NEW YORK -- Financial analysts and some people in the fitness industry are finding it difficult to break down the contents of the U.S. Securities and Exchange Commission's (SEC) investigation into Town Sports International (TSI).

Officially, the SEC is looking into TSI's deferral of certain payroll costs related to membership sales. More specifically, the SEC is examining how long it took the New York-based company to amortize certain payroll costs as an expense and some initiation fees as revenue.

“We're not quite sure what it means,” says Tom Shaw, an analyst with Stifel, Nicolaus & Co., a Baltimore-based company that keeps tabs on the health club industry. “The language here is pretty vague.”

Shaw and other industry observers say that the issue appears to revolve around the average length of memberships related to reporting expenses and revenues. Sales commissions on a new member sale should be recognized as an expense over the average length of a membership. If up-front initiation fees are collected as revenue, they also should be recognized over the same length of a membership and should not be considered revenue right away.

Recently, TSI lowered its average length of membership from 30 months to 28 months. (Similarly, Life Time Fitness, Chanhassen, MN, which like TSI is a public company, lowered its average length of membership last year from 33 months to 30 months.) As initiation fees fell as the result of recession-driven discounts, TSI and other club operators saw expenses rise in recent quarters, Shaw says.

“Basically, your revenues have to cover the expense side to be eligible to spread that revenue cost over the average life of a member,” Shaw says. “If that does not happen, accounting rules make it so that you have to expense that full commission in the time it's incurred. That's one of the reasons you see the extra margin pressure from Life Time and TSI. As enrollment fees have been dialed back, it's harder to offset that expense and amortize over the period.”

TSI and the SEC declined to comment for this story. The SEC typically does not comment on its investigations or filings.

The formal investigation into TSI, whose brands include New York Sports Clubs, Boston Sports Clubs, Washington Sports Clubs and Philadelphia Sports Clubs, began last month, but an informal investigation began in May 2008.

Shaw speculates that the motive for the investigation is the industry's poor reputation for handling financial matters, earned because of the accounting practices of Bally Total Fitness, Chicago, when it was a public company.

“People look at Bally as a bad example, sort of a black eye in terms of how a club should be run,” Shaw says. “One of the challenges for a public health club to overcome is the negative reputation.”

Although no one knows how severe any SEC action could be, TSI could face fines, but Shaw says the SEC could be making a “mountain out of a molehill.”

“It sounds bad, if nothing else, whenever this type of announcement is made,” Shaw says. “It will be interesting [to see] how it unfolds. For the sake of all the players, [we can hope] it's something fairly minor that doesn't really impact the business materially. But we'll see.”

Shaw expects TSI to report losses in the third and fourth quarters as the economy's effect on members and the SEC investigation wear on the company.

TSI's shares fell 7.5 percent to $2.59 after the announcement of the investigation. The stock, which had a 52-week high of $7.24, fell to as low as $1.40 earlier this year.

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