Theory of Governance

Joint Stock Company

 A joint stock company is a company which has issued shares.

 Joint stock companies started to form in 19th century.
 Shares of joint stock companies are traded in stock exchanges.
 Shareholders are the owners of the organizations and they delegate control
of the operations to professional managers (the board of directors) to run
the organizations on their behalf.
 Separation of ownership and control leads to a potential conflict of interest
between the directors and the shareholders.

What is corporate governance?

The system by which the companies are directed and controlled in the interests of
shareholders and other stakeholders.

Purpose/Use of corporate governance

The basic purpose of corporate governance is to monitor those parties within a

company which control the resources owned by investors.

Objective of corporate governance

The primary objective of sound corporate governance is to contribute to

improved corporate performance and accountability in creating long term
shareholder value.
Foundation to Governance

The foundation to governance is the action of the individuals. These actions are
guided by person’s moral stance.

Characteristics which are important in the development of an appropriate moral

stance include following,

Fairness

 A sense of equality in dealing with internal stakeholders

 A sense of even-handedness in dealing with external stakeholders
 An ability to reach an equitable judgment in a given ethical situation

Openness/Transparency

 The creation of a transparent relationship with shareholders through

development of appropriate accounting systems and standards to facilitate
this openness.
 Lack of withholding relevant information unless necessary.
 Transparency in strategic decision making to assist in the development of
an appropriate culture within the company.

Independence

 Independence from personal influence of senior management for non-

executive directors (NEDs).
 Independence of the board from operational involvement.
 Independence of directorship from evident personal motivation since the
organization should be run for the benefit of its owner.

Probity/honesty.

 Honesty in financial/positional reporting

 Perception of honesty of the finance from internal and external
stakeholders
Responsibility

 Willingness to accept liability for the outcome of governance decisions

 Clarity in the definition of roles and responsibilities for action
 Careful business and personal behavior

Accountability

 Accounting for business position as a result of acceptance of responsibility.

 Providing clarity in communication channels with internal and external
stakeholders.
 Development and maintenance of risk management and control.

Reputation

 Developing and sustaining personal reputation through other moral virtues

 Developing and sustaining the moral stance of the organization
 Developing and sustaining the moral stance of the accounting profession

Judgment

 The ability to reach and communicate meaningful conclusions

 The ability to weigh numerous issues and give each due consideration
 The development of a non-judgmental approach to business and personal
relationships

Is governance relevant to all companies???

 Corporate governance is a matter of great importance for large public

companies, where the separation of ownership from management is much
wider than for small private companies.
 Public companies raise capital on the stock markets, and institutional
investors hold vast portfolios of shares and other investments. Investors
need to know that their money is reasonably safe.
 Should there be any doubt about the integrity or intentions of the
individuals in charge of a public company, the value of the company’s
 shares will be affected and the company will have difficulty raising any new
capital should it wish to do so.
 The scope of corporate governance for private and not-for-profit
organizations will be much reduced when compared with a listed company,
especially as there are no legal or regulatory requirements to comply with.
 The ownership and controls are different in public and private companies,
therefore focus may be different from a listed company. However, many of
the governance principles will still be applicable to other entities.
 In not-for-profit organizations, a key governance focus will be to
demonstrate to existing and potential fund providers that money is being
spent in an appropriate manner, in line with the organizations’ objectives.

Large listed Private company Not-for-profit

company organization
Primary Shareholders and Shareholders Fund providers,
accountability regulators regulators, general
public
Principal Shareholders Shareholders Donors, grant
stakeholders providers,
regulators, general
public
Main methods of Financial Financial Financial
monitoring statements statements statements, other
performance financial and non-
financial measures
Governance/ Executive and Executive Volunteer
board structure NEDs, directors. trustees, paid and
appointment Appointment may unpaid
through formal be the result of management
process in line shareholding or team.
with governance other recruitment Appointments
requirements processes. through
recruitment, word
of mouth, or
election process
Openness and In line with Limited disclosure Limited
transparency corporate requirements requirements but
governance large demand due
requirements to methods of
funding

Corporate governance stakeholders

“Any person or group that can affect or be affected by the policies or activities of
an organization”

Internal corporate governance stakeholders

Stakeholder Operational role Corporate Main interest in the

governance role company
Directors Responsible for Control company • Pay
the actions of the in the best • Performance
corporation interest of the linked bonuses
stakeholders • Share options
• Status
• Reputation
• Power
Company Ensure Advise board on • Pay
secretary compliance with corporate • Performance
company governance linked bonuses
legislation and matters • Job stability
regulations and • Career progress
keep board • Status
members • Working hours
informed of their
legal
responsibilities
Management Run business • Identify and
operations. evaluate
Implement board risks faced
policies by the
company.
• Enforce
 controls.
• Monitor
success.
• Report
concerns.
Employees Carryout orders Comply with
of management internal control.
Report breaches.
Employee Protect Highlight and take • Power
representatives employee action against • Status
(unions) interests. breaches in
governance
requirement
(protection of
whistleblowers)

External corporate governance stakeholders

External party Main role Interests and claims

incompany
Auditors Independent review of Fees
company’s reported Reputation
financial statements. Quality of relationship
Compliance with audit
requirements
Regulators Implementing and Compliance with
monitoring regulations regulations
Effectiveness of
regulations
Government Implementing and Compliance with laws
maintaining laws with Payment of taxes
which all companies must Level of employment
comply Levels of imports/exports
Stock exchange Implementing and Compliance with rules
maintaining rules and and regulations
regulations for companies Fees
listed on the exchange
Institutional investors Through considered use Value of shares and
of their votes can (and dividend payments
should) beneficiallySecurity of funds invested
influence corporate Timeliness of information
policies received from company
Shareholder rights are
observed
Small investors Limited power with use of Maximization of
vote shareholder value

Agency Theory

 Agency relationships occur when one party, the principal, employs another
party, the agent, to perform a task on his behalf.
 Shareholders (principal) trust the directors (agents) to run the company in
their best interests. A fiduciary relationship exists between the principal
and the agent.
 Agency theory examines the duties and conflicts that occur between parties
who have an agency relationship.

Key concepts of agency theory

 An agent is employed by a principal to carry out a task on their behalf

 Agency refers to the relationship between a principal and their agent
 Agency costs are incurred by principals in monitoring agency behavior
 By accepting to undertake a task on their behalf, an agent becomes
accountable to the principal by whom they are employed. The agent is
accountable to that principal
 Directors (agents) have a fiduciary responsibility to the shareholders
(principal) of their organization (usually described through company law as
‘operating in the best interests of the shareholders’.)
 Stakeholders are any person or group that can affect or be affected by the
policies or activities of an organization
  Agent objectives (such as a desire for high salary, large bonus and status)
will differ from the principal’s objectives (wealth maximization for
shareholders)

 Shareholders and auditors-principal agent relationship

Agency costs

Agency costs arise largely from principals monitoring activities of agents, and may
be viewed in monetary terms, resources consumed or time taken in monitoring.
Examples of agency costs are as follows,

 Incentive schemes and remuneration packages for directors

 Costs of management providing annual report data such as committee
activity and risk management analysis, and cost of principal reviewing this
data
 Cost of meetings with financial analysts and principal shareholders
 Cost of monitoring behavior, such as by establishing management audit
procedures

Agent accountability

Accountability relates to:

 The need to act in shareholders’ interest

 The need to provide good information such as audited accounts and annual
reports
 The need to operate within a defined legal structure

• Directors are accountable to shareholders

• Directors must prove that they are discharging their responsibilities in line
with shareholder expectations in the form of financial results, a clean audit
report and reported compliance with the codes of corporate governance
 • If the shareholders do not like what they see, they ultimately have the
power to remove the directors and replace them

Other accountabilities within a company

 Managers to directors
 Employees to managers
 Management to creditors
 Auditors to shareholders