High prepayments can be indicative of companies making payments to connected parties for services that will never happen. In other works, they are extracting cash out of the company. These fake prepayments are then turned into fake inventory and parked on the balance sheet. As such, we use a combination of two red flags to highlight companies at risk:
- A high level of prepaid expenses (1 point). We include companies where prepaid expenses/sales are in excess of the 80th percentile relative to industry peers.
- A high level of prepaid expenses relative to inventory (1 point). We include companies where prepaid expenses/inventory are in excess of the 80th percentile relative to industry peers.
We downloaded over 3,000 Asian companies with a market capitalisation exceeding US$1bn and applied our cash extraction ratios to their 2015 financials. Around 2.5% of our sample triggered all two flags whereas theoretically it should have been closer to 1%. Large markets with the highest potential incidence of cash extraction fraud included Hong Kong with 5%, followed by China with 3.3%.