Signalling Theory

Signalling theory was originally developed and used to explain information asymmetry in labour markets (see Spence, 1973). This theory has also been widely used by accounting researchers as a further theory to explain why companies voluntarily disclose additional information in their annual reports (e.g. Raffournier, 1995; Haniffia and Cooke, 2002; Walston et al., 2002; Akhtaruddin and Hossain, 2008). According to Morris (1987) signalling is a common phenomenon relevant in the market with information asymmetry; hence the signalling theory shows how this asymmetry can be reduced by the party with additional information signalling it to others. Moreover, “signalling theory provides an unique, practical, and empirically testable perspective on problems of social selection under conditions of imperfect information” (Connelly et al., 2011, p. 63).

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A signal can be a visible action or structure utilised to indicate the sign of quality, typically the sending of a signal is grounded on the premise that it should be positive to the signaller (An et al., 2011). As explained by Morris (1987), in most signalling models, the subsequent steps are likely to occur: essentially, sellers in the market are assumed to own more information about their products than buyers. In this situation, the buyers have no information about particular products but they have some general perceptions. Then the buyers will individually value the sellers’ products at the same price which is a weighted average of their overall perceptions.

Under such a scenario, sellers of high average quality products incur an opportunity loss because their products could sell at a higher price if the buyers have been informed about the quality of products, whereas sellers of below average products make a chance gain. Alternatively, sellers of high quality products may have an incentive to withdraw their products from the market.

On the other hand, sellers of superior products may have an incentive to disclose their information (or signal) to the market to distinguish their products from that sold by other sellers who have lower value products (Dye, 2001, p. 217). As illuminated by Erdem and Swait (1998), sellers know better than buyers about the quality of products they are selling in the market (asymmetric information) and buyers cannot easily assess product quality (imperfect information).

Therefore, if the quality of the product cannot be signalled to the buyers, high and low quality products are selling for the same price. As a consequence, high quality products are underestimated and low quality products overestimated. As Akerlof (1970) stresses, the bad products sell at the same price as good products since it is difficult for the buyer to recognise the difference between a good and a bad product; only the seller knows. There are ways by which the high quality sellers’ products can distinguish themselves. One is to disclose information indicating quality then the buyer can verify certain of this information, and such self-verification will give credibility to the rest (Easterbrook and Fischel, 1984). Einhorn (2007) predicted that buyers sensibly interpret nondisclosure information (non-signalling) regarding the seller's products being sold as “bad news”. Therefore, the buyers will discount the price of the product up to a point at which it is in the seller’s interest to reveal the information. Kirmani and Rao (2000) argue that

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signalling may be mainly operative in the market for comparatively new products or products about which buyers are relatively uninformed. According to signalling theory the information asymmetry between sellers and the prospective buyers can be overcome by the sellers with more detailed information signalling it to buyers (Morris, 1987). As stated in Connelly et al. (2011, p. 39):

Signalling theory is useful for describing behaviour when two parties (individuals or organizations) have access to different information.

Typically, one party, the sender, must choose whether and how to communicate (or signal) that information, and the other party, the receiver, must choose how to interpret the signal.

In the corporate disclosure scenario, signalling theory hypothesises that the managers of superior performance companies use corporate disclosure to send signals to shareholders and the capital mar et. In accordance with this theory, a firm’s information disclosure can be considered a signal to capital markets, directed to reduce information asymmetry which often exists between management and stakeholders as well as to increase the firm’s value (Álvarez et al., 2008). More precisely, voluntarily disclosing information in annual reports can be used by companies’ managers as a signal to send specific information to the market participants (Khlifi and Bouri, 2010).

Based on the signalling theory viewpoint, companies’ managers are interested in disclosing ‘good news’ to the mar et participants in order to avoid the undervaluation of their shares (Inchausti, 1997). Additionally, managers of companies who are more interested to disclose additional information voluntarily bear in mind that this guarantees a good signal about their companies’ performance and wea ens information asymmetry (Khlifi and Bouri, 2010). Specifically, the signalling theory mainly has stressed the deliberate communication of positive information in an effort to express positive managerial attributes (Connelly et al., 2011).

From theoretical predictions in signalling theory, the management of high performance companies will choose accounting policies which allow their higher performance to be disclosed, whereas management of lower performance companies will choose accounting policies which attempt to hide their poor performance (Morris, 1987). For example, Cai et al. (2007) state that the management of higher quality companies may voluntarily adopt segment reporting to disclose the superior risk-return profile of its

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activities, whereas management of low quality companies would not (see Morris, 1987). Furthermore, management of higher quality companies are capable of closing the asymmetric information gap via using costly signals of quality, but management of poor quality companies are not capable of mimicking.

Besides, signalling theory’s prediction is that managers of companies released additional financial as well as non-financial information to signal that their performance is for the best interest of stakeholders (Akhtaruddin and Hossian, 2008). Therefore, companies’ managers will have an incentive to disclose all positive distinguishing qualities in order to maximise their own self-interest (Campbell et al., 2001). For instance, Easterbrook and Fischel (1984) point out that a company with a good project, seeking to discriminate itself from a company with an average project, will disclose greater information.

It has also been argued that management of a firm often attempts to adopt the same disclosure level as other firms within the same business. In this case, if a firm does not maintain the same disclosure level as others then stakeholders may be interpreted that the firm is hiding bad news (Victoria et al., 2009).

Moreover, managers would voluntarily reveal additional information to stakeholders and other investors than required by law or any specific regulations if they perceive welfare from doing so (Gray et al., 1995). For example, managers of firms may attempt to signal that they are superior to others by revealing certain environmental or social disclosure in their firms’ annual reports. However, if companies’ management expect that an obligation to disclose more information at present might be used to hold them further responsible for any following poor performance and therefore they possibly will not desire to increase the level of disclosure in a period of poor performance (Healy and Palepu, 2001).

Signalling is recognised as a feasible strategy when two situations hold: (і) for the management of a high-quality company, the benefits from signalling outweigh the benefits of any other strategy; (іі) for the management of a low-quality company, a non- signalling strategy supplies a superior payoff than does signalling (Kirmani and Rao, 2000). For management companies to signal their quality successfully, the signal must

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be credible and the credibility is achieved as eventually the true quality of the company will be confirmed. If the companies’ management misleadingly attempt to signal that they are of high quality, while they are in fact low quality, once this has been discovered the upcoming disclosures will not be considered credible (Watson et al., 2002).

Undoubtedly, managers have incentives to make self-serving voluntary disclosures; it is therefore unclear whether managers’ voluntary disclosures are credible. It has been argued by Easterbrook and Fischel (1984) that truthful information is essential to guarantee that money moves to managers who can utilise it most efficiently and that shareholders ma e ideal selections about the contents of their portfolios. Thus “a world without adequate truthful information, is a world with too little investment, and in the wrong things to boot” (Easterbrook and Fischel, 1984, P. 673).

Healy and Palepu (2001) suggest two feasible mechanisms for enhancing the credibility of corporate voluntary disclosures. First, third-party intermediaries (e.g. auditors and financial analysts) can provide guarantees about the quality of voluntary disclosures made by companies. Second, preceding corporate voluntary disclosures can be validated via the required financial reporting itself. However, disclosing certain information might harm the company's competitive position and consequences in higher costs of disclosure, which mirrors the proprietary nature of some information (Diamond, 1985). As Darrough (1993) asserts, public information disclosure in annual reports can influence a disclosing company negatively if market participants have a plan to utilise the information to their benefit.Further, it is believed that information disclosed by an economic entity regularly benefits competitors because competitors will enhance their skill to learn from informative disclosure and that would aid to maximise competitive disadvantage for the disclosing firm (Elliott and Jacobson, 1994). Inchausti (1997) also indicates that managers of firms have a disincentive to disclose certain sorts of information for competitive causes.

For example, Cormier and Magnan (1999) illustrate that there may be a cost from information disclosure when the information is utilised by external users against the company's benefit. firm’s management will choose not to provide certain voluntary disclosures when it believes that the hazard of competitive hurt outweighs the

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predictable advantage from revealing the voluntary disclosure of information (FASB, 2001). In this respect, Craswell and Taylor (1992) point out that regardless of whether information disclosure has a positive or negative influence on the company value, costs will be enforced on the company if competitors, dissident stockholders or employees can utilise the information in a way that damages the company’s prospects.

For instance, disseminating detailed information regarding oil and gas reserves may lessen their proprietary value to the disclosing firms, since competitors employ the information to plan their exploration and production strategies (see Craswell and Taylor, 1992). Elliott and Jacobson (1994) identified three categories of information that might generate a competitive disadvantage for the company, these are: (i) information about technological and managerial innovation, (ii) strategies, plans, and tactics, and (iii) information about operations.

In summary, signalling theory suggests that voluntary information disclosure in corporate annual reports can be used as a signal in order to improve the corporate image/reputation, attract new investors, lower capital costs and also help to improve its relationships with the relevant stakeholders. This theory would also suggest that superior performance economic entities should signal their benefits to the markets. Under this theory, companies’ managers tend to ma e voluntary disclosure decisions over nondisclosure decisions.

In this sense, signalling theory conceives voluntary disclosure as a signalling mechanism adopted by companies’ managers to distinguish themselves from others on achievements. As has been asserted by Álvarez et al., (2008) voluntary information disclosures can be considered a signal to capital markets, directed to reduce the asymmetry of information that often exists between insiders and outsiders of a company, and to enhance corporate value.