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«Department of Accounting and Finance        Working Paper Series      AF2014/15WP05    ...»

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Lancaster University

MANAGEMENT SCHOOL 

Department of Accounting and Finance 

 

 

 

Working Paper Series 

 

 

AF2014/15WP05 

 

R&D investments, profitability and regulation of the pharmaceutical industry 

 

Igor Goncharov, Jörg Mahlich and B. Burcin Yurtoglu 

 

 

 

 

 

 

 

 

Lancaster University Management School. University of Dusseldorf.  WHU‐Otto Beisheim School of Management  © Igor Goncharov, Jörge Mahlich and B. Burcin Yurtoglu All rights reserved. Short sections of text, not to exceed two paragraphs, may be quoted without explicit permission, provided that full acknowledgement is given.

  R&D Investments, Profitability and Regulation of the Pharmaceutical Industry Igor Goncharov Lancaster University Management School, Lancaster University Bailrigg, Lancaster, Lancashire LA1 4YX, U.K.

i.goncharov@lancaster.ac.uk Jörg Mahlich Janssen K.K., Tokyo, Japan & Düsseldorf Institute for Competition Economics (DICE), University of Düsseldorf, Universitätsstr. 1, 40225 Düsseldorf, Germany mahlich@dice.hhu.de B. Burcin Yurtoglu* Finance and Accounting Group WHU – Otto Beisheim School of Management Burgplatz 2, 56179 Vallendar, Germany burcin.yurtoglu@whu.edu 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.

Keywords: Pharmaceutical firms, ROE, accounting distortions, regulation * Contact author. Telephone: +49 (261) 6509 710.

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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.

Keywords: Pharmaceutical firms, ROE, accounting distortions, regulation

–  –  –

Pharmaceutical companies are frequently in the center of political debate due to their high profitability. Especially in the U.S., where drug prices are largely unregulated, the industry is blamed for “excessive profits as a result of overcharging American consumers and taxpayers” (Health Care for America Now, 2013). At first glance, accounting-based performance measures such as Return on Equity (ROE) in the pharmaceutical industry seem indeed to outperform profitability rates reported by firms in other industries. For example, the Fortune 500 list of largest companies in year 2012 reports a ROE of 9.8% for the pharmaceutical industry, which is higher than the ROE reported by firms for instance in telecommunication (2.6%) or machinery (6.5%).1 For some NGOs and other critical observers of the health care system this high ROE shows that pharmaceutical firms benefit at the cost of the insured patients and the society at large (Angell, 2004; Public Citizen, 2002).

The high profitability of pharmaceutical firms is also documented in the academic literature. Mueller (1986) reports that pharmaceutical firms have persistently high profitability exceeding the average of other manufacturing firms by 127%. Odagiri and Yamawaki (1990) report for Japan that the profitability of pharmaceutical firms is 72% above the average of the entire economy. High profits in turn may lead policy makers to argue that drug prices are too high and must be regulated to reduce pressure on public health care expenditures. Consistent with this view, most European countries employ a variety of regulatory measures both on the demand and on the supply side (Mossialos et al., 2004; U.S. Department of Commerce, 2004;





Vogler et al., 2009). In the U.K., for instance, the Pharmaceutical Price Regulation Scheme

                                                            

The U.S. Congressional Budget Office (2006, p. 44), using data from the Fortune magazine, documents that the median profitability of pharmaceutical firms has been persistently above the median profitability of firms from other industries over the 1986-2004 period.

  (PPRS) directly caps the return rate of drug companies with a current tolerated return on capital employed of 21% (Borrell, 1999; Department of Health, 2013).

In this study, we argue that abnormal profitability in the pharmaceutical industry stems, at least in part, from an illusion created by accounting standards and their influence on reported accounting profit and book equity – the two components of ROE. The internationally accepted accounting frameworks either do not permit capitalizing R&D investments as U.S. Generally Accepted Accounting Principles (U.S. GAAP) or limit capitalizing R&D investments as International Financial Reporting Standards (IFRS) applicable in the E.U. and most countries.

This treatment understates assets and equity, and can overstate reported profits because relevant cost components (amortization of R&D) are not deducted from revenues they generate. This accounting treatment biases profitability measures obtained based on reported financial statements, and can substantially increase accounting ROE relative to the true underlying economic profitability. While this argument is not new (Rajan et al., 2007; Salamon, 1982;

Salmi, 1982; Taylor, 1999), our study adds to the existing evidence (i) by showing how accounting treatment affects ROE, (ii) by updating prior evidence on the extent of the accounting bias, and (iii) by using novel methods to shed new light on the true economic profitability of pharmaceutical firms in the U.S. and 6 other major economies. Importantly, we next document that accounting profitability in the pharmaceutical industry drives regulatory activity and that the regulators ignore the accounting bias when they define the number and scope of regulatory restrictions surrounding the pharmaceutical industry. To the best of our knowledge, this is the first study to establish the link between biased profitability measures and product market regulation.

We conduct our analysis in three steps using international financial data of 413 pharmaceutical firms between 1972 and 2012. First, we examine the profitability of   pharmaceutical firms and compare it to the profitability of firms from other industries. Our findings confirm results in prior literature: ROE of pharmaceutical firms in the U.S. is 19.8% or

8.7 percentage point (p.p.) higher than the average ROE reported by firms in other industries.

Moreover, we find that the higher profitability of pharmaceutical firms is related to the R&D intensity in the pharmaceutical industry and shows a high and predictable variation over time. In a growing economy, pharmaceutical firms increase R&D investments, which lowers their profitability relative to firms in other industries that can capitalize their expenses (e.g., manufacturing firms capitalize investments in plant and equipment). In a contracting economy on the other hand, any cuts in pharmaceutical R&D investments have an immediate profit increasing effect. Furthermore, economic contraction triggers asset impairments in other industries, which further depresses their profit relative to pharmaceutical firms through reporting an impairment loss.

Because accounting practices distort profitability measures of pharmaceutical firms, in the second step we assess the economic or “true” profitability of pharmaceutical firms. We do so by recasting financial statements to undo the bias caused by R&D expensing and to assess the underlying economic performance of pharmaceutical firms. Particularly, we capitalize R&D and amortize it over the shelf-life of developed products, approximating the economic value creation.

We use three amortization approaches, namely linear amortization, declining-balance amortization and amortization based on empirical amortization rates (see Lev and Sougiannis, 1996). Over the three proposed amortization approaches, the corrected ROE of 14.1% is comparable to profitability reported by U.S. firms from other industries (ROE = 11.1%). NonU.S. pharmaceutical firms also have an adjusted ROE that is comparable to firms from other industries (7.6% pharma vs. 9.6% non-pharma).

  We then examine whether these ROE figures are related to the degree of regulation.

Similar to findings in other areas (Jones, 1991), we hypothesize that regulators will be attentive to high profitability of pharmaceutical firms leading to a greater oversight of the pharmaceutical industry. We also predict that similar to other stakeholders, regulators ignore the accounting bias due to R&D in their decision making. Given lack of systematic data in our international sample these tests are limited to the U.S., however, they indicate that higher ROE figures lead both to greater regulatory restrictions and greater scope of regulation in the pharmaceutical industry.

These results provide evidence that regulators fixate on aggregate earnings and do not adjust profitability for any accounting biases.

The remaining part of the paper is structured as follows. In chapter 2 we review related literature and provide theoretical underpinnings for our analysis. Our empirical approach is presented in chapter 3. We detail the construction of our sample in chapter 4. Chapter 5 presents our results. Chapter 6 offers a brief discussion and concluding remarks.

2. Related literature and hypothesis development Whether high accounting profits of pharmaceutical firms motivate further industry regulation has been a matter of considerable debate. In this paper we argue that a regulatory regime that ignores underlying economics of the industry is likely to distort incentives to invest in R&D. Therefore, our analysis aims at understanding the reasons for high profitability of pharmaceutical firms and whether high profitability affects regulation in the pharmaceutical industry.

Economic theory proposes three explanations for abnormally high profitability of pharmaceutical firms relative to firms from other industries or economy in general. First, early literature in industrial economics proposes that above-average returns can be due to market   power, that is caused by market concentration and entry barriers (Comanor and Wilson, 1967;

Porter, 1974). While this argument is theoretically compelling, the empirical effect of market concentration on profitability seems to be rather weak (Domowitz et al., 1986). The high risk associated with pharmaceutical R&D is sometimes put forward as a second explanation for above average returns (Schweitzer, 2006) since investors must be compensated for accepting higher risks. This explanation is plausible because investments in R&D are very high in pharmaceutical industry relative to other industries, and because investments in R&D are typically considered to be highly risky. For example, Grabowski and Vernon (1990) show that only a third of approved and marketed drugs manage to generate enough revenues to cover their development costs. At the same time, it is estimated that on average expenditures of $1 billion are needed to bring a new molecule to the market (Adams and Branter, 2010; DiMasi et al., 2003). Furthermore, as Grabowski and Mueller (1978) show, pharmaceutical firms have only few possibilities to diversify their risks. While there are some spill-over effects between the drug development projects within a firm (e.g., Cockburn and Henderson, 2001; Henderson and Cockburn, 1996), the potential to diversify investment risk at pharmaceutical firms is limited. Especially young firms of this industry face a high degree of non-diversifiable risk, which is expressed in betas of well above one (Bernardo et al., 2007; Giaccotto et al., 2011). Therefore, the higher average profitability in the pharmaceutical industry can be at least partly explained by higher risks of R&D investments.



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