Corporate Governance: Structure and Consequences

Abstract

We discuss in this chapter important aspects of the corporate governance structure andexamine its impact on corporate performance. We especially focus on internal and externalcontrol mechanism and discuss how they make corporate governance more effective,enhance the quality of financial reporting, improve the firm’s performance, and thusenhance firm value.With passage of the Sarbanes-Oxley Act in 2002 (SOX), two important changes havetaken placed in the internal control mechanism. First, the audit committee has receivedincreased attention; it has been given authority to appoint external auditors and to deal withthem directly on accounting issues. Moreover, it has the responsibility to ensure highquality of financial reporting. Second, internal controls have been strengthened to providean effective monitoring of managerial activities. The main objective of internal controls isto ensure that managerial activities are properly supervised and managers do not use theflexibility provided in the accounting standards to achieve their own goals that are inconsistentwith investors’ goals. In order to enhance the quality of financial reporting,managers are especially monitored to ensure that they do not engage in policies andactivities that result in manipulation of reported earnings.The SOX has also improved the external control mechanism, provided by externalauditors and market controls. The SOX especially focuses on ensuring independence ofexternal auditors by restricting their functions to auditing only and not permitting them toperform advisory and other forms of non-auditing services, with the exception of taxservices, so that their independence is not compromised. Additionally, the auditor inchargeis rotated under SOX to ensure his/her independence. We also discuss differentanti -takeover control devices, which are triggered when a firm becomes a target fortakeover because other firms perceive the target’s weak performance as an opportunityfor takeover and benefit from it.