In its IPO documents, Peloton warned it's got some particular shortcomings as a business that could lead to fraud or financial restatement

Peloton CEO John Foley

Peloton, which is planning to go public, disclosed in its IPO paperwork that it had discovered problems with its internal controls
Internal controls are the processes, rules, and checklists companies put in place to ensure the accuracy of their financial statements and to prevent fraud.
The fitness equipment maker said it found internal controls weaknesses in at least four different areas, including in its accounting processes.
The company hadn't fully fixed the problems by the end of June and warned that there may be other problems about which it's unaware, because it hasn't done a full audit of its controls.
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There's something important potential investors should know before getting on the treadmill with Peloton.

The hot fitness equipment manufacturer that's heading toward an initial public offering is likely at higher risk than the average company of misstating its financial reports or being the victim of, or even perpetrating, fraud.

Peloton on Tuesday made public its IPO paperwork. Like all such documents, the filing included a list of risk factors, which are typically a long catalogue of boilerplate items. But buried within that list was an unusual admission by the company — it had discovered significant flaws in its internal controls. Internal controls are the processes, rules, and checklists companies put in place to ensure their financial reports are accurate and to prevent fraud, among other things.

Read this: Exercise-bike startup Peloton filed for IPO and revealed a long list of risk factors that investors should know

Peloton isn't saying that the financial numbers in its S-1 are wrong. It's saying there's a possibility they could end up being wrong.

When a company admits it has a weakness in its internal controls, it's kind of like someone admitting they left their backdoor unlocked while they were away on vacation. It doesn't mean that anything was stolen while they were gone — and they may not yet know if anything was stolen — but the risk of discovering that something was taken is now much greater.

"We have identified material weaknesses in our internal control over financial reporting," the company warned in its IPO document. "If our remediation of such material weaknesses is not effective, or if we fail to develop and maintain an effective system of disclosure controls and internal control over financial reporting," it continued, "our ability to produce timely and accurate financial statements or comply with applicable laws and regulations could be impaired."

Peloton discovered the problems with its internal control while putting together its financial statements for its 2018 fiscal year, which ended in June of last year, it said in the filing. As of the end of June of this year, it hadn't fixed the weaknesses.

The fact that Peloton found these accounting weaknesses "should be a concern" to investors, said Albert Meyer, president and chief portfolio officer at Bastiat Capital and an accounting expert.

And that's especially so for a company that, according to some reports, could seek an $8 billion to $10 billion valuation in the public markets.

There could be more problems that are yet to be discovered

Peloton found flaws in its processes in at least four different areas: its controls over its information technology systems, the way it separates different accounting duties, how it reviews unspecified "journal entries," and how it reconciles and analyzes particular important accounts. It blamed the shortcomings on the fact that it's been a private company and, to this point, didn't need to have in place the kinds of accounting and other controls that are legally required of public companies.

Worse, there may be more problems than just the ones it already discovered. Because of a loophole in current law, the company and its auditors aren't required yet to do a complete audit of its internal controls, and they haven't done one, Peloton acknowledged in its document.

"Accordingly, we cannot assure you that we have identified all, or that we will not in the future have additional, material weaknesses," the company said.

To address the weaknesses it has found, Peloton said it has been hiring people with accounting and finance expertise who have worked at public companies and put in place new processes and controls over its IT systems and accounting operations. Still, it hasn't fully addressed all the problems it found, it acknowledged.

"We will not be able to fully remediate these material weaknesses until these steps have been completed and have been operating effectively for a sufficient period of time," Peloton said in its filing.

The impact of these kinds of weaknesses is not purely theoretical. A study by Utica College last year found that one of the top five reasons fraud occurs at companies was because of inadequate internal controls.

Peloton's disclosure was likely just an attempt to protect itself in case it later has to restate its revenue for the periods in which it found weaknesses, said Bastiat Capital's Meyer. He reckons the result of the flaws in controls described by Peloton could potentially represent a miscalculation of as much as 10% or 15% on its bottom line — anything larger would have been caught in its financial audit.

Even at that level, Wall Street will need to calculate that risk into the company's valuation.

"I think the market will discount it in some way or another," Meyer says.

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