MODULE 2.

2: CORPORATE GOVERNANCE, STAKEHOLDERS, AND AUDITING

Learning Objectives
By the end of this module, students should be able to:
1. Distinguish between shareholders, stakeholders, and their varying roles in governance.
2. Explain the principles, pillars, and significance of corporate governance.
3. Identify the roles, responsibilities, and classifications of directors.
4. Understand the function of audit committees and the internal audit in governance.
5. Analyze corporate scandals to understand failures of governance and auditing.
6. Recognize the importance of transparency and disclosure requirements.

A. STAKEHOLDERS AND CORPORATE RESPONSIBILITY

1. Stakeholders vs. Shareholders
• Shareholders are the individuals or entities that own shares of a corporation. Their main interest lies in
maximizing the value of their investment, often measured by dividends and stock price appreciation.
• Stakeholders, on the other hand, include all individuals, groups, or organizations that can affect or are
affected by the company’s actions, decisions, policies, practices, or outcomes.
2. Primary vs. Secondary Stakeholders
Stakeholders can be further classified into primary and secondary:
• Primary stakeholders are those whose support is essential for the company’s survival and long-term success.
Without them, the business cannot function. These include shareholders, employees, customers, suppliers,
and creditors.
• Secondary stakeholders are those who can influence or be influenced by the company but are not essential
to its immediate survival. They include media, special-interest groups, NGOs, and the general public.
3. Corporate Social Responsibility (CSR)
Corporate Social Responsibility (CSR) refers to a company’s commitment to act ethically and contribute to economic
development while improving the quality of life of its workforce, their families, the local community, and society at
large.
CSR can focus on:
• Community – Supporting local initiatives such as education, public health, infrastructure, or cultural programs.
• Environment – Reducing emissions, conserving energy, managing waste, and adopting sustainable
practices.
• Employees – Providing fair wages, safe working conditions, professional development, and respecting labor
rights.
• Investors – Ensuring transparency, accountability, and sound governance to protect long-term shareholder
value.

B. CORPORATE GOVERNANCE FUNDAMENTALS

1. Definition of Corporate Governance
Corporate governance refers to the system of rules, practices, and processes by which a company is directed and
controlled. It provides the framework that defines the relationships among the board of directors, management,
shareholders, and other stakeholders.
“Who makes decisions in the company, and how are those decisions monitored?”
2. Importance in Accountability, Oversight, and Control
Corporate governance plays a crucial role in three major areas:
• Accountability – Ensures that managers and directors are answerable for their decisions and actions. They
must explain how corporate resources are used and justify outcomes to shareholders and stakeholders.
• Oversight – Provides checks and balances through boards of directors, audit committees, and regulatory
bodies to prevent abuse of power, mismanagement, or fraud.
• Control – Establishes internal controls, risk management systems, and auditing practices to safeguard
company assets and maintain reliable financial reporting.
3. The Four Pillars of Corporate Governance
Effective corporate governance rests on four universally recognized pillars:
1. Responsibility – Corporate leaders are responsible for making decisions that protect the long-term health of
the company and its stakeholders.
2. Accountability – Decision-makers must be held accountable for their actions and results.

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3. Fairness – Companies must treat all stakeholders equitably.

4. Transparency – Organizations must provide accurate, timely, and reliable information about their operations,
financial performance, and governance practices.
4. Corporate Governance Across Different Cultural, Legal, and Economic Contexts
Corporate governance does not exist in a vacuum—it is shaped by the country’s culture, legal system, and economic
environment.
• Cultural Context: In some countries, business practices are heavily influenced by family ownership and
relationships.
• Legal Context: Strong legal systems provide better investor protection, stricter disclosure requirements, and
clearer rules on board responsibilities. Weak legal enforcement, by contrast, may allow corruption and abuse.
• Economic Context: In developed economies with mature capital markets, governance emphasizes
shareholder rights and regulatory compliance. In developing economies, governance may focus more on
attracting foreign investment and building trust with stakeholders.

C. BOARD OF DIRECTORS
1. Duties and Responsibilities of Directors
The board of directors is the governing body of a corporation, elected by shareholders to oversee the company’s
management and ensure that it acts in the best interest of stakeholders. Their responsibilities include:
• Strategic Direction – Setting long-term goals and approving major business strategies.
• Oversight of Management – Appointing, evaluating, and, if necessary, removing the CEO and senior
executives.
• Fiduciary Duty – Acting in good faith, with loyalty and due care, always prioritizing the interests of the
corporation over personal interests.
• Risk Management – Monitoring financial health, compliance with laws, and managing potential risks.
• Accountability to Stakeholders – Ensuring transparent reporting and safeguarding the rights of shareholders,
employees, and other stakeholders.
2. Independent vs. Non-Independent Directors
• Independent Directors – Members who do not have material relationships with the company. They provide
impartial judgment, free from conflicts of interest.
• Non-Independent Directors – Individuals who may have ties to the company, such as executives, major
shareholders, or family members of management.
3. Executive vs. Non-Executive Directors
• Executive Directors – They are part of the company’s management team (e.g., CEO, CFO).
• Non-Executive Directors – They are not part of management and mainly contribute oversight and strategic
advice.
4. Board Composition and Expertise
An effective board requires the right mix of skills, diversity, and expertise to make sound decisions.
• Diversity – Gender, cultural, and professional diversity strengthen decision-making and reduce groupthink.
• Expertise – Boards should have members with backgrounds in finance, law, strategy, sustainability, and
industry-specific knowledge.
• Size of the Board – Too small may limit expertise, too large may slow decision-making.
Many governance guidelines recommend balanced board composition that represents stakeholders’ interests
while ensuring efficiency.
5. Issues in Boards of Directors
• Director Compensation – How directors are paid can influence their independence. Excessive compensation
may compromise objectivity, while insufficient pay may discourage qualified candidates.
• Conflicts of Interest – Directors with personal or financial ties to the company may prioritize self-interest over
the corporation’s well-being.
• Board Effectiveness – Boards may become ineffective if dominated by management, lacking independence,
or if directors are disengaged.

D. AUDIT COMMITTEES AND AUDITING

1. Purpose and Structure of Audit Committees
The audit committee is a subcommittee of the board of directors that focuses specifically on oversight of financial
reporting, internal controls, and auditing processes.
Purpose:
• To safeguard the integrity of the company’s financial statements.

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• To oversee risk management, internal controls, and compliance with laws and regulations.
• To serve as a bridge between management, internal auditors, external auditors, and the board.
Structure:
• Composed mainly of independent directors to ensure impartiality.
• Often chaired by an independent director with expertise in finance, accounting, or auditing.
• Membership should include individuals with financial literacy and governance experience.
2. Relationship Between Management, Audit Committee, Internal Audit, and External Audit
The audit committee plays a central role in coordinating the work of various parties:
• Management – Prepares financial statements and is responsible for internal controls.
• Audit Committee – Provides independent oversight and ensures accountability of both management and
auditors.
• Internal Audit – Conducts ongoing reviews of operations, risk management, and internal controls. Reports
functionally to the audit committee, but administratively to management.
• External Audit – Independent auditors who examine the financial statements to provide assurance that they
are fair and accurate. They report findings directly to the audit committee.
3. Auditor Independence and Role in Financial Reporting
Auditor independence is crucial to ensure objectivity and reliability.
• Internal auditors must remain impartial, even though they are part of the organization.
• External auditors must avoid conflicts of interest, such as consulting engagements with the same client.
Their role in financial reporting is to give assurance that financial statements are:
• Accurate
• Complete
• In compliance with accounting standards and regulations
4. Oversight Responsibilities of Audit Committees
The audit committee’s responsibilities go beyond reviewing reports. They include:
• Overseeing the company’s financial reporting process.
• Reviewing and monitoring the effectiveness of internal controls.
• Approving the appointment, compensation, and performance of external auditors.
• Ensuring compliance with legal and regulatory requirements.
• Overseeing risk management policies.
• Reviewing related-party transactions to prevent fraud or self-dealing.
5. SEC and Disclosure Requirements
Regulatory bodies such as the Securities and Exchange Commission (SEC) mandate specific disclosure
requirements related to audit committees and auditors. These include:
• Public companies must disclose the composition and independence of their audit committees.
• Companies must report whether at least one member is a “financial expert.”
• Disclosure of fees paid to external auditors (audit vs. non-audit services).
• Audit committees must report their activities, findings, and statements in the annual report.

E. INTERNAL AUDITING AND INTERNAL CONTROLS

1. Internal Auditing: Independence, Objectivity, and Competence
Internal auditing is an assurance and consulting activity that provides value to an organization by evaluating the
effectiveness of risk management, control, and governance processes. For it to be credible and effective, three key
qualities are required:
• Independence – Internal auditors must be organizationally independent from the activities they audit.
• Objectivity – Internal auditors must maintain an impartial mindset.
• Competence – Internal auditors should have the professional skills and technical knowledge required in
auditing, accounting, risk analysis, and industry-specific practices.
2. Role in Risk Management and Control Assurance
Internal auditors serve as a critical component of the organization’s risk management framework. Their role includes:
• Identifying and evaluating risks that may affect financial reporting, compliance, and operations.
• Testing the design and effectiveness of internal controls.
• Advising management and the board on risk exposures and control weaknesses.
• Providing recommendations for improvements to strengthen control systems.

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First Semester AY 2025-2026
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3. Internal Audit as a Cornerstone of Governance

Effective corporate governance relies on checks and balances. Internal audit is often referred to as a cornerstone of
governance because:
• It provides independent assurance to the board and audit committee about how well management is
protecting organizational assets and complying with regulations.
• It enhances transparency by ensuring that reporting and control processes are working as intended.
• It helps build confidence among shareholders, regulators, and the public that the organization is being run
ethically and responsibly.
4. Management’s Responsibility for Implementing Internal Controls
It is important to distinguish between the roles of management and internal audit. While internal audit evaluates and
provides assurance, it is management’s responsibility to:
• Design appropriate internal control systems.
• Implement policies and procedures across all levels of the organization.
• Maintain compliance with applicable laws and regulations.
• Monitor day-to-day controls to ensure they are functioning properly.
Internal auditors do not own or enforce the controls—they only review them and make recommendations. The
accountability for operating effective internal controls rests squarely on management.

F. CORPORATE SCANDALS AND ETHICAL LESSONS

1. The Enron Case – Off-Balance Sheet Debt Entities
Enron, once a giant in the energy industry, collapsed in 2001 due to massive accounting fraud. The
company used special purpose entities (SPEs) to keep huge amounts of debt off its balance sheet, making
its financial position look much stronger than it truly was. Investors and regulators were misled into thinking
Enron was profitable, when in reality, it was drowning in debt. This highlighted the danger of complex
financial structures used to conceal liabilities.
2. The WorldCom Case – Expense Capitalization and Revenue Misstatements
WorldCom, a major telecommunications company, collapsed in 2002. Management inflated earnings by
capitalizing regular expenses (treating them as assets instead of costs) and overstating revenues. By doing
so, they presented a falsely positive picture of profitability. This manipulation misled shareholders and
resulted in one of the largest bankruptcies in U.S. history at that time.

Failure of Auditors and Governance Structures

Both Enron and WorldCom scandals revealed deep failures in auditing and governance systems. External auditors,
particularly Arthur Andersen in the Enron case, failed to exercise independence and objectivity. They had conflicts
of interest because of lucrative consulting contracts, which compromised their role as watchdogs. Similarly, boards
of directors and audit committees were either unaware or negligent in their oversight duties, allowing management
to engage in deceptive practices.

Ethical Lessons: Culture, Independence, and Accountability

These scandals underline the importance of:
• Strong ethical culture – Organizations must foster values of honesty, transparency, and integrity, rather than
short-term profit maximization.
• Independence – Both internal and external auditors must remain free from undue influence and conflicts of
interest to ensure credibility in financial reporting.
• Accountability – Management, boards, and auditors must all be held accountable for their responsibilities.
Effective governance requires clear lines of responsibility and consequences for misconduct.

G. TRANSPARENCY AND DISCLOSURE

Transparency and disclosure are at the heart of effective corporate governance because they provide stakeholders
with the information needed to make informed decisions and hold management accountable.
1. Required Disclosures
Corporations, especially those publicly listed, are required to provide regular disclosures to regulators,
investors, and the public. These include:
• Financial filings – such as quarterly and annual reports, which give insights into profitability, liquidity,
solvency, and overall financial health.
• Executive compensation – details on how much top executives are paid, which is important for assessing
fairness, alignment with performance, and potential excesses.
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First Semester AY 2025-2026
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• Insider trading disclosures – reports on when executives or insiders buy or sell company stock, since
these actions may signal confidence (or lack thereof) in the company’s future.
These disclosures are legally mandated by securities regulators (e.g., the SEC in the U.S. or SEC Philippines)
to ensure transparency in the marketplace.
2. Importance of Transparency in Governance
Transparency is fundamental to trust. When companies disclose accurate, timely, and relevant information,
stakeholders—including investors, employees, customers, and regulators—gain confidence in the
company’s governance and operations. Transparency reduces opportunities for fraud, corruption, and
mismanagement, and it strengthens accountability across all levels of the organization.
3. Balancing Transparency with Proprietary Concerns
While transparency is crucial, it must be balanced with the need to protect proprietary or sensitive
information. Companies may not disclose details about trade secrets, product strategies, or ongoing
negotiations, because competitors could exploit that information.
The challenge is finding the right balance between openness and protecting the company’s competitive
advantage.

Prepared by: DEMY N. CODNITA, CPA

First Semester AY 2025-2026
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