Turnaround at Bally Total Fitness

1. Turnaround at Bally Total Fitness

2. 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

3. 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.

4. 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

5. 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

6. 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

7. 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

8. 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

9. 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 184200 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

10. 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)

11. 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)

12. Bally Expense and Income Restatement

13. 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.

14. 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.

15. 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.

16. 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!)

17. 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.

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

20. 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.

21. 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.