Rules Based Approach vs Principles Based Approach in Corporate Governance
What is Corporate Governance
Corporate Governance is the system by which organizations are directed and controlled. Corporation governance ensures that the board of directors makes decisions to fulfill the long-term objectives of the shareholders, instead of focusing on short-term objectives. This is monitored and controlled in a way that the board of directors and other senior executives make decisions according to the best interest of the entire organization.
Corporate governance essentially involves balancing the interests of a company’s many stakeholders, such as shareholders, executive management, customers, suppliers, regulators, government, and the public.
There are two approaches or forms to ensure corporate governance in the organization, known as the following,
- Rules-Based Approach
- Principle-Based Approach
Rules-Based Approach in Corporate Governance
In a rules-based approach, there will be legal requirements for companies to adhere to the rules laid down. Organizations to follow legislation such as USA Sarbanes-Oxley Act. There will be legal consequences if the board fails to follow the requirements mentioned in the Act. Practically it is difficult to set up rules that are suitable for every set of circumstances. Compliance or non-compliance judgments are made by the court using this method.
Principle-Based Approach in Corporate Governance
A principle-based approach allows the board to adhere to best practices while remaining flexible based on different circumstances. Compliance or non-compliance Judgments are being made by the owners of the business. This is the usual approach that most organizations in the world practice.
As an example, in the United Kingdom (UK) company should agree to apply the UK Code of Corporate Governance after the company is listed. Listed companies in the UK are required to state in their financial statements whether they fully comply with the code. If not, the company needs to explain why they don’t and why. Investors will ultimately have the information they need to decide whether they are ok with the level of compliance of their company.
Difference between Rules Based Approach and Principles Based Approach in Corporate Governance
Difference between Rules-Based Approach and Principles-Based Approach are explained in the below table,
| Rules-Based Approach | Principle-Based Approach |
|---|---|
| Legal Requirement | Not a Legal Requirement |
| Code of Corporate Governance is a set of legal requirements mentioned in the Act. | Code of Corporate Governance is a set of best practices that companies should follow. |
| Compliance or non-compliance Judgements are being made by the court. | Compliance or non-compliance Judgements are being made by the owners of the business (shareholders) |
| Practically it is difficult to set up rules that are suitable for every set of circumstances. | This is the usual approach which most organizations in the world are practicing. |
| Non-compliance will result in heavy penalties in the form of fines. | Non-compliance will result in an explanation to the shareholders by the board. |
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