NOTES
TO FINANCIAL STATEMENTS
(Unaudited)
NOTE
1 – THE COMPANY
Cipherloc
Corporation (the “Company” or “Cipherloc”) was incorporated in Texas on June 22, 1953 as American Mortgage
Company. Effective August 27, 2014, the Company changed its name to Cipherloc Corporation.
NOTE
2 - BASIS OF PRESENTATION OF INTERIM FINANCIAL STATEMENTS
The
Company prepares its financial statements in accordance with accounting principles generally accepted in the United States of
America. The accompanying interim unaudited financial statements have been prepared in accordance with generally accepted accounting
principles for interim financial information in accordance with the instructions to Form 10-Q and Article 8 of Regulation S-X.
In the opinion of management, all adjustments (consisting of normal recurring adjustments) considered necessary for a fair presentation
have been included.
Operating
results for the three and nine months ended June 30, 2020 are not necessarily indicative of the results that may be expected for
the year ending September 30, 2020 or any future period. Notes to the unaudited interim financial statements that would substantially
duplicate the disclosures contained in the audited financial statements for the year ended September 30, 2019 have been omitted;
this report should be read in conjunction with the audited financial statements and the footnotes thereto for the fiscal year
ended September 30, 2019 included within the Company’s Form 10-K, as filed with the Securities and Exchange Commission.
NOTE
3 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
The
Company prepares its financial statements in accordance with accounting principles generally accepted in the United States of
America. Significant accounting policies are as follows:
Cash
and Cash Equivalents
The
Company considers all highly liquid investments with a maturity at the time of purchase of three months or less to be cash equivalents.
At June 30, 2020 and September 30, 2019, cash includes cash on hand and cash in the bank. The Company maintains its cash in accounts
held by a large, globally recognized bank, and the balance of such accounts, at times, may exceed federally insured limits, as
guaranteed by the Federal Deposit Insurance Corporation (“FDIC”). The FDIC insures these deposits up to $250,000.
At June 30, 2020, $1,977,830 of the Company’s cash balance was uninsured.
Basic
and Diluted Net Loss per Common Share
Basic
net loss per share is computed by dividing net loss for the period by the weighted-average number of common shares outstanding
during the reporting period. The weighted-average number of shares is calculated by taking the number of shares outstanding and
weighting them by the amount of time that they were outstanding. Diluted net loss per share reflects the potential dilution that
could occur if stock options, warrants, and other commitments to issue common stock were exercised or equity awards vest, resulting
in the issuance of common stock that could share in the earnings of the Company.
Diluted
net loss per share is the same as basic net loss per share during periods where net losses are incurred because the inclusion
of the potential common stock equivalents would be anti-dilutive as a result of the net loss. As of June 30, 2020, and September
30, 2019, the Company had 1,000,000 shares of preferred stock outstanding, which are convertible into 1,500,000 shares of common
stock. During the three and nine months ended June 30, 2020, 24,146,866 warrants and 1,000,000 as converted shares of convertible
preferred stock were excluded from the calculation of diluted net loss per share because their effect would be anti-dilutive.
During the three and nine months ended June 30, 2019, 25,015,866 warrants to purchase common stock and 1,500,000 as converted
shares of convertible preferred stock were excluded from the calculation of diluted net loss per share because their effect would
be anti-dilutive.
Research
and Development and Software Development Costs
The
Company expenses all research and development costs, including patent and software development costs. Our research and development
costs incurred for the nine months ended June 30, 2020 and 2019 were $1,544,205 and $1,303,680, respectively.
Revenue
Recognition
The
Company recognizes revenues in accordance with the provisions of Accounting Standards Update 2014-09, “Revenue from Contracts
with Customers,” and a series of amendments which together we identify as “ASC Topic 606”. This new accounting
standard, which we adopted on October 1, 2018 using the permitted modified retrospective method, outlines a single comprehensive
model for entities to use in accounting for revenues arising from contracts with customers. The new standard supersedes most previous
revenue recognition guidance, including industry-specific guidance. The effect of the adoption of ASC Topic 606 on retained earnings
as of October 1, 2018 was not material. The differences between our reported operating results for the nine months ended June
30, 2020, which reflect the application of the new standard on our contracts, and the results that would have been reported if
the accounting was performed pursuant to the accounting standards previously in effect, also were not material.
Central
to the new revenue recognition guidance is a five-step revenue recognition model that requires reporting entities to:
1.
|
Identify
the contract,
|
2.
|
Identify
the performance obligations of the contract,
|
3.
|
Determine
the transaction price of the contract,
|
4.
|
Allocate
the transaction price to the performance obligations, and
|
5.
|
Recognize
revenue.
|
The
Company accounts for a promise to provide a customer with a right to access the Company’s intellectual property as a performance
obligation satisfied over time because the customer will simultaneously receive and consume the benefit from the entity’s
performance of providing access to its intellectual property as the performance occurs.
SoundFi
– Software License Agreement
The
Company entered into a one-year agreement renewable for up to 4 years for an annual $50,000 Shield license fee and $25,000 watermark
base license fee with SoundFi LLC (“SoundFi”). Residual income to the Company is earned based on the number of audio
files downloaded per year with residual earnings of $.012 per download exceeding 3,000,001 and scaling up to $.00075 per download
exceeding 100,000,000. In February 2020, the company received $25,000 for the watermark base license fee. In May 2020, the company
received $10,000 for Shield license fee. During the nine months ended June 30, 2020, the Company recognized $39,233 in licensing
revenue. The Company has determined the best method for measuring licensing revenue to be the passage of time and more specifically
on a monthly basis. The recognition of residual income occurs on an annual basis based on download volume provided by SoundFi.
A download is defined as an audio file downloaded to a mobile device from the SoundFi servers.
Recent
Accounting Pronouncements
The
Financial Accounting Standards Board (“FASB”) issues Accounting Standards Updates (“ASU”) to amend the
authoritative literature in the ASC. There have been several ASUs to date that amend the original text of the ASCs. Other than
those discussed below, the Company believes those ASUs issued to date either (i) provide supplemental guidance, (ii) are technical
corrections, (iii) are not applicable to the Company or (iv) are not expected to have a significant impact on the Company.
In
August 2018, the FASB issued ASU 2018-13, Fair Value Measurements (Topic 820) – Disclosure Framework – Changes
to the Disclosure Requirements for Fair Value Measurement, to modify the disclosure requirements for fair value measurements.
The ASU removes certain disclosure requirements related to transfers between fair value hierarchy levels and valuation processes
for Level 3 fair value measurements. It modifies certain disclosure requirements for investments in entities that calculate net
asset value. It adds certain disclosure requirements regarding gains and losses for recurring Level 3 fair value measurements
and unobservable inputs used to develop Level 3 fair value measurements. ASU 2018-13 is effective for fiscal years, and interim
periods within those fiscal years, beginning after December 15, 2019. The Company adopted ASU 2018-13 on October 1, 2019 and the
adoption of this update did not have a material impact on the Company’s notes to the financial statements.
In
June 2018, the FASB issued ASU 2018-07, Compensation – Stock Compensation (Topic 718) – Improvements to Nonemployee
Share-Based Payment Accounting, to expand the scope of Topic 718, Compensation – Stock Compensation, which currently
only includes share-based payments to employees, to include share-based payments issued to nonemployees for goods or services.
Thus, accounting for share-based payments to nonemployees and employees will be substantially aligned. ASU 2018-07 is effective
for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2018. The Company adopted ASU 2018-07
on October 1, 2019 and the adoption of this update did not have a material impact on the Company’s financial position, results
of operations and cash flows.
In
February 2016, the FASB issued ASU 2016-02, Leases, which aims to make leasing activities more transparent and comparable and
requires substantially all leases be recognized by lessees on their balance sheet as a right-of-use asset (ROU) and corresponding
lease liability, including leases currently accounted for as operating leases. Leases of mineral reserves and related land leases
have been exempted from the standard. We adopted ASU 2016-02, Leases, on October 1, 2019. We elected the “package of practical
expedients” within the standard which permits us not to reassess prior conclusions about lease identification, lease classification
and initial direct costs. We made an accounting policy election to not separate lease and non-lease components for all leases.
The adoption of this standard resulted in the recognition of right-of-use assets and lease liabilities of $0.2 million, which
were not previously recorded on our balance sheet.
NOTE
4 – COMMITMENTS AND CONTINGENCIES
Litigation
The
Company is currently not involved in any litigation that it believes could have a material adverse effect on its financial condition
or results of operations.
A
disgruntled former consultant has brought an action in Texas state court against the Company and its former chief executive officer,
alleging fraud and misrepresentation pertaining to stock and payments alleged to be owed to the consultant. The Company believes
it has made all required payments and delivered the stock to the consultant. The consultant has also included a claim of partial
ownership of certain of the Company’s patents, which management believes is without merit. The case is currently being defended
by the Company and costs relating thereto have been submitted to the Company’s insurance carrier.
In
August 2019, the Board of Directors formed a special committee of independent directors (the “Special Committee”)
to investigate certain activities of Michael De La Garza (“De La Garza”), our former chief executive officer. The
Special Committee has retained legal counsel, and is authorized to retain forensic accountants, to assist the investigation.
In
August 2019, the Company initiated litigation against De La Garza in the District Court of Travis Country, Texas (the “Court”)
in order to stop him from misappropriating the company’s trade secrets, depleting its monies and other assets, damaging
the value of the company in the marketplace, and holding himself out as the company’s CEO. On September 25, 2019, the Court
entered a temporary injunction against De La Garza enjoining him from numerous acts including representing himself as the Company’s
CEO and from interfering with the current CEO’s management of the company. This litigation is ongoing, and its resolution
is unknown. The Special Committee is investigating certain activities of De La Garza, including the Ageos, LLC Operating Agreement,
the QHCI/Noun note receivable, an advance/bonus, personal expenditures, and other items. All amounts expended have been expensed
as of September 30, 2019. No amounts have been recorded in these financial statements as expected recoveries.
The Company is seeking to invalidate the
issuance of 10 million shares of Cipherloc preferred stock and the associated conversion of 9 million preferred shares into 13.5
million shares of common stock. Specifically, the Company is asking the court to invalidate the unauthorized issuance of 3 million
shares of preferred stock to De La Garza and 1 million preferred shares to former director and chief financial officer, Pamela
Thompson, which stock is now being held by the Carmel Trust II, in or around 2011. The Company is also seeking to invalidate the
subsequent issuance of 6 million preferred shares to De La Garza in 2015 and the conversion of the combined 9 million preferred
shares allegedly held by De La Garza into 13.5 million shares of common stock in 2018. As such, the Company has sued both De La
Garza and James LaGanke, as Trustee of Carmel Trust II, in federal court as part of its efforts to invalidate those shares. The
Company alleges that both De La Garza and Thompson failed to comply with both state law and Company bylaws when they caused the
Company to issue the preferred stock to themselves as purported compensation. The lawsuit is ongoing, and its resolution is unknown.
Leases
In
March 2019, the Company guaranteed a lease on behalf of Ageos, LLC in McLean, Virginia. The lease has a term of three years for
4,359 square feet of space in McClean, Virginia. The initial rent cost is $7,991 per month and the lease agreement provides for
annual rent increases of approximately 4.0%. The amount of future payments guaranteed is $267,389. The agreement with Ageos was
terminated in August 2019 and the Company has made an unwritten offer to assume the lease. No amounts have been accrued for this
commitment as of June 30, 2020.
In
February 2019, the Company and the landlord for its leased office space in Buda, Texas entered into a new lease agreement, and
the Company reduced its rented space from approximately 3,900 to 1,302 square feet. The new lease was effective February 1, 2019
and has a three-year term. The initial monthly rent is $2,566, and the lease agreement provides for annual rent increases of approximately
2.7%. The lease automatically renews for a three-year term, unless either party to the lease agreement notifies the other of the
intent to terminate the lease in writing at least 180 days prior to the expiration of the current term. In July 2020, the Company
executed a lease termination agreement with the landlord for an early termination fee of $10,546.20 and forfeited the existing
security deposit of $2,566.03. There are no future payments related to this lease.
In
October 2018, the Company leased approximately 3,900 square feet of office space on North Scottsdale Road in Scottsdale, Arizona.
The lease for this facility began on October 4, 2018 and continues until October 31, 2021. Annual rent of $77,180 was prepaid
for the first year from November 1, 2018 to October 31, 2019, and the lease agreement provides for annual rent increases of approximately
5.0%. In June 2020, the Company executed a lease termination agreement with the landlord for an early termination fee of $27,013
and forfeited the existing security deposit of $9,796.03. There are no future payments related to this lease.
In
February 2020, the Company leased approximately 3,666 square feet of office space on 2107 Wilson Boulevard, Arlington, Virginia.
The lease for this facility began on February 1, 2020 and continues until July 31, 2025. The base annual rent is $159,471, a $100,000
security deposit was paid, and abatement of monthly rent payments was provided until August 1, 2020, and the lease provides for
annual rent increases of approximately 2.5%. The amount of future payments guaranteed is $848,661.
As
the result of restructuring actions intended to conserve cash during the COVID-19 crisis, the landlords of the North Scottsdale
Road and the Wilson Boulevard spaces were notified that the Company no longer needed the spaces and is seeking an amicable and
reasonable termination of the lease agreements.
Our
significant accounting policies are detailed in Note 2 of our Annual Report on Form 10-K for the year ended September 30, 2019.
Changes to our accounting policies as a result of adopting ASU 2016-02 are discussed below.
As
of June 30, 2020, the Company had two lease agreements for facilities. Some leases include options to extend for one or more years.
These options are included in the lease term when it is reasonably certain that the option will be exercised.
Leases
with an initial term of 12 months or less are not recorded on our Balance Sheet; we recognize lease expense for these leases on
a straight-line basis over the lease term. Leases with initial terms in excess of 12 months are recorded as operating or financing
leases in our Balance Sheet.
Lease
assets and operating lease liabilities are recognized based on the present value of the future minimum lease payments over the
lease term at commencement date. As most of our leases do not provide an implicit rate, we use a secured incremental borrowing
rates based on the information available at commencement date, including lease term, in determining the present value of future
payments. The operating lease asset also includes any lease payments made and excludes lease incentives and initial direct costs
incurred. Our lease terms may include options to extend or terminate the lease when it is reasonably certain that the option will
be exercised.
At
inception, the Company determines if an arrangement contains a lease and whether that lease meets the classification criteria
of a finance or operating lease. Some of the Company’s lease arrangements contain lease components (e.g. minimum rent payments)
and non-lease components (e.g. maintenance, labor charges, etc.). The Company generally accounts for each component separately
based on the estimated standalone price of each component. For certain leases, the Company accounts for the lease and non-lease
components as a single lease component.
The
Company’s lease agreements do not contain any material residual value guarantees or material restrictive covenants.
Operating
Leases
Operating
leases are included in operating lease ROU lease assets, and operating lease liabilities and operating long-term lease liabilities
on the Balance Sheets. Lease expense for operating leases is recognized on a straight-line basis over the lease term. Variable
lease expense is recognized in the period in which the obligation for those payments is incurred. Lease expense is included in
general and administrative expense in the statements of operations and is reported net of lease income. Lease income is not material
to the results of operations for the quarter ended June 30, 2020. The Company announced a corporate restructuring on June 30,
2020 which will result in the abandonment of certain office spaces. The Company has recorded an impairment charge of approximately
$382,962 which is the estimate of the future payments less projected sublease income from the abandoned office space.
Cash
Flows
An
initial right-of-use asset of $233,751 was recognized as a non-cash asset addition with the adoption of the new lease accounting
standard. Cash paid for amounts included in the present value of operating lease liabilities was $28,534 during third quarter
2020 and is included in operating cash flows. In February 2020, the Company’s new lease in Arlington, Virginia added approximately
$734,000 in new lease obligations.
The
weighted average remaining lease terms and discount rates for all of our operating lease were as follows as of June 30, 2020:
Remaining lease term and discount rate:
|
|
June 30, 2020
|
|
Weighted average remaining lease terms (years)
|
|
|
|
|
Lease facilities
|
|
|
5.17
|
|
|
|
|
|
|
Weighted average discount rate
|
|
|
|
|
Lease facilities
|
|
|
4.35
|
%
|
Significant
Judgements
Significant
judgements include the discount rates applied, the expected lease terms, and lease renewal options. There are three leases with
a renewal option. Using the practical expedient, the Company utilized existing lease classifications as of September 30, 2019.
As a result, the lease renewal options were not changed on implementation.
Future
annual minimum lease obligations at June 30, 2020 are as follows:
Year ending September 30
|
|
Amount
|
|
2020
|
|
$
|
26,579
|
|
2021
|
|
|
162,135
|
|
2022
|
|
|
166,180
|
|
2023
|
|
|
170,322
|
|
2024
|
|
|
174,575
|
|
2025
|
|
|
148,870
|
|
|
|
$
|
848,661
|
|
Rent
expense totaled $177,785 and $118,602 for the nine months ended June 30, 2020 and 2019, respectively
NOTE
5 – DEBT
On
April 6, 2020, to supplement its cash balance, the Company submitted their application for a Paycheck Protection Program loan
(“SBA loan”) in the amount of $365,430. On April 12, 2020, Company’s SBA loan application was approved, and
the Company received loan proceeds on April 22, 2020. The SBA loan has an interest rate of 1% and matures in April 12, 2022.
Section
1106 of the CARES Act provides for forgiveness of up to the full principal amount of qualifying loans guaranteed under the PPP.
The PPP and loan forgiveness are intended to provide economic relief to small businesses, such as the Company, that are adversely
impacted under the COVID-19 Emergency Declaration issued by President Trump on March 13, 2020.
NOTE
6 - STOCKHOLDERS’ EQUITY
The
Company is authorized to issue 681,000,000 common shares and 10,000,000 preferred shares at a par value of $0.01 per share.
Common
Stock
Management
determines the fair value of stock issuances using the closing stock price on the grant date.
During
the nine months ended June 30, 2020, the Company came to a settlement with First Fire and purchased back 149,557 shares and recorded
such shares as Treasury Stock. First Fire received $150,000 in exchange for the 149,557 shares and associated warrants.
Preferred
Stock
Each
outstanding share of preferred stock is convertible into the Company’s common stock at a rate of one preferred share to
1.5 common shares. Each share of preferred stock has 1.5 votes on all matters presented to be voted by the holders of common stock.
The holders of preferred stock can only convert the shares upon approval of the Company’s board of directors. If declared
by the board of directors, holders of preferred stock are entitled to receive dividends prior and in preference to any declaration
or payment of any dividend on the common stock of the Company. In the event of liquidation or dissolution of the Company, holders
of preferred stock shall be paid out of the assets of the Company prior and in preference to any payment or distribution to holders
of common stock of the Company.
NOTE
7 - RELATED PARTY TRANSACTIONS
There
were no related party transactions.
NOTE
8 - SUBSEQUENT EVENTS
There
were no subsequent events as of the filing of this report.