PARTICIPANTS IN THE CORPORATE GOVERNANCE PROCESS (STUDY OBJECTIVE 2)

Recall from the previous section that corporate governance can be defined as an elaborate system of checks and balances. Corporate governance is considered elaborate not only because it is multifunctional, but also because of the variety of people involved in the system. The participants in the corporate governance process are often referred to as stakeholders. Stakeholders are all of the different people who have some form of involvement or interest in the business. They participate in or with the business in a manner that puts them in a position of financial interest or risk, or is otherwise significant to the overall strategies and operations of the business.

Stakeholders can be internal or external. Exhibit 5-1 presents an example of the various internal and external stakeholders of a typical corporation. Each of these stakeholder groups affects, or is affected by, corporate governance. For example, management has a huge direct impact on corporate governance, while the community is likely to be more indirectly affected by corporate governance. To understand corporate governance, it is important to grasp not only who the stakeholders are, but what their functions are, relative to the organization. The stakeholder groups from Exhibit 5-1 are described next, and the section that follows these descriptions explains their functions.

Exhibit 5-1 Stakeholders as Participants in the Corporate Governance Process

Internal stakeholders must work together in a proactive manner to foster continuous improvements in the company's reporting systems. The following parties are considered internal stakeholders:

The management team of a typical corporation is often divided into layers: top management, middle management, and supervisors. Top management is made up of the company's president and chief executive officer (CEO), as well as the remaining executive officers. This generally includes a vice president for each functional area of the company. Although the main responsibility of top managers has historically been corporate strategy and supervision, this is changing in the modern business world. Top managers are becoming more accountable for the details of the business. Middle managers coordinate a number of different departments or groups within the company by leading the supervisors in their respective areas of responsibility. Supervisors guide the work of a number of employees doing similar tasks within a given department or group.

Employees carry out the day-to-day operations and administrative functions of the company. The jobs performed by individual employees are each important, yet they make up a small component of the company's overall business. Employees rely on supervisors to oversee and coordinate their activities in order for them to work effectively to accomplish the company's overall objectives.

Internal auditors are employees of the corporation who help management establish and monitor internal controls by continuously looking for “red flags.” They rotate throughout the company, reviewing the policies, procedures, and reports in each area to determine whether or not they are working as planned. The internal audit function is usually a separate department within the business, comprising a number of managers, supervisors, and employees (depending upon the size of the company).

The board of directors is elected by the shareholders to direct the corporation. Its role is to align the interests of shareholders and management. Although not typically involved in day-to-day decision-making, the board of directors should have the highest level of authority with respect to the company's objectives and strategies. The board of directors is generally made up of a chairman and secretary, as well as several members who are independent from the company. A board of directors will often have subcommittees made up of a subset of the board's membership to handle specific tasks. Members should be professionally experienced so that they can effectively serve as advisors to the company.

THE REAL WORLD

The audit committee is a subcommittee of the board of directors. The audit committee is responsible for financial matters, including reporting, controls, and the audit function. The role of the audit committee is discussed in more detail later in this chapter.

Shareholders own a portion, or share, of the corporation. As owners, they have the ability to influence the company by voting on significant matters. Otherwise, shareholders are often not involved in daily operations, except in small companies. Because many corporations have millions of ownership shares, a typical individual shareholder owns a very small fraction of the company and therefore has little influence. Because of the lack of involvement and limited influence of individual shareholders, these parties are sometimes regarded as external stakeholders.

External stakeholders are people and organizations outside the corporation who have a financial interest in the corporation. In most situations, external stakeholders work with the company and are therefore interested in its inputs, outputs, and/or financial success. The following parties are generally considered external stakeholders:

The communities in which corporations are located have a stake in those corporations because of their impact on social, environmental, charitable, and employment practices in their areas. Companies may have a big influence in the communities in which they operate; therefore, the people and organizations that make up those communities tend to have a connection to the business, even if they are not otherwise involved as employees, customers, and so forth.

Investors are those who have an ownership interest in the company or who consider obtaining an ownership share. Although all shareholders are investors of the company, not all investors are shareholders. Investors are included as external stakeholders because this group includes potential shareholders, those people or organizations considering becoming shareholders. Investors, as well as each of the remaining external stakeholders to be described later, depend on the financial information presented by the company to serve as a basis for making decisions about their involvement (or potential involvement) with the company.

Creditors are those who help finance the company by lending money. They are genuinely interested in the company's financial health because it determines the company's ability to repay its obligations.

Customers and suppliers are involved with the company on a day-to-day basis by buying and selling, respectively. Customers purchase the company's products and services, whereas suppliers provide the resources needed for the company to do business.

One special type of supplier who provides important services for the company is the external auditor. External auditors lend credibility to the financial statements and are responsible for evaluating whether or not the company's financial information is prepared according to established accounting rules. External auditors must be independent from the company so that they can perform their work without bias. Accordingly, they should approach every audit with a skeptical attitude and think about ways that fraud might be carried out within client companies. This attitude allows auditors to be more thorough and objective.

Regulators are important stakeholders in the corporate governance process because they are responsible for the laws and guidelines that govern the company. Some of the most influential governing bodies in the area of corporate governance include the following:

• The Securities and Exchange Commission (SEC) is the federal regulatory agency responsible for protecting the interests of investors by making sure that public companies provide complete and transparent financial information.
• The Treadway Commission formed the Committee of Sponsoring Organizations (COSO) that created the framework for internal controls evaluations. The Treadway Commission was established by five organizations that are influential in the practice of accounting, including the American Institute of CPAs, The Institute of Internal Auditors, Financial Executives International, the Institute of Management Accountants, and the American Accounting Association. Chapter 4 introduced COSO and its importance in laying a foundation for establishing and monitoring internal controls.
• The Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB) in the United States and globally, respectively, are responsible for establishing applicable financial accounting and reporting standards. FASB and IASB are private organizations that have been influential in establishing accounting principles which provide information useful in business decision making.

An important feature of corporate governance is the need for the corporation to be conscientious about maintaining good working relationships with each group of stakeholders, both internal and external. One way to enhance good relationships is to ensure that certain stakeholders remain independent with respect to the company's financial reporting. For instance, the audit committee and external auditors should not allow any financial connections to influence the decisions they make about the company's financial statements or disclosures. Even the internal auditors should maintain an independent attitude. Although internal auditors are employees of the company and cannot therefore remain completely independent, the corporation should be structured in such a way that internal auditors do not have any reporting relationships or conflicting roles that impact their objectivity on the job.

The systems of checks and balances that constitute corporate governance involve the internal stakeholders working to perform several interrelated functions. Moreover, the company's success in maintaining good working relationships with each group of stakeholders will enhance the corporate governance functions. The next section describes these functions.