RECOGNIZING MEMBERSHIP FEES

Bally Total Fitness provided another case in which questions about revenue recognition contributed to an unfavorable stock market reaction to seem­ingly upbeat earnings news.

Investors were unwilling to accept Bally’s earnings increase at face value because of the company’s growing reliance on memberships that it fi­nanced, as opposed to selling for cash. Bally’s financed customers’ initial membership fees, which ranged from $600 to $1,400, for up to 36 months, charging annual interest rates of 16% to 18%.²⁰ (Ongoing dues represented just 27.9% of net revenues, with approximately 90% of members paying an average of only about seven dollars a month in 1998.) On the whole, the company’s reported profit margins benefited from the increase in financed memberships as a percentage of total revenues. The reported earnings, however, rested on assumptions regarding the percentage of customers who would ultimately fail to make all of the scheduled installments.

Even under the best of circumstances, a considerable portion of any health club’s new members let their memberships lapse, despite paying an ini­tial fee.

To be sure, Bally set aside reserves for uncollectible amounts, consistent with good accounting practice. The size of the reserves, however, required judgment about the credit quality of the new members. Because financed memberships were not entirely new to Bally, management had some experi­ence on which to base its assumptions. In addition, the company had suc­ceeded in increasing the use of an electronic funds transfer payment option in recent years. Collection rates were higher for members whose credit cards or bank accounts were automatically charged for fees than for those billed through monthly statements. There were risks, though, in stepping up reliance on customers who needed to borrow in order to join. As in any sales situation, aggressive pursuit of new business could result in acceptance of more marginally qualified customers. On average, the newer members might prove to be less financially capable or less committed to physical fit­ness than the previous purchasers of financed memberships. If more mem­bers failed on their payments than management assumed, Bally would prove in hindsight to have been too aggressive in recognizing revenue and would have to rescind previously reported income.

By taking the second-quarter 1998 earnings with a grain of salt, users of financial statements were not necessarily casting aspersions on Bally’s management. Rather, they were understandably applying caution in evalu­ating a company in a service industry historically identified with question­able revenue recognition practices. Some analysts sprang to Bally’s defense following the Wall Street Journal’s critical article by highlighting the com­pany’s adoption of a conservative practice at the Securities and Exchange Commission staff’s behest in July 1997.

The SEC’s urging of Bally’s to spread out its recognition of membership fees was part of a broader effort extending beyond the health club industry. There was no change in the accounting principle, namely, the matching con­cept. In the case of a health club, members’ up-front fees represent pay­ments for services received over the terms of their membership. Club operators should therefore recognize the revenue over the period in which they render the service. During the late 1990s, the underlying theory under­went no change, but the SEC intensified its focus on membership fees after determining that some companies were interpreting the rules too liberally. Among the industries that came under increased scrutiny were the member­ship club retailers. In this type of operation, consumers pay up-front fees for the privilege of shopping at stores that sell discounted merchandise.

On October 19, 1998, BJ’s Wholesale Club switched from immediate recognition of its annual membership fee (typically $35 for two family members) to incremental recognition of the fee over the full membership term, generally 12 months. In conjunction with the change in accounting policy, BJ’s restated its net income for the fiscal first half ending August 1 to $10.4 million. That was down 64% from the previously reported $28.6 million.

Just a month-and-a-half before these events, BJ’s had issued a press re­lease asserting that its practice of immediately recognizing annual member­ship fees was consistent with GAAP.²² Management had also argued that no deferral was required, on the grounds that BJ’s offered its members the right to cancel and receive refunds for only 90 days after enrollment. A mere 0.5% of members actually requested refunds. In contrast to the situation at Bally Total Fitness, moreover, membership fees represented a minor portion of BJ’s revenues, 98% of which derived from merchandise sales.

Under GAAP, however, the general requirement was to spread member­ship fees over the full membership period. If a company offered refunds, it could not book any of the revenue until the refund period expired, unless there was a sufficiently long history to enable management to estimate fu­ture experience with reasonable confidence. At most, BJ’s refund record might have entitled the company to begin booking the fees on the date that members enrolled. Spreading the revenue recognition over the membership period would have been mandatory in any case.²³

In December 1999, the SEC staff clarified the point by issuing “Staff Accounting Bulletin No. 101—Revenue Recognition in Financial State­ments” (SAB 101). The staff stated its preference that companies not book membership fees until refund privileges expired. MemberWorks, a provider of membership programs offering services and discounts in a wide range of fields including health care, personal finance, and travel, altered its ac­counting in response to SAB 101, effective July 1, 2000. A one-time non­cash charge of $25.7 million resulted, reflecting the deferral of previously recognized membership fees.²⁴