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Theoretical Basis of Corporate Governance

Theoretical Basis of Corporate Governance
There are four broad theories to explain and explicate corporate governance:
ƒ Agency Theory
ƒ Stewardship Theory
ƒ Stakeholder Theory
ƒ Sociological Theory
1. Agency Theory:
In agency theory terms, the owners are the principals and managers are the agents and the loss occurring due to mismatch of objectives is called the agency loss. The Agency theory specifies the mechanisms which reduce the agency losses. Two broad mechanisms that help reduce agency costs and improve corporate performance through better governance are:
Fair and accurate financial disclosure: Financial and non-financial disclosures, which relate to the role of the independent, statutory auditors appointed by shareholders to audit a company’s accounts should present a fair view of the financial health of the corporation.
Efficient and independent board of directors: A joint-stock company is owned by the shareholders, who appoint directors to supervise management and ensure that it does all that is necessary legal and ethical means to make the business grow and maximize long-term corporate value. Directors are fiduciaries of the shareholders, not of the management.

  1. Stewardship Theory:
    The stewardship theory of corporate governance discounts the possible conflicts between corporate management & owners and shows a preference for a board of directors made up primarily of corporate insiders. This theory assumes that managers are basically trustworthy and attach significant value to their own personal reputations.
  2. Stakeholder Theory:
    Stakeholder theory has a lengthy history that dates back to 1930s. The theory represents a synthesis of economics, behavioral science, business ethics and the stakeholder concept. The theory considers the firm as an input-output model by explicitly adding all interest groups – employees, customers, dealers, government and the society at large - to the corporate mix.

  3. Sociological Theory:
    The sociological approach to the study of corporate governance has focused mostly on board composition and the implications for power and wealth distribution in society. Problems of interlocking directorships and the concentration of directorships in the hands of a privileged class are viewed as major challenges to equity and social progress. Under this theory, board composition, financial reporting, disclosure and auditing are necessary mechanisms to promote equity and fairness in society.

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