What is Corporate Governance? Simple Illustration

I define Corporate Governance the way by which we can run the business effectively.

I always thought Corporate Governance (CG) is a pretty simple concept, but after a decade in a professional environment, I realized the concept is still confused by many professionals. Therefore, today I thought to give a brief explanation of the CG concept. There are many definitions of the CG, but I chose to keep this discussion simple in my own way to avoid unnecessary technical jargon.

Agency Theory

Before explaining the concept, it is important to understand the agency theory. Agency theory is used to understand the relationship between the Agent (company’s management team or managers) and the Principle (shareholder/business owner). The owner/shareholder of the company hires the executive managers to maximize their wealth, however, the executive managers (inherently) may have conflicting self-interest to maximize their income at the cost of the owner’s wealth.

In economics, we say moral hazard occurs when one person takes more risks because someone else bears the cost of those risks. We have seen this example in our daily life. The politician takes a decision on behalf of voters at times in their self-interest (help in their political agenda), which eventually affects the voters in the long run usually manifested by the negative consequences of their decision.

Similarly, in business, the executive management takes a decision which serves them to meet their short-term target to maximize their pay cheque (performance-based incentive) at the cost of company long-term growth. The following famous business scandals and many more demonstrate the agency problem:

• The fall of Enron – The executive manipulated the accounting report that made the stock seem more valuable than it truly was. After the scandal was uncovered, thousands of shareholders lost millions of dollars as Enron share values plummeted.
• Goldman Sachs and the real estate bubble – The financial analysts invest against the best interests of their clients in much risky mortgage-backed securities known as CDO’s, then sold them betting that the mortgages would undergo foreclosures. The bubble busted in 2008 and the prices of those CDO’s dropped, and the investors suffered at the cost of executive management decision.

How To Overcome The Agency Problem

The shareholders are sitting outside the organization and delegate to power to the executive management to run the business on their behalf to maximize their wealth while securing their long-term business sustainability and profit. The shareholders take some initiative under the CG concept to oversee the work of executive management, these are:

• The shareholders form a Board and nominate the Board of Director to oversee the work of the executive management.
• The Board make committees (comprises of the board member) to give special attention to certain areas e.g. remuneration and nomination committee (to oversee and decide the selection and remuneration of the executive management), audit committee (to oversee the companies operational controls effectiveness), risk committee (to oversee the risk exposure affecting the business) etc.
• These committees are assigned certain role and responsibilities and they make accountable management to perform their duties in the best interest of shareholders.
• The management develop operating procedures in the form of Policies and Procedures to run the business effectively. 
• The management is accountable to the Board and it's committees on their performance.
• Eventually, these committees report to the Board and the Board is accountable in front of the Shareholders to safeguard their interest.

Does CG Effective To Curb Business Wrong Doing?

Not really, but these initiatives are a positive move in the right direction. It is always a challenge to regulate human greed which is ultimate behind most of the financial wrongdoing in companies.

Based on the above initiative, we can conclude the concept of CG is nothing but “the way by which we can run a business effectively”.

There are certain bodies in the world that have device the concept of CG into a set of rules and regulations and sometime in the form of legislation e.g. the United States Congress passed the Sarbanes-Oxley Act (SOX) to protect shareholders and the general public from accounting errors and fraudulent practices in enterprises, and to improve the accuracy of corporate disclosures.

CG is still a new concept and evolving with the changes in the business environment. Like any other laws and regulations, the concept and the application of CG is maturing, and the legislators and government bodies are playing the catch-up roles to regulate the business doings in more ethical and effective manner. 

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ABOUT THE AUTHOR

Arif Zaman brings with more than a decade of proven experience in internal audit, risk management and fraud investigation. He is the Head of Internal Audit at Private Joint Stock Company based in Dubai, UAE. He holds a MSc in Professional Accountancy from University of London and BSc Hons in Applied Accounting from Oxford Brookes University along with an impressive set of professional certification including ACCA, CIA, CISA, CFE, CCSA, CRMA, CRBA, CPA and CGA etc.

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