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U.S. SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-QSB
(Mark One)
     
ž   QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2005
     
o   TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from                                                              to                                                             .
Commission File Number: 000-27031
FullNet Communications, Inc.
(Exact name of small business issuer as specified in its charter)
     
Oklahoma
(State or other jurisdiction of
incorporation or organization) 		  73–1473361
(I.R.S. Employer Identification No.)
201 Robert S. Kerr Avenue, Suite 210, Oklahoma City, Oklahoma 73102
(Address of principal executive offices)
(405) 236-8200
(Issuer’s telephone number)
Check whether the issuer (1) filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act during the past 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ž No o
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No ž
The number of shares outstanding of the Issuer’s Common Stock, $.00001 par value, as of November 10, 2005 was 6,723,135.
Transitional Small Business Disclosure Format (Check one): Yes o No ž

FORM 10–QSB
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PART I. FINANCIAL INFORMATION
        
 
        
Item 1. Financial Statements
        
 
        
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 Certification Pursuant to Rules 13a-14(a) and 15d-14(a) of Timothy J. Kilkenny
 Certification Pursuant to Rules 13a-14(a) and 15d-14(a) of Roger P. Baresel
 Certification Pursuant to Section 906 by Timothy J. Kilkenny
 Certification Pursuant to Section 906 by Roger P. Baresel

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FullNet Communications, Inc. and Subsidiaries
CONDENSED CONSOLIDATED BALANCE SHEETS (UNAUDITED)
                 
    SEPTEMBER 30,     DECEMBER 31,  
    2005     2004  
ASSETS
                
 
                
CURRENT ASSETS
                
Cash
   $ 14,785     $ 12,226  
Accounts receivable, net
     69,021       59,212  
Prepaid expenses and other current assets
     176,698       81,809  
 
            
 
                
Total current assets
     260,504       153,247  
 
                
PROPERTY AND EQUIPMENT, net
     886,539       990,863  
 
                
INTANGIBLE ASSETS, net
     100,760       160,010  
 
                
OTHER ASSETS
     5,250       5,250  
 
            
 
                
TOTAL
   $ 1,253,053     $ 1,309,370  
 
            
 
                
LIABILITIES AND STOCKHOLDERS’ DEFICIT
                
 
                
CURRENT LIABILITIES
                
Accounts payable – trade
   $ 160,344     $ 171,457  
Accounts payable – related party
     200,716       145,921  
Accrued and other current liabilities
     789,483       725,190  
Notes payable, current portion
     895,504       968,825  
Capital lease obligations, current portion
     —       12,761  
Deposits held
     64,408       79,898  
Deferred revenue
     185,277       187,194  
 
            
 
                
Total current liabilities
     2,295,732       2,291,246  
 
                
NOTES PAYABLE, less current portion
     114,443       205,070  
 
                
CAPITAL LEASE OBLIGATIONS, less current portion
     —       18,825  
 
                
OTHER
     81,803       88,726  
 
                
STOCKHOLDERS’ DEFICIT
                
Common stock — $.00001 par value; authorized, 10,000,000 shares; issued and outstanding, 6,652,878 shares in 2005 and 2004
     66       66  
Common stock issuable, 70,257 shares in 2005 and 2004
     57,596       57,596  
Additional paid-in capital
     8,328,004       8,328,004  
Accumulated deficit
     (9,624,591 )     (9,680,163 )
 
            
 
                
Total stockholders’ deficit
     (1,238,925 )     (1,294,497 )
 
            
 
                
TOTAL
   $ 1,253,053     $ 1,309,370  
 
            
See accompanying notes to financial statements.

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FullNet Communications, Inc. and Subsidiaries
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)
                                 
    Three Months Ended     Nine Months Ended  
    September     September     September     September  
    30, 2005     30, 2004     30, 2005     30, 2004  
 
REVENUES
                                
Access service revenues
   $ 213,654     $ 260,919     $ 666,301     $ 656,278  
Co-location and other revenues
     354,063       318,823       1,104,072       1,010,507  
 
                        
 
                                
Total revenues
     567,717       579,742       1,770,373       1,666,785  
 
                                
OPERATING COSTS AND EXPENSES
                                
Cost of access service revenues
     72,608       72,912       211,020       176,256  
Cost of co-location and other revenues
     42,171       29,756       124,305       82,731  
Telecommunication taxes and fees
     3,718       (44,490 )     8,942       (3,009 )
Selling, general and administrative expenses
     333,288       331,695       981,313       942,607  
Loss (gain) on sale of assets
     —       (2,771 )     —       4,253  
Depreciation and amortization
     106,289       99,557       317,173       295,713  
 
                        
 
                                
Total operating costs and expenses
     558,074       486,659       1,642,753       1,498,551  
 
                        
 
                                
INCOME (LOSS) FROM OPERATIONS
     9,643       93,083       127,620       168,234  
 
                                
GAIN ON DEBT FORGIVENESS
     1,212       111,334       1,212       157,717  
GAIN ON BAD DEBT RECOVERY, net
     —       —       17,500       —  
INTEREST EXPENSE
     (26,523 )     (39,956 )     (90,760 )     (137,560 )
 
                        
 
                                
INCOME (LOSS) before income taxes
     (15,668 )     164,461       55,572       188,391  
 
                                
Income tax expense (benefit)
     —       —       —       —  
 
                        
 
                                
NET INCOME (LOSS)
   $ (15,668 )   $ 164,461     $ 55,572     $ 188,391  
 
                        
 
                                
Net income (loss) per share – basic
   $ —     $ .02     $ .01     $ .03  
 
                        
Net income (loss) per share – assuming dilution
   $ —     $ .02     $ .01     $ .02  
 
                        
 
                                
Weighted average shares outstanding – basic
     6,723,135       6,713,360       6,723,135       6,713,209  
 
                        
Weighted average shares outstanding – assuming dilution
     6,723,135       7,608,035       8,276,638       7,607,884  
 
                        
See accompanying notes to financial statements.

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FullNet Communications, Inc. and Subsidiaries
CONDENSED CONSOLIDATED STATEMENT OF STOCKHOLDERS’ DEFICIT (UNAUDITED)
Nine Months Ended September 30, 2005
                                                 
                    Common                    
    Common stock     Stock     Additional     Accumulated        
    Shares     Amount     Issuable     paid-in capital     Deficit     Total  
Balance at January 1, 2005
     6,652,878     $ 66     $ 57,596     $ 8,328,004     $ (9,680,163 )   $ (1,294,497 )
 
                                                
Net income
     —       —       —       —       55,572       55,572  
 
                                    
 
                                                
Balance at September 30, 2005
     6,652,878     $ 66     $ 57,596     $ 8,328,004     $ (9,624,591 )   $ (1,238,925 )
 
                                    
See accompanying notes to financial statements.

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FullNet Communications, Inc. and Subsidiaries
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)
                 
    Nine Months Ended  
    September 30,     September 30,  
    2005     2004  
CASH FLOWS FROM OPERATING ACTIVITIES
                
Net income
   $ 55,572     $ 188,391  
Adjustments to reconcile net income to net cash provided by operating Activities
                
Depreciation and amortization
     317,173       295,713  
Amortization of discount and costs relating to financing
     —       1,757  
Gain on debt forgiveness
     (1,212 )     (157,717 )
Gain on bad debt recovery
     (17,500 )     —  
Loss on sale of assets
     —       4,253  
Provision for uncollectible accounts receivable
     21,383       46,690  
Net (increase) decrease in
                
Accounts receivable
     (13,690 )     (39,891 )
Prepaid expenses and other current assets
     (94,889 )     1,207  
Other assets
     —       1,521  
Net increase (decrease) in
                
Accounts payable – trade
     44,894       (31,743 )
Accrued and other liabilities
     41,877       165,467  
Deposits
     —       24,438  
Deferred revenue
     (1,917 )     (11,306 )
 
            
 
                
Net cash provided by operating activities
     351,691       488,780  
 
                
CASH FLOWS FROM INVESTING ACTIVITIES
                
Purchases of property and equipment
     (96,750 )     (162,140 )
Acquisition of assets
     (56,848 )     (29,109 )
 
            
 
                
Net cash used in investing activities
     (153,598 )     (191,249 )
 
                
CASH FLOWS FROM FINANCING ACTIVITIES
                
Principal payments on borrowings under notes payable
     (147,659 )     (247,824 )
Principal payments on note payable to related party
     (16,289 )     (7,812 )
Principal payments on capital lease obligations
     (31,586 )     (42,473 )
 
            
 
                
Net cash used in financing activities
     (195,534 )     (298,109 )
 
            
 
                
NET INCREASE (DECREASE) IN CASH
     2,559       (578 )
 
                
Cash at beginning of period
     12,226       11,480  
 
            
 
                
Cash at end of period
   $ 14,785     $ 10,902  
 
            
 
                
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION
                
Cash paid for interest
   $ 29,996     $ 62,150  
Assets acquired through issuance of capital lease
     —       54,992  
See accompanying notes to financial statements.

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FullNet Communications, Inc. and Subsidiaries
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
1.   UNAUDITED INTERIM FINANCIAL STATEMENTS
 
    The unaudited condensed consolidated financial statements and related notes have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission. Accordingly, certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been omitted pursuant to such rules and regulations. The accompanying unaudited condensed consolidated financial statements and related notes should be read in conjunction with the audited consolidated financial statements of the Company and notes thereto for the year ended December 31, 2004.
 
    The information furnished reflects, in the opinion of management, all adjustments, consisting of normal recurring accruals, necessary for a fair presentation of the results of the interim periods presented. Operating results of the interim period are not necessarily indicative of the amounts that will be reported for the year ending December 31, 2005. Certain reclassifications have been made to prior period balances to conform with the presentation for the current period.
 
2.   USE OF ESTIMATES
 
    The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect certain reported amounts and disclosures; accordingly, actual results could differ from those estimates.
 
3.   INCOME (LOSS) PER SHARE
 
    Income (loss) per share – basic is calculated by dividing net income (loss) by the weighted average number of shares of stock outstanding during the period, including shares issuable without additional consideration. Income (loss) per share – assuming dilution is calculated by dividing net income (loss) by the weighted average number of shares outstanding during the period adjusted for the effect of dilutive potential shares calculated using the treasury stock method.
                                 
    Three Months Ended     Nine Months Ended  
    September 30,     September 30,     September 30,     September 30,  
    2005     2004     2005     2004  
Numerator:
                                
Net income (loss)
   $ (15,668 )   $ 164,461     $ 55,572     $ 188,391  
Denominator:
                                
Weighted average shares outstanding – basic
     6,723,135       6,713,360       6,723,135       6,713,209  
Effect of dilutive stock options
     —       85,258       661,020       85,258  
Effect of dilutive warrants
     —       809,417       892,483       809,417  
 
                        
Weighted average shares outstanding – assuming dilution
     6,723,135       7,608,035       8,276,638       7,607,844  
 
                        
 
                                
Net income (loss) per share – basic
   $ —     $ .02     $ .01     $ .03  
 
                        
Net income (loss) per share — assuming dilution
   $ —     $ .02     $ .01     $ .02  
 
                        
Basic and diluted loss per share were the same for the three and nine months ended September 30, 2005 because there was a net loss for the period.

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    Stock options exercisable for the purchase of 1,235,921 and 1,453,588 common stock shares at exercise prices ranging from $0.08 to $3.00 and $0.05 to $3.00 per share were outstanding for the three and nine months ended September 30, 2005 and September 30, 2004, respectively, but were not included in the calculation of income (loss) per share – assuming dilution because the options were not dilutive.
 
    Warrants exercisable for the purchase of 1,023,248 and 1,135,623 common stock shares at exercise prices ranging from $0.08 to $2.00 and $0.05 to $2.77 per share were outstanding for the three and nine months ended September 30, 2005, and September 30, 2004, respectively, but were not included in the calculation of income (loss) per share – assuming dilution because the warrants were not dilutive.
 
    Convertible promissory notes convertible into 1,003,659 common stock shares at a conversion price of $1.00 per share were outstanding for the three and nine months ended September 30, 2005 and September 30, 2004, but were not included in the calculation of income (loss) per share – assuming dilution because the convertible notes were not dilutive.
 
4.   ACCOUNTS RECEIVABLE
 
    Accounts receivable consist of the following:
                 
    September 30,     December 31,  
    2005     2004  
Accounts receivable
   $ 175,877     $ 144,685  
Less allowance for doubtful accounts
     (106,856 )     (85,473 )
 
            
 
                
 
   $ 69,021     $ 59,212  
 
            
5.   PROPERTY AND EQUIPMENT
 
    Property and equipment consist of the following:
                 
    September 30,     December 31,  
    2005     2004  
Computers and equipment
   $ 1,260,347     $ 1,172,768  
Leasehold improvements
     940,032       930,861  
Software
     56,512       56,512  
Furniture and fixtures
     19,153       19,153  
 
            
 
     2,276,044       2,179,294  
Less accumulated depreciation
     (1,389,505 )     (1,188,431 )
 
            
 
   $ 886,539     $ 990,863  
 
            
    Depreciation expense for the three months ended September 30, 2005 and 2004 was $66,771 and $62,862, respectively. Depreciation expense for the nine months ended September 30, 2005 and 2004 was $201,074 and $184,659, respectively.
 
6.   INTANGIBLE ASSETS
 
    Intangible assets consist primarily of acquired customer bases and covenants not to compete and are carried net of accumulated amortization. Upon initial application of SFAS 142 as of January 1, 2002, the Company reassessed useful lives and began amortizing these intangible assets over their

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    estimated useful lives and in direct relation to any decreases in the acquired customer bases to which they relate. Management believes that such amortization reflects the pattern in which the economic benefits of the intangible asset are consumed or otherwise used.
 
    Amortization expense for the three months ended September 30, 2005 and 2004 relating to intangible assets was $39,518 and $36,695, respectively. Amortization expense for the nine months ended September 30, 2005 and 2004 relating to intangible assets was $116,099 and $111,054, respectively.
 
7.   COMMITMENTS
 
    Operating Leases

The Company leases certain office facilities used in its operations under non-cancelable operating leases expiring in 2009. Future minimum lease payments required at September 30, 2005 under non-cancelable operating leases that have initial lease terms exceeding one year are presented in the following table:
         
2005
   $ 42,571  
2006
     176,807  
2007
     183,330  
2008
     189,853  
2009
     196,376  
 
      
 
   $ 788,937  
 
      
Rental expense for all operating leases for the three and nine months ended September 30, 2005 and 2004 was approximately $159,774 and $163,125, respectively.
The Company’s long-term non-cancelable operating lease includes scheduled base rental increases over the term of the lease. The total amount of the base rental payments is charged to expense on the straight-line method over the term of the lease. The Company has recorded a deferred credit of $81,802 and $84,727 at September 30, 2005 and December 31, 2004, respectively, which is reflected in Other Long-term Liabilities on the Balance Sheet to reflect the net excess of rental expense over cash payments since inception of the lease. In addition to the base rent payments the Company pays a monthly allocation of the building’s operating expenses.

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8.   NOTES PAYABLE
 
    Notes payable consist of the following:
                 
    September 30,     December 31,  
    2005     2004  
Note payable to a bank