Turnaround at Bally Total Fitness. Case Overview A second revenue recognition case to compare and contrast with the Boston Chicken Case. New management.

Turnaround at Bally Total Fitness

Case Overview

A second revenue recognition case to compare and contrast with the Boston Chicken Case.

New management promotes installment membership plan that leads to dramatic turnaround in financial performance.

Is it a real economic turnaround, or is it accounting gimmickry?

Two key differences from Boston Chicken– Significant provision for loan losses on receivables– Revenues are deferred and recognized ratably over the life of

membership contracts

Overview of Business

The largest and only nationwide operator of fitness centers in the US (330 facilities; 4 million members)

Targets the 18 to 34-year old, middle income segments of the market

Members pay a one-time initial membership fee (about $1,000) and monthly dues (about $7)

Initial membership fee can be financed for up to 36 months, and new management are heavily promoting this option (aiming for 90% in 1999)

Large losses in 1996 and 1997 turned to healthy profits in 1998.

Summary of Business Strategy (I)

Key Success Factors Associated with Fitness Business

State-of-the-art fitness facilities Variety of membership plans, including affordable financed

membership programs Strategic clustering in major metropolitan areas increases

access to target customers and facilitates sale of all-club memberships

Brand identity associated with ‘Bally’ service mark Offer additional complimentary products and services

Summary of Business Strategy (2)

Key Risks Associated with Fitness Business Competition

– Key competitors are not-for-profits– Localized competitors can better serve needs of local

community Fitness craze is a fad High operating leverage due to fixed costs associated with

fitness centers Regulatory and legal risks

Summary of Business Strategy (3)

Key Success Factors Associated with Financing Business

Good access to customers High interest rates Low cost of default (suspend membership) Very pro-active in limiting defaults

– Electronic payments– “Aggressive” collection efforts

Summary of Business Strategy (4)

Key Risks Associated with Financing Business Defaults Competition (e.g., credit cards) Aggressive collection efforts result in reputation problems

– Check the web page below for examples (warning: may contain some unsavory language)

http://www.mwns.com/btf/ Regulatory and legal risks

Bally’s Accounting for Financed Memberships

Membership revenue recognition policy described on p. 31 of case

Revenues from initial membership fees are deferred and recognized ratably over the estimated life of memberships

Costs associated with membership origination are also capitalized and deferred

Finance charges are accrued as earned using the sum-of-the-months digits method, which approximates the effective interest method

Illustration of Accounting for a Financed Membership

Example: Three year membership with payments of $200 at the end of each year. Present value of payments is $497 (implicit financing rate is 10%). 

BFT Deferral Basis Cash Basis 

• Revenue Recognition Over ContractInterest Membership Total MembershipIncome Revenue Revenue

 50 166 216 20035 166 201 20018 166 184 200103 497 600 600

  Differs slightly from sum of numbers above due to rounding of numbers above.

• Balance Sheet at InceptionAccounts Receivable = 497 [no entry required]

Deferred Revenue = 497

GAAP Revenue Recognition Criteria

Revenue cannot be recognized until: An exchange transaction has taken place Earnings process is complete (delivery has occurred or

services have been rendered) The selling price is determinable Collectability is reasonably predictable

The accounting policies used by Bally are consistent with GAAP (assuming that they are being correctly applied)

Bally Revenue Restatement

BALLY TOTAL FITNESS HOLDING CORPConsolidated Statements of Income

31-Dec-98

In Thousands Except Per Share Amounts For Period Ended Dec 31, 1998 12/31/98 Restated Net revenues: -- -- Membership revenues -- -- Initial membership fees on financed memberships originated 414,190 217,200 Initial membership fees on paid-in-full memberships originated 30,318 30,318 Dues collected 205,104 205,104 Change in deferred revenues 3,122 0

$652,734 $452,622 Finance charges earned 50,160 50,160 Fees and other 39,631 39,631

$742,525 $542,413

Financed membership fees originated – Increase in installment contracts receivable= 414,190 – 196,990 = 217,200 (Note: 196,990 is from Statement of Cash Flows, p. 29)

Bally Expense and Income Restatement

Operating costs and expenses: -- -- Fitness center operations 423,502 423,502 Member processing and collection centers 39,185 39,185 Advertising 45,244 45,244 General and administrative 26,097 26,097 Provision for doubtful receivables 118,604 0 Depreciation and amortization 48,255 48,255 Change in deferred membership origination costs (11,164) (11,164)

$689,723 $571,119Operating income 52,802 (28,706) Interest income 2,514 2,514 Interest expense (41,494) (41,494)Income (loss) before income taxes and extraordinary items $13,822 $(67,686) Income tax provision (benefit) 525 525Income (loss) before extraordinary items $13,297 $(68,211)Extraordinary gain (loss) on extinguishment of debt -- --Net income (loss) $13,297 $(68,211)

Why Is Cash Basis Revenue and Income Lower?

Given that Bally makes a generous provision for uncollectables and defers unearned membership revenue, why are cash basis revenue and income so much lower?

Two main reasons: Bally is in the process of de-emphasizing paid-in-full

memberships. It is still recognizing deferred revenue on old paid-in-fulls, but is not collecting cash on new ones. Aggressive accounting results from the reversal of past conservative accounting.

Bally is in the process of emphasizing financed memberships, and accrued financing income is greater on new contracts.

Which Method of Accounting Best Reflects Economic Performance?

Cash basis is probably too conservative, as it ignores the expected future benefits associated with financed membership contracts.

Accrual basis that is used by Bally is probably closer to the economic reality, though the front-loading of financing fees may lead to an upward bias and their revenue growth rate will be difficult to sustain.

Bally is basically running a sub-prime consumer financing operation, but the accounting reflects this.

Overall Evaluation of Bally

Bally’s accounting provides a reasonable representation of performance for the period.

However, the sudden switch from paid-in-full to financed memberships has produced a one-off boost to revenue and income growth, so revenue and income growth should flatten moving forward.

The key tension in Bally’s new strategy is that their aggressive credit collection policies will damage their reputation and compromise future sales.

What Can Management Do?

Sell receivables (without recourse)

Provide detailed information concerning receivable collection rates and adequacy of allowance for uncollectables

Hold tight and let investors learn of merits of strategy through consistent record of results (assuming that this is what happens!)

What Happened at Bally?

Revenue growth slows and income turns negative Took a $55 million charge for membership receivable

reserve at the end of 2002. CEO resigns. Switched to modified cash-basis accounting at the end

of 2003, resulting in a non-cash charge of $675 million. CFO and auditor resign in 2004 in the midst of an SEC

investigation and shareholder lawsuits relating to its accounting between 1999 and 2003.

Extracts From Bally’s 2002 Annual Report (MD&A section)

Results of Operations

Comparison of the years ended December 31, 2002 and 2001

The special charges in 2002 included $55.0 million recorded as a reduction to net revenues to strengthen our installment contracts receivable reserves. In connection with our intentions to seek alternatives for the financing portion of our business model, we undertook a study to determine the net realizable values of recent years’ sales activity and membership installment contracts receivable on an accelerated monetization basis. Our previous method for estimating the adequacy of balance sheet reserves did not assume an accelerated monetization scenario. Given that the receivables portfolio may be substantially monetized during the next 12 to 18 months, strengthening our receivables reserves was warranted and resulted in the special charge.

Extracts from Press Release Announcing Bally’s 2003 Results

Importantly, effective with the 2003 period, the Company has elected to change from its prior method of estimation-based deferral accounting to a preferable, modified cash basis of accounting for its membership revenues. Under the modified cash basis of accounting, revenue is recognized upon the later of when collected or earned and costs associated with the sale of memberships are no longer deferred but are recognized when incurred. This change, which is an extension of the guidance in EITF 00-21 "Revenue Arrangements with Multiple Deliverables" pertaining to revenues from products and services embedded in membership contracts, is fully supported by the Company's independent auditors. The Company's independent auditors will be providing the Company with a preferability letter supporting the changes. In related actions, the Company also reduced the balance sheet carrying value of its deferred tax assets and corrected an error in the recognition of prepaid dues. The accounting change and these actions result in total non-cash charges of $675 million.

Key Takeaways

Shifts in business strategies have both economic and accounting consequences. Make sure that you understand both sets of consequences and how they relate to each other.

High levels of receivables and high levels of uncollectables do not necessarily indicate a problem with the underlying business or financial statements. But they should be an integral part of a sound business strategy and appropriately reflected in the financial statements.