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How To Spot Good Corporate Governance In A Company And Why Is It Important For Shareholders?

Good corporate governance in companies is one of the key requirements to look out for when investing in them. Corporate governance refers to a system of rules, practices, and processes by which a firm is directed and controlled. It involves the balancing of the interests of stakeholders, including shareholders, management, customers, employees, creditors and to an extent, even to others outside the company.

A company that has good corporate governance will more likely than not ensure that shareholder interests are looked after. It will also have controls in place to prevent fraudulent activities and bias accounting standards, which can hurt shareholders.

With that in mind, here are three things I look out for when assessing the corporate governance of a company.

Diversified and capable board

The primary role of the board of directors is to enhance the long-term shareholder value. Its role includes selecting the top executives, maintaining a succession plan, establishing overarching strategies and deciding the remuneration package for management.

Even though the board does not oversee the day-to-day management of the company, its role is of utmost importance to the company’s smooth running.

Therefore, investors should look for companies that have a capable and diversified set of board members. Board members should be independent and have no connection with the company, thereby ensuring that they can perform their role without bias. They should ideally have experience overseeing a company of that size and in that particular industry. Investors can do a simple background check on the board members through a Google search and on the company’s annual report.

Justified remuneration packages

Another important aspect to look out for is the remuneration packages of board members and executives. The remuneration package should be justified according to the size of the company. Remuneration packages that are comparatively larger than their peers should be a red flag.

Executives should also have targets in place that encourage them to achieve certain long-term goals, which leads me to the next point – sustainable and relevant goals.

Long-term goals over short-term, unsustainable targets

The executive should be given long-term and sustainable goals, rather than ones that focus on the short-term profitability of a company.

There are many companies that set goals based on share price or near-term earnings. Not only does this encourage short-term thinking among executives, but also creates incentives for an executive to cook the books to achieve these short-term targets.

The Foolish bottom line

Good corporate governance is essential to the smooth running and long-term sustainability of a company. Investors tend to disregard the corporate governance section of the annual report and jump straight to “more important” sections like the financial statements and management discussion. However, corporate governance should never be overlooked and should be one of the key things to look at when assessing a potential investment.

Warren Buffett once said:

“It takes 20 years to build a reputation and five minutes to ruin it.”

Good corporate governance can at least ensure that processes are in place to prevent reputation-loss.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore writer Jeremy Chia doesn’t own shares in any companies mentioned.