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By Jim Stice | Tuesday, August 12, 2014

What Is Corporate Governance?

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Do you own any shares of stock? Half of all U.S. households do.

The 2010 Survey of Consumer Finances (commissioned every three years by the Federal Reserve) found that 49.9 percent of all U.S. households own shares of stock, either as direct investments in specific companies, or as an investment in a mutual fund, retirement plan, or other stock investment vehicle. Even in households where the head of the house is younger than 35, 39.8 percent own some shares of stock.

If you own a mutual fund, then the mutual fund owns—on your behalf—a small number of shares of many different companies. One of the most popular types of mutual funds invests money in the Standard and Poor’s 500 (usually called the S&P 500), which is comprised of the 500 most valuable publicly traded companies in the United States.

Investments in an S&P 500 index fund are made in proportion to the relative market value of each of the 500 companies, with the highest proportion invested in the most valuable companies such as General Electric, Microsoft, ExxonMobil, and so forth.

For example, if you have invested in an S&P 500 index fund, then you own, through the fund, a few shares of stock in McDonald’s. In fact, as of May 2013, if you had $100 invested in an S&P 500 Index fund, approximately $0.71 of that amount would have been invested in McDonald’s stock.

So here are some questions for all of you McDonald’s stockholders:

  • Have you carefully considered the qualifications of those individuals nominated to sit on your board of directors? Do you know the name of the chairman of your board?
  • Have you scrutinized the proposals made by the board, such as the structure of the management compensation plan, the selection of the independent accounting firm that audits the company’s financial statements, and any proposals to add to your group of shareholders by issuing new shares of stock?
  • In fact, have you exercised any of your ownership rights?

Individual shareholders rarely exercise their ownership rights, except their rights to collect dividends and sell their shares. Typically, shareholders grant their voting rights to the existing board of directors; the board is said to vote by “proxy” on behalf of these shareholders. Alternatively, those who own shares indirectly through a mutual fund usually grant their “proxies” to the managers of the fund.

The classic dilemma in a modern corporation is finding the appropriate balance between the fundamental right of the shareholders to direct the affairs of the company and the frequent desire of shareholders to completely delegate their ownership privileges to the professional managers who run the company.

Corporate governance is the set of principles and practices that a corporation uses to regulate the relationship between the shareholders and the professional managers hired by the board of directors.

Because financial statements are one of the most important channels of communication between the managers and the shareholders, the financial statements are crucial to the process of corporate governance.

To learn more about financial statements, watch Accounting Fundamentals, the course my brother Kay and I created for lynda.com.

 

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