FUNCTIONS WITHIN THE CORPORATE GOVERNANCE PROCESS (STUDY OBJECTIVE 3)

The corporate governance process is composed of several interrelated functions, including management oversight, internal controls and compliance, financial stewardship, and ethical conduct.

MANAGEMENT OVERSIGHT

Who leads a company's leaders? This question relates to the concept of the management oversight function of corporate governance. There must be a level of supervision that oversees the company's leaders, including its board of directors, chief executives, and management team. Management oversight encompasses the policies and procedures in place to lead the directorship of the company.

The directorship of a company is generally considered to be its supervisors, managers, officers, and directors. A corporate organizational chart is typically structured in such a way that supervisors must report to managers, managers must report to an officer, and officers are responsible to the board of directors. The key to the effectiveness of this structure is the level of commitment from those in the positions of authority. Good management oversight involves leaders who are good communicators, attentive and responsive to those both above and below in the chain of command. These features make it possible for leaders to be effective at recruiting, motivating, evaluating, problem solving, and decision making. Overall, good leaders guide by example.

Management at every level within a company should communicate, both through words and by example, the importance of the policies and procedures that are in place and the ethical conduct that is required to achieve the company's goals. In order for this communication to be effective, a top-down approach must be in full force. This means that management's commitment must be demonstrated at the executive level, with the CEO at the forefront, and that every subordinate level within the company must recognize this commitment. In other words, the tone at the top is key to effective management oversight.

Even though the CEO is the top-ranking employee, he or she is not the “endall” in terms of management insight. The CEO must report to the company's board of directors and must feel a sense of responsibility to the board. The board of directors is therefore an important and active component of management and control. As such, it must take responsibility for overseeing the company's executive management team. In order to do this effectively, the board of directors must be engaged in the business. Although the board is not typically involved in all day-to-day activities, its involvement must be sufficient for its members to truly serve as directors rather than merely pose as figureheads. The board must have a thorough understanding of the company's business so that it can take part in strategic decision making and spearhead the systems of communication and accountability that management oversight is made of.

THE REAL WORLD

As these real-world examples demonstrate, management oversight cannot be taken for granted. Consistent reporting and oversight relationships should be in full force at every level of management to make sure that corruption does not bleed into the corporation. This is a tall order that requires a lot of support. One way that it can be realized is for the company to implement a thorough system of internal controls.

INTERNAL CONTROLS AND COMPLIANCE

As described in Chapters 3 and 4, internal controls are the systems by which companies control risks. Although the details of internal controls are addressed in previous chapters, some of the related concepts are worth reinforcing because they are a fundamental part of corporate governance. Of particular importance are the control mechanisms that

• address the selection and development of the organization's internal stakeholders, and dictate the manner in which rights and responsibilities are assigned to them
• ensure that the company is fulfilling its obligations with respect to adherence to corporate polices and procedures, accounting conventions, and regulatory requirements

The goal of corporate governance, with respect to internal controls and compliance, is to ensure that financial information is accurate, transparent, and complete. Accuracy relates to the correctness of the information presented; it is concerned with whether the financial information is verifiable and proper. Transparency relates to how clearly the financial information can be understood; it requires a straightforward and consistent approach. Completeness is concerned with avoiding omissions of important information. Companies that emphasize these points will have controls in place to make sure that transactions are recorded, processed, summarized, and reported in a timely and precise manner, and that the resulting reports tell the company's whole story, without contradiction. As a result, there will be fewer opportunities for errors or fraud. This does not necessarily mean that the company cannot be aggressive in its operating approach; but a strong system of checks and balances would be more likely to prevent opportunities for potential wrongdoers to cross the line into areas of fraud. If handled properly, this level of diligence in the preparation and presentation of financial information can help the company be more focused on the timely collection and use of data in a forward-thinking manner, which is likely to put the company in a better position to deal successfully with potential investors and creditors.

Establishing an internal control system to ensure accurate, transparent, and complete financial reporting requires a process approach. The following approach is suggested:

Six-step process for internal controls:⁴

1. Define the key activities and resources involved in each business activity. This should answer the question, “What is the related activity, and who is involved?”
2. Define the objectives of each activity. This step should answer the question, “Why is the activity being performed?”
3. Obtain input from experienced users and advisors on the effective design of controls.
4. Formally document the details of controls. Make sure that the documentation is thorough enough to answer the following questions:
   • Where, when, and how are activities being performed?
   • What records are being prepared?
   • Where, when, and how are records (both paper and electronic) being retained?
5. Test the effectiveness of controls to make sure they are operating as designed. Testing should be done by a combination of users, internal auditors, and external auditors.
6. Engage in continuous improvement to fix problems and upgrade controls.

These steps should be carried out for the most routine components of operations and should continue until they pervade the entire organization. When such processes are well planned and completed carefully and thoroughly, the outcome for the company should be a reliable system of internal controls that supports its compliance requirements.

Maintaining effective internal controls and ensuring compliance is an ongoing process. Many companies conduct surveys and organize task groups to monitor the effectiveness of internal controls and to determine whether the priorities communicated by their superiors are consistent with the company's official, documented goals. Companies that take part in this kind of ongoing monitoring often recognize the direct link between transparency and the relationships with external stakeholders. The next section addresses the importance of these relationships within the realm of corporate governance.

FINANCIAL STEWARDSHIP

Corporate governance is focused on the roles of managers and directors, who hold unique positions of responsibility. Managers and directors have a fiduciary duty to the shareholders of the company. A fiduciary duty is a special obligation of trust, especially with respect to the finances of another. In the corporate environment, “fiduciary” is a term which means that management has been entrusted with the power to manage the assets of the corporation, owned by the shareholders. The financial affairs of a corporation are expected to be managed in such a way as to maximize shareholders' wealth. Corporate leaders are required to be loyal to the shareholders; the personal interests and welfare of managers cannot overshadow this commitment to the shareholders. Since the business is owned and financed by the shareholders, the corporate leaders must serve as agents or stewards for the shareholders, leading the business in the best interest of the shareholders. Financial stewardship refers to the manner in which an agent handles the affairs and/or finances of another. Discipline, respect, and accountability encourage good financial stewardship.

Good communication and open dialogue are undoubtedly the most important factors for a leader to successfully fulfill the duty of financial stewardship. Corporate executives and managers must have frequent contact with the board of directors and shareholders in order to keep them informed of all that is going on in the business. The information provided must be thorough, accurate, and transparent.

To cultivate an environment where corporate leaders can be good financial stewards, there must be in place well-defined rules and procedures for making decisions on corporate affairs. Objectives must be considered at the starting point. Furthermore, any decision must be based on objectives that serve the interest of the shareholders. Finally, a means of monitoring performance, obtaining feedback, and continuous improvement should be part of the process. Accordingly, the six-step process described previously may serve as a guide to facilitating good financial stewardship.

In addition to their knowledge of good corporate governance techniques, corporate leaders should be aware of some warning signs that may indicate the occurrence of faulty practices. For instance, if managers are resorting to earnings management techniques as a means of maintaining a positive environment of financial stewardship, they could actually be putting the company at risk. Earnings management is the act of manipulating financial information in such a way as to shed more favorable light on the company or its management than is actually warranted. Some typical earnings management techniques include the following:

• Early recognition of revenues
• Early shipment of products
• Falsification of customers
• Falsification of invoices or other records
• Allowing customers to take products without taking title to the products

Earnings management is unethical, because it involves stretching the rules beyond their intended bounds. In addition, earnings management tends to have a snowball effect, meaning that once it is started, it must be continued in order to prevent a negative result in terms of financial stewardship.

These components of financial stewardship and the related processes are very closely tied to the other functions of corporate governance. In order to enhance financial stewardship, effective management oversight and internal control procedures must be in working order. Furthermore, an ethical foundation must be in place. The next section addresses the ethical considerations for corporate governance.

ETHICAL CONDUCT

From the preceding presentations on the functions of corporate governance, it should be clear that creating a culture of honesty is a fundamental part of the model of effective corporate governance. Integrity, fairness, and accountability are the underlying concepts in each of the other roles of corporate governance, including the descriptions for sound systems of management oversight, internal controls, and financial stewardship. Because of its widespread relevance, ethical conduct is often valued as the most important part of corporate governance.

Good corporate governance must rely on the professional integrity of the company's leaders. A system of corporate governance can be only as good as the people in charge (regardless of the policies and procedures in place to enhance the various functions within the structure). Although many suggestions have been published for enhancing corporate conduct through strong management oversight, internal controls, and financial stewardship, there is no replacement for integrity and ethical behavior.

The next section introduces some of the most significant laws that have influenced the changing face of corporate governance over the years.