Sample Management Essay Paper on Agency Theory And Corporate Governance

Agency Theory and Corporate Governance

            Corporate governance is an important pillar of success in enterprises. It defines how a corporation is controlled. It also provides guidelines on the strategic relationships between a corporation and its stakeholders with the view of improving operational and financial performance. Organizations are increasingly under pressure to establish a competitive edge in the market by their stakeholders. With a functional corporate governance system, they are better placed when it comes to affirming their credibility in a highly sensitive and globalized business environment than without (Argüden 2010). Credibility is an essential competitive tool, especially when it is entrenched in the governance structure of a company as a strategic, operational approach.

High corporate governance standards streamline operations significantly and reduce firm’s risks, which can translate into increased financial performance, which ultimately boosts investor confidence (Todorović 2013, 47). The firm stands to benefit from the resulting increased flow of investment funds. Over the past few decades, the United Kingdom has distinguished itself globally as one of the economies with a functioning corporate governance code. The publication of the Cadbury Report in 1992 marked a new chapter in the management of publicly traded companies as it introduces the position of outside directors to serve on the boards of these companies (Foley 2017). Additionally, various countries have followed suit in publishing similar corporate governance principles, codes, and guidelines. However, measuring their impact on company performance requires a suitable method that factors in all the variables affecting performance.

Models of Measuring the Impact of Corporate Governance

The indicators used for measuring corporate governance are varied depending on various factors including geopolitical region because different countries have different rules, regulations, and cultural factors that govern their corporate sectors and economy in general. The variations are also common between firms. Several countries around the world have published corporate governance guidelines, which firms can use to hinge their strategic management and performance. Similarly, firms within the same jurisdiction may implement different systems depending on their objectives, leadership structures, and nature among other factors. Furthermore, the point of departure between these systems is organizational control and ownership. That is the type of shareholder who has a controlling stake in the firm and the degree of their control (Hoi and Robin 2010, 125).

Power and responsibilities are distributed and shared between the shareholders differently depending on the system of corporate governance adopted by a firm (Maher and Andersson 1999, 4). Consequently, countries such as the United Kingdom (UK) and the United States (U.S.) have a corporate governance system marked by strong corporate managers and weak shareholders. In countries such as Japan and most of Europe wherein outsider, corporate governance system is predominant; the shareholders exert a greater degree of organizational control and ownership than when it is not. Regarding power, the managers in various firms across these regions are weak.

Both systems require balancing of the conflicting interests of managers and shareholders with the view of improving corporate performance. Studies have shown that the level of credibility and high performance as a result of effective corporate governance system attract investors. This preferential treatment by investors gives such firms a competitive edge in a marketplace that is increasingly becoming competitive. Such firms stand to benefit from the increased financial base, which is critical in actualizing a firm’s growth and development objective (Maher and Andersson 1999, 4-5). 

There are two primary models for gauging the impact of corporate governance on corporate performance: stakeholder and shareholder models. The main difference between these models is the perceived objective of the firm. Under the shareholder model, a firm’s primary objective is to advance the financial interests of the shareholders in the most efficient way. Such a profit maximization-oriented approach gauges the impact of corporate governance on the firm by looking at its market value. All productive efforts are channeled towards increasing shareholder value. This model outlines the duties and responsibilities of a firm’s senior management towards shareholders. The managers have no ownership rights but have objectives such as salary maximization that may conflict with the interests of the shareholders (Maher and Andersson 1999, 5-9).

On the other hand, a stakeholder model takes a broader view of the concept of a firm. The firm is made up of a network of relationships that extend beyond shareholders. Therefore, it should be managed in the best interest of all parties involved in the firm or whose lives are affected by its operations. Therefore, performance is measured according to the long-term impact that the firm has on the public and shareholders. Success is measured on the long basis and covers a broad range of performance metrics including social responsibilities, financial success and the strength of informal and formal relations with the stakeholders. However, the focus of this model can be narrowed down to those stakeholders who have a closer relationship with the firm such as customers and employees. Others include suppliers and other players in the company’s supply chain (Maher and Andersson 1999, 5-9).

Methods of Measuring the Impact of Corporate Governance

            Good corporate governance is marked by social legitimacy or credibility of a firm’s management and management approaches and financial efficiency. It revolves around helping the firm attain its strategic goals. Dahya and McConnell’s (2007) study established that companies complying with the guidelines and recommendations of the Cadbury Report or the Cadbury Code registered significant improvements in their operations especially when their return on assets (ROA) was gauged. In essence, the Cadbury Code particularly recommends a significant change in the management and control of publicly traded companies. The recommendation to include outside directors into the management structure of a firm potentially affects decision making, investor confidence, and firm credibility (Todorović 2013, 47). Undoubtedly, these factors combine to impact the financial and operational performance of any firm. The following two key methods were used in gauging the impact of corporate governance system on the performance of the firms.

Measuring Operating Performance

The implementation of a corporate governance system such as the Cadbury Code or the OECD Principles on Corporate Governance changes key operational areas. To statistically deduce these changes in the organizational operations, it is imperative that key areas that would be affected be identified. One such area is the return on assets (ROA) which is a component of a firm’s accounting earnings. The impact of corporate governance system can be measured by establishing the correlation between the number of outside directors and value of the company’s assets and equity (Gompers et al. 2003, 110). Additionally, such data is collected over a period and compared with those obtained from companies that do not use a definite corporate governance system over the same period. When broken down to its constituent indicators, measurement of ROA factors in the cost of goods sold by the firm, the sales volume, company expenses and the firm’s assets (Larcker, Richardson, and Tuna 2009, 970).

Studies have shown that companies that comply or implement the Cadbury Code show a significant improvement in their asset and equity values. Moreover, such companies record a significant growth in their sales and asset base. However, their expenses reduce significantly. The growth in ROA metrics such as equity and company value is as a result of improved investor confidence and preference (Todorović 2013, 47; Leuz, Lins, and Warnock 2009, 3246). More investors are willing to invest in such companies as they are perceived as well managed. This is further reinforced by the favorable perception investors have of such firms when it comes to credibility metric. The reduction in expenses is due to the streamlining of operations, which includes tighter measures to reduce overhead costs and management of payroll (Dahya and McConnell 2007, 552). These indicators point to a shareholder model whereby the primary objective of the senior management of these firms is to maximize profits and increase the shareholder value. However, measuring operating performance is also stakeholder-based model with characteristics of a shareholder model. It not only focuses on the shareholder; but also focuses on other factors that influence the operations of the firms. Furthermore, it factors in the contribution of customers and employees of these firms. Effective payroll management resulting from corporate management practices also benefits the employees. The increased sales and cost of goods sold are reflective of the firms’ improved relationship with the clients.    

Measuring Stock Prices   

The announcement of new inside and outside directors usually impacts the stock prices of companies whose shares are listed on the stock markets. Measuring the changes in stock value is a shareholder model that provides useful insights on how a corporate governance code applied by a firm can impact their stock prices (Aoki and Jackson 2008, 3). The appointment of additional outside directors improves the stock value of the firm. The study shows that firms that announce the election of at least three external directors records high levels of stock value growth compared to firms which appoint less than three outside directors. Additionally, companies which appoint inside directors typically register low growth in their stock value. This trend is indicative of investor confidence due to the perceived credibility of the firm (Todorović 2013, 47). While these methods provided definitive and statistically significant data to gauge how implementing a functional corporate governance code can affect a firm’s operations and stock value, some of the ways were ineffective. One such method is the measurement of the impact separating the chief executive officer, and chairman of the board would have on a firm’s return on assets and stock value. The power separation, as suggested by the Cadbury Code, has a statistically insignificant effect on these metrics for measuring organizational performance. Despite their failure, they point to a growing literature that supports the bundles approach to measuring how such codes affect performance.

The Bundles Approach  

According to Schnyder (2012), there are “four central claims or insights” that can be used to summarize this approach. These claims include the “degrees of implementation, equifinality, configurational, and contingency claims” (p. 11). The ‘degrees of implementation claim’ is founded on the view that corporate governance mechanisms and practices are implemented differently across various organizations. As such, firms can mix these systems differently and with varying intensity. In some cases, firms may configure their corporate governance mechanisms to tackle specific challenges prevailing within the firm at a specific time or to align the firm’s operations with the business environment. This configuration is the contingency claim of the bundle’s approach. The equifinality claim contextualizes the firm’s decision to substitute a specific corporate governance practice bundle with an option that will result in similar performance outcome. This functional equivalence of bundles allows for firms to choose the most efficient way of meeting the wealth needs of the shareholders. In the case of the stakeholder model, it allows the senior management to attain long-term growth and development in a socially responsible way. The configurational claim of corporate governance is founded on the substitutability and complimentary functioning of practices (Schnyder 2012, 12). Therefore, such mechanisms are only effective in positively impacting a company’s performance when combined. Additionally, finding the most effective combination of the practices can be achieved through substitution (Aguilera and Desender et al. 2012, 382; Aguilera et al. 2008, 476).

Problems in Undertaking the Studies

One of the greatest challenges in measuring the impact of corporate governance codes on organizational performance is the lack of a universally accepted code. Countries and firms implement these codes various combinations depending on various contingencies, rules, and cultural factors (Bebchuk and Hamdani 2009, 1264). This makes it relatively difficult to discern with certainty whether any particular guideline contained in the codes are effective or not. Additionally, it may be difficult to measure the cause and cost of non-compliance with these codes because they are variables that are affected by several factors that extend beyond compliance with these codes (Coles, Daniel, and Naveen 2007, 2). In his study of the bundles’ approaches, Schnyder (2012) acknowledges that proper an understanding of how corporate governance codes affect organizational operations requires a sophisticated methodology because of the intricate interconnection of factors that affect a firm’s performance. However, such a deep approach also requires factoring in of many factors that will eventually make such studies nonviable. It will increase the likelihood of adding numerous variables which are not correlated and hence their impact on an organization cannot be ascertained with accuracy.

Assumptions of the Study

The study conducted by Dahya and McConnell in 2007 made two fundamental assumptions that acted as the guiding pillars of the study. Like in previous literature, the study assumed that firms with more outsider directors on their board enjoy the better performance as they are bound to benefit from better decision making by the boards. Therefore, instead of testing whether there is a correlation between better decision making and outside directors, the researchers set to determine how such directors affect operational performance and stock values of firms. Additionally, the researchers assumed that changes made to the boards of the firms they sampled during the study period were not entirely endogenous (Dahya and McConnell 2007, 556).     

Conclusion

Since the publishing of the first Cadbury Report in 1992, there has been a growing push for corporations and countries to publish corporate governance guidelines that would set operational standards for management. Over the years, various countries have followed in the footsteps of the United States and the United Kingdom and published these codes. However, they vary between countries and firms due to economic and cultural issues. Rules, regulations, and laws in various geopolitical regions also lead to variations in the stipulations of these codes. Even between firms operating within the same geopolitical region, the codes can vary due to the lack of a universally accepted standard for corporate governance approach. As a result, corporations apply these codes in a variety of combinations that are reflective their preexisting challenges. Additionally, whether temporal, organizational or environmentally induced, the combinations of these codes have far-reaching effects on the operational performance of an organization. Moreover, with no universally applicable code and a plethora of factors that affect the performance of any organization, measuring the impact of these codes can be challenging.

            The Cadbury Code or its variants is widely used corporate governance code in territories beyond the United Kingdom. Its primary stipulation is that publicly held companies are mandated to include outside directors on their boards, which is informed by the assumption that such directors can potentially improve decision-making processes and consequently lead to improved corporate performance. Such an assumption primarily uses a shareholder model of measuring performance. It narrows down the concept of a firm and confines a firm’s primary objective as profit maximization. Therefore, performance within the context of such a code is primarily based on operating performance of the firm and growth of its stock value.

            The operating performance of a firm applying the Cadbury Code can be gauged by measuring the firm’s return on assets, and it includes measuring the market value of the firm’s equity and market value. Firms that have incorporated the code into their management practice usually enjoy greater investor confidence, which translates into improved operating performance. Optionally, firms can also measure the effect stipulations of the codes such as the number of outside directors appointed to the board on stock value. Despite the numerous factors that can affect such metrics, there is a positive correlation between implementing corporate governance systems and improved performance across key areas.

References

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Aguilera, RV et al., 2008. An organizational approach to comparative corporate governance: Costs, contingencies and complementarities. Organization Science 19(3), pp. 475-492.

Aoki, M and Jackson, G, 2008. Understanding an emerging diversity of corporate governance and organizational architecture: An essentially based analysis. Industrial and Corporate Change 17(1), pp. 1-27.

Argüden, Y, 2010. Measuring the effectiveness of corporate governance. INSEAD Knowledge. [Online] (Updated 16 April 2010). Available at: <https://knowledge.insead.edu/leadership-organisations/measuring-the-effectiveness-of-corporate-governance-1149> [Accessed 12 Oct. 2017].

Bebchuk, LA and Hamdani, A 2009. The elusive quest for global governance standards. University of Pennsylvania Law Review 157(5), pp. 1263-1317.

Coles, J, Daniel, ND, and Naveen, L, 2007. Board: Does one size fit all? Journal of Financial Economics.

Dahya, J and McConnell, JJ, 2007. “Board Composition, Corporate Performance, and the Cadbury Committee Recommendation.” The Journal of Financial and Quantitative Analysis, 42(3), pp. 535-564.

Foley, S, 2017. “The battle of the US corporate governance codes. Financial Times. [Online] (Updated 5 Feb. 2017). Available at: <https://www.ft.com/content/e52f6f22-e93c-11e6-893c-082c54a7f539?mhq5j=e7> [Accessed 12 Oct. 2017].

Gompers, PA et al., 2003. Corporate governance and equity prices. Quarterly Journal of Economics 118(1), pp. 107-155.

Hoi, C-K and Robin, A, 2010. Agency conflicts, controlling owner proximity, and firm value: An analysis of dual-class firms in the US. Corporate Governance: An International Review 18(2), pp. 124-135.

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Leuz, C, Lins, KV and Warnock, F, 2009. Do foreigners invest less in poorly governed firms? Review of Financial Studies, 22(8), pp. 3245-3285.

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Schnyder, G, 2012. Measuring corporate governance: Lessons from the ‘bundles approach.’ Centre for Business Research, University of Cambridge. Working Paper No. 438, 2012.