Signalling Theory

Student ID: 762152
Name: William Greig
Tutor: Vee Vien Tan

Tutorial: 1:00pm Wednesday

The purpose of a signal is to reduce the amount of information asymmetry between the intended users of the firms reports and the firm itself, intending to be distinguished as a higher type firm and separate it from others. To do this the firm must increase its disclosure to its stakeholders and investors as to decrease the information gap between the parties, thus creating the foundations for the signaling framework.

A sustainability report is a report in which non-financial information is measured, recorded and presented to the intended users, containing information about the social and environmental impacts that are caused through it day to day activities. As it has been found that non-financial information tends to correlate with future financial information, these reports have had an increased demand recently, with a survey finding that between 1999 and 2011 the amount of large business that produced these financial reports had increased to 95% from 35% (Higgins, Milne, & van Gramberg, 2014). The main reason for this jump in demand is the ability for a stakeholder/investor to view the non-financial reports and make an assumption about the business’s financials in the future.

A voluntary financial report is a strong signal of a high quality firm, as it is disclosing information at a cost, to prove that its day to day activities are better than its competitors. A low quality firm wouldn’t prepare such reports, as not only would it incur the costs of generating such reports, it would also be disclosing additional information that proves its day to day activities are worse than its competitors. These sustainable reports can be hard to interpret, as there are not nearly as many regulations as financial reports, meaning each firm can present them in whichever format they wish. Due to this it can be often hard to determine how one firm compares to the other. But high quality firms are inclined to have theirs in similar format, and to have them independently assured by a third party, which means that their information is free from bias and easily comparable, signaling their day to day activities are superior than its competitors.

The largest inceptive for a firm to undergo assurance on their financial reports is to attract additional capital through higher disclosure, giving the investors more information on which to make their decision. As share prices are tied to the current activities of a firm, a sustainability report not only tells the current position, but also indicates the future position of a firm through the transition of non-financial to financial information. Hence the release of a positive sustainability report would be expected to have a simultaneous increase in share price, enforcing the sustainable actions of the firm, improving its public image and becoming more appealing to investors.