What Is the Importance of Corporate Governance?

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You have probably seen the results of bad corporate governance in the news. Enron, for example, is an excellent example of poor corporate governance, and it had devastating consequences for shareholders and employees. Small businesses that are looking to grow, sell to another corporation or go public should consider following corporate governance guidelines around transparency, accountability and ethics.

TL;DR (Too Long; Didn't Read)

Corporate governance ensures that companies operate with integrity and that controls are in place to prevent fraud.

Transparent accounting, well-kept books, regular auditing and accountability to stakeholders ensure that your business is on the right track regardless of its size. Even small businesses may be subject to laws about data privacy and accounting depending on the size of the business and the industry. For example, financial services companies and health care companies have regulations to follow due to their respective industries.

What Is Corporate Governance?

Corporate governance refers to the rules and procedures an organization follows. Some of these procedures are required by government rules and regulations. The board of directors sets the corporate governance for a given corporation. Executives and managers implement the directives of the board of directors.

Corporate governance is a balancing act between the needs of shareholders, managers and executives and government regulations. The perceptions of the public also influence corporate governance. Ultimately, corporate governance should ensure that a company’s quest for profitability doesn’t lead to ethical lapses.

The Importance of Corporate Governance

It is hard to understate the importance of corporate governance. While it would be nice to think that people in corporate leadership would always do the right thing, sometimes the temptation to make money is too much. Corporate governance ensures that companies are honest about their financial status, even when it is not ideal.

Another one of the benefits of corporate governance is that it ensures that companies take steps to do the right thing for their customers and their shareholders, even when it means admitting to mistakes or missteps. The public will often forgive mistakes when companies admit to them and work to right their wrongs. Covering up mistakes and committing fraud is another story, though.

For example, companies often issue recalls for flawed products. Admitting the mistake and providing a way to fix it ensures the safety of consumers and protects profitability. Covering up mistakes leads to public mistrust at best and leads to consumer deaths at worst. For example, in the years leading up to 2014, the deaths of five people were linked to safety issues related to Toyota vehicles. Toyota was fined $1.2 billion for concealing information and not promptly recalling all impacted vehicles.

The Consequences of Bad Corporate Governance

One of the reasons for corporate governance is to ensure that a company has checks and balances in place to prevent fraud. Enron is an example of the consequences of poor corporate governance. When the company collapsed, it hurt employee pensions and the pensions of people who had their retirement invested in Enron. Enron had been viewed as a safe investment for many pensions since it was an energy company.

Enron was started in 1985 when two energy companies merged. Enron moved away from traditional accounting methods, which allowed it to hide its debts and liabilities. Eventually, Enron’s debts caught up with the company, and it filed for bankruptcy. Shareholders lost $74 billion. Enron’s executives were charged with securities fraud, conspiracy and more.

Enron’s collapse led directly to new regulations around financial reporting for publicly held companies. Although small, private companies aren’t necessarily bound to the same reporting requirements, Enron serves as a cautionary tale for all businesses and a reminder to do the right thing.

The Role of Government in Corporate Governance

At a minimum, corporate governance must meet the rules and regulations of the government of any country where a business operates. U.S. companies operating in the European Union, for example, must abide by the general data protection regulation. The GDPR regulates the storage and protection of consumer data and requires companies to act promptly and notify consumers when their data has been compromised.

Other important regulations that may impact U.S. businesses include:

  • The Sarbanes-Oxley Act. The Sarbanes-Oxley Act was passed in 2002 in response to the Enron scandal and other corporate instances of fraud. It includes requirements for financial reporting and requires companies to have internal controls.

  • The Gramm-Leach-Bliley Act. The GLBA addresses how financial institutions use personal information.

  • Basel II. Basel II is a set of international banking regulations. It establishes minimal capital requirements and provides a framework for regulatory bodies. 

Although regulations can be complex, they provide minimum standards for companies to meet.

The Role of the Board of Directors in Corporate Governance

The board of directors plays a critical role in corporate governance. The decisions the board makes set the tone for the rest of the company. Although the board is not typically involved in day-to-day decision making, it does make long-term strategic decisions. Perhaps the most important decisions a board makes is selecting a CEO for the company and then monitoring that CEO’s performance.

The board also determines the level of risk a company is willing to take and then makes decisions in accordance with that level of risk. The directors are also responsible for the company’s financial reporting and compliance program. If a compliance issue arises, it is the board’s responsibility to ensure that it is addressed promptly.

Board members are typically experienced executives who have the experience to lead and who understand the complex reporting involved with corporations. They should also have high standards of integrity and be willing to go against the grain and stand up for shareholders when needed. Board members are elected by shareholders, and they answer to shareholders as well.

The Role of Management in Corporate Governance

The CEO and managers of a company execute the strategic plans set by the board of directors. They are responsible for operating the business with integrity, including ensuring that financial reporting is done accurately. The management team also ensures that the internal control process is in place and is effective.

The management team also identifies risks and develops annual budgets, which are presented to the board. They also work closely with the board of directors to ensure that the business is prepared for a crisis. They also set the standard for ethics and integrity within the company. The board sets the tone, but the executive management team puts these principles into practice.

The Role of Employees in Corporate Governance

When corporate governance issues arise in a company, most of the attention is on the board of directors and executives. Employees play an important role too, though. They participate in preparing financial reports and following policies put into place by the board and senior management.

Employees can also be whistleblowers, and the Sarbanes-Oxley Act includes provisions to protect whistleblowers. Whistleblowers are employees who report fraud or who testify about fraud. They are protected by law against retaliation from their employers.

Companies that embrace a culture of compliance should encourage employees to come forward if they see an issue that needs to be addressed. Companies should also be open with employees about their financial status so employees can make informed decisions about their employment.

The Role of Shareholders in Corporate Governance

Shareholders win or lose based on the performance of the company. Poor corporate governance can be devastating for shareholders. Some shareholders take a passive approach, while others are actively involved in the company, discussing their concerns with the board and executive management.

At a minimum, shareholders elect the members of the board of directors, and the board sets the standards for corporate governance. The board may sometimes engage in dialogue with shareholders and make decisions it believes are in the best interest of shareholders.

Good corporate governance means making decisions that are in the best interest of shareholders over the long term. This means making decisions that might cost the company money over the next quarter or two, like a significant product recall, knowing that the long-term reputation of the company depends on being forthcoming with issues.

Auditing in Corporate Governance

Auditing plays a pivotal role in corporate governance. Internal auditing ensures that the controls that a company has in place are working and are in compliance with regulatory standards. Internal audits also prepare a company for external audits.

The board of directors typically has an audit committee, which is comprised of members with in-depth experience in corporate finance. The audit committee selects an outside auditor who maintains an independent relationship with the company being audited. In other words, the outside auditor shouldn’t have any financial ties to the company that could lead to audits being compromised.

An outside audit is completed once per year. The audit should ensure that financial reporting is accurate and should report any issues that need to be addressed. Since sensitive information can be revealed during an audit, the audit process typically remains confidential until the findings are ready for public release. Audits may also have to meet standards set by the Sarbanes-Oxley Act and other regulatory bodies.

Applying Corporate Governance to Small Businesses

Small businesses may not be subject to all the regulations that impact large corporations. They can use corporate governance principles to ensure their long-term well-being, though. Some principles to incorporate include:

  • Internal auditing. Small businesses should have a process in place to ensure their books are kept properly and to prevent fraud and theft.

  • External auditing. Having an independent, outside party review your internal processes can uncover mistakes and opportunities for growth.

  • Stakeholder communication. How often do you communicate with the people who invested in your business? How is communication between your employees and managers? Keep stakeholders in your business in the loop and provide them with opportunities to express their concerns.

  • Focus on the long term. Running a small business often means putting out fires on a day-to-day basis. While keeping things afloat in the short term is important, keep an eye on where you want to go over the next five years or more. What changes do you need to make to grow? Do you want to expand or sell your business down the road? Use your long-term goals to inform your decision making.

  • Protect consumer interests. Mistakes happen. If there is an issue with a product or service, admit the issue to your customers promptly along with a way to resolve the issue. Covering up mistakes can be devastating for businesses of any size. 

Good corporate governance means operating with integrity at every level. That is a philosophy that can serve businesses of any size.