Principles of Finance

Chapter 2: Corporate Structure and Governance

2.1 LO 1: Identify the business form created by most
organizations.
The four most common forms of business organizations:
• Sole proprietorships
• Partnerships
• Corporations
• Hybrids such as limited liability companies (LLCs) and limited liability
partnerships (LLPs)

Most businesses take the form of proprietorships; however, based on

total dollar value, more than 80% of business in the United States is
conducted by corporations.
2.1 LO 2: Contrast the advantages and disadvantages that
the corporate form has over proprietorships.

Limited Liability Corporation Limited Liability Partnership

Advantages Disadvantages Advantages Disadvantages
Fewer restrictions on Only certain
eligibility (only one professions eligible
member allowed; can
be professional,
although some states
disallow professionals)
Usually more personal Limited protection Personal protection as
liability protection from partners’ actions well as protection
from negligence of
other partners
Flexibility in taxation Earnings included in Earnings taxed just Must file taxes as
members’ personal once pass-through entity
taxes

Table 2.1 Advantages and Disadvantages of LLCs and LLPs

2.2 LO 1: Explain the difference between principals and
agents.
Principals and Agents
• Company principals are its shareholders (owners). Owners normally do not take
an active role in the management of the company and instead hire agents
(management) to conduct the operations on their behalf.
• Agents are entrusted with acting in the best interest of the principals.
• There should be no conflict of interest between the two. If there is, it creates a
principal-agent problem/conflict.
2.2 LO 2: List and discuss various stakeholders
associated
with a company and its operations.

A stakeholder is any individual, group, or party that has an interest in

an organization.

A shareholder is an owner of shares in the company's stock. Shares

may be in the following forms:
• Common: Hold simple voting rights
• Preferred: May hold “super” voting rights

A shareholder is one form of stakeholder.

2.2 LO 3: Explain how management impacts the
operations and future of a company.

Role of Management
The day-to-day management of a company is conducted through a
hierarchy of managers who provide leadership to departments in the
company and oversee operations to ensure that company goals are
met.
2.3 LO 1: Describe the oversight functions performed
by boards.

A board of directors is a panel of people elected to represent

shareholders and are ultimately responsible for governance and
oversight of the company.
• The bylaws of a company determine the structure, responsibilities, and powers
given to a board of directors.
• The board must represent shareholder interests.
• The board normally includes both internal and external members.
• There are internal directors and external directors. The internal directors are
members of the board who are hold management positions with the company.
External directors also represent the shareholders but have experience and
skills from outside of the company.
2.3 Role of the Board of Directors
Functions of the audit committee include the following:
• Confirm the accuracy of the firm’s financial reporting
• Verify internal control and risk management operate effectively
• Ensure compliance with legal and regulatory requirements
• Verify qualifications, independence, and performance of the external public
auditing firm
• Coordinate the activities and performance of the internal audit function

The audit committee expanded significantly and has become

exceedingly important with the enactment of the Sarbanes-Oxley Act in
2002.
2.4 Agency Issues: Shareholders and Corporate Boards
Agency problems are conflicts that occur when an agent (manager)
who is entrusted with pursuing the interests of the principals
(shareholders or owners) of an organization abuses their position to
further own personal goals.

Three primary types of agency problems:

• Stockholders versus management
• Investors versus creditors
• Stockholders versus other stakeholders
2.4 LO 2: Discuss conflicts of interest between board
members, company management, and employees.

Measures that can help mitigate agency problems:

• Offer incentives to management for strong performance and ethical behavior
• Award decision makers with stock packages, commissions, and other long-term
compensation packages to encourage long-term thinking and matching of
company objectives with shareholders
2.5 LO 1: Define the investor relations function.
The investor relations (IR) function responsibilities include the
following:
• Coordinate live shareholder meetings and press conferences
• Disseminate financial information to the investment community
• Conduct briefings to the financial community
• Publish the quarterly and annual reports
• Handle issues arising from financial disclosures

IR became far more important due to corporate reporting requirements

enforced by the SEC and the International Financial Reporting
Standards (IFRS). This is especially so since the Sarbanes-Oxley Act was
passed.
2.5 LO 3: Describe the topics most often discussed
during a quarterly conference call.

The best investor and shareholder meetings include the following:

• A strong, understandable corporate introduction
• An engaging story about the company’s successes
• A track record of growth and probability of favorable future prospects
• Senior management providing feedback and follow-up to the investor audience
2.6 LO 1: Explain why corporations expand beyond
domestic borders.
When a company becomes global:
• Analysis of the organization becomes more complex.
• There’s a need to determine what laws affect the company’s governance.
• It must determine which accounting rules are used to prepare its financial
reports.
• Domestic companies are governed by securities laws established by the Securities
and Exchange (SEC) and US accounting rules using Generally Accepted Accounting
Principles (GAAP).
• Most non-US multinationals follow the International Financial Reporting
Standards (IFRS).
GAAP and IFRS were both designed with similar objectives: to provide a
common and structured set of guidelines for preparation of accurate
and unbiased financial reporting for public corporations.
2.6 Companies in Domestic and Global Markets
Generally Accepted Accounting Principles (GAAP) and International Financial
Reporting Standards (IFRS) were designed with similar objectives: to provide
a common and structured set of guidelines to assist in the preparation of
accurate and unbiased financial reporting for public corporations.
Despite these commonalities, there are important differences, including the
following areas:
• Inventory accounting and reporting
• Guidelines for consolidation of subsidiaries
• Accounting and reporting of minority interests
GAAP is rules-based whereas IFRS is principles-based, meaning that IFRS leaves more
room for interpretation and can sometimes require lengthy disclosures on financial
statements.