The signaling theory: Corporate Financial Reporting

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Offline MD. ABDUR ROUF

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The signaling theory: Corporate Financial Reporting
« on: March 10, 2016, 08:51:29 AM »
the signaling theory assumes that firms with higher performance use financial information as a tool to transmit signals to the market. Signaling theory is useful for describing behavior 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 (Rouf, 2015). 
Signaling theory is focused on information asymmetry among parties that are involved in the allocation of firm funds. Financial markets are based on contractual relationships that occur under conflicting conditions where, if one market player benefits, another loses. Contractual relationships reflect economic decisions which, when approached rationally are based on the quality, the reliability, and the timeliness of information related to the contract “Insiders (Managers and Owners) know better”–When Firm’s future genuinely looks good(i.e. High forecasted Cash Flows, Earnings, NI, and ROE) then managers will choose to raise financing through debt (or Bonds or Loan) because they do not want to share the financial gain with more shareholders. Rather they prefer to take on debt and pay a small interest to the debt holders. There is almost no risk of default. When Firm’s outlook looks bad, then managers will choose to raise capital by issuing equity (or Stock) to be able to share the likely losses amongst more shareholders (Owners). If they took debt and couldn’t repay it, they might default and be forced to go bankrupt.
Dr. Md. Abdur Rouf
Associate Professor of Accounting
Faculty of Business and Economics
Daffodil International University

Offline Shakil Ahmad

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Re: The signaling theory: Corporate Financial Reporting
« Reply #1 on: March 10, 2016, 06:29:26 PM »
Nice post