The accounting trick that fooled Polly Peck's investors - MoneyWeek investment tutorials

it's all too easy to blame one man as on the deer he was sentenced last week for crimes including theft in relation to what was once his glorious PLC company listed in London Polly Peck in this video what I want to show you is that actually investors who say it was all his fault the reason I lost money when Polly Peck disappeared and it disappeared quite a long time ago now after which he fled to Cyprus to avoid being prosecuted here it's not good investors saying well the reason I lost money was him because actually Polly Peck was up to something that other companies can still use today and investors need to be alert - so this video will disappoint some people it's not a history of the Polly Peck collapse I'm not gonna stick to the exact facts either because what's done is done the past is the past as an investor you want to know well what do I take away from that to use now and that's what I want to get to because there was a little accounting trick used by Polly Peck but boosted profits for it went bust at the expense of its Baljeet okay and any investor could have spotted that happening and if you're investing today keep an eye out for it so what was the trick was the collapse of Polly Peck all down to one clearly slightly dodgy man who's now gonna spend some time in prison no actually that was part of the problem but too many people have jumped on the bandwagon is there well thanks to him might lost loads of money and actually they could have done a little more homework themselves to realize that all was not well and bailed out before the firm actually finally collapsed buried under a mound of losses okay so here we go a little bit fast and loose with the facts I'm going to keep the numbers nice and simple because I want anyone who's never seen this before to walk away with a rough understanding of what the problem is and how you could be fooled as an investor in another company was pulling the same trick so here's the story right now imagine you've got a UK that's the UK people to see my videos before when oh the graphics not one point okay Ireland now it's clear alright so here's the UK and you have a listed PLC public company in the UK alright and the next player in the story I want to introduce is what's called an overseas subsidiary very grand sounding title I'm afraid I'm slipping into accounting speak here don't worry that just means a big company overseas okay and we'll put that company in Cyprus now that company is owned by the listed PLC in the UK it's part of the same group okay so how is it financed how does it do anything as a separate operating company well the answer is there's a loan in Sterling okay and we'll call it well I'm gonna use very simple numbers here let's call it obviously far too small ten thousand pounds right they might say 10 million or a hundred millions more likely I'll get the number simple because it's the principle owned to get across here not the exact forensic facts all right so a overseas company in Cyprus is funded with a loan from its UK parent company then those matters borrow from its parent company to do what to invest in Turkish business operation okay so you have an overseas subsidiaries in Cyprus you have an operation in Turkey orange crows and the like okay and you have the Polly Peck listed UK plc at the front end alright and how is that Turkish operation funded well having taken a loan of ten thousand pounds from its parent company let's say the exchange rate to make it very very simple is one for one now I know that's a little unlikely sterling - Turkish lira okay let's say we fail it one the one so the 10,000 pounds has been taken by this subsidiary company switched into Turkish lira which is 10,000 degrees lira and that's been invested in high-yield Turkish operations the risky Turkish operations okay here's the point sterling is a strong currency let's say for the purposes of illustration the Turkish Liras a much weaker currency so the returns you expect to earn over here a much higher than what you expect have to pay an interest here and here's the trade okay so you're taking your 10,000 pound loan you switch it and change rate artificial I know of one to one and you invest your ten thousand Turkish lira over there now mhm less again the purpose administration keep the numbers very simple well let's say the interest rate on this loan is five percent and the return you expect to earn over here in the much weaker currency okay is more like 20 percent now here's the trick here's the trick coming up so what you've done mmm very simply his bow in a strong currency mm-hmm invest in a much weaker currency weak currencies generally offer a much higher rate of return why because central banks operating in weaker countries have to generally offer higher interest rates okay higher rates of return the central banks in much stronger countries all right so still true today the interest rate on things like pounds and dollars much much lower than is on say emerging market currencies right so far so what well here's the trick what you've effectively set up here in very simple terms is a tremendously profitable little operation because let's take a look at the income statement all right let's take but a very simple income statement but this little over CBC tree company all right it's earning 20% on ten thousand lira now imagine it's got a report back to its parent on how it's doing okay so a report back to Polly Peck Polly Peck after all is funded it with this 5/10 loan on how it's doing that's what it does it says well what a weirdo awry actually because we're earning 20% on our 10,000 lira okay that's two thousand lira and at a one-for-one exchange rate that's two thousand pounds in sterling to report back to the parent company so the income is looking good two thousand pound and our costs if you like just looking at two lines of the profit loss account are costs to generate two thousand pounds sterling that's 20% of ten thousand lira add an exchange rate of one to one is the five percent loan right so it's costing us five percent of ten thousand pounds right or let's say five hundred pounds annually so we're making a nice profit making up the numbers here of 1,500 all right very very simply we're earning a much higher return Turkish lira at this current exchange rate artificially I've made it one to one then we're paying on our loan so whoever's running this gig can report back to ever their bosses in the UK as it was good rather well actually I'm making a 1500 pound profit okay now here's the reality of course of weak currencies there's a clue in the term they get weaker so the exchange rate may have started out at 1 for 1 which makes this in sterling look like a pretty good operation but let's assume the Turkish lira does what weak currencies tend to do in relation to strong ones it weakens right so let's assume that offer a little while let's say a couple years later the exchange rate has moved like that let's move dramatically so now there are two Turkish lira for every pound because that happens weak currencies weaken right hell does the income statement now look for our overseas subsidiary when the boss rings up and says hey you going on out there okay that's the UK boss well let's take a look at it we're still learning let's assume 20 percent on an original investment of 10000 lira all right so that's 2,000 pounds but unfortunately the exchange rate has moved against us so in sterling that is only worth half what it was but it's still alright because you know half of 2,000 pounds is sterling because the exchange rate movement is still a thousand pounds is sterling so the exchange rate is has really changed the liras weaken there are more lira to a pound or income in sterling still not bad our costs in sterling are still five percent ten thousand pounds right so we can ring up the boss in the UK say well it's mocking as well as it was but overall in sterling terms we're still not doing too badly not as bad as few years ago but we're still making a profit all right and that's what's happening a polybag every year even though the currency of the operations of this massively important subsidiary what was weakening it was able to report back to the UK and the UK was able to subsume its results into its own results reporter 2 shells in the UK income net income get a different spin its income and its expenses but some of you will have spotted there must be a catch okay if it's otherwise some magic trick you just get income for investing what the same amount in a different currency we all said yes but of course it's a price and the price is this were you when the exchange rates moved from one to one to one to two were you to say what's our original investment worth now over in Turkey in sterling that's a check you'd say what we put a ten thousand pound in which was switched into lira direct one for one so unfortunately here's your problem what was a 10,000 pound original investment with an exchange rate of two to one switch that back into sterling of course the original investment then he worth half what it was so in sterling terms the original investment is now any worth five thousand pounds using these very simple numbers okay so there's a capital loss somewhere out there of a rather hefty five thousand pounds right so the income statement may still look fine all right but things are going a bit pear-shaped in investment terms now you might say well that's all right because everyone will realize that they'll be reported in the UK accounts and people go a high see how you're generating income it's at the expense of annihilating your investment in sterling terms in a weaker currency but no because the accounting rules the way without going into details is not an accounting degree but the way you bring this operation into the UK accounts means that all of this loss goes through the balance sheet of the listed plc in the UK okay it's there they go through the balance sheet so what you've got is this rather clever trick you've got a profit and loss an income statement generated here being subsumed here that shows shareholders here a pretty pretty picture and it could go on for a number of years even as the currency earlier weakens but anyone who read the balance sheet I stressed anyone who hits balance sheet and very few people do would have seen the balance sheet being crushed and crushed and crushed and crushed over the same time period so you had great income statement great profits and a shrinking balance sheet plenty of people looked at the former and went brilliant great job as Hill and didn't look at the latter where they realize there was a problem so after all of that jiggery-pokery and my slightly artificial numbers the takeaway is simply this for investors today you cannot just look at a profit loss account and go great profits coming through I don't need to worry fantastic company charismatic CEO what's not to like okay as Sir David Tweedy knighted for his contribution to accountancy and that's not easy to do okay once head of the International Accounting Standards Board said the most important financial statement you're ever look at is actually a balance sheet because only there could you have seen what was happening to paly back in reality and you could have seen it a few years before it was bust what's more so investors who blame has an idea that's fine he was a naughty man he's done some things which were not good but was he the sole reason people lost money on pulling back I say no he wasn't take away from this video as if you've never seen a balance sheet before and you plan to be any kind of semi serious investor please at least get to grips the basics of it and as luck would have it I have a video out already called what is a balance sheet and for anyone who's thinking I didn't really understand a word of that but Tim's he's been getting quite excited about it I'd urge you to go and have a look at that video right now to download this free video to your favorite mobile device find us on iTunes by searching for money week and the entire video archive is also available free just visit Manu eat calm

Channel: MoneyWeek

Views: 46,662

Keywords: The, accounting, trick, that, fooled, Polly, Peck's, investors, Asil, Nadir, Peck, Foreign, currency, Forex, losses, Hedging, inflation, bank, payments, system, German, claims, Fund, successful, Dividend, stocks/shares, Working, Cashflow, Overtrading, firms, profit, loss, trading, Bid, offer, spreads, MoneyWeek, Tutorial, Currency, credit, 'stock, market', investments, tutorials, Trading, Stocks, Analysis, Trade, Tim, Bennett, Economy, whiteboard, white, board, explained, Financial, Bloomberg

Id: X-b62ZYXAyw

Length: 14min 26sec (866 seconds)

Published: Thu Aug 30 2012