The Role of Corporate Governance in Improving Companies Performance - Literature review Example

The Role of Corporate Governance in Improving Companies’ Performance Introduction The concept of corporate governance has existed for a long time, although it attained full attention in the 1990s. More specifically, corporate governance received a lot of attention in the UK after the Cadbury’s report in 1992. Corporate governance denotes principles, processes, systems, and policies put in place to ensure that there is a salient protection of stakeholder interest in the governance of a company. As highlighted by Bijalwan and Madan (2013, p. 56), companies that register remarkable levels of corporate governance comply with both statutory and legal requirements in their specific industry. In basic terms, corporate governance deals with how a company is controlled and directed. It involves numerous structures and processes that exist in an effort to monitor the proper management of the company, ensuring that it exhibits ethical behaviour, and that it does not contravene existing laws. Other scholars have defined corporate governance as a complex relationship between the company’s board of directors, management team, shareholders, and stakeholders. The Organization for Economic Co-operation and Development (OECD) adopts this broad definition bringing into concepts the relationships between the management, the board of directors, and all the stakeholders of an organization. The management team and the board of directors play entirely different roles. According to Bhagat and Bolton (2013, p. 116), corporate governance places emphasis on the role of the board of directors in ensuring that managers perform their roles effectively. Scholars have focused on describing the existing relationship between corporate governance and the performance of a company. According to the research findings from numerous studies, there is a close association of good corporate governance and the remarkable performance of the organization. Emerging researches have been more specific in defining the significance of good corporate governance and the performance of a company. Currently, there are conflicting views on the effect of good corporate governance on the performance of the organization. This literature review will present a critical analysis of the existing literature concerning the effect of corporate governance on company performance. The corporate governance of any organization comprises of internal governance and external governance mechanisms. Both of these mechanisms have the potential to result in appropriate accountability as well as responsibility to stakeholders. The external governance mechanisms include international agencies, national regulatory agencies, as well as the professional institutes and other associations that affect the operations of the company. The internal control mechanisms involve the management strategies used within the organization. Many researchers opine that effective corporate governance can only result if the board of directors as well as the senior management team understand their roles clearly and work on building healthy relationships with other parties within the corporate structure. The concept of corporate governance has four fundamental pillars. These include accountability, transparency, responsibility, and fairness. Accountability in this case denotes clear governance roles, responsibilities, and effective support to the management team in an effort to promote shareholder interests. The board of directors has a critical role to play in ensuring that there is a high level of accountability in an organization. This is because the board of directors carries out the monitoring functions and ensures that the management team remains accountable. On its part, the board of directors should also prove accountable to the shareholders who are the real owners of the company. Many scholars agree on the role of the board of directors in ensuring that there is accountability. None of the existing literature underestimates the role of the board of directors in promoting accountability within an organization. The second pillar is transparency, which is evident when a company releases adequate information concerning its financial performance. Usually, companies face the compulsion of releasing annual reports of their financial performance as well as quarterly financial reports in each financial year. The third pillar deals with responsibility, which brings into concept the company's compliance with relevant regulations as well as corporate social responsibility. The fourth pillar is fairness, which promotes the protection of the rights of the shareholders irrespective of their position. These four pillars ensure that a company has good corporate governance practices in place. Different scholars have exhibited interest in determining the effect of good corporate governance on the performance of a company. In addition, there is a salient need to determine whether poor corporate governance can contribute to the declining performance of a company. According to Brown and Caylor (2004, p. 156), who sought to determine the relationship between corporate governance and firm performance, there is evidence that good corporate governance contributes positively to the remarkable performance of the company. The study sought to determine whether companies with poor corporate governance practices proved to be profitable. It emerged that only companies that exhibited good corporate governance practices were profitable in the market. This study also highlighted that companies that lack proper corporate governance are more vulnerable to risks and pay out minimal dividends to shareholders. On the other hand, companies with good corporate governance practices did not exhibit a higher level of vulnerability to risks in the market and paid remarkable dividends to shareholders (Sicoli 2013, p. 9). The study focused on four aspects that define corporate governance in an effort to identify which of the factors had more influence of corporate governance. They focused on board composition, compensation, takeover defences, and audit. It emerged that board composition is one of the critical factors that determines, whether a company exhibits good corporate governance practices. In an additional study carried out by Chiang (2005, p. 127), it emerged that transparency of an organization had a direct relationship with its corporate performance. This empirical study sought to determine whether transparency of the corporate had any impact on the operating performance. Findings from this study highlighted that corporate transparency was one of the critical indicators in determining corporate performance. It emerges that, the composition of the board, as well as the transparency level of the company, are some of the critical factors that determine the performance of the company. Transparency is one of the pillars of corporate governance as described above (Simberova, Kocmanova, & Nemecek 2012, p. 1587). Therefore, it is evident that corporate governance has a direct effect on the performance of any company. Epstein and Roy (2004, p. 1) have highlighted that the board’s composition has emerged as one of the aspects of corporate governance that has received attention from many scholars. The Cadbury report produced in 1992 placed emphasis on the need for non-executive directors on the board. Worth noting is the fact that the board comprises of either executive directors connected non-executive directors as well as independent non-executive directors. Prior to the Cadbury case, many organizations had executive directors forming the entire board. Worth noting is the fact that executive directors have a role on the board and have other responsibilities in the operations of the organization. According to Ferrer and Banderlipe (2012, p. 127), non-executive directors do not play other roles within the organization. However, some of them may have affiliations to the organizations while others remain entirely independent. Hu, Tam, and Tan (2010, p. 734), have exhibited their conviction that there should be a higher number of independent directors in the composition of the board. This is in accordance with the agency theory, which highlights that self-interested actors will only promote their own interests. The presence of independent directors on the board is a measure of ensuring that the chief executive officer does not have excessive powers in decision-making. Therefore, independent directors control the powers of the chief executive officer and bring expertise into the board, a factor that ensures effective decision-making. A number of researches have highlighted that board independence is one of the critical aspects of good corporate governance. This has triggered further research in an effort to determine whether companies that have an independent board are more likely to register long-term company performance ('Good practice boosts performance' 2003, p. 222). None of these studies have highlighted that an independent board offers the assurance that a company will register high performance. This means that there are numerous factors related to corporate governance that affects the company’s performance (Saltaji 2013, p. 140). One of the main setbacks in determining the effect of corporate governance on company performance is that company performance is highly volatile and subject to numerous changes in the market. On the other hand, measures or indicators of determining good corporate governance need time because corporate governance changes take place slowly. As highlighted by Ismail, Nur, and Shukeri (2014, p. 373) it places barriers in the determination of whether company performance at a specific time is because of the prevailing corporate governance practices. However, studies that can monitor corporate governance changes and the responding company performance over a given period are more likely to present reliable results. Needles and his colleagues (2012, p. 515) argue that one of the factors that have contributed to the conviction that corporate governance has a direct effect on company performance is the fact that investors exhibit a lot of interest in companies with good corporate governance reputation. This places companies with good corporate governance at an advantage because they have a non-limited cash flow from external investors as highlighted by Nur'ainy and his colleagues (2013, p. 91). This fact has the potential of driving an organization to a higher performance in the market. Eventually, this serves to increase the share value of the company and the share performance in the stock market. On the other hand, no investor exhibits interest in companies with poor corporate governance practices (Nuryanah and Sardar 2011, p. 20). Therefore, such companies have to rely on their internal cash flow or loans, which attract high interest rates. All these factors can contribute to a lower performance of such a company. According to McCahery, Vermeulen, and Hisatake (2013, p. 120), the board of directors has a critical role in ensuring that the company has a risk management framework as well as internal control procedures. The board must ensure that it carries out a rigorous assessment of any business risk before the company can venture into it. It must ensure that the risk is worth taking in an effort to protect the interests of the shareholders. Therefore, companies with good corporate governance only take calculated risks with a clear understanding of all the implications of the risk. This one strategy can drive a company to remarkable performance in the market (Kocmanova & Simberova 2012, p. 487). On the other hand, poor corporate governance means that the company can take risks without proper risk assessment frameworks. This may lead to a decline in the company’s performance if the venture fails. In the end, this may affect both the reputation and the performance of the company. Some researchers have highlighted that the board of directors may prove extremely cautious denying the company an opportunity to take worthy risks. This may have a negative effect on the company performance in the end. However, such occurrences are rare and the assessment of the risks by the board has often prevented companies from making financial mistakes. Jennifer, Vivian, and Lung (2007, p. 267) assert that one of the aspects of corporate governance promoted is the separation of the company chairperson and the chief executive officer. Proponents of this often highlight that when one individual plays both roles, the interests of the shareholders are at a greater risk. Therefore, proponents of this separation argue that an independent chairperson of the board of directors will embrace the role completely and appropriately, ensuring that the board of directors performs its monitoring roles on the managerial action. In such a case, the chief executive officer will focus on managing the operations of the company. Evidently, researchers have sought to determine whether the separation of the chair and the CEO has any positive effect on the company’s performance (Jackling & Johl 2009, p. 500). Earlier researchers in this aspect did not highlight any direct relationship between the separation of the chair and the CEO and the performance of the company. Evidently, further research needs to determine whether the separation of the chair and the CEO is a measure of good corporate governance and whether it can have any direct effect on the company performance (Sáenz & García-Meca 2014, p. 425). Conclusion Evidently, some researches have highlighted that good corporate governance can affect the performance of a company. This is especially the case because poor corporate governance taints the image of a company keeping away investors. One aspect is evident that some aspects of corporate governance do have a remarkable effect on the performance of a company while others may not present any direct relationship. However, a close analysis of companies with poor performance reveals that the board of directors often faces an increased pressure to adopt new corporate governance strategies. In the markets, companies that have reputable corporate governance practices often enjoy premium prices of their shares. Future research is of critical importance in identifying the existing relationships between all the aspects of corporate governance and company performance. Bibliography Bhagat, S, & Bolton, B 2013, 'Director Ownership, Governance, and Performance', Journal of Financial & Quantitative Analysis, 48, 1, pp. 105-135, Business Source Complete, EBSCOhost, viewed 9 December 2014. Bijalwan, J, & Madan, P 2013, 'Corporate Governance Practices, Transparency and Performance of Indian Companies', IUP Journal Of Corporate Governance, 12, 3, pp. 45-79, Business Source Premier, EBSCOhost, viewed 9 December 2014. Brown, S. & Caylor, D 2004, Corporate Governance and Firm Performance, European Financial Management, 2, 10, pp. 151-170. Chiang, H 2005, “An Empirical Study of Corporate Governance and Corporate Performance”, the Journal of Law and Economics, 31, 1, pp. 122-140. Epstein, M, & Roy, M 2004, 'Improving the Performance of Corporate Boards: Identifying and Measuring the Key Drivers of Success', Journal of General Management, 29, 3, p. 1, Advanced Placement Source, EBSCOhost, viewed 9 December 2014. Ferrer, R, & Banderlipe II, M 2012, 'The influence of corporate board characteristics on firm performance of publicly listed property companies in the Philippines', Academy of Accounting & Financial Studies Journal, 16, 4, pp. 123-142, Business Source Complete, EBSCOhost, viewed 9 December 2014. 'Good practice boosts performance' 2003, Euromoney, 34, 412, p. 222, Advanced Placement Source, EBSCOhost, viewed 9 December 2014. Hu, H, Tam, O, & Tan, M 2010, 'Internal governance mechanisms and firm performance in China', Asia Pacific Journal of Management, 27, 4, pp. 727-749, Business Source Complete, EBSCOhost, viewed 9 December 2014. Ismail, N, and Shukeri, S 2014, "The Impact of Corporate Governance on Firm Performance: Banking Industries In Malaysia," Advances in Environmental Biology, pp. 373. Academic OneFile. Web. 9 Dec. 2014. Jackling, B, & Johl, S 2009, 'Board Structure and Firm Performance: Evidence from India's Top Companies', Corporate Governance: An International Review, 17, 4, pp. 492-509, Business Source Premier, EBSCOhost, viewed 9 December 2014. Jennifer L JW, W, Vivian VJ, J, & Jin Lung JP, P 2007, 'The Impact of Corporate Governance Structure on the Efficiency Performance of Insurance Companies in Taiwan*', Geneva Papers On Risk & Insurance - Issues & Practice, 32, 2, pp. 264-282, Business Source Premier, EBSCOhost, viewed 9 December 2014. Kocmanova, A, & Simberova, I 2012, 'Modelling of Corporate Governance Performance Indicators', Engineering Economics, 23, 5, pp. 485-495, Business Source Complete, EBSCOhost, viewed 9 December 2014. McCahery, J, Vermeulen, E, & Hisatake, M 2013, 'The Present and Future of Corporate Governance: Re-Examining the Role of the Board of Directors and Investor Relations in Listed Companies', European Company & Financial Law Review, 10, 2, pp. 117-163, Business Source Complete, EBSCOhost, viewed 9 December 2014. Needles, B, Turel, A, Sengur, E, & Turel, A 2012, 'Corporate governance in Turkey: issues and practices of high-performance companies', Accounting & Management Information Systems / Contabilitate Si Informatica De Gestiune, 11, 4, pp. 510-531, Business Source Complete, EBSCOhost, viewed 9 December 2014. Nur'ainy, R, Nurcahyo, B, Kurniasih, S, & Sugiharti, B 2013, 'Implementation of good corporate governance and its impact on corporate performance: the mediation role of firm size (empirical study from Indonesia)', Global Business and Management Research: An International Journal, 2, p. 91, Academic OneFile, EBSCOhost, viewed 9 December 2014. Nuryanah, Siti, and Sardar MN 2011, "Corporate governance and performance: evidence from an emerging market, " Malaysian Accounting Review 10, 1, pp. 17-42. Business Source Complete, EBSCOhost (accessed December 9, 2014). Sáenz González, J, & García-Meca, E 2014, 'Does Corporate Governance Influence Earnings Management in Latin American Markets?', Journal of Business Ethics, 121, 3, pp. 419-440, Business Source Complete, EBSCOhost, viewed 9 December 2014. Saltaji, IM 2013, 'Corporate governance relation with corporate sustainability', Internal Auditing & Risk Management, 8, 2, pp. 137-147, Business Source Complete, EBSCOhost, viewed 9 December 2014. Sicoli, G 2013, 'Role of corporate governance in the family business', Global Conference on Business & Finance Proceedings, 8, 1, pp. 8-16, Business Source Complete, EBSCOhost, viewed 9 December 2014. Simberova, I, Kocmanova, A, & Nemecek, P 2012, 'Corporate governance performance measurement - key performance indicators', Economics & Management, 17, 4, pp. 1585-1593, Business Source Complete, EBSCOhost, viewed 9 December 2014. Read More