Accounting Profitability and the Political Process : The Case of R&D Accounting in the Pharmaceutical Industry

Pharmaceutical firms frequently attract political attention due to their high accounting profitability. We study the U.S. pharmaceutical industry to test the two opposing views of how regulators use accounting information in the political process: The “public interest hypothesis” predicts that while regulators act in the public interest, they may find it costly to infer whether accounting profitability accurately captures monopolistic rents. The “private interest hypothesis” predicts that while regulators may know how accounting rules and their application distort profits, they choose to use unadjusted profits in regulation to achieve private benefits. We show that the abnormal profitability of pharmaceutical firms is a distortion introduced by the requirement for the immediate expensing of R&D costs and the effect of such expensing on reported accounting profits and book equity. We further show that the pharmaceutical firms’ high profitability triggers excessive regulatory scrutiny and increases regulation of the pharmaceutical industry. Although the high profitability has a greater impact on regulation when the public is more receptive to populist ideas, its effect is reduced when pharmaceutical firms increase their political contributions. Overall, our results both support the private interest hypothesis and help explain why regulators do not undo accounting distortions