Turnaround at Bally Total Fitness

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Turnaround at Bally Total Fitness
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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

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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.

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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

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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

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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

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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

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Ballys 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

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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 Contract
• Interest Membership Total Membership
• Income Revenue Revenue
•  
• 50 166 216 200
• 35 166 201 200
• 18 166 184 200
• 103 497? 600? 600
•  ? Differs slightly from sum of numbers above due
  to rounding of numbers above.
• Balance Sheet at Inception
• Accounts Receivable 497 no entry required
• Deferred Revenue 497

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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)

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Bally Revenue Restatement
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)
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Bally Expense and Income Restatement
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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.

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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.

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Overall Evaluation of Bally

• Ballys 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 Ballys new strategy is that
  their aggressive credit collection policies will
  damage their reputation and compromise future
  sales.

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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!)

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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.

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Extracts From Ballys 2002 Annual Report (MDA
section)
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Extracts from Press Release Announcing Ballys
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.

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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.