Importance of Corporate Governance to a Firm’s Performance

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CORPORATE GOVERNANCE 15

Corporate governance is the system used to manage and control acompany. It refers to the rules that delineate the relationshipbetween a company’s board of directors, management, shareholdersand stakeholders. Basically, corporate governance focuses on issuesrelating to the separation of power and ownership in a company.However, it is not restricted to the establishment of therelationship between different members of an organization. Corporategovernance additionally outlines the structure used to set acompany’s objectives, how to achieve the objectives and monitorperformance. Corporate governance is significant to every companybecause it is linked to performance. Good corporate governance isassociated with a firm’s high performance, while poor corporategovernance results in a firm’s poor performance. In the followingdiscussion, the research paper focuses on depicting the relationshipbetween good corporate governance and high firm performance.

The Relationship between Good Corporate Governance and HighPerformance

Good Corporate Governance

Prior to exploring the relationship between good corporategovernance and high firm performance, it is essential to explain whatgood corporate governance entails. According to Akdogan andBoyacioglu (2014) good corporate governance is evident when a firm’smanagement system is capable of solving conflicts amid majority andminority shareholders. The system should also be effective in solvingconflicts of interest between managers and shareholders. Thus,corporate governance should focus on ensuring that the interests ofall individuals in a company are met. It entails the interests of notonly those that own the company, but people affected by the actionstaken by a firm. In addition, the authors explain that it isanticipated that apart from allowing all the stakeholders access to afirm’s information, an appropriate corporate governance system hasan impact on the company’s economic actions through reducingcapital expense (Akdogan &amp Boyacioglu, 2014).

Cheema and Din (2013) further explain that good corporate governanceis evident in a company, when the firm is able to maintain acompetitive advantage over its competitors. The authors argue thatcorporate governance comprises of practices aimed at stabilizing andstrengthening the capital markets (Cheema &amp Din, 2013).Therefore, as capital markets become stronger and stable, investorsare attracted to a firm. As more investors invest in a firm, thecompetitiveness of the company in the business environment improves.In addition, good corporate governance ensures that a firm is able toset up strategies that improve success in business. Hence, goodcorporate governance is manifested in the ability of the board ofdirectors, to implement and monitor policies that are successful inachieving the company’s mission and vision.

In any firm, corporate governance acts as a major factor determiningthe capability of the business to thrive despite economic challenges.The wellbeing of a company relies on the fundamental reliability ofits structures. Good corporate governance, hence results insustainable economic growth through the enhancement of a company’sperformance as well as improving their access to outside capital(Sarbah &amp Xiao, 2015). A number of characteristics are used todetermine the effectiveness of a company’s corporate governance.The characteristics are also significant in demonstrating therelationship between good corporate governance and high firmperformance.

Characteristics of Good Corporate Governance

Board size. Shungu, Ngirande and Ndolvu (2014) describe boardsize as the figure of directors that make up a firm’s boardstructure. The number as well as effectiveness of directors has animpact on board functions that in turn affect performance. Researchindicates that the number of directors required in a board is hard todetermine (Shungu, Ngirande &amp Ndolvu, 2014). Owing to the factthat companies are of different sizes, the number of directors canonly be determined by the size of the company. Hence, directorsdiffer from one firm to another. However, a large board size ispreferred by most organizations, because it resonates to more skillsand knowledge input in a firm, which improves performance.

On the other hand, large board sizes are discouraged, as they enhancethe probability of conflict arising among directors. High conflictlevels among directors reduce performance because the board is moreconcerned about bureaucratic issues, as opposed to the wellbeing ofthe firm. Nevertheless, Zabri, Ahmad and Wah (2016), explain that anideal board size should comprise of the executive as well asnon-executive directors. The authors further explain that it isimportant to have an effective board that ensures the company isproperly governed (Zabri, Ahmad &amp Wah, 2016). Board size seems todiffer from one company to another due to different working cultures.Thus, there is no best possible board size for companies. Rather, thenumber of directors that should make up a company’s board should bedependent on the directors’ ability to work as a team (Zabri, Ahmad&amp Wah, 2016).

Nevertheless, it is important for a firm to have a board size thataligns to the size of the company. For instance, a small companyshould not have an oversized board. According to Horvath andSpirollari (2012), firms that have an oversized board are lesseffective. The large number of decision makers might reduce the inputof some directors. As a result, a company ends up incurring financiallosses in paying directors who do not add value to the firm. Theappropriate board size results in increased performance, specificallyin reference to financial performance. Most directors receive hugesalaries that increase the financial expenses of a firm. However,with a sizeable board size, a firm’s monetary expenses are reducedand in the process saving costs for the company that resonates toimproved financial performance (Horvath &amp Spirollari, 2012).

Board composition. Board composition refers to the skills andqualifications of the directors that make up a board (Post, Rahman &ampMcQuillen, 2015). It is a key characteristic of good corporategovernance because the decisions made by directors influence thefirm’s performance. Board composition has the power to influenceboard deliberations as well as the ability to control decisions madeby top management (Shungu, Ngirande &amp Ndolvu, 2014). The boardshould comprise of individuals who are independent from the firm.Independence enhances the level of corporate accountability asdecisions are not influenced by those within the company. The numberof directors external to the firm is likely to have a higher impacton proper decision making that in turn improves performance (Post,Rahman &amp McQuillen, 2015). On the contrary, when a firm comprisesof a higher representation of board directors, directly linked to thefirm’s operations, the level of conflict and inability to makedecisions increases. The latter affects performance negatively.

An equally important factor to consider in regard to boardcomposition is the educational qualifications of the board ofdirectors (Vo &amp Phan, 2013). Bearing in mind that the board issupposed to guide management in making decisions that result in thesuccess of the company, it is important for the board to comprise ofindividuals who are well educated. For instance, a company that dealswith finance ought to employ a board of directors that are qualifiedin financial matters. The objective of emphasizing on educationalqualifications is to ensure that the decisions made by directors arerelevant to a firm’s operation. For instance, a director withknowledge in finance is better placed to work in a financialinstitution. The directors also bring in their professional as wellas educational experience in the management of company affairs thatin the process enhances performance.

Board committee. Board committee refers to an external groupof directors that are responsible for supervising the decisions madeby the internal board of directors (Shungu, Ngirande &amp Ndolvu,2014). The committee is a significant characteristic of goodcorporate governance due to its role in monitoring corporateactivities. In addition, the committee ensures that shareholderinterests are protected. The board committee acts as an audit for thefirm’s activities. Although the board of directors is responsiblefor overseeing the proper governance of a firm, at times thedirectors may be guided by self interest. Hence, good corporategovernance is enhanced by the presence of board committees thatreview the company’s performance based on the decisions made byinternal directors and managers (Joseph,Ocasio &amp McDonnell, 2014).

The committee is also accountable for the firing and hiring ofdirectors. Uncommitted directors are fired from a company, whilecommitted directors are retained (Shungu, Ngirande &amp Ndolvu,2014). Bearing in mind that directors hold a significant position inthe company, their actions have a greater impact on the operations ofa firm. Also, directors are in charge of other senior members in acompany, such as the chief executive officer and managers. Thus, inmost cases directors make unsupervised decisions that cannot becontested by managers and other stakeholders. In cases where thedirectors are guided by self interest, they could decide, forinstance to increase their salaries. Such decisions reduce firmperformance by increasing corporate expenses. As such, boardcommittees result in improved firm performance by ensuring that thedirectors are committed to the success of a company. The committeesmonitor the actions of the board of directors and ensure thatdecisions made add value to a firm.

Board diversity. Board diversity is in reference to themixture of individuals that make up a board of directors. The mixturecomprises of males and females, directors of different ages,ethnicities, culture and racial backgrounds (Shungu, Ngirande &ampNdolvu, 2014). Presently, the inclusion of women into corporateboards is seen as an important characteristic of good corporategovernance. It communicates to the public that the firm is fairtowards individuals of all genders. Board diversity may have a director indirect impact on good corporate governance and henceperformance. The direct impact derives from the decisions made by aboard. A board that comprises of directors of different genders,ages, race and ethnicity is more effective, because decisions arediverse. Thus, greater performance is expected from such a board ascompared to one that lacks diversity. Good corporate governance isdirected by the diversity of thoughts when making decisions thataffect the firm.

Board diversity is related to high firm performance as diversityresonates to additional perspectives (Fauzi &amp Locke, 2012).Diverse perspectives are an effective way of improving a firm’soperations, because as different ideas and perspectives are shared,performance improves. A board of directors that comprises ofindividuals of different ages and genders provides connection toadditional resources. It also ensures that the different stakeholdersare properly represented in a firm. Since the role of the board ofdirectors is to make decisions that have a direct impact on theperformance of the company, a diverse board is one that is balanced(Fauzi &amp Locke, 2012). Thus, the decisions made arerepresentative of the needs of stakeholders of different ages, races,gender or ethnicity.

Research indicates that high firm performance is evident incompanies that have a diverse board (Fauzi &amp Locke, 2012).Diversity is an effective way of ensuring that companies are properlyintegrated into all communities. Such integration is achieved throughthe representation of individuals from different backgrounds in acompany. As a result, it becomes possible for the firm to penetrateinto different markets as well as segments. Board diversityguarantees that the board comprises of directors who are aware of theneeds of consumers of different ages and from different races. Hence,when making decisions, for instance, such as introducing a newproduct in the market, it becomes possible to make the mostappropriate decision on how to target consumers of a specific age.

For instance, during policy making on marketing products to youths,the marketing strategy to be used is likely to be more effective whensuggested by a director who is young. The individual understands theneeds of the target consumers. On the contrary, if the decision ismade by an older director, it may be ineffective because the directorhas a limited understanding of the needs of the target consumers.Consequently, diversity guarantees that the decisions made by a boardmirror the needs of all stakeholders that will be affected by thedecision making process. High firm performance is noticeable throughincreased return on investment, as stakeholders are more likely toinvest in a company they believe caters for their needs.

Board independence. An independent board refers to a boardthat comprises of more outside directors as compared to internaldirectors. Outside directors are individuals who lack affiliationswith the management of a company. The function of outside directorsin corporate governance is to monitor the operation and performanceof a firm. Effective monitoring results in high performance byreducing agency problems that may arise in a company (Fuzi, Halim &ampJulizaerma, 2016). Agency problems refer to the disagreements thatmay arise when directors are expected to act in the interest ofmanagement. Such problems are common in a company whereby thedirectors are directly affiliated to management. Hence, the directorsfeel obliged to meet the demands or interests of the managers. Bydoing so, the interests of other stakeholders are ignored thatresonates to ineffective monitoring of a company’s operations.

According to Fuzi, Halim and Julizaerma (2016), board independenceadditionally enhances internal control as well as risk management ina firm. Outside directors act in the interest of all involved partieswithin an organization. On the contrary, directors directlyaffiliated to a company may act in the interest of a few, likemanagers. As such, it becomes harder to maintain an effective levelof internal control of operations within a firm that lacks boardindependence. However, independence ensures that the internaloperations of a firm are properly controlled and in the process risksare properly managed.

Rutledge, Karim and Lu (2016) demonstrate how board independenceresonates to high firm performance through the agency and stewardshiptheory. The authors note that according to agency theory, thereexists conflict amid the principal, for example the board ofdirectors, and the agent, for instance the chief executive officer(Rutledge, Karim &amp Lu, 2016). The conflict arises from the factthat the agent acts in their own self interest instead of theinterest of the principal. In instances where the chief executiveofficer of a firm is concerned about their self interest, firmperformance declines. As such, agency theory proposes that havingoutside directors as members of a board results in high firmperformance. It is because the outside directors act in the interestof the firm. Hence, they are highly likely to make decisions thatimprove performance.

Alternatively, stewardship theory presumes that directors act asstewards (Rutledge, Karim &amp Lu, 2016). Therefore, they areresponsible for making decisions on behalf of all shareholdersaffiliated to a firm. The motivation of the directors derives fromthe need to perform effectively and at the same time ensure the firmis successful. Outside directors tend to focus more on the success ofa firm, contrary to independent directors who have individualinterests. Thus, board independence ensures that directors focus onthe improvement of corporate performance that resonates to high firmperformance (Rutledge, Karim &amp Lu, 2016).

Illustrations of Good and Bad Corporate Governance

Good corporate governance. The Coca-Cola Company can be usedto illustrate good corporate governance. The company’s success canbe attributed to the fact that Coca-Cola has a board of directorsthat meet the key characteristics of good corporate governance. Thedirectors are elected to become members of the board based on theirqualifications and independence. As a result, board independence isprevalent in the company that ensures decision making is notinfluenced by management affiliations. The fact that directors areelected based on their qualifications, enhances the effectiveness oftheir decision making process. Decisions are made by individuals whohave knowledge about the industry under which Coca-Cola operates,thus leading to high firm performance.

AT&ampT is another example of good corporate governance. The companyoperates in the telecommunications industry and is listed among thetop a hundred companies by Forbes. It is also listed as one of thebest corporate companies in America. AT&ampT has a board ofdirectors that aligns to the characteristics of good corporategovernance, in regard to board independence and composition. Theboard is composed of directors who have knowledge in thetelecommunications industry. Board composition ensures that informeddecisions affecting the company are made based on the expertise ofthe directors. Board independence has led to the high performance ofAT&ampT because the directors are able to effectively monitor theactions and decisions made by managers. The board of directorsensures that the decisions result in the success of AT&ampT.

Bad corporate governance. WorldCom is one of the companiesthat have been affected by bad corporate governance. In 2002, thecompany filed for bankruptcy protection (Soltani, 2014). It was amajor bankruptcy file in the history of the United States that was asa result of an accounting scandal that led to the company losingbillions. Thousands of employees lost their jobs, while investorslost billions. WorldCom’s failure is attributed to poor corporategovernance. The poor decision making of the board of directorsresulted in the ineffective management of the company.

Research indicates that the board of directors failed to monitor howthe company was operating (Soltani, 2014). As a result, WorldComborrowed billions of funds that were misappropriated and at the sametime, huge borrowing resulted in depreciation in the firm’s assetvalue. From 2000 to 2001, the board was involved in the offering ofloans to Ebbers with the objective of preventing the sale of margincalls (Sorensen &amp Miller,2017). At the same time, the board of directors took part inthe enactment of decisions made by management without properscrutiny. Realizing that the company was about to go bankrupt, thedirectors participated in the manipulation of reserve accounts withthe objective of increasing figures.

The corporate failure at WorldCom is largely attributed to lack ofboard independence and a board committee. The board of directorscomprised of individuals who were directly affiliated to theoperations of the firm. As a result, it was easier for the board towork in collaboration with the management in concealing WorldCom’sfailures. At the same time, the board did not point out the mistakesthat were made by the company. In addition, due to the fact that thefirm did not have a board committee, the decisions made by the boardof directors were not monitored. Since most of the decisions weredetrimental to the company, they resulted in poor performance.

Another illustration of poor corporate governance is the case ofLehman Brothers Holdings Inc. The firm filed for bankruptcy in 2007(Milne, 2014). The company’s failure is attributed to the fact thatit had an ineffective board of directors. The board comprised ofdirectors who had retired and were aged above 60 years (Milne, 2014).Also, a limited number of the directors had experience in thefinancial service business, while only one of the directors hadknowledge in the financial sector (Milne, 2014). Key characteristicsof good corporate governance were lacking at Lehman Brothers HoldingsInc. The characteristics are board diversity and board composition.

The fact that the company comprised of a board of directors agedabove 60 years, is a clear indication of a lack of board diversity.Age is one of the factors considered in the diversity of a board. Itis important for a firm to include board members of different ages,as it ensures that there is diversity in the decisions made. Theboard comprised of directors who did not have knowledge in themanagement of financial issues. As such, their education andexperience in issues affecting the company were limited. The boardmade decisions that did not align with the needs of the stakeholders.In addition, the decisions were misguided, resulting in the firm’spoor performance.

Conclusion

Corporate governance is related to a firm’s performance. Goodcorporate governance results in high firm performance, while poorcorporate governance is linked to poor performance. Good corporategovernance is a management system that is able to effectively manageand control the operations of a company. Key corporatecharacteristics must be met in order for a firm to attain goodcorporate governance. The characteristics are board size,composition, diversity, committee and independence. In order for afirm to attain high performance, the board size should align with thesize of the company, the board should comprise of directors with anarray of skills and educational qualifications and the directorsought to be of different ages, gender and race. In addition, firmsneed to elect a board committee that supervises the board ofdirectors, while the directors should not be affiliated to thecompany.

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