What Is Corporate Governance, and Why Is It Important?

I present corporate governance now because I want to expose you to the topic even before we start.  Corporate governance is referred to throughout this course and extensively in the auditing standards.  DO NOT endow the board of directors or a company’s senior management with traits of honesty, trustworthiness or high ethical standards.  Auditors never assume.  An auditor expects these qualities to be present; however the audit procedures require us to substantiate the facts.  We need proof.  The auditor finds evidence that confirms or denies the existence of these qualities.

The concept of corporate governance has been evolving over time. The OECD Principles of Corporate Governance states:

"Corporate governance involves a set of relationships between a company’s management, its board, its shareholders and other stakeholders. Corporate governance also provides the structure through which the objectives of the company are set, and the means of attaining those objectives and monitoring performance are determined."

You can’t discuss corporate governance without a mention of “agency theory.” The officers of the company act as agents for the shareholder according to agency theory.  In other words, the officers have jobs in order to maximize the shareholder’s wealth.  All activities of the company should be directed at that sole purpose. True?

In general, the officers should be focused on maximizing shareholder wealth. But other stakeholders exist to which the corporation is accountable, such as:

• External auditors
• Government regulators
• Society
• Employees
• Customers
• Vendors

So what is the due and appropriate role of business?  Consider Milton Friedman’s (noted conservative economist) view of social responsibility:  “There is one and only one social responsibility of business – to use its resources and engage in activities designed to increase its profits so long as it stays within the rules of the game, which is to say, engages in open and free competition without deception and fraud."

Elements of Governance

Governance covers some big territory.  Most certainly it includes the agency theory that we previously discussed.  What are some of the other elements of governance to consider?  How about a code of ethics for an organization?  How do Boards of Directors establish expectations for corporate behavior, communicate those standards to stakeholders, and enforce those standards? Dentsply International has published a good example of their corporate ethics.

As this course is being written, the U.S. is in the midst of a protracted recession that began in 2008.  The 2008 recession was a “bubble” - a real estate lending bubble. Mortgage lenders and their financiers pulled some fast ones, such as:

• Giving out mortgages to people who didn’t warrant the credit.
• Giving mortgages to dual income couples that required the income of both to make the payments (with a divorce rate of 50%, how likely was a problem with, oh, about half of those mortgages).
• Creating accumulations of those stinky mortgages as “collateralized mortgage obligations or “CMOs” and sold them in the security markets.

It was a different bubble that popped at the turn of the millenium.  Enron was one of the best places to work year after year.  That “successful” energy trading company was in fact a house of cards whose demise also brought down their auditor, Arthur Andersen.  Check out the analysis from the Journal of Criminal Law and Criminology from ProQuest (using the Penn State Library links we just explored).  As a result of these activities, we ended up with the Sarbanes Oxley Act of 2002. We’ll talk more about that statute later.

My hope is that you’ll see that strong governance IS IMPORTANT.  Good governance can help create a distinct competitive advantage like what Dentsply enjoys.  Ineffective governance structures can literally put an organization out of business.