We penalise companies with a high and/or rising level of prepaid expenses relative to industry peers. Prepaid expenses are future expenses that have been paid in advance. There are a number of reasons to be concerned about high levels of prepaid expenses:
- Cash extraction: High prepayments can be indicative of companies making payments to connected parties for services that will never happen.
- Flatter financial statements: Companies might receive prepayments from connected parties in order to make their balance sheets appears stronger. The prepayment would appear as a non-interesting bearing liability whilst its proceeds would be included in cash. As such, net debt would fall.
Prepaid expenses are a relatively rare occurrence with just 24% of the 16,000 companies in our sample having recorded some. After all, why would a company pay in advance for goods or services? Well, some industries have long lead-times, such as real estate, which require deposits, as shown in Figure 9.
There is also some variance in prepayments by country. For example, prepayments tend to be larger in China, at 2.5% of sales on average between 2010 and 2015, as shown in Figure 11, although there is an incidence rate of just 24%, as shown in Figure 12. Prepayments are far more common in Vietnam where there is an incidence rate of 79% but these are very small at just 0.1% of sales on average.
Our accounting screen is set to trigger a red flag when prepaid expenses/sales exceeds the 80th percentile (i.e. they are very high) relative to GICS industry peers, and/or when there is an abnormally large build-up in prepaid expenses relative to the normal rate of change amongst industry peers over one and three years. This latter red flag is triggered when the deterioration in prepaid expenses exceeds the 80th percentile relative to the change experienced by industry peers between 2010 and 2015.