NEW YORK (CNN/Money) - Drug stocks took their turn under investors' accounting microscope this week. And the results weren't pretty.

On Monday, Merck came under fire for an accounting snafu at its Medco division. And on Thursday, Bristol-Myers Squibb announced that the Securities and Exchange Commission was looking into whether or not the company inflated revenues.

As a result of these reports, Merck's stock was down 6.4 percent this week while shares of Bristol-Myers plunged 11.3 percent. And the news dragged down the entire sector. The Philadelphia Drug Index, a collection of 15 large-cap pharmaceutical companies, fell 8.2 percent.

However, in the case of Merck and Bristol-Myers, the accounting concerns appear to be overdone.

Merck was lambasted by investors for recording more than $12 billion in co-payments that customers made to pharmacies for prescription drugs as revenue. Merck's pharmacy-benefits management subsidiary Medco never actually collects this revenue because its role is to reimburse the drug store for the remainder of a drug's cost.

But Greg Aurand, co-manager of the Orbitex Health and Biotechnology and Orbitex Medical Sciences funds, says that the market's reaction to Merck's disclosure was "ignorant" because it is an accepted accounting practice for pharmacy-benefits companies to book co-payments as revenue. As long as a company simultaneously accounts for the same amount as an expense, which Merck did, there is no impact on net income. He adds that Caremark, a competitor of Medco, also uses this accounting method. Aurand owns both stocks in the Orbitex Health and Biotechnology fund.

Paul Abel, manager of the Kinetics Medical Fund, attributes the market's treatment of drug stocks this week to overall skittishness about the quality of earnings and called the selling, particularly of Merck, "ridiculous." If anything, Abel argues, the addition of co-payments on the income statement actually hurt Merck. That's because the Medco unit is not as profitable as Merck's pharmaceutical business. So by including these revenues, Merck's profit margins actually appear lower than they should be.

Drug downdraft       Most large-cap drug stocks took a hit this week. Bristol-Myers Squibb: down 11.3% Pharmacia: down 8.6% Merck: down 6.4% Pfizer: down 5.6% Eli Lilly: down 3.6% Schering-Plough: down 2.7%

"If they had not booked co-payments, you probably would have read the article about how Merck artificially inflated its gross margins," Abel quips. As of May 31, Merck was the eighth largest holding in Abel's fund.

Merck has been trying to shed the lower-margin Medco business through an initial public offering. A Medco IPO was supposed to take place this week but was postponed on Tuesday.

As for Bristol-Myers, Henssler Equity fund co-manager Ted Parrish says that the issue of inflated sales is old news. In fact, the company already announced in April that its sales and earnings for 2002 would be lower than expected due to inventory issues. Bristol-Myers apparently sold too much of some of its drugs to drug wholesalers last year. And that's a big reason why the stock is down 55 percent year to date.

"The SEC is adding fuel to a fire that had already pretty much gone out," Parrish says. As of June 30, 14 percent of the Henssler Equity fund's assets were invested in healthcare stocks, including shares of Bristol-Myers.

Aurand, who does not own Bristol-Myers, says he doubts the SEC will find anything wrong with Bristol Myers's sales to wholesalers. He says the issue is not fraud, just bad business decisions. "There's nothing criminal at Bristol-Myers but certainly you could suggest that they aren't great managers," says Aurand.

Of course, investors' fears about Merck and Bristol-Myers, as well as other drug stocks, are somewhat warranted -- just not for accounting reasons. Although drug stocks are typically seen as solid defensive plays during an economic downturn, that hasn't been the case in this bear market. With patents on several blockbuster drugs expiring, the major pharmaceutical companies are faced with increased competition from generic drug companies who make cheaper versions of the formerly patent-protected drugs. So managers advise selectivity. "Clearly not all drug stocks are created equal," Abel says.

For example, the patents for two of Merck's biggest selling drugs (heartburn treatment Pepcid and hypertension drug Vasotec) expired last year and the patent on its biggest seller, ulcer drug Prilosec, is set to expire this year. As a result, earnings for Merck are expected to be flat this year. And earnings for Bristol-Myers and Eli Lilly are expected to fall this year, in large part due to patent expirations.

Abel says patent concerns have caused him to significantly reduce his position in Schering-Plough, which makes the allergy drug Claritin. That drug's patent is set to expire at the end of the year. Although Schering-Plough has a new prescription allergy drug Clarinex, Abel says he's unsure that this drug can duplicate the success of Claritin since Schering-Plough will be offering a lower-priced over-the counter version of Claritin later this year.

Still, managers say this week's turmoil has created buying opportunities for a handful of drug companies that aren't faced with major patent concerns. Parrish says one example is Pharmacia. Even though the stock fell about 9 percent this week Parrish says he bought shares. The company is now trading at just 17 times 2002 earnings estimates and earnings are expected to increase at a 14 percent clip over the next three to five years.

Parrish says what intrigues him the most is the fact that none of Pharmacia's four big drugs have patents set to expire anytime soon. The patent for the company's cancer drug Campostar will expire in 2007. And that's the earliest expiration. Xalatan, a drug used to treat glaucoma, won't go off patent until 2011. Incontinence drug Detrol's patent expires in 2012. The patent for Pharmacia's biggest selling drug, arthritis treatment Celebrex, doesn't expire until 2013.

Pfizer is another drug stock that appears to have been oversold this week. Shares fell 5.6 percent. And like Pharmacia, Pfizer has no major patent problems looming.

Patents on hypertension drug Norvasc and antidepressant Zoloft expire in 2006. The patent for cholesterol drug Lipitor doesn't expire until 2010. And the patent for Viagra (we probably don't need to tell you what that drug is for) won't expire until 2011.

The stock is trading at 20 times 2002 earnings estimates and earnings are expected to increase 20 percent this year and 16 percent next year. "In terms of steady Eddies, Pfizer is the steadiest of the Eddies," says Aurand.

But Parrish thinks the threat from generic drug companies is a real one. That's why he also bought shares of Mylan Laboratories this week. The company's best selling product is buspirone, a generic version of Bristol-Myers' anti-anxiety drug BuSpar. The patent on BuSpar expired in 2000. Mylan trades at just 14 times earnings estimates for fiscal 2003 (which ends in March) and earnings are expected to increase 15 percent a year for the next three to five years.