MODULE 1

Good Governance and Social Responsibility

SESSION TOPIC 1: The Corporation and Corporate Governance

LEARNING OUTCOMES:
At the end of this module, learners must be able to:
1. Review the basics of a corporation
2. explain the concepts of corporate governance
3. discuss the different theories in corporate governance
4. determine the environment of Philippine corporate governance
KEY POINTS

Corporation Governance Shareholder Stakeholder

Fraud Conflict of interest Principal-agent Transaction cost

CORE CONTENT
Introduction:

Individual freedom and institutional power rivalry is a continuing theme of history. Today, the debate is
about making corporate power compatible with the needs of a democratic society. The modern corporation has not
only created untold wealth and given individuals the opportunity to express their genius and develop their talents but
also has imposed costs on individuals and society. How to encourage the liberation of individual energy without
inflicting unacceptable costs on individuals and society, therefore, has emerged as a key challenge.

Corporate governance lies at the heart of this challenge. It deals with the systems, rules, and processes by
which corporate activity is directed. This module focuses on the concept on corporate governance by starting with a
brief review of basic information about corporation which were already discussed in your other business courses.
This module also covers the theories and elements of corporate governance. Furthermore, the environment of
Philippine corporate governance will be briefly discussed.

IN-TEXT ACTIVITY

I The Corporation
A corporation is an artificial being created by operation of law, having the right of succession and the powers,
attributes and properties expressly authorized by law or incident to its existence. In other words, it is a legal or
juridical person with a personality separate and apart from its individual members or stockholders, who as a natural
person, are merged in the corporate body. It is not actually a person but the law treats it as though it is a person.
As a consequence of this legal concept:
1. The corporation is not liable for the debts of its stockholders – the latter are not individually liable for the
corporation’s debts.
2. It may acquire and possess property of all kinds, as well as incur obligations and bring civil and criminal
actions in its own name
3) Property conveyed to or acquired by the corporation is in law the property of the corporation itself as a
distinct legal entity and not that of the members or stockholders.
4) All contracts entered into in its name by its regular appointed officers and agents are the contracts of the
corporation and not those of the members of stockholders.
5) Tax exemption granted to a corporation cannot be extended to include the dividends paid by such
corporation to its stockholders
6) A corporation has no personality to bring an action for and in behalf of its stockholders or members for the
purpose of recovering property which belongs to said stockholders.
7) An entity distinct from its members or stockholders, a corporation remains unchanged and unaffected in its
identity by changes in its individual members.

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 8) It has continuous existence since it would exist even if all the stockholders die.
Considering the corporation merely as an association of persons, or where there are 2 corporations, they will be
considered as one, the one being merely regarded as part or the instrumentality of the other. A corporation
functions for the benefit of a single person who has complete control over the funds and the said person is the sole
owner.The business channel of the owner and the property of the corporation may be considered the property of the
controlling stakeholder and may be seized in action against the latter.
A corporation is a mere instrumentality of the individual stockholders – the latter must individually answer for the
corporation obligations. To hold stockholders liable for the corporation obligations is not really to ignore the
corporation’s separate entity but merely to apply the established principle that such entity cannot be invoked.
ACTIVITY: Corporate Governance problem https://rb.gy/jxgwiy
Lesson learned from Corporate Scandals according to Prof. Aliza Racelis:

1. Some corporate executives will do almost anything to meet earnings, expectations and keep the firm’s stock
price stable or rising. Often, the goal is one on personal enrichment through the executives’ exercise of
options and sale of company’s stock.
2. The ethical climate in a firm is set by top management. Chief executive officers and chief financial officers
must establish and demand the integrity of the firm’s disclosure-both financial and non-financial.
3. Auditors and their clients can get too close. An auditor’s independence is a necessary condition for a
meaningful audit, and auditing firms need to take a close look at the relationship/s between a firm and its
external auditors.
4. Application of GAAP is subject to significant management discretion and forms must take their earnings
more transparent.
5. No matter how good or effective the accounting principles are, there is no way for accounting standards to
stop fraud. Auditors and SEC, however may be able to make some progress in reducing fraud.
6. Financial statements are only part of the information which investors need to evaluate a company’s past,
present and future. Over-reliance on a single amount-earnings per share-can be a disaster.

II Corporate Governance
A. Definition and Background
Several definitions of Corporate Governance
 “…refers to a system whereby shareholders, creditors and other stakeholders of a corporation ensure that
management enhances the value of the corporation as it competes in an increasingly global market place”
(Philippine SEC Code of Corporate Governance)
 “deals with the ways in which suppliers of finance to corporations assure themselves of getting a return on
their investment.” (Schleifer & Vishny, A Survey of Corporate Governance”, Journal of Finance, Vol. 52,
No.2 )
 …reflects and enforces the company’s values.

Governance is the rules and practices by which the board of directors ensures accountability, fairness and
transparency in its decision making. Why is it important? Good governance is a robust and reliable system for
making confident and timely decisions. Good governance gives members confidence in the decision making
process and lead to better decisions. It builds trust and respect between members and elected leaders and it
ensures ethical decision making. Below are some specific reasons why corporate governance is important:
1. It mitigates accounting scandal/fraud;
2. It helps in avoiding financial crises (referring to past experiences);
3. It serves as monitoring and control systems;
4. It helps in ensuring stability of the economy in general; and
5. It cater the need of globalization.

B. Elements of Corporate Governance

Governance determines who has a voice in making decisions, how those decisions are made, and who is
accountable. The rules for governing are defined in the associations’ by-laws and other governance documents.
Ultimately, however, it’s the norms and actions of the association’s leaders that determines the effectiveness of
governance. Here are the most important characteristics of good governance:

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 1. Accountable. Associations have an obligation to communicate, explain and answer to members for the
consequences of the decisions they made. Member should be able to follow and understand the
decision-making process including how and why a decision was made.
a. Follow the rules of law. Board decisions should be consistent with relevant legislation common
law and the association’s letter patent.
b. Responsive. Board of directors makes decisions based on what is best for the membership
which requires that they solicit and listen to their needs.
c. Effective and efficient. Associations should implement decisions, follow processes that make
the best use of resources available while mitigating risks.

ACTIVITY: Short Video ,https://rb.gy/66n8lx

C. Theories of Corporate Governance

For us to understand the relationship between fraud, earnings management, corporate governance and firm
performance, we need some concepts that may help us understand the behavior, motives and actions of the
corporate decision makers.

Shareholder Stakeholder
Theory Theory

Agency Transaction
Theory cost Theory
Corporate
Governance

Figure 1. Theories in Corporate Governance

1. Agency Theory
Agency theory concentrated on the relationship between agent and principal. Agent represent the
managers and shareholders are the principal. In this relationship, the principal appoints the agent for him to
make decisions in behalf of the principal. The agents are expected to protect the interest of the principal
and perform their duty diligently. They have to exercise their ability to maximize the shareholder’s wealth
and fulfill their expectations.

Principal-agent problems. Agency theory assumes that people in the market are rational which means managers,
shareholders, creditors, analysts, governments and all market players tend to make decisions that will enhance their
personal welfare or their personal benefit. Therefore, agency theory assumes that managers tend to be involved in
opportunistic behavior that potentially increases a firm’s agency cost (monitoring cost, boding cost, residual loss).
Here are the two basic principal-agent problems:
1. Conflict of interest-This may occur when agent acts to fulfill their own personal interest when making
decisions while ignoring the implications for shareholders. In this instance, agent tend to prioritize their
own self-interest rather than the interest of the principal. Self-interest motivate the agent to divert the

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 corporation’s resources to activities that are detrimental to the objectives of maximizing shareholder’s
wealth. Example could be agents paying higher bonuses, enjoying paid holidays, having a luxurious
office regardless of performance. The corporation pays for these perks which lead to the reduction of
shareholder’s wealth

2. Information asymmetry. This represents the gap of information between agent and principal. Agent
work in the firm everyday and are knowledgeable about all business transactions and affairs. Thus,
agent and or managers surely have more information about the firms rather than the principals. With
more information in their hands, managers therefore tend to make decisions that benefit themselves.
The shareholders depend on the information supplied to the through annual reports or firm’s website.

2. Shareholder theory
This theory views that the only duty of a corporation is to maximize the profits accruing to its
shareholders. This is the traditional view of the purpose of a corporation, since many people buy shares in a
company strictly in order to earn the maximum possible return on their funds. If a company were to do
anything not associated with earning a profit, the shareholder would either attempt to remove the board of
directors or would sell his shares and use the funds to buy shares in some other company that is more
committed to earning a profit.
Under shareholder theory, the only reason management is working on behalf of shareholders is to
deliver maximum returns to them, either in the form of dividends or an increased share price. Thus,
managers have an ethical duty to the owners to generate significant value.
To take this concept one step further, a corporation should not engage in any type of philanthropy,
since that is not its purpose. Instead, the corporation can deliver dividends to its shareholders, who then
have the option to donate the money for philanthropic purposes, if they choose to do so. The only case in
which a corporation should donate money is when the amount of the donation creates a benefit that is
approximately equivalent to or greater than the amount of the donation.
When a corporation is owned by just a few shareholders, any attempts by management to engage
in significant amounts of philanthropy can cause turmoil among the owners, if they are not all supportive of
this alternative use of company earnings.

3. Stakeholder Theory
This theory focuses on the role of firms in fulfilling the interest of all stakeholders, rather than
shareholders only. Stakeholder theory stipulates that a corporate firm or entity works to improve a balance
between the interests of its diverse stakeholders in such a way that each stakeholder receives some degree
of satisfaction. Companies have no longer sole responsibility towards their shareholders only but also to the
society in which they reside and operates in. Stakeholders of a company consists its employees,
customers, suppliers, shareholders, investors, creditors, government, banks and many more.
Stakeholder theory proposed that organizations are separate entities and they are connected with
many parties while achieving their targets. Therefore, it is management’s duty to make sensible decisions
and put their best efforts in attaining the benefits that satisfy all stakeholders.

4. Transaction Cost theory

This theory emerged from the agency theory of corporate governance. It is based on the principle that costs
will arise when you get someone else to do something for you (e.g. directors to run the business you own).
Transaction cost theory is an alternative variant of the agency understanding of governance assumptions. It
describes governance frameworks as being based on the net effects of internal and external transactions,
rather than as contractual relationships outside the firm (i.e. with shareholders).

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Figure 2. Types of cost (TCT)

Transaction costs will occur when dealing with another external party: Search and information costs: to find the
supplier; Bargaining and decision costs: to purchase the component; and Policing and enforcement costs: to
monitor quality.
The way in which a company is organized can determine its control over transactions, and hence costs. It is in
the interests of management to internalize transactions as much as possible, to remove these costs and the
resulting risks and uncertainties about prices and quality. For example a beer company owning breweries, public
houses and suppliers removes the problems of negotiating prices between supplier and retailer.
Transaction costs still occur within a company, transacting between departments or business units. The same
concepts of bounded rationality and opportunism on the part of directors or managers can be used to view the
motivation behind any decision. Opportunistic behaviour could have dire consequences on financing and strategy of
businesses, hence discouraging potential investors. Businesses therefore organize themselves to minimize the
impact of bounded rationality and opportunism as much as possible-Governance costs build up including internal
controls to monitor management.
Transaction cost theory and agency theory essentially deal with the same issues and problems. Where agency
theory focuses on the individual agent, transaction cost theory focuses on the individual transaction. Agency theory
looks at the tendency of directors to act in their own best interests, pursuing salary and status. Transaction cost
theory considers that managers (or directors) may arrange transactions in an opportunistic way.
The corporate governance problem of transaction cost theory is, however, not the protection of ownership rights
of shareholders (as is the agency theory focus), rather the effective and efficient accomplishment of transactions by
firms.
D. Philippine Corporate Governance
Dr. Elinda Echanis described the Philippine Corporate Governance and the factors affecting it.

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 Legal
System

Philippine
Regulatory Financial
Corporate
System Governance Reporting

JUdiciary
system

Figure 3. Philippine Corporate Governance Environment

1. Legal System. The legal system which represents the process of enforcing the law consists the
Corporation Code, Securities Regulation Code (R.A. 87990) which encourages widest participation of
ownership in enterprises and the filing of annual and periodic reports. This also includes the General
Banking law and Central bank Act.

2. Financial Reporting System. This is equivalent to the Philippine Generally Accepted Accounting
Principles or much known as GAAP. This is governed by the Securities and Exchange Commission
(SEC), and Financial Reporting Standards Council.

3. Regulatory System. This pertains to the rules and regulations issued by agencies that regulate such
as:
Securities and Exchange Commission (SEC)– corporate entities
Philippine Stock Exchange (PSE)-publicly-listed firms
Bangko Sentral ng Pilipinas (BSP)- financial institutions

4. Judiciary System. Philippine system of courts that applies the law in legal cases is now vested with
original jurisdiction to hear cases that used to be resolved by the SEC. Example: Acts of board of
director officers which are detrimental to the interest of the public or shareholders; controversies in the
election of appointments of directors, officers or managers of corporations, etc.

Most experts say-managers, SEC and academic researchers- that the most important component of
corporate governance is an ethical climate which top management set.

SESSION SUMMARY

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 A corporation is a legal or juridical person with a personality separate and apart from its individual members
or stockholders, who as a natural person, are merged in the corporate body. Governance is the rules and practices
by which the board of directors ensures accountability, fairness and transparency in its decision making. It builds
trust and respect between members and elected leaders and it ensures ethical decision making. Corporate
governance refers to a system whereby shareholders, creditors and other stakeholders of a corporation ensure that
management enhances the value of the corporation as it competes in an increasingly global market place
Corporate governance can be better understood through the different theories that explains how leaders
make decisions. These theories are: The Agency theory, The Shareholder Theory, The Stakeholders theory and the
Transaction cost theory.
Every country has its own corporate governance environment. In the Philippines, the basic components of
corporate governance are: the legal system, financial reporting system, regulatory system and the judiciary system.

SELF-ASSESSMENT

Guide Questions
1. Discuss and support your position on the debate that managers should run a corporation primarily or solely
in the interests of its legal owners—the shareholders (the shareholder perspective)—or should they actively
concern themselves with the needs of other constituencies (the stakeholder perspective).
2. Research a particular accounting or corporate scandal in the Philippines in the past and list down the
lessons that have been generated from such failures.

Note: Online chapter quiz will be sent through your LPU email.

REFERENCES

Shareholder Theory. Accouting Tools. Obtained from 2019/1/25/shareholder-theory rb.gy/nugx2n

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