MODULE 2

Corporate Governance Fundamentals

Introduction
Over the last several years, the external environment in which public
companies operate has become increasingly complex for companies and
shareholders alike. The increased regulatory burdens imposed on public companies
in recent years have added to the costs and complexity of overseeing and managing
a corporation’s business and bring new challenges from operational, regulatory and
compliance perspectives. In addition, many public companies have a global profile;
they interact with investors, suppliers, customers, and government regulators around
the world and do so in an era in which instant communication is the norm, (Harvard
Law School Forum on Corporate Governance). This presents the basics of corporate
governance.

Learning Objectives

After studying this module, you should be able to:

1. Understand the concept of governance
2. Know the various models of corporate governance
3. Categorize the theories affecting corporate governance development
scenarios.
4. Know the guiding principles of corporate governance
5. Describe the importance of shareholders and stakeholders’ role in corporate
governance
6. Identify the different responsibilities of stakeholders

Learning Content

The concept of "governance" is not new. However, it means different things to

different people, therefore we must get our focus right. The actual meaning of the
concept depends on the level of governance we are talking about, the goals to be
achieved and the approach being followed.
The concept has been around in both political and academic discourse for a long
time, referring in a generic sense to the task of running a government, or any other
appropriate entity for that matter. In this regard the general definition provided by
Webster's Third New International Dictionary (1986:982) is of some assistance,
indicating only that governance is a synonym for government, or "the act or process of
governing, specifically authoritative direction and control". This interpretation specifically
focuses on the effectiveness of the executive branch of government.
The working definition used by the British Council, however, emphasizes that
"governance" is a broader notion than government (and for that matter also related
concepts like the state, good government and regime), and goes on to state:
"Governance involves interaction between the formal institutions and those in civil
society. Governance refers to a process whereby elements in society wield power,
authority and influence and enact policies and decisions concerning public life and
social upliftment."

Figure 1. Urban Actors

"Governance", therefore, not only encompasses but transcends the collective
meaning of related concepts like the state, government, regime, and good government.
Many of the elements and principles underlying "good government" have become an
integral part of the meaning of "governance". John Healey and Mark Robinson define
"good government" as follows: "It implies a high level of organizational effectiveness in
relation to policy-formulation and the policies actually pursued, especially in the conduct
of economic policy and its contribution to growth, stability and popular welfare. Good
government also implies accountability, transparency, participation, openness, and the
rule of law. It does not necessarily presuppose a value judgement, for example, a
healthy respect for civil and political liberties, although good government tends to be a
prerequisite for political legitimacy".
Governance can be used in several contexts such as corporate governance,
international governance, national governance, and local governance. Since
governance is the process of decision making and the process by which decisions are
implemented, an analysis of governance focuses on the formal and informal actors
involved in decision-making and implementing the decisions made and the formal and
informal structures that have been set in place to arrive at and implement the decision.
 Government is one of the actors in governance. Other actors involved in
governance vary depending on the level of government that is under discussion. In rural
areas, for example, other actors may include influential landlords, associations of
peasant farmers, cooperatives, NGOs, research institutes, religious leaders, finance
institutions political parties, the military etc. The situation in urban areas is much more
complex. Figure 1 provides the interconnections between actors involved in urban
governance. At the national level, in addition to the above actors, media, lobbyists,
international donors, multi-national corporations, etc. may play a role in decision making
or in influencing the decision-making process.
Corporate Governance
From the academic standpoint, corporate governance is seen as one that
addresses “the problems that result from the separation of ownership and control.”
Viewed from this perspective, corporate governance focusses on some structures and
mechanisms that would ensure a proper internal structure and the rules of the board of
directors; the creation of independent committees; the rules for disclosure of information
to shareholders and creditors; a transparency of operations and an impeccable process
of decision-making and the control of management.
A recent academic survey of corporate governance defined it as follows:
“Corporate governance deals with the ways in which suppliers of finance to corporations
assure themselves of getting a return for their investment. How do the suppliers of
finance get the managers to return some of the profits to them? How do they make sure
that the managers do not steal the capital they supply or invest it in bad projects? How
do suppliers of finance control the managers?”
From this point of view, the corporate governance tends to focus on a simple model:
1. Shareholders elect directors who represent them. – Participation, Equity and
Inclusiveness
2. Directors vote on key matters and adopt the majority decision. - Consensus
3. Decisions are made in a transparent manner so that the shareholders and
others can hold directors accountable. – Transparency and Accountability
4. The company adopts the accounting standards to generate the information
necessary for directors, investors, and other stakeholders to make decisions. –
Effectivity and Efficiency
5. The company’s policies and practices adhere to applicable national, state, and
local laws. – Rule of Law, Responsiveness
A McKinsey & Company Report published in 2001 under the title “Giving New
Life to the Corporate Governance Reform Agenda for Emerging Markets” suggests that
by using a two-version “governance” chain model, we can illustrate the governance
practices throughout the world.
 Model 1
In the first version of McKinsey’s model called “The Market Model” governance
chain, there are efficient, well-developed equity markets and dispersed ownership,
something common in the developed industrial nations such as the US, the UK, Canada
and Australia. Corporate governance is basically how companies deal fairly with
problems that arise from “separation of ownership and effective control.” This model
illustrates conditions and governance practices that are better understood and
appreciated and as such highly valued by sophisticated global investors.

The “Market Model” governance Chain

Model 2
In the second version of McKinsey’s model called “The Control Model,”
governance chain is represented by underdeveloped equity markets,
concentrated(family) ownership, less shareholder transparency and inadequate
protection of minority and foreign shareholders, a paradigm more familiar in Asia, Latin
America and some east European nations. In such transitional and developing
economies there is a need to build, nurture and grow supporting institutions such as a
strong and efficient capital market regulator and judiciary to enforce contracts or protect
property rights.

The “Control Model” Governance Chain

Theories of Corporate Governance
Though the concept of modern corporate governance is of recent origin, it was
deeply rooted in the corporate history from the days the corporate form of business
establishments began. As this form of business passed through several stages of its
growth to the present form, corporate governance also passed through different stages
to reach the present form. The subject of corporate governance is based on strong
theoretical foundation derived from several disciplines as finance, economic,
accounting, management, law, organizational behavior, etc. As such it is
multidisciplinary in nature. It can be observed that though legally corporate form of
business has unidimensional characteristics all over the world now, the governance
system prevailing in different countries are multi-dimensional in nature.
Theoretical base upon which the corporate governance has been developed
plays a significant role in the type of corporate governance in a country. Economic
system, political system and governance, path dependency, resource dependency and
institutional environment also play a dominant role in corporate governance.
Agency Theory
Agency theory identifies the agency relationship where one party (the principal)
delegates work to another party (the agent). In the context of corporations and issues of
corporate control, agency theory views corporate governance mechanisms, especially
the board of directors, as being an essential monitoring device to try to ensure that any
problems that may be brought about by the principal–agent relationship are minimized.
Blair (1996) states:
Managers are supposed to be the ‘agents’ of a corporation’s
‘owners’, but managers must be monitored, and institutional
arrangements must provide some checks and balances to make
sure they do not abuse their power. The costs resulting from
managers misusing their position, as well as the costs of
monitoring and disciplining them to try to prevent abuse, have been
called ‘agency costs’.
Much of agency theory as related to corporations is set in the context of the
separation of ownership and control as described in the work of Berle and Means
(1932). In this perspective, the agents are the managers and the principals are the
shareholders, and this is the most cited agency relationship in the corporate governance
context. However, it is useful to be aware that the agency relationship can also cover
various other relationships, including those of company and creditor, and of employer
and employee.
Separation of Ownership and Control
The potential problems of the separation of ownership and control were identified
in the eighteenth century by Smith: ‘the directors of such companies [joint stock
companies] however being the managers rather of other people’s money than of their
own, it cannot well be expected that they should watch over it with the same anxious
vigilance [as if it were their own]’. However, in many countries, especially where there is
a code of civil law as opposed to common law, the protection of minority shareholders is
not effective and so there has been less impetus for a broad shareholder base.
In the last few years, there has been increasing pressure on shareholders, and
particularly on institutional shareholders who own shares on behalf of the ‘man in the
street’, to act more as owners and not just as holders of shares. The drive for more
effective shareholders, who act as owners, has come about because there have been
numerous instances of corporate excesses and abuses, such as perceived
overpayment of directors for poor performance, corporate collapses, and scandals,
which have resulted in corporate pension funds being wiped out, and shareholders
losing their investment. The call for improved transparency and disclosure, embodied in
corporate governance codes and in International Accounting Standards (IASs), should
improve the information asymmetry situation so that investors are better informed about
the company’s activities and strategies.
Once shareholders do begin to act like owners again, then they will be able to
exercise a more direct influence on companies and their boards, so that boards will be
more accountable for their actions and, in that sense, the power of ownership will be
returned to the owners (the shareholders). However, that institutional investors will
ultimately become accountable to the millions of ultimate owners who may come to
question the policies of the new powers that be. Then the questions may expand from
whether the professional money managers are achieving maximum private return to
whether they are fostering maximum public good. Their demands for downsizing and
single-minded focus on shareholder benefits—whatever the costs—may come to
constitute a new target of ownership challenge (Useem, 1996).
Transaction Cost Economics (TCE)
Unlike the Agency Theory, the transaction cost theory explicitly uses the concept
of corporate governance. This theory states that the company is a relatively efficient
hierarchical structure that serves as framework to run the contractual relationships. The
main concern in transaction cost theory is to explain the transactions conducted in
terms of efficiency of governance structures. This theory was first initiated by Cyert and
March (1963) and later it was described and exposed by Williamson (1996). The
Transaction cost theory was interdisciplinary in nature covering the disciplines of law,
economics and organizations. This theory attempts to view the firm as an organization
comprising people with different views and objectives.
TCE views the firm as a governance structure whereas agency theory views the
firm as a nexus of contracts. Essentially, the latter means that there is a connected
group or series of contracts amongst the various players, arising because it is
seemingly impossible to have a contract that perfectly aligns the interests of principal
and agent in a corporate control situation.
As firms have grown in size, whether caused by the desire to achieve economies
of scale, by technological advances, or by the fact that natural monopolies have
evolved, they have increasingly required more capital, which has needed to be raised
from the capital markets and a wider shareholder base has been established. The
problems of the separation of ownership and control, and the resultant corporate
governance issues have thus arisen.
In other words, there are certain economic benefits to the firm itself to undertake
transactions internally rather than externally. In its turn, a firm becomes larger the more
transactions it undertakes and will expand up to the point where it becomes cheaper or
more efficient for the transaction to be undertaken externally. Coase (1937) therefore
posits that firms may become less efficient the larger they become; equally, he states
that ‘all changes which improve managerial technique will tend to increase the size of
the firm’.
Stiles and Taylor (2001) point out that ‘both theories [TCE and agency] are
concerned with managerial discretion, and both assume that managers are given to
opportunism (self-interest seeking) and moral hazard, and that managers operate under
bounded rationality . . . [and] both agency theory and TCE regard the board of directors
as an instrument of control’. In this context, ‘bounded rationality’ means that managers
will tend to satisfice rather than maximize profit (this, of course, not being in the best
interests of shareholders).
Stakeholder Theory
Stakeholder theory takes account of a wider group of constituents rather than
focusing on shareholders. A consequence of focusing on shareholders is that the
maintenance or enhancement of shareholder value is paramount, whereas when a
wider stakeholder group—such as employees, providers of credit, customers, suppliers,
government, and the local community—is taken into account, the overriding focus on
shareholder value becomes less self-evident. Nonetheless, many companies do strive
to maximize shareholder value whilst at the same time trying to consider the interests of
the wider stakeholder group. One rationale for effectively privileging shareholders over
other stakeholders is that they are the recipients of the residual free cash flow (being
the profits remaining once other stakeholders, such as loan creditors, have been paid).
This means that the shareholders have a vested interest in trying to ensure that
resources are used to maximum effect, which in turn should be to the benefit of society.
The theory is grounded in many normative theoretical perspectives including the
ethics of care, the ethics of fiduciary relationships, social contract theory, theory of
property rights, theory of the stakeholders as investors, communitarian ethics, critical
theory, etc. While it is possible to develop stakeholder analysis from a variety of
theoretical perspectives, in practice much of stakeholder analysis does not firmly or
explicitly root itself in a given theoretical tradition, but rather operates at the level of
individual principles and norms for which it provides little formal justification. Insofar as
stakeholder approaches uphold responsibilities to non-shareholder groups, they tend to
be in some tension with the Anglo-American model of corporate governance, which
generally emphasizes the primacy of “fiduciary obligations” owed to shareholders over
any stakeholder claims.
An interesting development is that put forward by Jensen (2001), who states that
traditional stakeholder theory argues that the managers of a firm should take account of
the interests of all stakeholders in a firm but, because the theorists refuse to say how
the trade-offs against the interests of each of these stakeholder groups might be made,
there are no defined measurable objectives and this leaves managers unaccountable
for their actions. Jensen therefore advocates enlightened value maximization, which he
says is identical to enlightened stakeholder theory: ‘Enlightened value maximization
utilizes much of the structure of stakeholder theory but accepts maximization of the
long-run value of the firm as the criterion for making the requisite trade-offs among its
stakeholders and therefore solves the problems that arise from multiple objectives that
accompany traditional stakeholder theory’.
Managers accomplish their organizational tasks as efficiently as possible by
drawing on stakeholders as a resource. This is in effect a “contract” between the two,
and one that must be equitable for both parties to benefit.
Stewardship Theory
The Stewardship Theory of corporate governance discounts the possible
conflicts between corporate management and owners and shows a preference for a
board of directors made up primarily of corporate insiders. This theory assumes that
managers are basically trustworthy and attach significant value to their own personal
reputations. The market for managers with strong personal reputations serves as the
primary mechanism to control behavior, with more reputable managers being offered
higher compensation packages. Financial reporting, disclosure and auditing are still
important mechanisms, but there is a fundamental presumption that these mechanisms
are needed to confirm managements’ inherent trustworthiness.
This emphasis on the responsibility of the board to shareholders in the Anglo–
Saxon model of corporate governance in terms of stewardship and trusteeship is
nowhere better articulated than in the Canadian guidelines. It is stated therein:
“Stewardship refers to the responsibility of the board to oversee the conduct of the
business and to supervise management which is responsible for the day-to-day conduct
of the business. In addition, as stewards of the business, the director’s function as the
catch-all to ensure no issue affecting the business and affairs of the company falls
between cracks.” Similar views, though differently told, predominate in corporate
governance guidelines of many countries of the world.
 Though the Agency and the Stewardship Theories have something in common,
there are certain basic differences. The tables set out below summarizes the main
differences between the two theories.
Behavioral Differences

Phycological Means

Situational Mechanism

(Adapted from “Development of Corporate Governance System:

Agency Theory Versus Stewardship Theory in Welsh Agrarian
Cooperative Societies” by, Dr. Alfonso Vargas Sanchez.)
Other Corporate Governance Theories
Managerial hegemony and class hegemony theories highlight the potential for a
gap between what boards are expected to do and what they do in
practice. Mace (1971) points out that managers may circumvent control
away from the board by various means, including information asymmetry
and elite networks. Huse (2007) made a significant contribution to the
thinking on how research into boards and board behavior might be carried
out by applying lessons from the behavioral theory of the firm.
Resource dependence theory views the board of directors as ‘the lynch pin
between a company and the resources it needs to achieve its objectives’
(Tricker, 2009, 2012).
Path dependence theory identifies two sources of path dependence: structure
driven and rule driven, pointing out that corporate structures depend on
the structures with which the economy started: ‘Initial ownership structures
can affect both the identity of the rules that would be efficient and the
interest group politics that can determine which rules would actually be
chosen’ (Bebchuk and Roe, 1999).
Institutional theory looks at the institutional environment, its influence on societal
beliefs and practices which impact on various ‘actors’ within society (Scott,
1987).
Political theory is identified as having a deep influence on different ownership
and governance structures (Roe, 2003).
Network governance building on the work of Jones et al. (1997), Turnbull
advocated the adoption of network governance as a logical way to extend
the science of cybernetics to organizations. Pirson and Turnbull (2011)
argue that companies should have a structure of network governance and
suggest ‘increasing board level information processing and decision-
making capabilities by including multiple boards for different stakeholders
to create a division of power and labor’ which would allow superior risk
management.
Guiding Principles of Corporate Governance
1. The board approves corporate strategies that are intended to build sustainable
long-term value; selects a chief executive officer (CEO); oversees the CEO and
senior management in operating the company’s business, including allocating
capital for long-term growth and assessing and managing risks; and sets the
“tone at the top” for ethical conduct.
2. Management develops and implements corporate strategy and operates the
company’s business under the board’s oversight, with the goal of producing
sustainable long-term value creation.
 3. Management, under the oversight of the board and its audit committee, produces
financial statements that fairly present the company’s financial condition and
results of operations and makes the timely disclosures investors need to assess
the financial and business soundness and risks of the company.
4. The audit committee of the board retains and manages the relationship with the
outside auditor, oversees the company’s annual financial statement audit and
internal controls over financial reporting, and oversees the company’s risk
management and compliance programs.
5. The nominating/corporate governance committee of the board plays a leadership
role in shaping the corporate governance of the company, strives to build an
engaged and diverse board whose composition is appropriate in light of the
company’s needs and strategy, and actively conducts succession planning for
the board.
6. The compensation committee of the board develops an executive compensation
philosophy, adopts and oversees the implementation of compensation policies
that fit within its philosophy, designs compensation packages for the CEO and
senior management to incentivize the creation of long-term value, and develops
meaningful goals for performance-based compensation that support the
company’s long-term value creation strategy.
7. The board and management should engage with long-term shareholders on
issues and concerns that are of widespread interest to them and that affect the
company’s long-term value creation. Shareholders that engage with the board
and management in a manner that may affect corporate decision making or
strategies are encouraged to disclose appropriate identifying information and to
assume some accountability for the long-term interests of the company and its
shareholders as a whole. As part of this responsibility, shareholders should
recognize that the board must continually weigh both short-term and long-term
uses of capital when determining how to allocate it in a way that is most
beneficial to shareholders and to building long-term value.
8. In making decisions, the board may consider the interests of all of the company’s
constituencies, including stakeholders such as employees, customers, suppliers
and the community in which the company does business, when doing so
contributes in a direct and meaningful way to building long-term value creation

Shareholders and Stakeholders

The term ‘stakeholder’ can encompass a wide range of interests: it refers to any
individual or group on which the activities of the company have an impact. Shareholders
can be viewed as a stakeholder group but, for the purposes of this discussion, we will
view shareholders as being distinct from other stakeholder groups. Why? First,
shareholders invest their money to provide risk capital for the company and, secondly,
in many legal jurisdictions, shareholders’ rights are enshrined in law whereas those of
the wider group of stakeholders are not. Of course, this varies from jurisdiction to
jurisdiction, with creditors’ rights strongly protected in some countries, and employee
rights strongly protected in others.
The simplest definition of a shareholder seems straightforward enough: an
individual, institution, firm, or other entity that owns shares in a company. Of course, the
reality of the situation can be much more complicated with beneficial owners and
crossholdings making the chain of ownership complex. Shareholders’ rights are
generally protected by law, although the extent and effectiveness of this protection
varies from country to country.
There are various stakeholder groups that may have an interest in a company’s
performance and activities. Stakeholders include employees, suppliers, customers,
banks, and other creditors; the government; various ‘interest’ groups, for example,
environmental groups; indeed, anyone on whom the activities of the company may have
an impact.
Shareholders—The Prime Stakeholders:
Being the contributors of capital, the shareholders are the prime stakeholders.
They are engaged in the economic transactions with the organization and become the
residual owners of the company. In the words of the Birla Committee on Corporate
Governance, ‘The shareholders are the primary stakeholders hence, the report primarily
focused on shareholders. The Committee recognizes that the fundamental objective of
corporate governance is the enhancement of shareholder value, keeping in view the
interests of other stakeholder’.
Stakeholder Group. There are various
stakeholder groups: some directly related
to the company, such as employees,
providers of credit, suppliers and
customers; others more indirectly related
to the company, such as the local
communities of the towns or cities in
which it operates; environmental groups;
and the government. Looking at each of
these in turn, we can clarify the interest
that each group might have as a
stakeholder.
Employees
The employees of a company
have an interest in the company because
it provides their livelihood in the present
day and, at some future point, employees will often also be in receipt of a pension
provided by the company’s pension scheme. In terms of present-day employment,
employees will be concerned with their pay and working conditions, and how the
company’s strategy will impact on these. Of course, the long-term growth and prosperity
of the company is important for the longer-term view of the employees, particularly as
concerns pension benefits in the future.
Most companies include, in their annual report and accounts, a statement or
report to the employees stating in what ways they are looking after the employees’
interests. The report will usually mention training programs, working conditions, and
equal opportunities. Many companies have employee share schemes that give the
employees the opportunity to own shares in the company, and feel more of a part of it;
the theory being that the better the company performs (through employees’ efforts,
etc.), the more the employees themselves will benefit as their shares increase in price.
Companies need also to consider and work with the employees’ trade unions,
recognizing that a good relationship with the unions is desirable. The trade unions may,
amongst other things, act as a conduit for company employee information
dissemination, or be helpful when trying to ascertain the employees’ views. Increasingly,
trade unions are exerting their influence, via the pension funds, pressing for change by
use of their voting rights.
Providers of Credit
These include banks and other financial institutions. Providers of credit want to
be confident that the companies to which they lend are going to be able to repay their
debts. They will seek assurance from the annual report and accounts, and from various
management accounts and forecasts that companies produce. It is in the company’s
best interests to maintain the confidence of providers of finance to ensure that no calls
are made for repayment of funds, that they are willing to lend to the company in the
future, and that the company is able to borrow at the best possible rate.
Suppliers
These stakeholders have an interest in the companies that they supply on two
grounds. First, having supplied the company with goods or services, they want to be
sure that they will be paid for these and in a timely fashion. Secondly, they will be
interested in the continuance of the company because they will wish to have a
sustainable outlet for their goods and services.
Sometimes, suppliers will be supplying specialized equipment or services and, if
the company it supplies has financial difficulties, then this can have a severe impact on
the supplier as well. Of course, on an ongoing basis, suppliers of goods and services
will also like to be paid on time because otherwise they will have problems with their
own cash flow and meeting their own costs, such as labor and materials, incurred in
supplying the company in the first place. So, ideally, the companies supplied will treat
their suppliers with understanding and ensure that they settle their debts on time. In
practice, many large companies will make their suppliers wait for payment, occasionally
for such a length of time that the supplier either ends up with severe financial difficulties
or refuses to supply the company in future.
Customers
A company’s customers will want to try to make sure that they can buy the same
product time and again from the company. The company itself will presumably be
building up its customer loyalty through various marketing exercises, and customers
themselves will get used to a familiar product that they will want to buy in the future.
Sometimes, a product bought from one company will become part of a product made by
the customer, and again it will be important for the customer to be assured that they can
continue to buy and incorporate that product into their own production.
Increasingly, customers are also more aware of social, environmental, and
ethical aspects of corporate behavior and will try to ensure that the company supplying
them is acting in a corporately socially responsible manner.
Local Communities
Local communities have several interests in the companies that operate in their
region. First, the companies will be employing large numbers of local people and it will
be in the interest of sustained employment levels that companies in the locality operate
in an efficient way. Should the company’s fortunes start to decline, then unemployment
might rise and may lead to part of the workforce moving away from the area to seek
jobs elsewhere. This, in turn, would influence local schools, as the number of pupils
declined, and the housing market would be hit too, as demand for housing in the area
declined. However, local communities will also be concerned that companies in the area
act in an environmentally friendly way because the last thing they want is pollution in
local rivers, in the soil, or in the atmosphere more generally. It is therefore in the local
community’s interest that companies in their locality continue to thrive but do so in a
way that takes account of local and national concerns.
Environmental Groups
These stakeholder groups will seek to ensure that companies operate to both
national and international environmental standards such as the Ceres Principles and the
Global Reporting Initiative Sustainability Guidelines. Increasingly, environmental issues
are viewed as part of the mainstream rather than being at the periphery as a ‘wish list’.
The recognition that an environmentally responsible company should also, in the longer
term, be as profitable, if not more so, as one that does not act in an environmentally
responsible way is in many ways self-evident. An environmentally responsible company
will not subject its workers to potentially hazardous processes without adequate
protection (which unfortunately does still happen despite the best endeavors of health
and safety regulations); will not pollute the environment; and will, where possible, use
recyclable materials or engage in a recycling process. Ultimately, all these things will
benefit society at large and the company itself.
Government
The government has an interest in companies for several diverse reasons. First,
as with the local and environmental groups—although not always with such commitment
—it will try to make sure that companies act in a socially responsible way, taking
account of social, ethical, and environmental considerations. Secondly, it will analyze
corporate trends for purposes such as employment levels, monetary policy, and market
supply and demand of goods and services. Lastly, but not least, it will be looking at
various aspects to do with fiscal policy, such as capital allowances, incentives for
investing in various industries or various parts of the country, and, of course, the
taxation raised from companies.
Unitary Board VS Dual Board
A major corporate governance difference between countries is the board
structure, which may be unitary or dual depending on the country. As in the UK, in most
of the EU Member States, the unitary board structure is predominant (in five states, the
dual structure is also available). However, in Austria, Germany, the Netherlands, and
Denmark, the dual structure is predominant. In the dual structure, employees may have
representation on the supervisory board but this may vary from country to country.
Unitary Board
A unitary board of directors is the form of board structure in the UK and in
the USA and is characterized by one single board comprising both
executive and non-executive directors. The unitary board is responsible
for all aspects of the company’s activities, and all the directors are working
to achieve the same ends. The shareholders elect the directors to the
board at the company’s annual general meeting (AGM).
Dual Board
A dual board system consists of a supervisory board and an executive
board of management. However, in a dual board system, there is a clear
separation between the functions of supervision (monitoring) and that of
management. The supervisory board oversees the direction of the
business, whilst the management board is responsible for the running of
the business. Members of one board cannot be members of another, so
there is a clear distinction between management and control.
Shareholders appoint the members of the supervisory board (other than
the employee members), whilst the supervisory board appoints the
members of the management board.
There are many similarities in board practice between a unitary and a dual board
system. The unitary board and the supervisory board usually appoint the members of
the managerial body: the group of managers to whom the unitary board delegates
authority in the unitary system and the management board in a dual system. Both
bodies usually have responsibility for ensuring that financial reporting and control
systems are operating properly and for ensuring compliance with the law.
Usually, both the unitary board of directors and the supervisory board (in a dual
system) are elected by shareholders (in some countries, such as Germany, employees
may elect some supervisory board members).
Advocates of each type of board structure identify their main advantages as: in a
one-tier system, there is a closer relationship and better information flow as all directors,
both executive and non-executive, are on the same single board; in a dual system,
there is a more distinct and formal separation between the supervisory body and those
being ‘supervised’, because of the separate management board and supervisory board
structures. However, whether the structure is unitary or dual, many codes seem to have
a common approach to areas relating to the function of boards and key board
committees, to independence, and to the consideration of shareholder and shareholder
rights.
The Board of Directors (OECD Principles of Corporate Governance, 2015)
The board is chiefly responsible for monitoring managerial performance and
achieving an adequate return for shareholders, while preventing conflicts of interest and
balancing competing demands on the corporation. For boards to effectively fulfil their
responsibilities they must be able to exercise objective and independent judgement.
Another important board responsibility is to oversee the risk management system and
systems designed to ensure that the corporation obeys applicable laws, including tax,
competition, labor, environmental, equal opportunity, health and safety laws. In some
countries, companies have found it useful to explicitly articulate the responsibilities that
the board assumes and those for which management is accountable.
The board is not only accountable to the company and its shareholders but also
has a duty to act in their best interests. In addition, boards are expected to take due
regard of, and deal fairly with, other stakeholder interests including those of employees,
creditors, customers, suppliers, and local communities. Observance of environmental
and social standards is relevant in this context. The following are the duties and
responsibilities of the board:
a. Board members should act on a fully informed basis, in good faith, with
due diligence and care, and in the best interest of the company and the
shareholders.
b. Where board decisions may affect different shareholder groups differently,
the board should treat all shareholders fairly.
c. The board should apply high ethical standards. It should take into account
the interests of stakeholders.
d. The board should fulfil certain key functions, including:
 Reviewing and guiding corporate strategy, major plans of action,
risk management policies and procedures, annual budgets, and
 business plans; setting performance objectives; monitoring
implementation and corporate performance; and overseeing major
capital expenditures, acquisitions and divestitures
 Monitoring the effectiveness of the company’s governance
practices and making changes as needed
 Selecting, compensating, monitoring and, when necessary,
replacing key executives and overseeing succession planning.
 Aligning key executive and board remuneration with the longer term
interests of the company and its shareholders.
 Ensuring a formal and transparent board nomination and election
process.
 Monitoring and managing potential conflicts of interest of
management, board members and shareholders, including misuse
of corporate assets and abuse in related party transactions.
 Ensuring the integrity of the corporation’s accounting and financial
reporting systems, including the independent audit, and that
appropriate systems of control are in place, in particular, systems
for risk management, financial and operational control, and
compliance with the law and relevant standards.
 Overseeing the process of disclosure and communications.
e. The board should be able to exercise objective independent judgement on
corporate affairs.
 Boards should consider assigning enough nonexecutive board
members capable of exercising independent judgement to tasks
where there is a potential for conflict of interest. Examples of such
key responsibilities are ensuring the integrity of financial and non-
financial reporting, the review of related party transactions,
nomination of board members and key executives, and board
remuneration.
 Boards should consider setting up specialized committees to
support the full board in performing its functions, particularly in
respect to audit, and, depending upon the company’s size and risk
profile, also in respect to risk management and remuneration.
When committees of the board are established, their mandate,
composition and working procedures should be well defined and
disclosed by the board.
 Board members should be able to commit themselves effectively to
their responsibilities.
 Boards should regularly carry out evaluations to appraise their
performance and assess whether they possess the right mix of
background and competences.
f. To fulfil their responsibilities, board members should have access to
accurate, relevant and timely information.
 g. When employee representation on the board is mandated, mechanisms
should be developed to facilitate access to information and training for
employee representatives, so that this representation is exercised
effectively and best contributes to the enhancement of board skills,
information, and independence.

Chief Executive Officer (SEC Code of Corporate Governance)

To avoid conflict or a split board and to foster an appropriate balance of power,
increased accountability, and better capacity for independent decision-making, it is
recommended that the positions of Chairman and Chief Executive Officer (CEO) be
held by different individuals. This type of organizational structure facilitates effective
decision making and good governance. In addition, the division of responsibilities and
accountabilities between the Chairman and CEO is clearly defined and delineated and
disclosed in the Board Charter.
The CEO has the following roles and responsibilities, among others:
a. Determines the corporation’s strategic direction and formulates and
implements its strategic plan on the direction of the business;
b. Communicates and implements the corporation’s vision, mission, values
and overall strategy and promotes any organization or stakeholder change
in relation to the same;
c. Oversees the operations of the corporation and manages human and
financial resources in accordance with the strategic plan;
d. Has a good working knowledge of the corporation’s industry and market
and keeps up to date with its core business purpose;
e. Directs, evaluates and guides the work of the key officers of the
corporation;
f. Manages the corporation’s resources prudently and ensures a proper
balance of the same;
g. Provides the Board with timely information and interfaces between the
Board and the employees;
h. Builds the corporate culture and motivates the employees of the
corporation; and
i. Serves as the link between internal operations and external stakeholders.
Audit Committee (SEC Code of Corporate Governance)
The Audit Committee is responsible for overseeing the senior management in
establishing and maintaining an adequate, effective and efficient internal control
framework. It ensures that systems and processes are designed to provide assurance in
areas including reporting, monitoring compliance with laws, regulations and internal
policies, efficiency and effectiveness of operations, and safeguarding of assets.
The Audit Committee has the following duties and responsibilities, among others:
a. Recommends the approval the Internal Audit Charter (IA Charter), which
formally defines the role of Internal Audit and the audit plan as well as
oversees the implementation of the IA Charter;
b. Through the Internal Audit (IA) Department, monitors and evaluates the
adequacy and effectiveness of the corporation’s internal control system,
integrity of financial reporting, and security of physical and information
assets. Well-designed internal control procedures and processes that will
provide a system of checks and balances should be in place in order to
(a) safeguard the company’s resources and ensure their effective
utilization,
(b) prevent occurrence of fraud and other irregularities,
(c) protect the accuracy and reliability of the company’s financial data,
and
(d) ensure compliance with applicable laws and regulations;
c. Oversees the Internal Audit Department, and recommends the
appointment and/or grounds for approval of an internal audit head or Chief
Audit Executive (CAE). The Audit Committee should also approve the
terms and conditions for outsourcing internal audit services;
d. Establishes and identifies the reporting line of the Internal Auditor to
enable him to properly fulfill his duties and responsibilities. For this
purpose, he should directly report to the Audit Committee;
e. Reviews and monitors Management’s responsiveness to the Internal
Auditor’s findings and recommendations;
f. Prior to the commencement of the audit, discusses with the External
Auditor the nature, scope and expenses of the audit, and ensures the
proper coordination if more than one audit firm is involved in the activity to
secure proper coverage and minimize duplication of efforts;
g. Evaluates and determines the non-audit work, if any, of the External
Auditor, and periodically reviews the non-audit fees paid to the External
Auditor in relation to the total fees paid to him and to the corporation’s
overall consultancy expenses. The committee should disallow any non-
audit work that will conflict with his duties as an External Auditor or may
pose a threat to his independence3. The non-audit work, if allowed, should
be disclosed in the corporation’s Annual Report and Annual Corporate
Governance Report;
h. Reviews and approves the Interim and Annual Financial Statements
before their submission to the Board, with particular focus on the following
matters:
• Any change/s in accounting policies and practices
• Areas where a significant amount of judgment has been
exercised
• Significant adjustments resulting from the audit
 • Going concern assumptions
• Compliance with accounting standards
• Compliance with tax, legal and regulatory requirements
i. Reviews the disposition of the recommendations in the External Auditor’s
management letter;
j. Performs oversight functions over the corporation’s Internal and External
Auditors. It ensures the independence of Internal and External Auditors,
and that both auditors are given unrestricted access to all records,
properties and personnel to enable them to perform their respective audit
functions;
k. Coordinates, monitors and facilitates compliance with laws, rules and
regulations;
l. Recommends to the Board the appointment, reappointment, removal and
fees of the External Auditor, duly accredited by the Commission, who
undertakes an independent audit of the corporation, and provides an
objective assurance on the manner by which the financial statements
should be prepared and presented to the stockholders
Internal Audit (SEC Code of Corporate Governance)
A separate internal audit function is essential to monitor and guide the
implementation of company policies. It helps the company accomplish its objectives by
bringing a systematic, disciplined approach to evaluating and improving the
effectiveness of the company’s governance, risk management and control functions.
The following are the functions of the internal audit, among others:
a. Provides an independent risk-based assurance service to the Board, Audit
Committee and Management, focusing on reviewing the effectiveness of
the governance and control processes in
(1) promoting the right values and ethics,
(2) ensuring effective performance management and accounting in
the organization,
(3) communicating risk and control information, and
(4) coordinating the activities and information among the Board,
external and internal auditors, and Management;
b. Performs regular and special audit as contained in the annual audit plan
and/or based on the company’s risk assessment;
c. Performs consulting and advisory services related to governance and
control as appropriate for the organization;
d. Performs compliance audit of relevant laws, rules and regulations,
contractual obligations and other commitments, which could have a
significant impact on the organization;
e. Reviews, audits and assesses the efficiency and effectiveness of the
internal control system of all areas of the company;
 f. Evaluates operations or programs to ascertain whether results are
consistent with established objectives and goals, and whether the
operations or programs are being carried out as planned;
g. Evaluates specific operations at the request of the Board or Management,
as appropriate; and
h. Monitors and evaluates governance processes.
External Audit (Wallstreet E-Journal)
This is the audit of the financial records of the company in which independent
auditors perform the task of examining validity of financial records of the company
carefully in order to find out if there is any misstatement in the records due to fraud,
error or embezzlement and then reporting the same to the stakeholders of the company.
The objective of the external audit includes the determination of the
completeness and accuracy of the accounting records of the client, to ensure that the
records of the clients are prepared as per the accounting framework which applies to
them and to ensure that the financial statements of the client present the true and fair
results and the financial position. The roles and responsibility of the external audit:
a. Verify the general ledger of the company and make all other essential
inquiries from the management of the company. It helps to determine the
real picture of the company’s market situation and the financial situation,
which further provides the basis for managerial decisions.
b. Examine the validity of financial records to find out if there is any
misstatement in the company’s record because of fraud, error, or
embezzlement. So, it increases the authenticity and credibility of financial
statements as the financial statements of the company.
c. If there are errors in the accounting process of the company, then it may
prohibit the owner of the company is taking the decisions which are best
for the company. An audit helps in overcoming this problem to a great
extent as the procedures in the audit are designed in such a way that they
help in detecting the errors in the system and the other fraudulent activity.
The audits also ensure the recording of accounting transactions as per the
generally accepted accounting principle. It helps the owner of the business
to cover themselves when it comes to following the different rules and
regulations which the registered entity needs to follow.
Limitations of External Audit
The audit is conducted by reviewing the sample data of the company,
which the auditor thinks is material for his examination. An auditor does not
assess and review all the transactions which occurred in the company. Thus, he
merely expresses his audit opinion on the financial statements and data based
on the sample data provided to him. So this does not give the total assurance
about the financial position of the company.
 Important Points in External Audit
The main purpose for which the external audit is conducted includes the
determination of the completeness and accuracy of the accounting records of the
client, to ensure that the records of the clients are prepared as per the
accounting framework which applies to them and to ensure that the financial
statements of the client present the true and fair results and the financial position.
A statutory auditor can ask for the company’s financial books, records, or
information in relation to that for which the management cannot deny him.
After conducting the audit and gathering necessary information, the
external auditor is supposed to give its audit report in writing, which will be based
on the various evidence and data collected on the true and fair view of the
financial statements provided to him to the concerned parties.
Most commonly, an external audit is intended to get the certification of
financial statements of the company. Certain investors and the lenders require
this certification for their analysis. Also, all publicly traded businesses or the
corporations which sell their shares to the public are legally required to get their
financial statements audited and get this certification.

Learning Activity

Activity 3.
Make an essay reflection on the article “Integrity is the Key to Good
Governance” by Phillip Armstrong and James Spellman.

Learning Assessment

Answer the following in 1-2 sentence(s) each.

1. What do you understand by the term governance?
2. Differentiate the market model and control model.
3. What stakeholder groups might directors of a company have to take
into consideration, and how might the stakeholders’ interests’ impact on the
company?
4. In what way(s) might stakeholders’ interests’ conflict with each
other?
5. What role do you believe stakeholders should play in corporate
governance?

Answer Rubric:
Criteria Pts.
Sentence 5
Organization
Voice 10
Word Choice 5