Ecuador como promotor del emprendimiento

Accounting practice is governed by a given set of accounting standards, by which the corporate earnings should be determined and reported on an accrual basis. However, accounting standards provide discretionary power to managers - for some accounting transactions - to choose among different acceptable accounting methods and, eventually, the reported earnings can be affected by this managerial discretion. In fact, there is no extant theory that can precisely prescribe the ideal accounting choice that managers should adopt. Nevertheless, there have been attempts in the literature to develop a theory that can contribute to the understanding of the accounting choice, such as the Positive Accounting Theory, which is considerably relevant to the specific context of this thesis as well as to the broader area of financial accounting research.

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The Positive Accounting Theory aims at predicting “the choices of accounting policies by firm managers and how managers will respond to proposed new accounting standards (Scott 2003, p.273)”. Indeed, the evolution of the school of positivism has had imperative implications for financial reporting policy, in general, and on reporting earnings, in particular given its attempts to provide reasonable predictions of the events of the real world.

Back to the 1930s, the securities acts in the US were enacted for regulating disclosure and reporting by those firms with securities listed on the stock exchanges, and for creating the US Securities and Exchange Commission (hereafter SEC) “to enforce the newly-passed securities laws, to promote stability in the markets and, most importantly, to protect investors (SEC 2011, p.3).” After having the securities exchanges regulated, the theorists’ main concern moved towards developing accounting theory. The primary purpose of accounting theory, according to Demski (1973, p.718), is to explain which accounting policy should be used, whereas Watts and Zimmerman (1986, p.2) argue that the objective of accounting theory is to explain as well as to predict accounting practice. The explanation role includes offering reasons for an observed practice and the prediction role includes forecasting unobserved accounting phenomena.

Until the 1960s, the normative approach had been dominant concerning the accounting policy recommendations, research and textbooks9. A normative, prescriptive or regulative science,

9 _{For example, Watts and Zimmerman (1986) noted that text books in the 1960s advocated accounting}

methods on prescriptive (i.e. normative) basis without providing a scientific method for testing their validity. Among the examples they provide about this issue are Edwards, E. O. and P. W. Bell (1961). The Theory and Measurement of Business Income. Berkeley, Univeristy of California Press., Chambers, R. J. (1964). "Measurement and Objectivity in Accounting." Accounting Review 39(2):

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from the perspective of Friedman (1953, p.3), is a body of “systematized knowledge discussing criteria of what ought to be”.

The propositions, under which the prescriptive (i.e. normative) arguments rest, are constructed in an irrefutable manner. For example, the normativists may advocate a particular prescription that firms should follow to report their assets, such as current cost method, assuming that this accounting alternative serves a certain objective, such as economic efficiency, without providing a basis to assess their hypothesised relationship between the proposed policy and its respective objective (Watts and Zimmerman 1986).

Accordingly, the normative theory of accounting policy has been strongly criticised that it does not provide empirical validation of the hypotheses on which the theory’s prescriptions rest, assuming that these prescriptions were “self-evident” (Demski 1973; Jensen 1978; Watts and Zimmerman 1978; Watts and Zimmerman 1990).

Unlike the normative school, the positivist approach of theorisation does not prescribe “what ought to be” in terms of accounting policy, but it attempts to explain the “what is” (Scott 2003). In advocating positivism in accounting, Watts and Zimmerman (1986) argue that the objective of the accounting policy is not the theorist’s choice but the user’s.

This debate has been on the rise since the 1960s, when Ball and Brown (1968) and Beaver (1968) and others initiated the empirical research in accounting, benefiting from previous

Princtice-Hall Inc. advocated current cash equivalent and current costs as valuation methods for assets.

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economic and financial methods (for example see Demski 1973; Chambers 1976; Demski 1976; Tinker et al. 1982; Vickrey 1982; Christenson 1983; Watts and Zimmerman 1990).

The early encouraging results from testing the relation between accounting earnings and share prices (or changes in share prices), alongside the ambition to report evidence of capital market efficiency in finance and economics, have left a great impact on accounting literature (also see Ball 1978; Watts 1978).

In fact, the development and testing of the EMH in the 1970s, which is explained in the previous section, provided more support to the challengers10 of the normative school. For example, Watts and Zimmerman (1986) noted that the development of the EMH has “spawned” an enormous empirical examination over the association between accounting earnings (and changes in reporting procedures) and share prices.

Holthausen and Watts (2001), in their literature review paper “The Relevance of the Value- Relevance”, noted that this debate, which started in the 1960s, has led accounting researchers to draw implications for standard-setting. Watts and Zimmerman (1978) focused on these implications to draw a positive theory of the determination of accounting standards to understand the influences of the accounting standard-setting process. They adopted the view that management is central to any discussion of financial reporting and they aimed to understand the incentives of management to oppose or advocate different standards.

10 _{The literature sometimes refers to those who challenged the normative approach in accounting}

theorisation as “The Rochester School of Accounting”, specifically Jensen, Watts and Zimmerman. This term was coined by Jensen (1976) and used afterwards by many such as Tinker et al. (1982) and Christenson (1983).

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Many proposed these changes in financial accounting standards since they blamed the generally accepted accounting principles (GAAP) for the low correlation between earnings and future market prices of shares (Lev 1989) and, therefore, the informativeness of earnings came to be questioned. Ronen and Yari (2008) argue that the informativeness role of earnings is questioned by the fact that investors may prefer the analysts’ earnings forecasts over GAAP earnings when they predict the future risks and expected cash flows. Bradshaw and Sloan (2004) note that the increasing focus on alternative definitions of earnings, such as “Street” earnings numbers11,is driven primarily by the reporting strategies of firms’ managers.