Accounting- versus economic-based rates of return: Implications for profitability measures in the pharmaceutical industry

Abstract

Background: Accounting-based profits have indicated that pharmaceutical firms have achieved greater returns relative to other sectors. However, partially due to the theoretically inappropriate reporting of research and development (R&D) expenditures according to generally accepted accounting principles, evidence suggests that a substantial and upward bias is present in accounting-based rates of return for corporations with high levels of intangible assets. Given the intensity of R&D in pharmaceutical firms, accounting-based profit metrics in the drug sector may be affected to a greater extent than other industries. Objective: The aim of this work was to address measurement issues associated with corporate performance and factors that contribute to the bias within accounting-based rates of return. Methods: Seminal and broadly cited works on the subject of accounting- versus economic-based rates of return were reviewed from the economic and finance literature, with an emphasis placed on issues and scientific evidence directly related to the drug development process and pharmaceutical industry. Results: With international convergence and harmonization of accounting standards being imminent, stricter adherence to theoretically sound economic principles is advocated, particularly those based on discounted cash-flow methods. Researchers, financial analysts, and policy makers must be cognizant of the biases and limitations present within numerous corporate performance measures. Furthermore, the development of more robust and valid economic models of the pharmaceutical industry is required to capture the unique dimensions of risk and return of the drug development process. Conclusions: Empiric work has illustrated that estimates of economic-based rates of return range from ∼2 to ∼11 percentage points below various accounting-based rates of return for drug companies. Because differences in the nature of risk and uncertainty borne by drug manufacturers versus other sectors make comparative assessments of performance challenging and often inappropriate, continued work in this area is warranted.