Morris (1987) argued that the signalling theory and agency theory are complementary
theories, which indicates that the two theories can be applied together in a study. These two
theories are consistent when the necessary conditions of signalling theory and agency theory
coincide. The necessary condition of signalling theory is information asymmetry, while the
individual rational wealth maximisation and separation of resource ownership and control are
the necessary conditions of agency theory. Morris (1987) argued that the necessary
conditions of these two theories do not conflict with each other because positive monitoring
costs and separation of ownership and control imply information asymmetry between
managers, investors and creditors. The separation of ownership and control and the
assumption of individual rational wealth maximisation may lead to possible conflict of
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party who controls the entity and may hide unfavourable information or misuse the capital
funds. The principal (resource ownership) will require the entity to incur positive monitoring
costs in order to prevent the opportunistic behaviour of the agent (party who has control).
Table 3.3 shows how the agency and signalling theories have been used in previous studies.
Table 3. 3: Application of agency and signalling theories in previous literature
Authors The Application of Agency and Signalling Theories
Arrow (1986) This study used agency and signalling theories to explain
that when principals are competing against each other for the agents, the principals should visibly signal their unique differences. For instance, clients with lower health risk (signallers and principals) have to signal their differences to obtain lower premiums from the insurance company (receivers and agents).
Jain and Kini (1994) This study examined the change in the operating
performance of companies when they make the transition from private to public ownership. This study found a decline in post-issue operating performance for the IPO firms. The agency and signalling theories were used to explain the lower operating performance in post-IPO period. Post-IPO implies a reduction in management ownership which in turn may lead to greater agency problems (Jensen & Meckling 1976) and may signal that the quality of the project is lower (Leland & Pyle 1977).
Menon and Williams (1994) This study applied agency and signalling theories to
hypothesise that audit committee activity are more likely to increase and companies are more likely to exclude managers from audit committees when there is a greater proportion of independent directors on the board. This is based on the assumption that having a greater proportion of insiders on the board sends a strong signal that the company will be dominated by managers. The incentives offered to
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managers may conflict with the shareholders, and independent directors are important for the board’s effectiveness.
Watson, Shrives and Marston (2002)
The study examined whether the agency and signalling theories can be used to explain the voluntary disclosure of financial ratios in the corporate annual reports. Signalling theory predicts that companies with good performance will signal their quality to investors, while agency theory predicts that companies with good performance will disclose detailed information to ensure the continuance of their position in the next period.
Tsalavoutas (2011) This study examined the level of IFRS compliance by the
listed companies in Greece. From the signalling theory perspective, the study assumed that companies will have higher level of compliance with IFRS if the adjustment is positive. Agency theory assumes that companies will have a lower level of IFRS compliance if the adjustment is negative.
Elzahar and Hussainey (2012) This study investigated the determinants of narrative risk information disclosed in interim reports based on a sample of non-financial U.K. companies. The study applied both agency and signalling theories to hypothesise the association between firm size and corporate risk disclosure. Agency theory assumes that larger companies will disclose more information than smaller companies in order to reduce agency cost or information asymmetry because they need capital from external sources. The disclosure of a greater amount of risk information will signal to investors and creditors the company’s ability to manage risk.
The studies listed in Table 3.3 show how the agency and signalling theories can work
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and Kini (1994) used agency and signalling theories to explain why there is a decline after the
post-issue operating performance for the IPO firms, but Tsalavoutas (2011) used signalling
theory to explain that companies will have a higher level of IFRS compliance if the
adjustment is positive and used agency theory to explain that companies will have a lower
level of IFRS compliance if the adjustment in negative. The signallers and receivers can be
either the agents or principals. For instance, the clients with lower health risks (signallers and
principals) signal their health issues to the insurance companies (receivers and agents)
(Arrow 1986). In the Tsalavoutas (2011) study, the managers are both agents and signallers,
and the shareholders are the principals and receivers.
Agency and Signalling in this Thesis
The first research aim of this study is to evaluate the impact of full IFRS convergence on the
financial statements and financial ratios of the listed companies on Bursa Malaysia.
Signalling theory is used to explain how IFRS convergence will lead to the changes in
financial statements and financial ratios for these listed companies. The transition from local
GAAP to IFRS is meant to improve the quality of financial reporting. To achieve this, the
financial statements prepared under IFRS must be different from those prepared under the
local GAAP. The full IFRS convergence in Malaysia signals to the stock market participants
that there is a change in financial reporting. Using the signalling theory, it is predicted that
the full IFRS convergence in Malaysia will have an impact on financial statements and
financial ratios. Figure 3.3 illustrates the application of signalling theory associated with the
102 Figure 3. 3: Application of signalling theory
The second research aim of this thesis is to evaluate whether the full convergence with IFRS
in Malaysia has improved the quality of financial reporting for the companies listed on Bursa
Malaysia. Agency theory predicts that the full IFRS convergence acts as a bonding device to
prevent the management of listed companies from engaging in earnings manipulation. On the
other hand, signalling theory predicts that the full IFRS convergence signals a higher quality
of financial reporting to the stock market stakeholders. Based on both agency and signalling
theory, the full convergence with IFRS should lead to less earnings management. If the
earnings management does not decrease, this indicates that full IFRS convergence is not
effective in restricting managers from manipulating earnings and the signal sent to the stock
market is false. Figure 3.4 illustrates the application of agency and signalling theory
associated with the second research aim.
Figure 3. 4: Application of agency and signalling theories MASB
(Signaller)
Full IFRS Convergence
Signal of high quality financial reporting and change in financial statements Stock Market Participants (Receivers) Bonding Device (Restrict the manipulation of financial information) Full IFRS Convergence Management of listed companies on Bursa Malaysia Signalling (Higher quality financial reporting) Participants on Bursa Malaysia Decrease in earnings management
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This thesis also determines whether the size of audit firms influences the impact of full IFRS
convergence on earnings management. The appointment of external auditors acts as a
monitoring mechanism that restricts the management of listed companies from manipulating
the financial information. In the principal-agent relationship, the external auditors are the
agents hired by the principal (i.e. financial statement users) to provide an audit service to
ensure that material financial information is reported. Prior studies have argued that Big 4
auditors are more likely to provide higher audit quality than non-Big 4 auditors because Big 4
auditors have a greater number of clients with a smaller fraction of quasi-rent and have a
stronger brand name than non-Big 4 audit firms. Based on agency theory, it is predicted that
the listed companies audited by Big 4 have less earnings management than non-Big 4 clients
when financial statements are prepared under IFRS.
3.6Chapter summary
Agency theory is concerned with the agency problem that arises from the principal-agent
relationship. Principal-agent relationship exists when there is a separation of ownership and
control within a company (Jensen & Meckling 1976). Agency theory assumes that both
principals and agents are rational wealth maximisers. Based on this assumption, a conflict of
interests may arise between these two parties. The agents might not act in the principals’ best
interests if this means a personal loss of wealth. The opportunistic behaviour of the agent
creates the agency problem and more agency costs. The agency problem can be reduced
when a monitoring or bonding mechanism is applied. Signalling theory is concerned with
information asymmetry when one party holds more information than the other parties
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reduced when the party with more information (i.e. signallers) is willing to signal more
information to the other parties (i.e. receivers).
These two theories can be applied together when the necessary conditions of the two theories
are consistent with each other (Morris 1987). The necessary conditions of agency theory are
individual rational wealth maximisation and separation of resource ownership and control.
When these two conditions are met, a conflict of interests between principal and agent is
more likely to occur. The necessary condition of signalling theory is information asymmetry.
Information asymmetry is the reason for signalling. Information asymmetry may arise from
the opportunistic behaviour of the agent. The agent may decide to conceal negative
information from the principal in order to secure his/her own interests such as remuneration
and position. The information asymmetry can be reduced when effective monitoring and
bonding devices are established.
Both the agency and signalling theories have been applied in this thesis. Based on the
signalling theory, it is predicted that the full convergence with IFRS in Malaysia will have an
impact on the financial statements and financial ratios of the companies listed on Bursa
Malaysia. The transition from local GAAP to IFRS signals a possible change in the quality
of financial reporting. If there is such a change, then there must be changes in financial
statements and financial ratios. The agency theory and signalling theory predict that the full
IFRS convergence will lead to less earnings management for the companies listed on Bursa
Malaysia. Agency theory assumes that the managements of listed companies are restricted
from engaging in earnings management when financial statements are prepared under IFRS
than the local GAAP. Signalling theory assumes that full convergence with IFRS reduces the
information asymmetry between managements and the Bursa Malaysia stock market
members. Agency theory is also used to predict that the listed companies audited by Big 4
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reported under IFRS. These theoretical arguments are used to develop the research
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