Home Corporate Governance Influence of corporate governance laws on financial performance and stability of an...

Influence of corporate governance laws on financial performance and stability of an enterprise

March 19, 2024

392

This article has been written by Tejal Vengurlekar pursuing a Diploma in Corporate Law & Practice: Transactions, Governance and Disputes course from LawSikho.

This article has been edited and published by Shashwat Kaushik.

Introduction

Corporate governance laws have a major impact on the financial performance and stability of a company. These laws set guidelines for how businesses should be run, emphasising transparency, accountability, and ethical behaviour. When companies follow these laws, they are more likely to have strong financial controls, accurate reporting, and effective risk management practices. This helps improve their financial performance by reducing the likelihood of fraud or mismanagement. Additionally, corporate governance laws often require independent oversight through boards of directors and audit committees, ensuring that decisions are made in the best interest of the company and its shareholders. This contributes to the overall financial stability of the enterprise. So, implementing good governance practices is very important for companies to thrive financially.

Need for corporate governance

The need for corporate governance is important for companies to be well-managed, accountable, and transparent. Corporate governance is about how a company is directed and controlled. The governance structure decides who has what rights and responsibilities in the company, like the board of directors, managers, shareholders, creditors, auditors, regulators, and other people involved. It also sets the rules and procedures for making decisions about the company. The following are corporate governance requirements:

Changing structure of ownership

Corporate governance protects the rights of stakeholders by making sure they are followed. Since a company has many stakeholders with different views, corporate governance helps in managing the ownership structure of the company without harming its reputation.

Therefore, corporate governance helps in changing the ownership structure of the company, and it would not affect the goodwill of the company.

Enhancing enterprise valuation

Enhancing operational transparency and management accountability is like giving a power boost to the company. When the company becomes more transparent and holds its management accountable, it builds trust with investors. And this trust increases the worth of the corporation.

Social responsibility

The importance of social responsibility is increasing day by day. The Board of Directors plays a crucial role in safeguarding the rights of customers, employees, shareholders, and other stakeholders. This can become possible only if the board of directors uses corporate governance.

Growing number of scams

In recent years, we’ve been witnessing an increase in scams, frauds, and corrupt practices not only in India but worldwide. The misuse and misappropriation of public money are serious issues that need to be addressed. One effective way to prevent these scams and financial irregularities is for the company to start implementing corporate governance principles.

Globalisation

The big companies that are selling their goods in the global market need to attract foreign investors and foreign customers. They have to follow foreign rules and regulations. Without corporate governance, it would be nearly impossible for companies to enter, survive, and thrive in the global market.

Better-decision making

Good governance plays a vital role in ensuring well-managed and accountable decision-making throughout a business. When decisions are made with transparency and accountability, they tend to be of higher quality and lead to better outcomes for the company.

Corporate governance and financial performance

Theoretical review

Agency theory

Agency theory is really important when it comes to studying corporate governance. It provides insights into how the relationship between managers and shareholders can affect the company’s bottom line.

By aligning the interests of managers with the financial performance of the company, such as through variable remuneration based on growth, the agency theory helps ensure that managers act in the best interest of shareholders. This can lead to improved decision-making, increased accountability, and ultimately better financial results.

Additionally, agency theory emphasises the importance of transparency, control mechanisms, and proper governance practices. By implementing these measures, companies can reduce conflicts of interest, mitigate agency costs, and enhance overall financial performance. By implementing suitable incentives and controls, corporate governance helps to minimise conflicts of interest and enhance the company’s financial performance.

In summary, agency theory contributes to the understanding of how governance structures and incentives impact the financial performance of an enterprise. By aligning the interests of managers and shareholders and implementing effective control mechanisms, companies can strive for improved financial outcomes.

Stewardship theory

Stewardship theory suggests that when managers have a sense of ownership and act as stewards of the company, it can positively influence financial performance.

In stewardship theory, managers are seen as responsible caretakers of the company’s resources and are motivated to act in the best interest of shareholders. They focus on long-term goals, make decisions that benefit the company as a whole, and prioritise the sustainable growth and profitability of the enterprise.

When managers embrace the principles of stewardship, it can lead to improved financial performance. Their commitment to the company’s success can result in better decision-making, increased innovation, efficient resource allocation, and stronger relationships with stakeholders. These factors ultimately contribute to enhanced financial outcomes for the enterprise.

Resource dependence theory

Resource dependence theory is an interesting perspective to explore when considering the impact on the financial performance of an enterprise. According to this theory, organisations rely on external resources such as capital, information, and partnerships to function effectively. When an enterprise effectively manages its external resource dependencies, it can positively influence its financial

Transaction cost theory

Transaction cost theory suggests that the costs associated with conducting business transactions can impact the financial performance of an enterprise. These costs include not only the actual monetary costs of transactions but also the time, efforts, and resources required to complete them. By understanding and managing transaction costs effectively, businesses can improve their overall financial performance.

Stakeholder theory

Stakeholder theory states that considering the interests and needs of various stakeholders, such as customers, employees, suppliers, and the community, can positively impact the financial performance of the enterprise. By prioritising stakeholder relationships and addressing their concerns, businesses can enhance customer loyalty, attract talented employees, strengthen supplier’s relationships, and build a strong reputation in the community. All these factors can contribute to improved financial performance. The companies have accountability for management to a wide range of stakeholders, such as employees, customers, and suppliers. The theory focuses on managerial decision-making and the interests of all stakeholders.

Thus, effective corporate governance will consider the interests of both stakeholders and shareholders.

Effect of governance on performance

Corporate governance is a significant factor that influences an economy’s growth prospects. Good governance practices reduce investor risk, improve financial performance, and attract more investors. At its most basic level, corporate governance addresses issues that arise from the separation of ownership and control. But corporate governance goes beyond just establishing a clear relationship between shareholders and managers. Strong governance standards provide better access to capital and contribute to economic growth.

When a firm adopts corporate governance, it appears to have a better risk return for investors. These governance mechanisms assure investors that they will receive satisfactory returns on their investments. If these mechanisms did not exist or did not function properly, outside investors would be less inclined to invest in the firms or buy their equity securities. This would lead to missed business opportunities and financial distress that could spread to firms, employees, and consumers.

Poor corporate governance in a company often stems from a lack of understanding of how to implement effective corporate practices in business activities. As a result, some companies experience losses and even face the risk of bankruptcy. This is caused by an unset relationship between stakeholders and investors, inefficient financial reporting, and weak enforcement of laws within the company. On the other hand, implementing good corporate governance practices can lead to more effective and efficient financial performance.

Thus, corporate governance measures have a significant impact on a company’s financial performance.

Corporate governance laws in India

Companies Act, 2013

This Act lays down the structure for corporate governance in India. It includes provisions related to the composition and functioning of boards of directors, shareholder rights, disclosure requirements, and the responsibilities of directors and auditors. Key provisions of the Act include:

Board of directors
- Composition: The Act mandates the inclusion of independent directors in the board, ensuring a balance of interests and promoting transparency.
- Functioning: The Act requires regular board meetings, outlining the duties and responsibilities of directors, including decision-making processes and risk management.
Shareholder rights
- Voting: The Act safeguards shareholder rights by providing voting rights on important corporate matters, empowering them to influence decision-making.
- Information disclosure: Companies are required to disclose financial statements, director remuneration, related party transactions, and other relevant information to shareholders.
Disclosure requirements
- Financial reporting: The Act prescribes stringent financial reporting standards, ensuring transparency and accountability in financial disclosures.
- Corporate social responsibility: Companies are mandated to undertake corporate social responsibility (CSR) activities, fostering a sense of social responsibility among businesses.
Responsibilities of directors and auditors
- Directors’ duties: The Act outlines the duties and responsibilities of directors, emphasising the importance of acting in the best interests of the company and exercising due diligence.
- Auditors’ responsibilities: The Act defines the role and responsibilities of auditors, emphasising their independence and the need for thorough audits to ensure the accuracy and reliability of financial statements.

The Companies Act of 2013 aims to establish a robust corporate governance framework in India, promoting transparency, accountability, and ethical practices in the corporate sector. It seeks to protect the interests of shareholders, creditors, and other stakeholders, fostering a conducive environment for investment and economic growth

SEBI Listing Regulations

The Securities and Exchange Board of India (SEBI) has established listing regulations that govern companies listed on stock exchanges. These regulations cover various aspects of corporate governance, including board composition, audit committees, related-party transactions, and disclosure requirements.

Independent directors

The Companies Act, 2013 requires certain companies to appoint independent directors on their boards. These directors are expected to provide unbiased and objective judgement in decision-making processes.

Insider trading regulations

SEBI has implemented regulations to prevent insider trading, which is the illegal practice of trading securities based on non-public information. The main objectives of these regulations are to make sure that markets are fair and transparent.

These are examples of the corporate governance laws in India. It’s important for companies to comply with these laws to maintain good governance practices.

Corporate governance impact on financial stability

Corporate governance has a positive impact on the financial stability of an enterprise. When a company has effective governance practices in place, it helps ensure that the company is being managed in a responsible and transparent manner; this, in turn, can lead to better financial performance and stability.

With strong corporate governance, there is a clear structure and accountability within the organisation. This helps in making informed and strategic decisions, which can contribute to long-term financial stability. It also helps in managing risks effectively, preventing fraud, and ensuring compliance with laws and regulations.

Financial stability can be achieved only by the interaction of three basic pillars: sound leadership within the company, effective regulation and supervision, and market discipline. These three elements form the foundation for a healthy financial system. At the firm level, sound leadership is crucial in safeguarding against financial system instability. It starts with good corporate governance, which includes having capable and experienced directors and management. They should have a clear and logical strategy and business plan in place. Responsibility and accountability are also key aspects of sound leadership.

On the other hand, weak corporate governance can lead to financial instability. Lack of transparency, inadequate risk management, and unethical practices can spoil an investor’s confidence and result in financial difficulties for the enterprise.

In short, strong corporate governance positively impacts the financial stability of an enterprise by promoting responsible management, risk mitigation, investor confidence, and access to capital.

Conclusion

It is concluded from the above that corporate governance laws have a significant impact on the financial performance and stability of an enterprise. These laws ensure transparency, accountability, and ethical behaviour within companies. By following these laws, companies can improve their financial performance through risk management, strong internal controls, and accurate financial reporting. Additionally, corporate governance laws promote investor confidence and attract capital, contributing to the overall financial stability of the enterprise.

Therefore, if companies aim to enhance their value and growth, it is imperative for them to adopt corporate governance principles and effective decision-making processes.