As indicated earlier, corporate governance refers to mechanisms that encourage management to act in the interest of—and report in good faith to—the shareholders. Components of corporate governance include financial information users and capital markets, contracts between management and debt and equity investors, financial reporting regulations and standards, independent auditors, boards of directors and audit committees, internal controls ensuring that the company is in compliance with financial reporting regulations, legal liability, professional reputation, and ethics. As discussed below, each of these components somehow involves the financial statements, and an effective financial reporting system is critical for effective corporate governance.
Financial Information Users and Capital Markets
Financial statements are used by a variety of groups and can be divided into three categories: equity investors, debt investors, and others (including management).
Equity investors (often referred to simply as investors) purchase shares of stock, which represent ownership interests in a company. Ownership of an equity security entitles the holder to two basic rights: (1) to vote for company directors at the annual shareholders' meeting and (2) to receive dividends if paid. Equity investors can be classified into two groups. The first owns a substantial amount of the company's stock and uses the voting rights associated with that ownership to exert influence ...