Corporate governance and control in business firms

Corporate governance is the system by which profit making companies are directed and controlled. The board of directors of a company is responsible for the governance of the company. The role of shareholders in governance is to appoint the directors and the auditors and satisfy themselves that a suitable governance structure is in place. In the meantime, the responsibilities of the board include setting the company’s strategic goals, providing the leadership to put them into effect, overseeing the management of the entity, and reporting to shareholders on their stewardship. The actions taken by the board are always subject to laws, regulations and decisions taken by shareholders at general meetings.

Corporate governance involves a set of interactions between the management, board, shareholders and other stakeholders of a company. It addresses the prevention of the conflict of interests of stakeholders. A significant theme of corporate governance is the extent of accountability of people involved in the organization, and methods of reducing the principal agent conflicts. Click to read further about principal agent conflicts. In many countries, legislation is based on the theory that a board of directors represents the interest of the shareholders. But in practice it is often dominated by the executive management. Nevertheless, statutory control of corporate governance has been there for a long time and it has increased over time.

Due to the high profile collapses of large corporations such as Enron and WorldCom, there has been renewed interest in the corporate governance practices since 2001. Most of these collapses involved accounting fraud.

The Cadbury Report on Financial Aspects of Corporate Governance and OECD Principles of Corporate Governance (Organization for Economic Co-operation and Development) have emphasized the general principles around which companies are expected to operate to guarantee proper governance. The Sarbanes-Oxley Act of USA has attempted to legislate many of these principles recommended in the Cadbury and OECD reports. These include:

  • Companies should respect the rights of shareholders and help them to exercise their rights by effective communication of information and by encouraging them to participate in company general meetings.
  • Companies should recognize that they have obligations to other stakeholders, including employees, customers, suppliers, lenders, society and the government.
  • The board needs to have relevant skills and knowledge to review management performance and appropriate levels of independence and commitment.
  • In selecting corporate managers and directors, integrity should be considered as a fundamental requirement. A code of conduct should be developed by companies for their directors and managers to promote ethical and responsible decision making.
  • In order to provide stakeholders with a level of accountability, companies should declare the roles and responsibilities of directors and management. Companies should implement measures to independently verify and safeguard the integrity of the financial reports of the company. All investors have access to clear and factual information and in that material matters concerning the organization should be disclosed.

The recommendations on corporate governance in the Combined Code on Corporate Governance issued by London Stock Exchange in 2003 include:

  • The roles of Chairman and Chief Executive should in general be separate.
  • The board should include a balance of executive directors and non-executive directors.
  • Directors should not be involved in deciding own remuneration.
  • The performance related features of remuneration should form a substantial proportion of the total remuneration package of executive directors.
  • The board should form an audit committee to monitor the integrity of financial statements.
  • The board should maintain a comprehensive system of internal controls.
  • The board should use the annual general meeting to communicate to investors and boost their participation.

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