In simple terms, Governance means “the process of decision-making and the process by which decisions are implemented”. Thus governance related to large businesses is called Corporate Governance. Firms are social entities and have certain social obligations. A firm needs coordination between many groups of people known as stakeholders. The stakeholders are the owners, the managers, the workers, the suppliers, the creditors, the customers, the competitors, the government, and even the society at large. The stakes of various stakeholders are:
- Owners get a share of the profits
- Managers get salaries.
- Workers get wages
- Suppliers get paid for their inputs to the firm
- Customers want to get good quality products at reasonable prices
- Creditors wants their loans to be repaid in time
- Competitors want fair competition in the market place.
- Government wants the firm to declare its true earnings and pay appropriate taxes
Good Corporate Governance requires that the firm:
- Pursue its goal efficiently
- At the same time take into account the harm that it is causing to some stakeholders and try to ensure that those losers are adequately compensated.
The corporate form of business raises large capital from public; therefore there are millions of shareholders contributing small capital. Since contribution of shareholder is small, it is not practically possible for shareholders to run the day-to-day management of business. Thus in between owners and business, a corporate form of business introduced a new entity called Management. This management consists of professional managers who manages the company and take the important decisions.
Corporate Governance and Agency Problem
We have seen that in corporate form of business, there is separation of ownership and business. This creates a unique type of problem known as Agency Problem. The problem of Principal-Agent is universal. Agents (Managers) are expected to work for the benefit of principal (owners) and take decisions that are beneficial for the principal. However often agents take decisions that are beneficial for themselves. When ownership and business is separated, the managers are expected to act for the benefits of the owners. However, there is chance that managers may pursue certain alternative objectives that are beneficial to themselves rather than owners. The conflict is called Agency Problem.
Mitigating Agency Problem
One solution to mitigate the agency problem is to appoint the honest and ethical managers. But question is how to determine whether a manager is honest/ethical or not. Thus there is need to do something beyond appointment of managers.
- Traditionally auditing was instituted to resolve the agency conflict. Auditors are expected to work on behalf of owners and examine the conduct of business run by managers and submit the report to owners. However the auditing is restricted to financial auditing which can unearth the financial frauds. But it cannot question the managerial efficiency.
- In addition to auditing, the corporate governance is used to resolve the agency conflict. Under the corporate governance, the emphasis is on the board including the appointment of directors for the board, who are expected to be independent and expert in their fields. In addition, the board forms sub-committees to have more close interaction with management.
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