Determinants of Economic and Accounting Components of Residual Income: An Application to the Pharmaceutical Industry

Abstract

This study investigates determinants of the present value of future residual income for firms operating in the pharmaceutical industry. It is well known that residual income has both economic and accounting components. We exploit the industrial organization and competitive strategy literatures to identify general features of economic context that are likely to be related to the generation of economic profit. Applying this framework to the pharmaceutical industry, we identify product innovation, product promotion, strategic success, and operating efficiency as four determinants of the economic component of residual income and select ten accounting variables to proxy for these determinants. We then draw on prior accounting research to specify when we expect accounting rules to create period-by-period timing differences between economic profit and residual income. In the pharmaceutical industry, research and development and advertising are important activities and the accounting rules for these items are likely to systematically bias residual income relative to economic profit. We combine our analysis of economic and accounting determinants of residual income to develop industry-wide hypotheses relating the ten accounting variables to the prediction of the present value of future residual income. The results of our empirical analyses are generally consistent with these hypotheses and the explanatory power of the model is quite high. Most firms in the pharmaceutical industry offer a mix of products that span three product segments with differing economic and accounting contexts. We exploit this richness of the pharmaceutical industry to develop hypotheses for industry segment related differences in the magnitudes of the multipliers on the ten accounting variables. The results are generally consistent with our predictions that the magnitudes of these multipliers are conditioned on the firm?s product mix and that the impact of accounting bias introduced by certain accounting rules varies as predicted. We supplement the analysis of the present value of residual income with a direct examination of the explanatory power of the ten accounting variables for equity value. The explanatory power of our model is again quite high and is considerably higher than that of comparison models taken from the prior literature. Overall, our approach for considering economic and accounting contexts in the pharmaceutical industry is successful in identifying value relevant accounting data beyond earnings and beyond a simple decomposition of earnings. Key Words: Economic context; Accounting Context; Value relevance; Residual income; Abnormal earnings; Structure; conduct; Performance; Pharmaceutical industry; Industry segments; Non-financial data