occurrences in the future. Institutional stock holders interested in a the shares of a company can raise prices through their large block orders but when these find a better stock or see the stock as flawed then these can also drive down share price by pulling out and selling their stocks in bulk. This could cause a series of pullout that could cause the fall of companies. (Colley et al., 2005) The effect on corporate governance is that the board, controlled by institutional shareholders would want to increase their share value to the point that these shareholders, directly or indirectly, influence investments and other decision. Companies fearing a crash would do everything to keep institutional stockholders satisfied with the operation and performance of the company.
On one hand, this benefits the firm by motivating leadership to direct the company towards continues growth but on the other hand, a difference in objectives between the company and institutional shareholders could influence corporate leadership to yield the goals of the firm (Colley et al., 2005). Institutional stock ownership influence corporate governance by affecting leadership decision on key areas such as investments and management strategies. In the case of Yahoo, institutional shareholders controlling one-third of shares voted against the renewal of the term of office of some directors because of disappointment in the poor performance of the company. In the case of Colgate-Palmolive and Pfizer, large institutional shareholders succeeded in amending the number of votes required to elect a member of the board from simple plurality to majority votes. (Iwata, 2007) In these cases, institutional stock ownership has improved the corporate governance practice when compared to Enron and WorldCom that practiced poor corporate governance because of limited or lack of oversight and institutional holders influencing the board and board membership according to personal gains. In Enron, many external stockholders held large shares and voted in favor of their interests so that coupled with weak oversight, risky financial decisions were implemented. (Wearing, 2005)
In addition, scandals on corporate governance and management failures also revolve around the reasonableness of executive compensation. In determining the reasonableness of compensation of executives, the purpose is the rendering of service and not the distribution of gains. The amount is reasonable if these are justified based on common standards and the limit of allowances. (Monks & Minow, 2003) Many companies that went bankrupt and created a corporate governance scandal gave unreasonable executive compensation. At Enron, the executives received compensation plus consulting fees. Since the amount depended on earnings as performance threshold, there was a high motivation to achieve continuous levels of earning that led to the manipulation of the financial records when the company started to experience losses. In the case of WorldCom, executive compensation also depended on the earnings of the company that led to accounts manipulation. In addition, the board also extended a very generous loan to the CEO at a very low interest so that this amounted to gratuitous payment disguised as loan. (Wearing, 2005)
In these scandals, the maximization of shareholder wealth expressed in poor corporate governance sacrifice the interests of employees, suppliers, customers and the public sector. Maximization of shareholder wealth pertains to the process of enhancing the market value of the common prices of stocks of existing shareholders (Monks & Minow, 2003). If this forms part of the operational architecture of companies then corporate management should result to sound financial decisions that enhance the credit rating and firm equity that in turn raises the value of shares as well as profitable investment decisions that involve higher dividends for existing shareholders. Enron and WorldCom made risky decisions that focused only on increasing and maintaining share value leading to the collapse of these companies. This meant the loss of job of thousands of employees, losses for small shareholders, unpaid debt to suppliers and unfinished contracts due to the bankruptcy, and loss of public trust in shares investment that required the stringent Sarbanes-Oxley to provide security to various stakeholders. In addition, Enron formed special purpose entities (SPEs), which are external parties tasked to obtain investment from third parties by offering shares, with these investors eventually losing out in the end because of uncontrolled share offerings. WorldCom’s subsidiaries performed poorly and losses were pinned on customers through over billing and charges for services that customers never obtained. (Wearing, 2005)
Colley, J. L., Stettinius, W., Doyle, J. L., & Logan, G. (2005). What is corporate governance?. New York: McGraw-Hill.
Iwata, E. (2007, 7 September). Boardroom opens up to investor’s input. USA Today. Retrieved May 12, 2008, from http://www.usatoday.com/money/companies/management/2007-09-06-shareholders-fight_N.htm
Monks, R., & Minow, N. (2003). Corporate governance. Oxford: Blackwell Publishing.
Tirole, J. (2001). Corporate Governance. Econometrica, 69(1), 1–35.
Wearing , R. (2005). Cases in corporate governance. Thousand Oaks, CA: Sage Publications.