R&D Investments, Profitability and Regulation of the Pharmaceutical Industry

Abstract

Pharmaceutical firms are frequently in the center of political debate due to their high accounting profitability. We show that abnormal profitability in the pharmaceutical industry is a kind of optical illusion created by accounting standards for investment in research and development and their influence on reported accounting profit and book equity. Based on international financial data of 413 pharmaceutical firms between 1972 and 2012, we assess the “true” profitability of pharmaceutical firms by capitalizing R&D and amortizing it using three different methods. We find that pharmaceutical firms accounting profitability is biased and that the sign and magnitude of this bias is shaped by accounting rules and R&D intensities. After adjusting for accounting distortions, ROE of pharmaceutical firms is generally comparable in magnitude to ROE reported by firms from other industry sectors. We further show that the perception of high profitability of U.S. pharmaceutical firms triggers excessive regulatory scrutiny and increases regulation of the pharmaceutical industry. Regulators seem to fixate on reported profitability and do not adjust for accounting distortions caused by R&D accounting. We discuss the likely consequences of regulation that is largely motivated by distorted profitability.