Page 39 - FINAL CFA II SLIDES JUNE 2019 DAY 6

LOS 24.a: Describe objectives and core attributes of an effective
corporate governance system and evaluate whether a company’s READING 24: CORPORATE GOVERNANCE
corporate governance has those attributes

Corporate governance is “the system of principles, policies, procedures, and clearly defined responsibilities and accountabilities used by
stakeholders to overcome conflicts of interest inherent in the corporate form.” Corporate governance has two major objectives:
1. Eliminate or reduce conflicts of interest. Although many conflicts of interest exist in a corporation, most corporate governance systems focus on
the conflict between management and shareholders.
2. Use the company’s assets in a manner consistent with the best interests of investors and other stakeholders.

Corporate governance systems will differ according to the legal environment, culture, and industry in which a firm operates; however, there are core
attributes that all effective corporate governance systems share. An effective corporate governance system will:
• Define the rights of shareholders and other important stakeholders.
• Define and communicate to stakeholders the oversight responsibilities of managers and directors.
• Provide for fair and equitable treatment in all dealings between managers, directors, and shareholders.
• Have complete transparency and accuracy in disclosures regarding operations, performance, risk, and financial position.

LOS 24.b: Compare major business forms and describe the conflicts of interest associated with each.

Sole proprietorships are businesses owned and operated by a single individual. From a legal standpoint, there is no distinction between the business
and its owner, resulting in liability for the owner that is potentially unlimited.
Partnerships are composed of two or more owners/managers, but are otherwise similar to a sole proprietorship in that there is no legal distinction
between the business and its owners. Liability is unlimited, but is shared among the partners. The primary advantage of a partnership structure is that
partners can pool knowledge and capital, as well as share in business risks. Law firms, real estate firms, and advertising agencies are often organized
as partnerships.
Corporations are distinct legal entities that have rights similar to those of an individual person. The top managers of a corporation are empowered to
act as agents of the company and control all corporate activities, including signing contracts, on behalf of the business. Compared to sole
proprietorships or partnerships, corporations have several advantages:
• It is much easier to raise large amounts of capital. A corporation can raise capital by issuing common stock to the public, selling ownership interests
to private investors in exchange for cash, or borrowing money from creditors.
• There is no need for owners to be industry experts. Any individual with sufficient capital can become a shareholder.
• Ownership stakes are easily transferable, which allows a corporation to have an unlimited life.
• Corporate shareholders have limited liability. Since there is a legal distinction between a corporation and its shareholders, the most a shareholder
can lose is the amount invested, nothing more.

Conflict of interest concerns. Corporate shareholders typically have no input in day-to-day management of the firm and usually have difficulty
monitoring a firm’s operations and the actions of management. Separation of ownership and control creates the potential for conflicts between
management and shareholders.