of having poor results.

Managers of firms with bad news would have incentives not

to report. However, they would also have the incentive to report their bad news, to
maintain credibility in effective markets where their shares are traded. Assuming these
incentives to signal information to capital markets, signalling theory predicts that firms
will disclose more information than is demanded.
The logical consequence of signalling theory is that there are incentives for all
managers to signal expectations of future profits because, if investors believe the signals,
share prices will increase and the shareholders (and managers acting in their interests)
will benefit. However, one problem therefore arises: how does a firm ensure that its
signal is seen as credible by investors, given that other firms will also try to signal 'good
news'? For a signal via the accounts to be credible to users, that signal must not be
easily and costlessly replicated by another firm. Costs can include the long-term loss of
credibility if actual performance does not match the level that has been signalled via
the way in which profitability has been represented in the accounts.
One way is to provide a;:!.9i1iQnaLcr.edib.ility..JOeam~.Qgs signal by Qrovidlugill:ll.i.d.end
~gIlals. '1'hese are costly as they involve cash payouts to sha.£.eholders. Furthermore,
firms generally snroOththeir dividends and managers are very reluctant to re..duce

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dividends. Thus, if di;iQends increase, maOARers are reasonably sure that they will not
s,ubsequently decrease. So the increase can create an expectation of future increased
profits sufficient to support the higher level of dividends into the future .
. Research into signalling incentives includes studies that investigate why firms
voluntarily disclose bad news, reduce and increase dividends, smooth earnings
and revalue and impair assets, and recognise internally generated assets. Theory
in action 11.3 provides an example of how one firm has signalled its e.,xpectations
regarding future profitability.

What do profits signal?

Navitas e arniJ gs soar in slump

by Sara Rich
Education provider Navitas has achieved a 32 per c'ent rise in full-year profit and says the
global financial crisis may be working in its favour, with another year of double-digit earnings
growth expected.
Net profit for the year ended june 30 climbed to $49.2 million compared with $37.4 m a
year ago, while revenue rose 36 per cent to $470.7 m.
The Perth-based company provides university pathway programs for domestic and
international students, as well as language training, work-force education and student
recruitment services.
Navitas chief executive Rod jones said the company, which had low debt levels and good
cashflow, had not been affected by the downturn and that student numbers were at record
highs. Last financial year, the number of students in Navitas's university programs surged
26 per cent to about 20 000. In total, there are about 45 000 domestic and overseas students
using the education provider's services,
"When employment opportunities reduce, many students turn back to education," Mr jones
said.
He said this had helped drive a 22 per cent increase in earnings before interest, tax,
depreciation and amortisation to $77.1 m for the company.
Earnings per share climbed 32 per cent to 14.3c, while operating cashflow was up 33 per
centat$104.3 m.
Navitas declared a final dividend of 8.8c, up from 6.2c last year, taking the full-year
payment to 14.3c, compared with the previous year's 10. 9c.

PART 3 Accounting and research

 Last financial year was the fifth year in a row that Navitas achieved more than 10 per cent
growth in earnings, revenue and operating cashflow.
The compan y's share price climbed 5.45 per cent, or 15c yesterday to $2.90.
Source : Excerp ts irom Th e Australian , S August 2009 , p. 24, www .thea ustralia n.conl .a u.

Questions
1. Navitas's announcement of soaring profit is a strong signal of the firm 's earnings prospects.

Other comments in the article reinforce that signal. What could Navitas do in relation to

its profits to strengthen the signal even further? Explain your answer.

2. What factors might increase or decrease the credibility of the signal provided by Navitas's

announcement and press attention ?

3. What do you expect will be the impact of the 'soaring' profits oil management compensation

contracts of Navitas?

POLITICAL PROCESSES
Positive accounting theory also models the political process involving the reJationsb.ip
between the firm anL a.th.e.Lpgrties interested in the firm.. such .as.-government,
trade unions and community grQ!!Qs. As in the context of debt and management
com ensatio~contractiI1g, accounting is important in the political process as one of
the sources of information about firms.
The major difference between the pglitical market and the capital market is that there
js generally less demand, and therefore less incentive, for the productio n of information
in political markets. Economic analysis suggests that this results from the lower marginal
benefit to individuals in the political process, because it is harder for individuals or
groups to capture benefits from that information. 2G There are high information costs to
individuals, heterogeneity (diversity) of interests, and organisational costs.
High information costs arise because in the political environment, the probability
that one individual's actions will affect that person's wealth is small. Each individual is
only one of many 'voters' in the political arena, there are many political decisions being
made at any time, and many of them are likely to affect that individual's wealth. To be
informed on all the issues is unlikely to be cost-beneficial given the low probability that
the individual will affect the political outcome. PoJiticaLc..o.s.ts can be diffused among
imli-Yid.u<!ls. Take for example, the political decision to increase the price of milk by
. 10 cents per litre. The costs are diffused across consumers but the total amount received
by the milk corporation is substantial. The lobbying cost/ benefit for individuals is high .
If consumers form interest groups and group lobby then this increases the likelihood
of a particular political outcome. However, heterogeneity of interests within the group
means that group actions will not necessarily be in a particular individual's interests.
further, the formation of interest groups is costly. Not only must group members
incur the search costs of identifying each other to form the group, but the group incurs
additional costs to lobby for its cause, inform its members, and so on. These transaction
costs mean that individuals either will choose to stay rationally uninformed or if the
individual gains are high enough they will form interest groups to capture economies of
scale in the information-generation process, despite the organisational costs of doing so.
The amount of information generated for political and social purposes will therefore
depend on the diffusive effects of government policy and the transaction costs of
effective 10bbying.27 Hence, because of the greater information costs, diffused rewards,
and high monitoring costs, there is greater scope for residual opportunism to occur.
Positive accounting theorists often cite the 1931 and 1933 Securities Acts in the
United States which followed the 1929 stock market crash as an example of political

CHAPTER 11 Positive theory of accounting polic y and disclosu re 377