Corporate Governance Topic Overview
One of the features that make corporations unique in how they are run, operated, and managed is its structure of corporate governance. In a traditional private business, the owners and strategic managers of a firm or organization are typically the same people or entity. However, in a publicly traded corporation, the owners of a firm and its management are usually two distinct groups. The shareholders of a firm’s stock are the owners of the business, and the Board of Directors is the group that performs the firm’s long-term strategic management. Given its role as the managerial authority of a particular firm or business, the Board of Directors has a number of important functions it must serve for the firm—establish long-term policies and objectives, select the firm’s chief executives (CEO and CFO), approve annual budgets, set salaries and compensation levels for company management, and ensure the availability of financial resources for any upcoming projects or investments. Consequently, the actions of the board and its relationship with company shareholders (especially large blockholders like Warren Buffet or Carl Icahn) have a clear and obvious effect on stock price and firm value.
Like all things, there are some flaws and issues with this standard of corporate governance. First and foremost, there are some agency problems that exist in the current structure. Members of the board of directors and the chief executives such as the CEO and CFO are supposed to act in accordance with the primary goal of financial management: to maximize shareholder value. However, given that the compensation of corporate executives is often tied to bonuses contingent upon achieving certain financial benchmarks, managers may often be tempted to act in way to advance what is in essence their own self-interest rather than the interests of shareholders. The way that the management of Enron used deceptive, improper revenue recognition techniques and special purpose accounts to hide badly performing assets (as a method of maintaining current compensation levels and Wall Street expectations) is a prominent example of this. However, shareholders are not entirely powerless if questionable management is in charge of a firm. They have the power to add and (if necessary) remove certain members of the board if they see fit; most individual investors, unfortunately simply do not have the financial expertise and sophistication that can identify bad managerial practices. Large blockholders such as Warren Buffet and Carl Icahn, however, typically do have considerable financial expertise and can remove badly acting directors. Whether they do so or not largely depends on their investing philosophy and current economic conditions.
The first case that we examined related to the concept of corporate governance was concerning Enron, its board of directors (especially its CEO and CFO), and the degree to which firm management was involved in the accounting scandal that ultimately led to the dissolution and bankruptcy of the company in December of 2001. The collapse of the firm and its subsequent dissolution was primarily the result of egregious accounting improprieties—especially concerning its revenue recognition techniques—through merchant model accounting and mark-to-market accounting. Under Enron’s method of merchant model accounting, they were recording the entire sale of an item or commodity as revenue; however, being only a broker of most of their sales, recording only brokerage fees as revenue is more appropriate. Under mark-to-market accounting, Enron was overstating their revenues by recording the present value of future cash flows of a particular project as revenue. In addition, whenever a particular project or investment segment was not performing to optimal Wall Street standards, the firm would hide these assets in so-called special purpose entities (SPEs) on their balance sheets. While I do