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SIGNALING THEORY

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on 23 November 2014

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Transcript of SIGNALING THEORY

EXAMPLES OF SIGNALING THEORY
HISTORY
Signaling theory was developed by Michael Spence in 1973

context of job market.

Example: Employers can rely on applicant’s chosen level of education/certain education credentials as a credible signal of that person’s underlying competence.

SIGNALING IN ACCOUNTING
The signaling theory argues that the existence of information asymmetry can also be taken as a reason for good companies to use financial information to send signals to the market . (Ross (1977)
EXAMPLES OF FINANCIAL SIGNALS
PROFITABILITY
Firms that voluntary apply IFRS create a certain reputation and image which in turn signal their ambitions which can be used as advertising to become more competitive ( Campbell, Shrives and Bohmbach-Saager, 2001)

A high payout ratio may signal a firm as having a confident future

For an entrepreneur to go public, equity retained is a signal because it is not rational for a bad-news manager to retain a high equity position


CORE QUESTION OF SIGNALING THEORY
What keeps signals reliable??

Costs. A signal will be reliable if it is beneficial to produce truthfully , yet prohibitively costly to produce falsely

According to Bhattacharya and Dittmar (2004), managers would not announce the good news that they have because all the companies could do this without being valid.

Two main sources of these costs:
i) The signal itself may be costly to produce
ii) the punishment if caught cheating may be high.
Theory suggest:
A positive relationship between voluntary disclosure and profitability. (Watson, Shrives, Marston, 2002)

Profitable firms provides additional information to the market in order to signal quality (Prencipe, 2004)

Corporations disclose more voluntary information during prosperous times than during poor (Holland, 2005)

ARTICLE:
VOLUNTARY DISCLOSURE OF FINANCIAL TARGETS
The article discuss the relationship between the firms characteristic and degree of voluntary disclosure in the context of signaling theory

The firms characteristic that have been tested:
Profitability
Size


Elies Bazine & Derya Vural (2011)

SIGNALING THEORY
Prepared by:
Nuridayu binti Yunus
P76541

Information disclosed by managers to the market reduces information asymmetry and is interpreted as a good signal by the market.

Increase leverage of the firm. The firms that want to send the signal that they have good prospects, increase their leverage.
In contrast, the overestimated firms are not willing to undertake the burden of lending because in this way they face the risk of bankruptcy
SIZE
Theory suggest:
Studies have shown a positive relationship between firm size and the degree of voluntary disclosure

Public demand for more information from larger firms than from smaller firms.

Voluntary disclosure can be explained as an effort to reduce monitoring and political costs by signaling their legitimacy. (Scoot, 2003).

SIGNAL
A perceivable action or structure that is intended to or has evolved to indicate an otherwise not perceivable quality about the signaler or the signaler's environment


The purpose of signal is to indicate a certain quality.
Signaling theory useful for describing behavior when two parties ( individuals or organizations) have access to different information (information asymmetry)
Signaling occurs in competitive environment
Dividend
Leverage
Voluntary Disclosure
Equity retained
EXAMPLE
Result/Finding
The theory is supported. The results shows a positive and coefficient of our proxy for profitability.

The result also supported the Holland( 2005), which suggest that degree of voluntary disclosure increase during prosperous time and decrease during poor.

Results/Findings
This study further establishes the significant relationship between size and voluntary disclosure, which is confirmed by a significance of 99 per cent for positive coefficient.

The results confirms that larger firms have greater public pressure to signal additional information in their annual reports.

CONCLUSION
Information asymmetric can be reduced if the party with more information signals to others.

These signals are sent out in order to provide investors with more information (Spence 1973).

Corporations use voluntary disclosure to satisfy investors by positive signaling about the firm value.(Watson, Shrives, Marston, 2002).

High quality firms want to differentiate themselves from low quality firms through voluntary disclosure.

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