Accounting Profitability and the Political Process: The Case of R&D Accounting in the Pharmaceutical Industry
47 Pages Posted: 29 Nov 2014 Last revised: 20 Dec 2017
Date Written: April 24, 2017
Pharmaceutical firms are frequently in the center of political debate due to their high accounting profitability. We use the U.S. pharmaceutical industry to test the two opposing views of how accounting information is used in the political process: The “public interest hypothesis” predicts that regulators act in public interest, but it may be costly for them to infer whether accounting profitability accurately captures monopolistic rents. Alternatively, the “private interest hypothesis” predicts that regulators may know how accounting rules and their application distort profits, but choose to use unadjusted profits to achieve private benefits. We show that abnormal profitability of pharmaceutical firms 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. We further show that the perception of pharmaceutical firms’ high profitability triggers excessive regulatory scrutiny and increases regulation of the pharmaceutical industry. The high profitability has a greater impact on regulation when the public is more perceptive to populist ideas, while the effect of high profitability on regulation is reduced when pharmaceutical firms increase their political contributions. Overall, our results support the private interest hypothesis and help explain why regulators do not undo accounting distortions.
Keywords: Pharmaceutical Firms, ROE, Accounting for R&D, Regulation, Public Interest, Interest Groups
JEL Classification: L65, M41, G18
Suggested Citation: Suggested Citation