Corporate Governance: Structure and Consequences

We discuss in this chapter important aspects of corporate governance structure and examine its impact on corporate performance. We especially focus on the internal and external control mechanism and discuss how they make corporate governance more effective, enhance the quality of financial reporting, improve firm performance, and thus enhance firm value. With passage of the Sarbanes-Oxley Act in 2002 (SOX), two important changes have taken place in the internal control mechanism. First, the audit committee has received increased attention; it has been given authority to appoint external auditors and to deal with them directly on accounting issues. Moreover, it has the responsibility to ensure high quality financial reporting. Second, internal controls have been strengthened to provide an effective monitoring of managerial activities. The main objective of internal controls is to ensure that managerial activities are properly supervised and managers do not use the flexibility provided in accounting standards to achieve their personal goals that are inconsistent with investors’ goals. In order to enhance the quality of financial reporting, managers are especially monitored to ensure that they do not engage in policies and activities that result in manipulation of reported earnings. The SOX has also improved the external control mechanism, provided by external auditors and market controls. The SOX especially focuses on ensuring independence of external auditors by restricting their functions to auditing only and not permitting them to perform advisory and other forms of nonauditing services, with the exception of tax services, so that their independence is not compromised. Additionally, the auditor in-charge is rotated under SOX to ensure his/her independence. We also discuss different antitakeover control devices, which are triggered when a firm becomes a target for takeover because other firms perceive the target’s weak performance as an opportunity for takeover and benefit from it.