The successful production of a new drug benefits people with medical needs and investors alike. Yet, the time from R&D to product launch spans years, many drugs never make it very far along in the process, and the cost—beginning with R&D through clinical trials to market—runs in the billions of dollars. How can investors—absolutely critical to pharmaceutical companies—make prudent decisions about where and when to invest their money for a good return?
As with any investment, relevant and reliable accounting information helps, but in this sector, such information does not come easily. That’s in part because the future economic benefit of R&D costs is highly uncertain. Also, to comply with the conservatism principle in accounting, in which managers assume no economic benefit, companies must expense R&D costs, where the bulk of the outlay occurs.
“Regulations in the United States and in the United Kingdom, which are where we focused our study, dictate that companies treat R&D expenditures as expenses and deduct those costs from earnings, rather than treating them as capital expenditures,” said Stephen Lin, associate professor, School of Accounting, College of Business Administration. “This accounting practice has significantly reduced quality of earnings, since many pharmaceutical or biotech companies literally never make any profit.”
Study tracks announcement timing and market response.
Over a two-year period, Lin and three colleagues, including two members of the college’s Department of Finance and Real Estate—Arun Prakash, Knight Ridder Center Research Professor; and Chun-Hao Chang, associate professor—studied data collected between 1990 and 1998 on voluntary disclosure practices in the UK’s pharmaceutical industry. They wanted to identify the market reactions to the release of drug development information—the key way investors can find out about a company’s prospects.
“Investors have to depend on managers within the drug companies for drug development information, but what managers provide is not always accurate.”
—Stephen Lin, associate professor, School of Accounting, College of Business Administration
“Such releases are discretionary, and that poses problems,” Lin said. “Investors have to depend on managers within the drug companies for drug development information, but what managers provide is not always accurate. In addition, we learned that details tend to come late in the developmental lifecycle, when the news is more likely to be positive, but when the timing for investment isn’t as favorable.”
What’s an investor to do?
Given the nature of the pharmaceutical/biotech industry—high risk, lack of accounting information, and generally upbeat news from the drug companies themselves—can people make a profit from their investments in this sector? Lin said it’s very difficult, but not impossible.
“Potential investors need to research the industry thoroughly, since it has rather unique characteristics, and interpret company announcements carefully,” he said. “Doing so may improve their chances for a long-term reward.”
“Voluntary Disclosure and Its Impact on Share Prices: Evidence from the UK Biotechnology Sector,” published in Journal of Accounting and Public Policy, one of the leading accounting journals, captures the explorations and conclusions of the cross-disciplinary researchers.
“This is a unique and highly appropriate publication because it focuses on how accounting affects public interest,” said Lin, who expects to collaborate with colleagues in the area of finance again.